Directors’ Fiduciary Duties: Increasing Focus on Good Faith and Independence
The corporate board of directors has well-established fiduciary duties to the corporation and its shareholders. Recent cases against directors for breach of fiduciary duty increasingly focus on allegations of failure to act in good faith predicated on inaction and lack of oversight and allegations of lack of independence. This article discusses the changing legal standards and expectations for directors of Florida corporations and provides practical guidance for counsel regarding how to advise directors to reduce the risk of suit.
Basic Fiduciary Duties
Under Florida law, directors oversee the management of the business and affairs of the corporation,1 and their actions are governed by a mixture of statutory and common law principles.2 The directors owe a fiduciary duty to the corporation and its shareholders,3 which is generally expressed in terms of good faith,4 the duty of care, and the duty of loyalty. The directors’ fiduciary duty has been codified in F.S. §607.0830(1) (2008):
A director shall discharge his or her duties as a director, including his or her duties as a member of a committee: (a) in good faith; (b) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (c) in a manner he or she reasonably believes to be in the best interests of the corporation.
The Florida Supreme Court, in the early case of Orlando Orange Groves Co. v. Hale, 144 So. 674, 677 (Fla. 1932), summarized the directors’ fiduciary duty as follows:
While directors of a corporation may not be in the strict sense trustees, it is well established by the decisions that they occupy a quasi fiduciary relation to the corporation and its stockholders. They are required to act in utmost good faith, and in accepting the office they impliedly undertake to give to the enterprise the benefit of their best care and judgment, and to exercise the powers conferred solely in the interests of the corporation.
Every director must work for the benefit of all the shareholders, even when nominated or designated by a particular group of shareholders.
Boards have traditionally performed a decisionmaking function, such as evaluating and, if appropriate, approving significant business transactions and investments. Directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available.5 This does not mean the board must be informed of every fact, but only material facts that are reasonably available.6 The board is also expected to act “in a deliberate and knowledgeable way in identifying and exploring alternatives.”7
The Florida Business Corporation Act, F.S. §607.0830(2), authorizes directors to rely on information, opinions, and reports provided by corporate officers and employees and legal counsel, public accountant, and other experts, so long as the directors reasonably and in good faith believe them to be reliable and competent. Obtaining reports from management and guidance from outside advisors is a hallmark of a careful decisionmaking process.8 Of course, no board is obligated to heed the counsel of any of its advisors.9 One recent case found the directors breached their fiduciary duty by abdicating crucial decisionmaking authority to the outside advisor.10 In some situations, sole reliance on hired experts and management can taint the process.11 The directors must exercise their independent business judgment.
The Florida Business Corporation Act, F.S. §607.0830(3), authorizes directors to consider the interests of employees, suppliers, and customers and the communities in which the company operates when making business decisions.12 However, the board is primarily responsible for the economic performance of the corporation and maximization of shareholder value. This so-called “stakeholder” or “other constituencies” statute is best understood as authorizing other factors to be considered in the decisionmaking process rather than creating independent corporate objectives.13
The areas of board decisionmaking that currently produce the most litigation, and, therefore, warrant extra caution, include the potential sale of the company or other change of control transaction;14 the selection, evaluation, and compensation of senior executives;15 investigation of potential unlawful activity;16 and situations when the company is experiencing financial difficulties.17
There is no preset formula that corporate boards must follow to be considered properly informed.18 Factors considered by the courts include whether agendas and materials are provided to directors prior to meetings, whether directors are prepared and participate actively in discussions, whether the board receives advice, when appropriate, from financial and legal advisors, and whether the board devotes the time to deliberate carefully, including possibly considering the issue at multiple meetings.
In addition to the traditional decisionmaking function, directors are increasingly called upon to serve an oversight function. In recent years, the board has become expected to be an active monitor of corporate performance and assess whether the company has established appropriate information and reporting systems and controls to provide the board and senior management with accurate financial reporting and to assure compliance with law and corporate policy.19 Today, directors are expected to “exercise a good faith judgment that the corporation’s information and reporting is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.”20
The board also is expected to establish the proper “tone at the top” by setting clear expectations for the corporation’s ethical behavior and compliance with law.21 Needless to say, directors violate their duty to the extent they knowingly cause the company to violate the law or act in an illegal fashion, even if they believe the illegal activity is undertaken in the corporation’s best interests and is profitable.22
Business Judgment Rule
Directors are protected against lawsuits asserting deficient conduct by the business judgment rule.23 The business judgment rule is a standard of judicial review for director conduct, not a description of a duty or a standard for determining whether a breach of duty has occurred. The rule is applied to determine whether the directors’ decision can be subject to challenge in court and whether the directors can be held personally liable.
The business judgment rule is a judicially created presumption that decisions are made by disinterested directors on an informed basis in a good faith belief that the decision will serve the best interest of the corporation. If the plaintiff cannot overcome the presumption, usually by specific proof of conflict of interest, illegality, fraud, or bad faith, the rule prohibits the court from going further and examining the merits of the underlying business decision and directors are protected from personal liability.24 One court described the rule as follows:
[T]he business judgment rule is a policy of judicial restraint born of the recognition that directors are, in most cases, more qualified to make business decisions than are judges. In this light, the rule may be viewed as a method of preventing a fact finder, in hindsight, from second guessing the decisions of directors.
[D]irectors are protected by the business judgment rule under Florida law no matter how poor their business judgment, unless they acted fraudulently, illegally, oppressively, or in bad faith. Said differently, so long as due care was exercised, the rule protects a “good director” (one who did not act fraudulently, illegally, oppressively, or in bad faith) who made an honest error or mistake in judgment, but not a “bad director” (one who acted fraudulently, illegally, oppressively, or in bad faith) who made a bad decision.25
In order to maximize the likelihood that a court will afford directors the protection of the business judgment rule with respect to a potentially controversial decision, the directors should pay careful attention to the adequacy of the board’s decisionmaking process and make sure that the minutes adequately reflect the board’s factual foundation for the decision, any recommendations or reports received from management or outside experts, and the board’s consideration of potential alternatives. Directors may find it desirable to consider potentially controversial decisions at more than one meeting in order to strengthen the argument that adequate deliberation occurred.
The concept of director interestedness comes into play during a potential conflict of interest situation. “A director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders, or will suffer a detrimental impact from the proposed transaction.”26
The Florida Business Corporation Act, F.S. §607.0832, provides a safe harbor procedure to insulate transactions from shareholder challenge based on director conflict of interest.27 The statute protects an interested director transaction if the facts of the transaction, including the conflict of interest, are fully disclosed and the transaction is approved by the disinterested directors or shareholders.
When reviewing a transaction involving a potential conflict of interest or self-dealing elements, the ABA Corporate Director Handbook recommends that the disinterested director should seek to determine the following:
Whether the terms of the proposed transaction are at least as favorable to the corporation and its shareholders as might be available from unrelated persons or entities; [w]hether the proposed transaction is reasonably likely to further the corporation’s business activities; and [w]hether the process by which the decision is approved or ratified is fair.28
The concept of director independence has recently received increased attention in the context of both the applicability of the business judgment rule and the authority of independent directors to terminate a potential shareholder derivative action. The test for director independence appears to be more strict in the latter context because the courts appear less likely to apply a presumption of independence.
“[I]ndependence exists if a director’s decision is based on the corporate merits of the subject before the board rather than on extraneous considerations or influences.”29 “Directors lack independence when they are beholden to an interested director or so under the influence of an interested director that their discretion would be sterilized.”30
A director is beholden to an interested director if the director receives a benefit upon which the director is so dependent or is of such subjective material importance that its threatened loss might create a reason to question whether the director is able to consider the corporate merits of the challenged transaction objectively.31
Within the contact of dismissal of a shareholder derivative action, a court recently held that “a broader test [of independence] is required under the Florida statute which is ultimately a determination, based on the totality of the circumstances, as to whether a director is, for any substantial reason, incapable of making a decision with only the best interest of the corporation in mind.”32
The issue is not the integrity of the directors, but their objectivity and impartiality, both in fact and in perception, and whether their decision was anything but the exercise of considered and unbiased judgment.33
The Delaware Supreme Court has examined the directors’ duty to act in good faith in three recent decisions.34 Bad faith, sometimes referred to as the lack of good faith, has been defined as a “conscious and intentional disregard of responsibilities, adopting a ‘we don’t care about the risk attitude’” and as “a conscious disregard for one’s responsibilities.”35 Subjective bad faith, which is the classic, quintessential bad faith, is fiduciary conduct motivated by an actual intent to do harm.36 Bad faith also may be shown where a director intentionally acts with a purpose other than advancing the best interests of the corporation or the intent to violate applicable positive law or where a director intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.37
A director’s gross negligence, without more, does not constitute a breach of the fiduciary duty to act in good faith.38 Greater culpability, such as a conscious disregard of one’s responsibilities or intentional dereliction of duty is required.39 Imposition of liability against a director for bad faith “requires a showing the directors knew that they were not discharging their fiduciary obligations.”40
The legal requirements and expectations for corporate directors have grown in recent years. The recent case law trends suggests greater risk of personal liability. More attention is required to monitor the corporation’s performance, its internal controls, and reporting systems in order to assure ethical behavior, reliable financial reporting, and compliance with law and corporate policy. More sensitivity is required regarding conflicts of interest and personal relationships that may compromise a director’s independence, objectivity, and ability to act solely in the corporation’s best interest. Directors must be actively engaged in the supervision of the company. Directors’ knowing failure to undertake their responsibilities constitutes bad faith, which constitutes a breach of their duty of loyalty. In the final analysis, however, the outside director’s fundamental duty remains to exercise informed, independent business judgment to manage the business and affairs of the corporation in a manner that he or she believes to be in the best interest of the corporation and its shareholders.
1 Fla. Stat. §607.0801(2)(2008)
2 See S. Cohn and S. Ames, Florida Business Corporations — Overview, Florida Business Laws Annotated 3 (2007-08).
3 When the corporation enters the “zone of insolvency,” the directors’ fiduciary obligations extend to include creditors. See In re: Toy King Distributors, Inc., 256 BR 1 (Bankr. M.D. Fla. 2000); G. Davis and K. Webb, Directors of the Financially Troubled Company: Guidance for a Thankless Job, 76 Fla. B. J. 42 (2002). However, individual creditors do not have the right to bring direct claims against directors for breach of fiduciary duty. Mukamal, 383 B.R. at 820 (S.D. Fla. 2007) (applying Delaware law); see N. Am. Catholic Educ. Programming Fund, Inc. v. Gheeuballa, 930 A.2d 92 (Del. 2007).
4 In Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) (the Delaware Supreme Court ruled that “although good faith may be described colloquially as part of a ‘triad’ of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty”).
5 Stepak v. Addison, 20 F.3d 398, 410-11 (11 Cir 1994); see Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984);
6 Brehm v. Eisner, 746 A.2d 244, 259 (Del. 2000).
7 Citron v. Fairchild Camera and Instrument Corp., 569 A.2d 53, 66 (Del. 1989).
8 Committee on Corporate Laws – ABA Section of Business Law, Corporate Director’s Guidebook (5th ed.), 62 Bus. Law. 1479, 1496 (2007).
9 In re IXC Communications, Inc. Shareholders Litig., 1999 WL 1009174 *6 (Del. Ch. 1999).
10 Bridgeport Holdings, Inc. Liquidating Trust v. Boyer, 388 B.R. 548, 556 (Bankr. D. Del. 2008).
11 Citron, 569 A.2d at 66 (Del. 1989); Mills Acquisition Co. v. MacMillam, Inc., 559 A.2d 1261, 1281 (Del. 1988).
12 Kloha v. Duda, 246 F. Supp. 1237, 1246 (M.D. Fla. 2003).
13 Corporate Directors Guidebook, 62 Bus. Law. at 1491 (2007).
14 Hastings-Murtagh v. Texas Air Corp., 649 F.Supp. 479 (S.D. Fla. 1986); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).
15 Klein v. FPL Group, Inc., 2004 WL 302292 (S.D. Fla. 2007); In re Walt Disney Co. Deriv. Litig., 906 A.2d 27 (Del. 2006).
16 McCabe v. Foley, 424 F. Supp. 1315 (M.D. Fla. 2006); In re Caremark Int’l Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).
17 Mukamal, 383 B.R. 798 (S.D. Fla. 2007); Bridgeport Holdings, 388 B.R. 549 (Bankr. D. Del. 2008).
18 Stepak v. Addison, 20 F.3d 398, 410 (11 Cir. 1994).
19 Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006); see In re Caremark Int’l Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
21 Corporate Director’s Guidebook, 62 Bus. Law. at 1491 (2007).
22 Desimone v. Barrows, 924 A.2d 908, 934 (Del. Ch. 2007).
23 See J. Carroll, The Business Judgment Rule in Florida — On Paper and in The Trenches, 80 Fla. B. J. 55 (2006).
24 Kloha v. Duda, 246 F. Supp. 2d 1237, 1244-45 (M.D. Fla. 2003).
25 Bal Harbour Club, Inc. v. AVA Dev., Inc., 316 F.3d 1192, 1994-95 (11 Cir. 2003), quoting, Int’l Ins. Co. v. Johns, 874 F.2d 1447, 1458 (11 Cir. 1989), and FDIC v. Stahl, 89 F.3d 1510, 1517 (11 Cir. 1996) (citations omitted); see also Lake Region Packing Assn., Inc. v. Furze, 372 So. 2d 212, 216 (Fla. 1976).
26 McCabe, 424 F. Supp. 2d. at 1319 (M.D. Fla. 2006); see Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993).
27 G. Davis, Director Conflicts of Interest Under the Florida Business Corporation Act: Hidden Shoals in a Safe Harbor, 72 Fla. B. J. 31 (1998).
28 Corporate Director’s Guidebook, 62 Bus. Law. at 15 (2007).
29 Story v. Kang, 2006 W.L. 163078 *2 (M.D. Fla. 2006); see Rales, 634 A.2d at 936 (Del. 1993).
30 McCabe, 424 F. Supp. 2d at 1320 (M.D. Fla. 2006); see Rales, 634 A.2d at 936 (Del. 1993).
31 In re Infousa, Inc. Shareholders Litig., 2007 WL 5315015 *13 (Del. Ch. 2007); see Texlon Corp. v. Meyerson, 802 A.2d 257 (Del. 2002).
32 Klien v. FPL Group, Inc., 2004 WL 302292 *19 (S.D. Fla. 2004).
33 Klein, 2004 WL 302292 *20 (S.D. Fla. 2004).
34 Lyondell Chemical Company v. Ryan, 2009 WL 790477 (Del. March 25, 2009); Stone v. Ritter, 911 A.2d 362 (Del. 2006); In re Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. 2006).
35 In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 63 (Del. 2006); see Lyondell Chemical Co., 2009 WL 790477 *6 (Del. March 25, 2009); Mukamal v. Bakes, 383 B.R. 798, 823-25 (S.D. Fla. 2007).
36 Lyondell Chemical Company, 2009 WL 790477 *6 (Del. March 25, 2009) (quoting, In re Walt Disney Co. Deriv. Litig., 906 A.2d at 64 (Del. 2006)).
37 Mukamal, 383 B.R. at 825 (S.D. Fla. 2007); see Stone, 911 A.2d at 369 (Del. 2006).
38 In re Walt Disney Co. Derivative Litig., 906 A.2d at 64-65 (Del. 2005); see Stone, 911 A.2d at 269 (Del. 2006).
40 Lyondell Chemical Co., 2009 WL 790477 *7 (Del. March 25, 2009) (quoting, Stone, 911 A.2d at 370 (Del. 2006).
Gardner Davis graduated from Duke Law School. Danielle Whitley graduated from University of Florida Law School. Ms. Whitley and Mr. Davis are business lawyers in the Jacksonville office of Foley & Lardner, LLP. The authors gratefully acknowledge the research assistance of Xinning Shirley Liu.
This column is submitted on behalf of the Business Law Section, Louis T. M. Conti, chair, and Melanie E. Damian and Peter F. Valori, editors.