Directors’ Duty of Loyalty

In this post, I discuss the directors’ duty of loyalty to the company they manage and how this may interact with potential legal liabilities.

*Photo by blue_quartz is licensed under CC 2.0. *

As I discussed in a previous post, there is a division between directors and shareholders within a corporation. The directors are responsible for running the business and in almost all circumstances may make decisions without the approval or consent of the shareholders—except where provided in the corporation’s bylaws. The shareholders own the corporation, but their influence is limited to their ability to name the directors.

Protecting the Shareholders

Recognizing the relative disadvantage of the shareholders, the law imposes various duties upon directors to ensure that they act in the best interest of the corporation and, by extension, the shareholders. That is to say that directors cannot use their position to enrich themselves at the expense of the shareholders.

This is generally referred to as the duty of loyalty.

The Duty of Loyalty

The duty of loyalty states that the directors may not act where there is a conflict of interest. That is, a director—or a member of his family—cannot be on one side of the contract where the corporation is on the other side. Allowing this would provide too great an opportunity for a director to use his position to make deals that benefit him personally at the expense of the corporation.

Conflicts of interest are not, however, always impermissible. A conflict of interest is permissible and does not run afoul of the director’s duty of loyalty under the following circumstances:

1. The presence of the conflict of interest and the material facts of the deal were made known to the directors and they approved it. Approval cannot occur, however, unless two independent directors—that is, directors that are not parties to the agreement and do not stand to benefit from it—approve it.
2. The conflict of interest and the material fact of the deal were disclosed to the shareholders, and the shareholders approved it.
3. The deal is fair.

Corporate Opportunity Doctrine

The Corporate Opportunity Doctrine exists within the director’s wider duty of loyalty. Simply put, a corporate officer or director may not personally take advantage of a business opportunity if:

1. The corporation is financially able to exploit the opportunity;
2. The opportunity is within the corporation’s line of business;
3. The corporation has an interest or expectancy in the opportunity; and
4. By taking the opportunity for his own, the director or officer will thereby be placed in a position inconsistent with his duties to the corporation, particularly his duty of loyalty.

A director or officer may, however, take a corporate opportunity if:

1. The opportunity is presented to the director or officer in his individual and not his corporate capacity;
2. The opportunity is not essential to the corporation;
3. The corporation holds no interest or expectancy in the opportunity; and
4. The director or officer has not wrongfully employed the resources of the corporation in pursuing or exploiting the opportunity.

Duty of Loyalty In Sum

The duty of loyalty that the law imposes on a corporation’s directors helps to protect shareholders against the exploitative behavior of unscrupulous corporate insiders. The duty of loyalty also imposes some requirements of which a director may unintentionally run afoul, so a proper understanding of the law’s requirements is critical for anyone taking on a position of leadership within a company, particularly those who may serve on a board of directors that meet only a few times per year.

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See Also:

Shareholders and Directors

The Corporation