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Blog Archive :: March 2014

Mar 27, 2014

Corporate Compliance Starts with Good Governance at the Top

Corporate compliance for any organization starts at the top with the the organization’s governing board. This is the first blog of a series of blogs on compliance issues for governing boards. The complete series will include posts on the following topics:

  • Fiduciary duties under state corporation law which are the minimum standards to avoid legal liability;
  • Federal sentencing guidelines which are taken into account in determining legal liability; and
  • Best practices which are practices boards should use as benchmarks.

Fiduciary Duties of Board Members

We begin with fiduciary duties under state corporation law because we set the minimum standards to avoid personal liability to board members, and generally board members lose (i) their rights to indemnification by the organization and (ii) protection of a Directors and Officers (D&O) insurance.

Board members have fiduciary duties under either state statutory law or state common law.  Under Ohio law, these duties are statutory. The duties include:

  • Duty of care – to exercise the care that an ordinarily prudent person in a like position would use under similar circumstances.  Under most states’ laws, a board member must perform his duties as a board member, including his duties as a member of any committee of the board members upon which he may serve, with the care that an ordinarily prudent person in a like position would use under similar circumstances.
  • Duty of loyalty – to act in good faith, in a manner he or she reasonably believes to be in or not opposed to the best interests of the organization.

Duty of care

The duty of care requires that a board member inform himself of all material information reasonably available before making a business decision.  This duty also requires board members to inform themselves of alternatives to a proposed business decision.  The more important the decision, the greater the need to consider additional information and alternatives.  Once a board member has become adequately informed, the board member must act with the requisite care in performing his or her duties.  A claim of “good faith” alone is no defense if a board member fails to exercise the duty of care in order to arrive at an informed business decision.

The duty of care requires board members to become and stay reasonably informed.  This generally includes:

  • Attending meetings of the board and of the committees to which they belong;
  • Reviewing and understanding financial statements, financial reports (especially forms 10-K or 10-KSB and 10-Q or 10-QSB filed with the SEC and the annual report and any interim report sent to shareholders) and materials furnished by the organization for review by board members;
  • Asking questions (in order to be able to rely upon management and others on any matters, you must have a reasonable belief that they are reliable and competent for such matters.  The best way to form a belief on competence is to ask questions, and the best way to form a belief on reliability is to ask the same questions of different persons); and
  • Making reasonable attempts at detection and prevention of illegal conduct.

Courts have held that a board member's responsibilities include “a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may . . . render a board member liable.”  The level of detail that is appropriate for such an information system has been held as a question of business judgment.  Nevertheless, the leading case held that “only a sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.”

Duty of loyalty

In General

There are three components to the duty of loyalty:

  1. A board member should act to the extent possible in a disinterested manner.  That means not being influenced by any financial or personal interest in the matter under consideration by the organization.  A board member should be alert and sensitive to any interest he or she may have that might be considered to conflict with the best interests of the organization. When a board member, directly or indirectly, has a financial or personal interest in a contract or transaction to which the organization is to be a party or is contemplating entering into a transaction that involves use of corporate assets of or competition against the organization, the board member is considered to be "interested" in the matter.  This then requires disclosure by the board member of that financial or personal interest.
  2. The second component, which naturally follows from the first, is full disclosure, especially of possible financial or personal interests in any matter under consideration.  In common law before statutory corporate law, courts often treated as void or voidable any contract or transaction approved by a board if a board member had a financial or other personal interest in the contract or transaction.  Many states’ statutory laws provide that any contract, action or transaction considered by the board or one of its committees is not void or voidable because of a financial or personal interest of a board member if the material facts regarding that interest are disclosed or otherwise known to the board or the committee before the consideration.  Any board member having a possible financial or personal interest in any contract or transaction to which the organization is to be a party should first make full disclosure to, subject to any confidentiality obligations owed to others outside the organization, and seek approval of the contract or transaction by, those of the other board members who do not have any such interest.  This generally requires the interested board member to abstain from voting on the matter and, in most situations, after disclosing the interest, describing the relevant facts, responding to any questions and not further participating in the meeting while the disinterested board members complete their discussion and vote.
  3. The third component is substantive “fairness.”  Under many states’ statutory laws, no contract, transaction or other action of a board is void or voidable, even if there is a financial or personal interest which is not fully disclosed, if the action is “fair to the organization” as of the time it is authorized or approved.  However, because what is “fair to the organization” is a question of fact upon which reasonable minds may differ, board members should rely on full disclosure.  Substantive fairness generally requires disinterested board members to determine:
    • Whether the proposed transaction is on terms at least as favorable to the organization as might be available from other persons or entities;
    • Whether it is reasonably likely to further the organization's business activities; and
    • Whether the process by which the decision is approved or ratified is fair.

If minority shareholders could be adversely affected, the board members should be especially concerned that the minority interests respecting the transaction receive fair treatment.  This concern is heightened when a board member or dominant shareholder or shareholder group has a divergent or conflicting interest.

Officers also have common law duties that are similar to board members’ duties of care and loyalty. Officers too must act as an ordinarily prudent person in a like position would act under similar circumstances.  They too must act in good faith and in a manner they reasonably believed to be in or not opposed to the best interests of the organization.

Whose Interest?

In determining the best interests of the organization, a board member is required to take into account the interest of stockholders, if the organization is a stock organization; members, if the organization is a member organization; partners, if the organization is a partnership; and similar constituents of other forms of organization.  In certain cases, the best interests of the organization may include its creditors.


An important part of both the duty of care and the duty of loyalty is to keep confidential all matters involving the organization that have not been disclosed to the general public.  Board members and officers should presume and treat as confidential all matters involving the organization until there has been a general public disclosure or unless the information is a matter of public record or common knowledge.  This presumption should apply to all current information about legitimate board or corporate activities.

Problems may arise when board members and officers of one organization are board members or officers of another organization that may benefit from knowing confidential information of the organization.  For this reason, board members and officers of the organization should disclose to the organization positions held with other organizations.  In such situations, board members and officers of the organization should presume that their duty of confidentiality to the organization prevails over any duty of care or loyalty that might compel unauthorized disclosure to the other organization.  If a board member or officer believes this presumption may conflict with his or her duty to the other organization, the board member or officer should consider resigning from his or her conflicting positions either with the organization or with the other organization.

A board member of a publicly held organization is sometimes asked by investors, analysts or investment advisors to comment on sensitive issues, particularly financial information; however, an individual board member is not usually authorized to be a spokesperson for the organization and, particularly when confidential or market-sensitive information is involved, should avoid responding to such inquiries.  Even information that is not market-sensitive may be confidential – for example, information about new products or proprietary processes or strategic plans.  A board member who improperly discloses such information to persons outside the organization can cause the organization to violate federal securities regulations and can cause damage to investor relations, trigger personal liability as a "tipper" of inside information and harm the organization's competitive position.  Board members should refer requests for corporate information to the CEO or other person designated by the organization to deal with such inquiries.

Corporate Opportunity

Another part of both the duty of care and the duty of loyalty is to protect corporate property and opportunity.  A board member must exercise care that he does not usurp a business opportunity that is related to the business of the organization and is otherwise available to the organization.  The duty of loyalty may require the board member to first offer that opportunity to the organization before taking the opportunity for his or another’s account, including the account of any other company of which he is a board member, officer or employee.

Whether such an opportunity must first be offered to the organization will often depend upon one or more of the following:

  • The correlation of the opportunity to the organization's existing or contemplated business;
  • The circumstances in which the board member became aware of the opportunity;
  • The possible significance of the opportunity to the organization and the degree of interest of the organization in the opportunity; or
  • The reasonableness of the basis for the organization to expect that the board member should make the opportunity available to the organization.

If a board member believes that a contemplated transaction might be found to be a corporate opportunity, the board member should bring it to the attention of the board.  If the board, acting through its disinterested board members, disclaims interest in the opportunity on the part of the organization, then the board member is free to pursue it. A board member should bear in mind that the obligation to put the organization's interests first also applies to opportunities for subsidiaries or affiliates of the organization.

Speak with One Voice

Another important part of both the duty of care and the duty of loyalty is that organizations and their governing boards should speak with one voice or not at all.  Board members should presume that this applies to all matters coming before the board for its consideration.  An individual board member has no authority under applicable law.  Instead, authority is vested in board members collectively as they determine by a majority vote at a meeting at which a quorum is present.  This does not require unanimity in decisions, but instead requires a recognition that a board speaks only as a board as determined by a majority of its members at meeting in which a quorum is present.  Occasionally on matters where it is important to have a single message, a board will speak only through its chairperson or the chairperson’s designee.

A board member who dissents has the right to have his or her dissent reflected, with attribution, in the minutes of the meeting and may continue soliciting support for his or her position until the minutes are approved.  Thereafter, the board member may, subject to any rules of the board, request the board’s reconsideration of the matter.  However, the confidentiality obligation that is part of each board member’s duty of care requires that the matter remain within the board room, and the board member’s ultimate right in any disagreement is to resign.

Other Duties

Board members have duties from other sources.  These other sources include:

  • Contractual Sources:  Often, the organization’s governing documents, especially the committee charters, as well as any board member agreements will generally create duties or obligations on the part of board members.  The audit, compensation and nominating/governance committee charters are intended to create duties for the members of those committees on which other board members may rely.
  • Federal securities laws:  These include duties regarding registration statements filed with The U.S. Securities and Exchange Commission; duties as control persons; duties to report illegal acts not timely remedied; duties not to mislead an auditor; duties to disclose stock ownership; duties to avoid short-swing transaction in stock; duties to receive the audit report; duties to appoint independent board members to an audit committee; et seq.

The next post will continue on the topic of fiduciary duties with focus on some of the special areas of concern for board members under their fiduciary duties.


Posted by J. Beavers in  Fiduciary Duties   |  Permalink




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