Officer and Director Liability

Sections within this essay:

Background

Decisions made by officers and directors of corporations typically have not subjected these individuals to personal liability. Even if an officer or director makes what turns out to be a bad business decision, the law does not render the person liable unless that decision violates a specific duty imposed on the officer or director.

On the other hand, the law governing corporations has expanded liability in many instances. This is especially applicable when a director or officer makes a decision that causes financial harm to a corporation, acts in their own interests in making decisions to the detriment of the corporation, or commits a wrongful act or crime.

High-profile cases involving wrongdoing by corporate executives in the early 2000s intensified the exposure on how decisions made by those executives can impact a large number of people. For example, Enron Corporation, an energy company based in Houston, Texas, suffered a major collapse in 2001 that led to the largest bankruptcy in U.S. history. Acts of fraud on the part of corporate officers and others caused many of the problems. Employees of the company lost most of their retirement investments as a result of the company's collapse. Other companies, such as WorldCom, Tyco International, and Global Crossing, suffered similar fates.

Both officers and directors of those corporations faced civil and criminal liability. Members of boards of directors for Enron and WorldCom agreed to pay millions of dollars out of their own pockets as part of settlement agreements. The U.S. Securities and Exchange Commission brought charges against top company officers, seeking to recover large fines in addition to criminal convictions. These incidents also led to major changes in federal securities laws regarding the potential liability for officers and directors.

Officers' and Directors' Roles in Corporate Governance

Officer and directors share in the responsibility of governing a corporation. Shareholders in the corpo-ration elect a board of directors to be in charge of the business. The board of directors is primarily responsible for making decisions, but not for carrying out those decisions. The task of carrying out the decisions made by the board falls on the officers, such as the chief executive officer and the chief financial officer.

State law prescribes the basic powers of officers and directors. Many states have adopted provisions of the American Bar Association's Model Business Corporation Act (MBCA) or Delaware's corporation laws. Other states have adopted their own unique laws. In general, if a state law does not provide a requirement pertaining to officers or directors, then the corporation's articles of incorporation and/or bylaws usually establish these requirements.

Officers

The MBCA and the Delaware corporation statute allow a corporation's bylaws or board of directors to specify which officers the corporation must have. In many jurisdictions, though, state law requires each corporation to have certain officers, such as a president, secretary, and treasurer. Smaller corporations generally have only a few officers, such as a president who serves as the executive officer and a treasurer who serves as the financial officer. Larger corporations have many more officers and subordinates.

In some instances, a state's corporation statute may dictate the functions of corporate officers. Some states allow the corporation's articles of incorporation or bylaws to dictate the officers' functions. The MBCA provides, "Each officer has the authority and shall perform the functions set forth in the bylaws or, to the extent consistent with the bylaws, the functions prescribed by the board of directors or by direction of an officer authorized by the board of directors to prescribe the functions of other officers."

The issue of the authority that is delegated to an officer usually pertains to whether the officer has bound the corporation to another party. If the officer had express authority or implied authority to enter into a transaction on behalf of a corporation, then the officer's actions could lead to liability on the part of the corporation. Typically, however, an officer of a corporation, even if the officer is the president of the corporation, has less power than the board of directors.

Directors

The vast majority of states and the MBCA require corporations to have one or more directors, as specified in the corporation's articles of incorporation or bylaws. This number may be increased or decreased as needed by amending the articles or bylaws. In many states, the board of directors itself may increase or decrease its size. Most modern statutes allow corporations to compensate directors for their services. A board may take an official action if it has a quorum present at its meeting, meaning that at least half of the board members are in attendance.

A director of a corporation is well-advised to stay abreast of the activities of the board. A director has the legal right to have access to information that allows the director to perform his or her job. To perform properly, a director should be diligent in studying the information that is available. This may include the following:

• Review board meeting agendas.
• Review minutes of corporation board meetings.
• Inspect books and records of the corporation, as well as any other data that the director may reasonably request.
• Inspect corporate facilities as appropriate

Directors may take steps to negate the possibility of becoming personally liable if the board of directors approves a questionable transaction. Under the MBCA, a board member who is present at a meeting assents to a board action unless the board member takes one of three steps. These include the following:

• Objecting at the beginning of a meeting to holding the meeting or transacting business at the meeting;
• Dissenting or abstaining from the action and having the dissent or abstention recorded in the minutes of the meeting; or
• Delivering written notice of the dissent or abstention to the presiding officer of the meeting before or immediately after the adjournment of the meeting.

A director who is not present at a meeting is not deemed to have assented to any action of the board in the director's absence. However, a director who votes in favor of a corporation's actions cannot later submit a dissent or abstention.

Responsibilities of Officers and Directors

Whereas the powers of a director or an officer usually do not give rise to liability, the responsibilities of these positions may give rise to litigation. Directors and officers both owe certain duties to the corporation, and breach of these duties can give rise to liability.

Decision-making Responsibilities

Most duties that apply to corporate governance relate to decision-making responsibilities. Duties most clearly apply to the directors of a corporation since the directors are the decision-makers in the business. Officers owe similar duties as directors, especially officers that exercise judgment or discretion. In a closely held corporation, the same individual may serve as an officer and as a director, and so the same duties would apply to the person's title in either position.

Fiduciary Duties

Directors and officers owe what are termed fiduciary duties to the corporation due to the positions of trust that these individuals have within the corporation. The MBCA prescribes several aspects of this type of fiduciary relationship, including the following:

• Act in good faith: this is carried out by acting honestly and dealing fairly.
• Reasonably believe that the director is acting in the corporation's best interests: reviewed objectively, the director has acted with the corporation's interests in mind, rather than his or her own.
• Exercise duties with a level of care that a person in a like position would under similar circumstances.

Duty of Care

The duty of care that an officer or director must exercise relates to the diligence that the person uses to make decisions. In order to fulfill this duty, an officer or director should follow several practices, including the following:

• Regularly attend board and committee meetings.
• Remain informed about the business and affairs of the corporation.
• Rely on information provided by others, such as reports, financial statements, and opinions.
• Make inquiries about problems that may arise with respect to the corporation.

Duty of Loyalty

The duty of loyalty requires an officer or director to act in the best interests of the corporation and not in the person's own best interest. Several instances may give rise to issues that implicate the duty of loyalty, and an officer or director should be aware of how to handle each of these instances should they arise.

• An officer's or director's conflict of interest may or may not cause the person to breach the duty of loyalty, but the officer or director should always disclose conflicts with other directors. The disinterested directors may elect to allow the corporation complete a transaction where a conflict exists, but the interested director should not take part in this vote.
• If an officer or director identifies a business opportunity that could benefit the corporation, the officer or director must first allow the corporation to pursue the opportunity before pursuing the opportunity himself or herself.
• Any transaction that involves a conflict of interest or self-dealing on the part of an officer or director must be fair to the corporation.
• Any conflict of interest and subsequent actions taken by the board with respect to the conflict must be documented.
• Corporations should adopt written policies governing conflicts of interest.
• A corporation should seek independent advice regarding transactions that involve conflicts of interest.

Business Judgment Rule

The business judgment rule is a doctrine developed by courts in reviewing the actions of directors. Generally, courts do not hold directors personally liable for a business decision, even when a decision turns out to be a bad one, so long as the director has not breached a duty to the corporation. A director who acts in good faith, remains informed about the corporation's business, and does not engage in self-dealing or transactions involving conflicts of interest will not be subject to personal liability.

Securities Regulations

The Enron and WorldCom fiascos, along with others referred to in the discussion above, gave rise to the Sarbanes-Oxley Act of 2002, a federal statute that placed greater controls on how publicly traded corporations must conduct business. Under this statute, officer and directors who commit fraud or other crimes face greater penalties than they did in the past. The statute also gave greater power to the Securities and Exchange Commission in investigating and prosecuting acts of wrongdoing by corporate officers and directors.

Rights and Duties of Shareholders

Shareholders in publicly-traded corporations generally are not involved in decisions made by the corporation, other than their act of electing members of the board of directors. In a closely-held corporation, however, it is common that a shareholder or group of shareholders control the corporation. Most courts require that the controlling shareholders uphold a duty of fairness in dealing with the non-controlling shareholders. Minority shareholders in some instances may also demand an appraisal of the fair value of their shares or may demand that the corporation dissolve due to one of several occurrences.

Insurance and Indemnification

Liability insurance and indemnification by the corporation provide protection to an officer or director of a corporation from having to pay out-of-pocket for expenses that arise due to litigation. Indemnification refers to an agreement by the corporation to pay legal fees and other expenses when an officer or director faces a civil claim or criminal prosecution. An indemnification agreement also requires the corporation to pay a settlement or judgment against an officer or director. In some instances, public policy may limit when a corporation may indemnify an officer or director, such as when litigation is based on intentional wrongdoing.

Liability insurance for directors and officers, also referred to as D & O insurance, is provided by third party insurers to provide protection for the corporation and the directors and officers for expenses that arise due to litigation. Most state statutes expressly permit corporations to purchase D & O insurance, although policies are very expensive, potentially costing hundreds of thousands of dollars for larger corporations.

State Laws Governing Officer and Director Liability

Most state statutes governing corporations contain provisions that prescribe the situations in which an officer or director may be liable. Below is a sampling of some of these state statutes.

ALABAMA: The statute imposes a duty of good faith on directors and officers. A director or an officer may not act with intent to depreciate stocks or bonds with the further intent to buy the depreciated stocks or bonds.

ARKANSAS: The statute does not allow a corporation to limit or eliminate liability for any of the following: breach of the duty of loyalty; acts that are not carried out in good faith or that involve intentional misconduct; unlawful distributions; transactions that involve an improper personal benefit; or any breach of duty that creates third party liability.

CALIFORNIA: The director's standard of care is to serve the corporation in good faith and in the best interests of the corporation. The director must exercise such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use in similar circumstances.

CONNECTICUT: A director may be liable for the willful nonpayment of certain taxes. A director must perform duties in good faith, with care an ordinarily prudent person in a like position would exercise in a similar circumstance, and in a manner that the director reasonably believes is in the best interests of the corporation.

DELAWARE: A director may be liable for the payment of an unlawful dividend or from an unlawful stock purchase or redemption, unless the director's dissent or absence is noted in the corporation's minutes. Liability for breach of fiduciary duty may be limited or eliminated in some circumstances.

FLORIDA: A director who acts in good faith, in a manner that the director reasonably believes is in the best interests of the corporation, and with the degree of diligence, care, and skill that an ordinarily prudent person would exercise under similar circumstances will not be subject to personal liability.

HAWAII: A corporation may not limit or eliminate the personal liability of a director in the following instances: the director receives an a financial benefit for which the director is not entitled; the director intentionally inflicts harm on the corporation or the shareholders; or the director intentionally violates criminal law.

ILLINOIS: A director faces penalties for improperly paying dividends or distributing assets, for failing to take reasonable steps to cause notice of dissolution to be mailed to known creditors, or for actively carrying on a business after filing articles of dissolution. A corporate director who commits an act of commercial bride or who receives a commercial bribe is liable to the corporation for three times the aggregate amount given or received in the bribe, plus attorneys' fees.

KENTUCKY: A director is not liable for monetary damages unless the director has breached a fiduciary duty in a manner that constitutes willful misconduct or wanton or reckless disregard for the best interests of the corporation.

LOUISIANA: A director or an officer of a corporation may be liable if the corporation transacts business before capital is received or the director or officer consent to the issuance of shares in violation of the law.

MARYLAND: A corporation's charter may expand or limit the liability of a director for money damages unless: the director received an improper benefit or profit; the director is adjudicated to have been guilty of active and deliberate dishonesty that was material to the cause of action; or the director was also a director of certain banking and/or financial institutions.

NEVADA: A director may be liable for the following: breach of fiduciary duty where breach involved intentional misconduct, fraud, or knowing violation of the law; wrongful declaration of distributions; or debts or liabilities where the director acts as the alter ego of the corporation.

NEW YORK: A director who votes for or concurs in the following actions may be liable to the corporation for the benefit of creditors and shareholders: improper declaration of a dividend; improper purchase or redemption of the corporation's shares; improper distribution of assets after dissolution; or improper loans made to the director.

TENNESSEE: A director may not participate in a transaction involving a known conflict of interest without the approval of the shareholders or other directors unless the transaction was fair; make loans to officers or directors without shareholder approval; or vote for or assent to distribution in violation of the law or the corporation's charter.

TEXAS: A director or an officer may demonstrate that he or she exercised ordinary care by relying on certain statements, opinions, reports, and other documents. An officer may be personally liable for tortious acts when the officer participates in the wrongdoing.

Additional Resources

Corporation Law. Gevurtz, Franklin A., West Group, 2000.

Folk on the Delaware General Corporation Law. Rodman Ward, Jr., Edward P. Welch, and Andrew J. Turezyn, Aspen Law and Business, 1999.

The Law of Corporations in a Nutshell. Hamilton, Robert W., Thomson/West, 2000.

Macey on Corporation Laws. Johnathan R. Macey, Aspen Publishers, 2005.

Managing Closely Held Corporations: A Legal Guidebook. Committee on Corporate Laws, American Bar Association, 2003.

West's Encyclopedia of American Law, 2nd Edition. West Group, 2004.

Organizations

Association of Corporate Counsel

1025 Connecticut Avenue, NW, Suite 200
Washington, D.C. 20036 USA
Phone: (202) 293-4103
URL: http:\\www.state.de.us.corp

Business Law Section, American Bar Association

321 North Clark Street
Chicago, Illinois 60610 USA
Phone: (800) 285-2221
URL: http://www.abanet.org/buslaw/home.shtml

Council of Better Business Bureaus

4200 Wilson Blvd, Suite 800
Arlington, Virginia 22203 USA
Phone: (703) 276-0100
URL: http://www.bbb.org

Delaware Division of Corporations

401 Federal Street, Suite 4
Dover, Delaware 19901 USA
Phone: (302) 739-3073
URL: http:\\www.state.de.us.corp