Director Liability

You've been asked to join the Board of Directors of a corporation – private, public or even not-for- profit. You should be rightfully proud. But, do you know that serving on a board carries with it serious responsibilities and potential liabilities?

A Board of Directors is responsible for managing the affairs of a corporation. Of course, that doesn't mean that the board handles the day-to-day operations. Instead, it's often been said that a board is responsible for ensuring adequate management of the organization. Said another way, a board sets the policy and the staff, selected by the board, carries it out.

A true Board of Directors, as opposed to an advisory Board, is the final authority for an organization and can be legally responsible for the work of the staff they select. As such, a Board of Directors is expected to be informed, competent, and cognizant of all actions taken in the name of the organization.

Indeed, new standards of accountability have been established for the Boards of Directors of publicly traded corporations. Under the Sarbanes-Oxley Act, a federal law, board members risk large fines, and perhaps even prison sentences, for malfeasance or failure to attend to board responsibilities – especially in the case of accounting crimes.

The primary duty of a director is that of good faith. This means that a director must perform his or her duties honestly, conscientiously, and fairly. A director must act in the best interest of the shareholders or interested parties and not for the benefit of any particular group or individual. That means that a director can't use his or her position for personal gain to the detriment of the corporation. For example, a director can't generally accept free products or services from the corporation. Nor can a director "usurp corporate opportunity" by using inside information to compete directly with the corporation. In other words, accepting a position as a director is not an excuse to line your own pockets no matter how trivial it may seem.

The second general duty of a director is that of due care. At the very least, a director is required to see that a corporation is operated according it its own bylaws and the law. Part if the duty of due care is the duty to reasonably inquire. That is, a director must be informed about the condition of the organization and the conduct of its affairs. For this reason, a director can't generally claim ignorance as a defense to fraud when reasonable attention would have revealed the misconduct. This concept has been used to hold directors liable when they have delegated management functions to committees that have mismanaged the corporation.

Nonetheless, the law recognizes that directors, most of whom devote part-time efforts, usually can't research every issue themselves. For this reason, directors are generally allowed to rely on the advice of professionals – such as accountants and lawyers. However, there is no right of reliance oif a director has actual or constructive knowledge of information that makes reliance unwarranted.

As long as a director's decision is made in good faith and with due care, directors are generally protected from claims of personal responsibility. This is commonly known as the "Business Judgment Rule." According to the rule, a Board will not be held responsible for:

a business judgment;
made by disinterested directors;
within the scope of their authority;
in good faith;
with reasonable care; and
nor for their own self-interests.

For example, assume a director is using his or her position for direct personal benefit as opposed to the general good of the corporation. In that event, a director cannot be able to claim the protection of the business judgment rule. Or, if a director fails to make a decision based on all information reasonably available, or does so in a manner that is not reasonably in the best interests of the corporation, liability may well follow. As with most situations, those who use common sense and are honest won't have anything to worry about. Woe, however, to the dishonest or lazy director.

Because of the possibility of such liability, many corporations provide what is commonly known as D&O Liability Insurance. The well-advised director should insist that the company provide such insurance coverage, with separate coverage limits for themselves individually or as a group, to protect their private assets against claims of board negligence. Talk to your legal or insurance advisor to discuss the details.

The best way to avoid liability is to follow three general principles. First, maintain your independence and guard against conflicts between your personal interests and those of the company. Second, hire and rely on qualified experts when analysis beyond the board's level of experience is required for an informed decision. Third, keep copies of all board minutes and agendas, which identify attendees of meetings and topics discussed, together with all information provided by outside advisors.

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