In light of the disruption caused by the COVID-19 pandemic and resulting global economic slowdown, many companies—even previously healthy ones—are now faced with difficult decisions regarding investments, loans, employees, and myriad other matters in order to ensure their survival. It is in these times that directors must be especially aware of and abide by their fiduciary duties. Failure to do so may harm the company and may expose the directors to personal liability. Fortunately, while the challenges posed by the COVID-19 virus may be novel, the virus does not alter the standards by which directors’ decisions are measured.
Directors’ duties are determined by the laws of the state of organization of the company. Therefore, it is essential for directors to understand their duties and ensure compliance or risk personal liability. This blog focuses primarily on the corporate fiduciary duties required by Delaware law given the relatively high number of corporations that are incorporated there. We note that for other business organizations, including limited liability companies and limited partnerships, Delaware allows for substantial modification and even elimination of fiduciary duties. This blog post only addresses Delaware fiduciary duty principles as applicable to corporations.
In Delaware, directors owe two principal fiduciary duties to the company and its stakeholders: (1) the duty of care; and (2) the duty of loyalty. The duty of care generally requires a director to be reasonably informed and to act in a deliberate and prudent manner when making business decisions. To fulfill the duty of care, directors must, at a minimum, inform themselves of all material information reasonably available, monitor and oversee officers, and act with due care in discharge of their duties. Directors are permitted to, and should, rely on qualified and experienced professionals to help discharge their duty of care particularly in areas in which directors have no specialized expertise. This may include legal, financial and accounting matters. The duty of loyalty requires that directors act in, and make decisions based on, the best interests of the corporation and, when the corporation is solvent, its shareholders. This means that directors must not put their own personal interests or the interests of any other person above those of the company and its shareholders. In determining whether directors have fulfilled their fiduciary duties, directors’ actions are analyzed using the deferential “business judgment rule,” which presumes that directors act on an informed basis, in good faith and in the best interests of the corporation, and places the burden of proving otherwise on challenging parties. Should a director breach one or more of these fiduciary duties, he or she could become personally liable.
Generally, if a corporation is solvent, fiduciary duties are owed only to company and its shareholders. If the corporation is insolvent, however, the fiduciary duties are owed to the company and its creditors. Recognizing the shift in to whom fiduciary duties are owed is critical since at the point when a corporation becomes insolvent, directors must then consider the interests of creditors. While there is a shift in the identity of the parties to whom a director may owe fiduciary duties, the shift does not alter the fiduciary duties to which the directors must adhere.
Oftentimes we see directors who confuse their loyalties when the company begins to experience financial distress, especially in smaller enterprises where directors also are equity holders, officers and perhaps even guarantors. Indeed, the challenge of prioritizing one’s duties to the company becomes most apparent when the director is a personal guarantor of the company’s debt and the company is at risk of, or already in, default. Often, the loan documents will allow lenders to pursue recovery from the guarantor before seeking repayment from the primary obligor—the company. Nonetheless, the director’s obligation is to act in the company’s interest, even to her own personal risk, and if the director is incapable of upholding those duties, she should resign. We recommend that distressed companies consider adding independent directors, both to replace conflicted directors and to enhance the effectiveness of the board of a distressed company, and thereby adding a layer of protection for the board and company generally.
In times of crisis it is especially helpful to engage outside counsel to guide the board through its decision-making process and to assist with complying with corporate governance requirements. Understanding that a director risks personal liability for breaching her fiduciary duties and that the party to whom those duties are owed may shift based on the financial health of the company, the best thing a director can do is:
- Stay active and involved in the company’s business decisions, by:
- Participating in board meetings;
- Taking care to be properly informed;
- Asking questions and challenging management;
- Reviewing management reports and other information;
- Requiring complete and detailed meeting minutes;
- Retaining competent professionals – investment bankers, accountants and lawyers; and
- Exercising an active oversight role and not being simply a rubber stamp.
- Ensure that officers are well-qualified.
- Refrain from engaging in self-dealing, by:
- Avoiding even the appearance of being on both sides of a transaction; and
- Not giving special treatment to insiders.
Ensuring robust corporate governance compliance is essential to successfully weathering financial difficulty. Such compliance can be complicated and involve the expenditure of precious resources including for the retention of experienced advisors. However, better business decisions will result and officers and directors will be protected against potential claims.