The Duty of Care
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 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..."
• "...and with that
degree of diligence, care, and skill..."
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..."
• "...under similar
circumstances in a like position."
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.
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 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.