Corporations and their directors are better equipped with knowledge of director’s liability
By Mogens Dyhr Vestergaard, Attorney at Law, Advokat (L), LL.M.*
These days the newspapers in Denmark as well as in the U.S. are regularly reporting from several spectacular ongoing legal proceedings pending against officers and directors of corporations who are sought held liable for losses inflicted upon their corporation, its shareholders or its creditors. This article puts focus on the Danish as well as the U.S. rules on director’s liability which all companies as well as their officers and directors should have in mind, not least in times like these with stormy economic weather.
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Pending Matters
The high profile matters on which the press puts focus on a regular basis these days span across a broad spectrum of issues, ranging from the fraud with criminal intent conducted by Stein Bagger against the shareholders and creditors of IT Factory, through the liability for lack of control with his affairs as corporate officer currently sought established against the directors of the same corporation. Also, liability is currently sought established against the directors of several crashed banks in that their decisions causing the losses leading to bankruptcy allegedly were made without procuring the information necessary for making informed business decisions. Most recently, in the wake of the Mexican Gulf oil spill disaster various shareholder derivative suits have been launched against BP corporate officers seeking damages from them for harming the company (exposing it to liability) by undermining safety in a reckless pursuit of profits.
The basis for liability
Danish law
The legal basis for making a claim in tort against the directors and officers of a corporation is to be found in section 361 of the Limited Company Act.
The provision codifies the generally applicable case law based Danish rule on tort liability – the so-called culpa rule (culpa = Latin for negligence).
Under the culpa rule a person will be subject to liability with respect to wrongful acts or omissions intentionally or negligently caused by him.
The culpa rule is as appears just a legal standard which in itself does not provide much guidance as to when a person becomes subject to liability in tort. Thus, it does not contain a definition of when an act or omission is wrongful.
Originally, guidance as to whether a behavior was wrongful under the culpa rule was sought in the so-called Bonus Pater standard derived from Roman law. Under the Bonus Pater standard a person would be liable for damage caused to the extent his behavior in the situation causing the damage deviates from that of a “Bonus Pater Familias” (a good and reasonable family father).
As society grew more and more complex and in recognition of the fact that the infallible good and reasonable family father is a legal fiction, the Bonus Pater standard in recent times has stepped into the background.
Rather, under the modern approach, the determination as to whether liability under the culpa rule has been triggered takes its starting point in the tortfeasor ’s possible violation of applicable rules of conduct within the relevant field.
Thus, when the courts today are to determine whether the directors or officers of a company have incurred liability in tort, they will initially inquire as to whether such persons acted (or omitted to act) in violation of the tasks and duties which they are subject to under the Limited Company Act. The determination as to whether their conduct was in violation of the tasks and duties which the Limited Company Act (as well as any other legislation governing corporations) expressly imposes on officers and directors is supplemented with common sense judgments as to whether an act or omission in a given situation under the circumstances was reasonable.
U.S. law
One should initially bear in mind that corporate law in the U.S. is regulated at the state level as opposed to at the federal level.
Thus, faced with 50 jurisdictions, each with separate corporate laws, one could rightfully ask as to whether it at all makes sense to give a general description of the U.S. rules on directors’ liability.
The answer is that it does, for two reasons.
First, the legal systems of all the 50 states have their historic common roots in the common law of England, maintained and nurtured over the centuries by the courts’ of each state looking to decisions rendered by the courts of the other states of the union when deciding in common law based matters.
Second, the lack of federal regulation of corporate law combined with the fact that a corporation domiciled in one U.S. state constitutionally is entitled to establish itself in other states of the union has had the effect that the corporate legislation of all American states today is framed and inspired by the very liberal corporate laws of the state of Delaware. The state of Delaware for many years was the front runner in the competition to offer businesses as liberal corporate laws as possible. In consequence, a very significant share of the biggest US corporations shifted their place of incorporation to (and still maintain being incorporated in) Delaware. In the public debate such phenomenon is determined the “Race to the bottom” or the “Delaware Effect”. Also this dynamic has worked to keep the corporate laws of the various states sufficiently similar, that a general description of U.S. law within this field at the overview level makes sense.
Similar to what is the case in Denmark, the basis for imposing liability on directors and officers for losses inflicted on the corporation, its shareholders and creditors has its roots in general tort law principles (the tort of negligence). Thus, the corporate statutes of the various states typically express that directors must discharge their responsibilities with the degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions. As is the case under Danish law, when the courts are to apply this standard in the determination of whether the directors or officers of a company have incurred liability in tort, they will look into whether such persons acted (or omitted to act) in violation of the tasks and duties imposed on them in their capacities as such.
This basic comparison of the basis for directors’ liability in Danish and U.S. law is a typical example that what strikes Danes when facing the U.S. legal system is not huge differences in the basic principles of substantive law which are often quite similar. Rather, what comes as a surprise is 1) the difficulty in foreseeing one’s exact legal position, 2) the complexity of the litigation process as well as 3) the compensation level when the courts are awarding damages, which is significantly higher than is the case in Denmark. Obviously, the roots of such traits are many. However, among the most significant should be mentioned 1) the legal culture arising out of the common law tradition with its focus on case law and with its use of jury trials also in civil matters, as well as 2) the U.S. system of federalism with its division of power (jurisdiction) between federal and state authorities, including federal courts vs. state courts and the federal congress vs. the state legislatures.
The duties of directors and officers
Danish law
The central provision in the Limited Company Act on the duties of a company’s Board of Directors is found in section 115.
It follows from such provision that the Board of Directors in addition to being responsible for the overall and strategic management as well as for ensuring an effective organization of the corporation must see to it that:
1. the bookkeeping and the financial reporting take place in a satisfactory way, taking into consideration the corporation’s affairs,
2. sufficient procedures for risk management and internal control have been established,
3. it receives the necessary reporting on the financial affairs of the corporation on an ongoing basis,
4. the officers of the company are conducting their tasks in an appropriate manner and in accordance with the guidelines established by the Board of Directors, and that
5. the sufficiency of the corporation’s funds at any time is at a justifiable level, including that there is sufficient liquidity to pay debts as they become due.
Section 117 of the Limited Company Act determines that it is the task of the officers of the corporation to conduct its daily management. Further, the provision establishes that the officers must follow the guidelines and instructions provided by the Board of Directors.
Section 118 of the Limited Company Act prescribes that the officers must ensure that the corporation’s bookkeeping lives up to applicable law requirements and that the administration of the corporation’s funds is conducted in an adequately prudent manner.
Furthermore, it is prescribed that the officers must ensure that the corporation’s funds at any time are adequate, including that its liquidity is sufficient to pay its debts as they become due.
In addition to this general description of the duties of officers and directors, the Limited Company Act contains various rules prescribing duties of directors and officers aimed at specific situations. As a few examples among many should be mentioned the Limited Company Act’s provision prescribing a duty on the part of directors and officers not to participate in actions aimed at conferring improper advantages on individual shareholders, as well as on actions which are in violation of the law or the corporation’s bylaws.
U.S. law
The corporate statutes of the various states typically do not contain a general detailed description of the duties of the directors and officers of a corporation such as is the case in the Danish Limited Company Act.
Rather the corporate laws of the various states at this point rely on rules defining the duties of directors and officers developed over the centuries in common law.
The common law based duties of officers and directors are developed from general principles applicable to persons trusted with authority to act for the benefit of others, inspired by the rules applying to trustees and agents.
In the same fashion as trustees are said to have a fiduciary duty to their trust beneficiaries and as agents are said to have a fiduciary duty to their principals, directors and officers have a fiduciary duty to the corporation and in some situations to its constituencies (most notably shareholders and creditors).
The fiduciary duty of directors and officers in turn encompasses two more specific duties.
First, directors and officers are said to have a duty to exercise care and to avoid harm to the corporation. Second, directors and officers are said to have a duty to loyally place the corporation’s interests ahead of ones own.
Based on such two general principles, the extent of the duties of directors and officers has been detailed over the years through a very extensive volume of case law, largely corresponding to the catalogue of duties codified in the Danish Limited Company Act, as described above.
Types of liability matters
As a rough outline based on U.S. as well as Danish case law, the following occurring main types of director’s and officer’s liability matters can be listed:
1. Matters on liability towards the corporation or its estate
Officers and directors are first and foremost liable for losses inflicted on the corporation for actions taken serving a disloyal aim. Matters on liability within this category span from actions taken with a direct fraudulent intent through situations where the management violated their duty with a much less grave degree of culpability – e.g. caused assets of the company to be sold to themselves or to single shareholders at a price shown to be below the fair market value.
Furthermore, the directors of a corporation will under the circumstances be subject to liability for losses inflicted on the corporation by their having failed their duty to supervise the officers of the company in order to ensure that their tasks are carried out in a proper manner.
Also, officers as well as directors will be subject to liability towards the corporation for losses inflicted upon it, caused by having failed their duty to monitor the corporation’s economic development or having failed to decide on and handle the corporation’s financial and legal risks.
Furthermore, the corporation has a duty towards the corporation to strive to operate its business in an economically efficient manner. However, directors and officers are allowed broad discretion when using their judgment in making business decisions. Thus, directors are not subject to liability just for having made a decision which proved commercially unwise. On the other hand, it can lead to liability on the part of the Board of Directors if it did not show care in procuring a reasonably informed basis for its decision. The doctrine that the Board of Directors is granted broad discretion when making judgment based business decisions is often characterized as the “business judgment rule”.
Finally, the directors and officers under the circumstances will be subject to liability towards the corporation for losses inflicted upon it through violation of specific duties to act flowing from the corporate statute of the jurisdiction question.
2. Liability towards single shareholders
The directors and officers of a corporation will under the circumstances be subject to separate liability for losses caused by negligent behavior aimed specifically towards single shareholders.
Most notably this might be the case in situations where shareholders have acted based on information from the management on the corporation’s accounts, annual reports and the like (e.g. contained in a prospectus issued by the corporation).
3. Liability towards single creditors
Directors and officers under the circumstances will be subject to liability towards single creditors in situations where those were motivated to extend credit to the corporation based on incorrect facts as to the corporation’s financial situation, e.g. by showing to them misleading financial reports.
Another category of matters where the directors and officers might be subject to liability for losses inflicted upon single creditors would be the situation where management neglected its duty to realize that the corporation’s financial situation was hopeless as well as to take the appropriate consequences hereof. Most often the appropriate consequences would be to cease the corporation’s activities and in this connection not least activities resulting in the incurring of new debts.
Shareholder’s liability
In conjunction with contemplations of launching a claim for director’s liability for losses inflicted upon the creditors of a corporation, it is often also considered whether there is a basis for directing a claim against the shareholders of the corporation. Accordingly, this topic should also briefly be touched upon.
As a general rule, a corporation is regarded as an entity distinct from its individual members and shareholders. In legal terms, the business of a corporation cannot be said to be that of its individual shareholders. The shareholders are therefore not ordinarily personally liable for acts and obligations of the corporation.
In light of the strong presumption in favor of honoring the separateness of a corporation an exception is only justified under extraordinary circumstances.
Under U.S. law, liability of shareholders for the corporation’s obligations is from time to time established when it is found that there are grounds for “piercing of the corporate veil”. Generally, the courts will not consider piercing of the corporate veil unless there is a showing of improper conduct consisting of some form of abuse of the legal fiction of the separate entity by the shareholder, combined with one ore more other factors. Such other factors most frequently would be undercapitalization, ignorance of corporate formalities, complete domination and control of the corporation by the shareholder and wrongful dealings in the corporation’s assets.
While it has been argued among scholars that also Danish law should facilitate liability of shareholders based on the theory of piercing of the corporate veil, case law has so far only shown very few decisions which can be interpreted to that effect. In turn, section 362 of the Limited Company Act provides a basis for making a claim in tort against shareholders for losses which they inflicted upon the corporation, other shareholders or creditors through intentional or grossly negligent acts.
Be aware of exposure to director’s liability
All corporations as well as directors and officers should bear in mind the rules on director’s and officer’s liability, not least in times like these with economic storm.
Thus, as a director or officer one should ascertain that the corporation has implemented procedures (e.g. formalized through the Board of Directors’ Rules of Procedure) which in an efficient manner aim at addressing the management’s duties to act as described above. If your corporation has not implemented such procedures you should ascertain that this happens. Also, you should ascertain that any existing formalized procedures in an adequate manner address the increased need for focus arising out of the economic crisis.
Similarly, to the extent your company has suffered losses due to an economic crash in one of its business partners it should be considered whether in the specific situation there is basis for directing a claim for liability towards the management of such business partner.
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In case of questions or should you wish an elaboration of the subject, please contact:
Mogens Dyhr Vestergaard, Advokat (L), LL.M.*
PHILIP Law Firm
Vognmagergade 7
1120 København K
TEL.: 33 13 11 12
E-mail: mdv (at) philip.dk
* Mogens Dyhr Vestergaard is admitted to practice law in Denmark as well as in California.
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