The Duty of Care

Terms:

Due Diligence
There have been several references to “due diligence” throughout the material so far. Often, in your legal practice, you are likely to hear that attorneys are on their way to a “due diligence” meeting or going to do “diligence” on a company. This phrase simply means that the attorney is going to do research on the firm by meeting with its management and employees to assess the firm, its operations, and finances. Additionally, in the context of directors, this means that the directors have performed their fiduciary duties and have thoroughly investigated the ramifications of their decisions, prior to putting any plan in action that may affect the company.

Financial Literacy
Financial literacy refers to competency in basic accounting and financial principals. Generally, directors are assumed to have a level of understanding that at least allows them to read and understand the standard financial reports of a company along with its balance sheet and cash flow statements.

Defining the Duty of Care

To start our study of the duty of care, we begin with a working definition of the standard to consider:

A director or officer must discharge her duties in good faith and with that degree of diligence, care, and skill that an ordinarily prudent person would exercise under similar circumstances in a like position.

Tearing this definition apart, we get the following elements:

• "A director or officer must discharge her duties in good faith..."

As discussed in the previous chapter on the duty of loyalty, good faith is a legal term of art. It is not always clear what good faith means standing alone, except to say that the director or officer needs to act to the best of her abilities to ensure that the good of all involved in the company and the company itself are well served by her actions.

• "...and with that degree of diligence, care, and skill..."

Breaking down this clause, the student of the law will find the following as the courts' guidance in this area:

Diligence – The obligation of the director is to act diligently in her decisions on behalf of the corporation. This translates most simply as an obligation of the director to do her homework before deciding on a course of action for the firm. Before making a decision of any weight, the director needs to study the financial impact, effect on operations, and long-term benefits and detriments that the decision will have on the company and its owners. See Williams v. Chamer, 32 Va. Cir. 12 (Va. Cir. Ct. 1993).

Care – It seems a touch redundant to include “care” as an element of the duty of care. However, care is probably the best word to sum up the obligation of the directors to question and concern themselves with any information they receive from the company and outsiders. Directors are tasked with the ultimate responsibility for the actions of the firm. Based on their position within the corporation, they are often unable to fully investigate information that affects their decision that is received from others or to carry out their decisions on their own. As such “care” might readily translate to an obligation to act in an oversight capacity and to question the acts of subordinates when they seem abnormal, or might not conform with the company's best interests. See In re Baxter Int'l, 654 A.2d 1268 (Del. Ct of Chancery 1995).

Skill – This final element of the active part of the definition of the duty of care recognizes the fact that different individuals are elected to the board of directors under different sets of circumstances and based on their different backgrounds. Generally, members of the board should be financially literate and should task themselves with understanding the operating principles of their business. However, people elected to the board based on a specific skill set – be it an accounting background, legal know-how, academic knowledge of the business, etc. – need to exercise their obligations on the board with specific reference to the fact that other board members may be relying on them for their particular knowledge.

EXAMPLE: Tammy was elected to the board of Growing Co. because of her financial expertise as a CPA and financial advisor. As such, she took special care in her dealings with the company to ensure that she thoroughly understood the finances of the firm and reported any financial problems and anomalies to the whole board at the moment that she saw them. By acting in this way, with the level of skill that she possessed, Tammy fulfilled her obligations as a director under the duty of care.

• "...that an ordinarily prudent person would exercise..."

An important difference between the duties of care and loyalty is that the standard for conduct set by the duty of care is an objective, general, and lower standard than that required by the duty of loyalty. Namely, the duty of care requires a director to perform only as an “ordinarily prudent person” would as opposed to as a “fiduciary” would be expected to (as under the duty of loyalty). The “ordinarily prudent person” standard suggests that the director need only act to the best of his or her abilities, rather than conform to the much higher standard of a “fiduciary.” This difference is largely due to the fact that the duty of care concerns itself with the director’s duty as to management of the firm. The duty of loyalty deals with the manner in which the manager conducts herself with respect to the firm. In other words, the law will not require the director to make the right decision every time. Instead, the obligation on the director is simply to make decisions as a regular person would, based on the information that person has at his disposal. However, the duty to put the company’s interest above one’s own (the duty of loyalty) is a constant duty that must be adhered to on a much higher level.

• "...under similar circumstances in a like position."

The final part of the duty of care standard further explicates how the director needs to act given her position. The standard dictates that the board member must act with regard to the “circumstances” he encounters. In other words, the manager of a healthy firm, with strong profits and a sound business plan, might act differently than the director of a firm on the verge of bankruptcy facing a host of lawsuits. Thus, when conducting her business, the director must consider the context of her decisions and act with those conditions in mind when making her choice.


Consequences of a Breach of the Duty of Care

A director who breaches the duty of care in the manners discussed above may face, depending on the nature and extent of her actions, a variety of legal or court-made remedies including censure, dismissal, and/or civil and criminal liability.

• Nonfeasance

Nonfeasance is the term applied to a director who has failed to act in the manner that an ordinarily prudent person would. See Hoye v. Meek, 795 F.2d 893 (10th Cir. 1986). For example, an average person would show up to meetings if required to do so by the rules of an organization she belonged to. Therefore, if a director simply fails to make an appearance at a board meeting absent appropriate excuses and attempts to correct for missing the meeting, she has failed to act as an ordinary person would under the circumstances.

The difficulty in a “nonfeasance” situation is equating the failure to act with a specific liability. However, certain circumstances might be imagined where the director’s failure to act, such as failure to attend a meeting, might result in a direct injury to the firm. Consider the following as an example:

EXAMPLE: Troubled, Inc. was in danger of going bankrupt. As such, the firm, during its most recent annual meeting had elected a bankruptcy expert to the board to help guide them through the process and avoid legal difficulties. However, given the troubled times, the bankruptcy expert was extremely busy and often unable to attend board meetings. Ultimately, Troubled was sued by both shareholders and bondholders who were upset about how the bankruptcy was proceeding. In the end, one group of shareholders decided that another target of their legal fight should be to sue the bankruptcy expert for failing to act under his duty of care, which required him to act with that skill he possessed for the benefit of the company. In handing down its opinion, the court cited “nonfeasance,” due to the director’s failure to attend any meetings, as the grounds for finding against the director.


• Misfeasance

Misfeasance is the appropriate cause of action when a director’s behavior is so outside the realm of good faith so as to equate to recklessness or bad faith activity. Generally, and as we will discuss in the next section of this chapter, courts do not like to second guess the business decisions of a manager as such second guessing would replace the court’s ex-post facto (after the fact) judgment with that of the director who was faced with a real, live decision without the benefit of hindsight. As such, the Business Judgment Rule (BJR -- which will be discussed further in the next subchapter) will generally protect any decision by a director that was made upon full knowledge and after a thorough investigation. See Gries Sports Enterprises, Inc. v. Cleveland Browns Football Co., Inc., 496 N.E.2d 959 (Ohio 1986).

Misfeasance enters the equation when the director has failed to fully inform herself of the nature or effects of the decision, and has therefore acted rashly and without proper regard to the consequences of her action. In such a situation, or in a case where the director has committed outright fraud, the court will likely dismiss the protection of the BJR and hold the director liable in misfeasance for her actions.

EXAMPLE: The board of Oops, Inc. had hired a consultant to help it identify a new location for its manufacturing plant. The board, based solely on the consultant’s advice, decided to buy a large tract of land for the plant. However, in time, it was discovered that not only was the consultant a con artist who absconded with some of the company’s money, but the land was purchased at a price that was twenty times its actual value and had a huge environmental cleanup liability associated with its ownership. Due to the loss of value, the firm’s shareholders decided to sue the directors in their personal capacities for misfeasance in failing to properly investigate the circumstances before making their decision.

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