A corporation is a distinct type of business entity. Although each state establishes the rules for its business entities, a corporation’s structure always involves shareholders, directors, and officers.
Directors and officers always owe certain duties (“fiduciary duties”) to the corporation and its shareholders. Shareholders sometimes owe these duties.
Fiduciaries in Corporations
A fiduciary is a person or entity that acts on behalf of another person or entity and is obligated to protect the interests of that other person or entity. In a corporation, directors and officers are the primary fiduciaries.
As discussed below, shareholders don’t owe fiduciary duties to the corporation, but majority shareholders might owe fiduciary duties to minority shareholders.
State law determines the specifics of corporate fiduciary duties. Sometimes those duties can be modified in the corporation’s bylaws or its shareholder agreement. At a minimum, though, state laws impose a duty of care and a duty of loyalty on corporate directors and officers that cannot be modified away.
Fiduciary Duties of Directors
Under most states’ laws, directors have two primary fiduciary duties: the duty of care and the duty of loyalty.
Fiduciary Duty of Care
The duty of care requires directors to act in good faith to promote the best interests of the corporation. In carrying out their corporate responsibilities, directors are expected to exercise reasonable care and diligence.
For example, directors are expected to regularly attend board meetings, to stay informed on important corporate matters, and to take action as appropriate to promote the corporation’s interest and avoid harm to the corporation.
Fiduciary Duty of Loyalty
The duty of loyalty requires directors to always put the interests of the corporation and its stockholders above their own personal interests. Directors cannot engage in and must avoid any conflict between their duty to the corporation and their personal self-interest.
As part of this duty of loyalty, directors must act with utmost honesty and cannot take advantage of their position as director or engage in any secret transactions that benefit them at the expense of the corporation. A breach or violation of this duty typically occurs where directors self-deal to their own benefit and to the detriment of the corporation.
Whenever the corporation is considering entering into a contract or other business transaction with one of its directors, the parties should follow certain procedures to make sure there’s no violation of the director’s duty of loyalty.
For example, if a corporation is going to lease property from a director, the director has a conflict of interest. To address the conflict, the board of directors should make sure that:
- The director who owns the property discloses the potential conflict to the board and abstains from voting on the proposed lease.
- The board has an opportunity to discuss and vote on the transaction without the interested director present, determining whether the proposed transaction is in the best interest of the corporation.
- The corporate minutes show all of the above.
In any dispute involving possible self-dealing or a conflict of interest, the burden of proof is on the “conflicted” director to establish they acted in good faith and fairly.
The Business Judgment Rule
Though directors have the two duties covered above, they do receive the benefit of the business judgment rule. Under this rule, directors aren’t liable for a decision that results in harm to the corporation as long as they acted reasonably under the circumstances.
In most states, the business judgment rule creates a presumption that, in making a business decision, the directors were reasonably informed and acted in good faith, and that the action taken was in the corporation’s best interests. Being reasonably informed includes relying on outside experts’ opinions and informational reports provided by company employees.
As long as there wasn’t gross negligence or self-dealing in the decision-making process, directors generally won’t be held liable for bad decisions or mistakes that result in harm to the corporation.
The business judgment rule was intended to protect directors from errors in judgments and mistakes. Without this protection, people might not be willing to serve as directors on boards because of the possibility of liability for business decisions that turn out badly.
Fiduciary Duties of Officers
Most boards of directors delegate responsibility for the day-to-day oversight of the corporation’s business to officers of the corporation. Like directors, corporate officers owe a to the corporation and its stockholders in carrying out their responsibilities.
Officers are expected to act in good faith and to use the same care that a reasonably prudent person would use in similar circumstances in making decisions and taking action on behalf of the corporation. They also must avoid conflicts of interests and self-dealing.
Like directors, officers are protected by the or business decisions they make in their capacity as officers of the corporation. They aren’t personally liable for reasonable mistakes of judgment and business decisions that turn out to be bad for the corporation—as long as they were reasonably informed, acted in good faith, and believed their action to be in the best interests of the company.
Fiduciary Duties of Shareholders
A corporation’s shareholders, as owners, aren’t normally subject to any fiduciary duty. Shareholders generally don’t act in any managerial or oversight capacity . Their primary source of control with respect to the corporation is the power to elect the members of the board of directors.
However, a majority shareholder may take on fiduciary duties toward other shareholders if they assume control of the corporation through the board (making them not just majority shareholder, but a “controlling shareholder”). Controlling shareholders owe a duty of loyalty to the minority shareholders when they make decisions or take action on behalf of the corporation.
If a controlling shareholder engages in a transaction with the corporation that they stand to personally benefit from, the controlling shareholder has the burden of showing that the transaction is fair to the business and the other shareholders.
A controlling shareholder also cannot use a controlling position to deprive minority shareholders of their role in governing the corporation (known as a “freeze-out”).
Consequences for Breach of Fiduciary Duty
If a director, officer, or controlling shareholder breaches a fiduciary duty and the corporation suffers financial harm as a result, harmed individuals can sue the fiduciary. Typically, the harmed individuals are the shareholders who lost money as a result of the breach.
A lawsuit brought by a shareholder against directors, officers, or other shareholders for breach of fiduciary duty is called a “derivative action.” If the lawsuit is successful, the fiduciary will be personally responsible for the corporation's estimated lost profits due to the breach of the duty of care, and for repaying profits the fiduciary got from any self-dealing.
In cases where the breach was intentional, a court might award punitive damages, which serve to punish the fiduciary. Depending on the state law and the circumstances, punitive damages might be much higher than lost profits.
How to Fulfill Your Fiduciary Duties
If you’re a director, officer, or majority shareholder of a corporation, the first step toward upholding your fiduciary duties is to understand them. This article has hopefully helped you do that.
When you are involved in decisions or actions that require you to exercise your duty of care, gather the information you need to make an informed decision and apply your best, good faith judgment to the decision.
If you’re faced with a potential or actual conflict of interest, disclose it in writing to your fellow shareholders or the board of directors, and abstain from voting on the relevant decision or action.
For important business decisions, keep copious records to document how you made decisions for the company, including what information you consulted. In conflict or potential conflict-of-interest situations, disclose information in writing—for example, by sending an email to the relevant parties.
Consulting a Business Attorney
If you have questions about what’s required of you as a corporate fiduciary in a particular situation, or if you believe that a director, officer, or shareholder has breached their fiduciary duty to your corporation, consult a business attorney to help you determine the best course of action. Do the same if you face an accusation of breaching your fiduciary duties.