Company Formation – Fiduciary Duties (the Basics)

With deep thanks to Bree Archambault, one of my startup lawyer associates in DBR’s Philadelphia office, for doing the heavy lifting on this post.

As touched on in the earlier post, Company Formation – Separation and Control, directors of a startup are obligated to perform their role as directors in accordance with certain duties to act in the best interests of the startup.   Such duties – “fiduciary duties” being the appropriate legal term – are discussed in greater detail below.   It is important for individuals serving as directors of a startup to understand and abide by such duties, as doing so will benefit, and is in the best interests of, the startup and failing to do so will expose a director who breaches such duties to potential claims and liability.

Duty of Due Care. The duty of care means that directors must act on behalf of the corporation as a reasonably prudent person would under similar circumstances. This comes up in two contexts – active decisions by the board of directors and oversight of the general management of the business. To fulfill the duty of due care, a director must be informed and devote sufficient time and attention to his or her duties as a director. At the most basic level, this includes reviewing relevant materials prior to board meetings; regular attendance at the meetings; and monitoring of management and delegates. Directors should also consider reasonable alternatives to a proposed action and should take the time necessary to make thoughtful and considered decisions with respect to matters presented to the board of directors for approval.     Additional considerations relating to the duty of due care include:

1. Oversight. Within the sphere of due care, the directors also have a duty of oversight regarding the legal and regulatory compliance of the company. This means directors must take affirmative steps to ensure that information and reporting systems exist within the company to provide accurate and sufficient information to management and the board. This is likely easier to accomplish within the smaller startup company, where the founders and initial employees are a close-knit group, who confer with each other for new ideas and perspectives on issues encountered in the company’s growth. In such an environment, the senior management will naturally have the information to relay to directors, without more formalized controls and processes. However, as a company grows larger, with the entrance of angel investors or VCs, it is important to plan for scalable process and controls that allow the board to perform its oversight duties.
2. Use of Experts. The requirement to be adequately informed does not prohibit directors from relying on others for information. Directors acting in good faith may reasonably rely on records, opinions, reports and other forms of information received from a board committee, from the corporation’s officers and employees, or from hired experts within the scope of their professional expertise (legal, accounting, etc.). Delaware (along with most other states) has codified this option. It is important that the board understand the processes and assumptions that underlies the presented information. If a director has reason to doubt the information presented, then he or she should fully vet those concerns. The obligation to dig deeper and acquire more information is proportionate to the importance of the decision at hand.
3. Process. Underlying the duty of due care is an emphasis on process – this originates from the willingness of courts to apply a deferential standard of review to board decisions (see discussion below of the business judgment rule) when the process is documented and the directors took the necessary steps to inform themselves (and met the other fiduciary obligations). Therefore minutes of meetings of the board of directors should memorialize the following good corporate practices: the distribution to directors, in advance of the meeting, of relevant documents and information; the adequate questioning of management, members of committees, and experts whose opinions were provided for consideration; a full and fair discussion of the issue at hand; and the allotment of sufficient time to consider and deliberate the issue, as appropriate.
4. Business Judgment Rule.   Notwithstanding the requirements of the duty of due care, it is important to note that corporate directors are not liable for actions or omissions within the sphere of their business judgment, including imprudence or honest errors of judgment. This is called the business judgment rule. The business judgment rule does not remove the duties of directors to act with due care and with loyalty, but avoids the application of hindsight to business decisions and gives the directors the presumption, under judicial review, that the action or omission was proper. If a decision is challenged, the business judgment rule is applied where the directors acted (1) on an informed basis, (2) in good faith, (3) without a conflict of interest, and (4) in the furtherance of some rational business purpose. The rationale for the business judgment rule is that judges should not second-guess decisions of corporate boards. If the judges ordinarily applied a higher level of scrutiny, it would undermine the entrepreneurial spirit of the marketplace and dampen innovation. Also, judges are not necessarily qualified to act as directors and are not accountable to the shareholders of the corporation (or elected) as the directors are.

Duty of Loyalty. The duty of loyalty requires that directors avoid conflict between their status as director (pursuing the best interest of the corporation) and their personal gain or self-interest.   Directors expose themselves to potential claims and liability if they engage in self-dealing or take advantage of their position on the board to get a plum inside deal with the company (whether an inflated compensation arrangement, preferential terms in a supply or service agreement with the director’s other company, or other favoritism). In the context of startup companies, where founders often serve as both directors and investors or employees, it is especially important to document the decisions and rationale of the board in exercising its duties in situations where there is a conflict of interest. The presence of outside independent directors can help substantiate the fairness and justification of board decisions in these cases.   This is not to say that a company should never engage in inside transactions. The connections and resources provided by the board of directors are often an asset to the startup company. Under the corporate law in Delaware (and most other states), an inside transaction is “cleansed” if the interest of the insider(s) is fully disclosed and the transaction is approved by a majority of the disinterested directors or if it is approved by the shareholders.   However, even after such approval, an inside transaction may be challenged and subjected to a “fairness” review. If the transaction is fair to the corporation, both in price and in dealing, it will be upheld. Fairness may be more difficult to demonstrate without prior approval of disinterested directors. Therefore, if there are not enough disinterested directors to approve a matter (as a consequence of a small startup board or another reason), then the board should take steps to ascertain the transaction is structured as an arms-length deal, at market terms.

Corollary Duties.  As part and parcel to the due care and loyalty duties, directors must act in good faith, maintain confidential information, use candor with other directors, disclose information to shareholders, exhibit independence in fulfilling the role of director, and not take as their own a business opportunity that rightfully belongs to the startup.