The Duty Of Loyalty Law Company Business Partnership Essay

Published Date: 02 Nov 2017

Introduction

In modern industrialized world, corporations have taken a dominant place in the form of organizations. The internal regulations of the corporations/companies have to be managed to bring about harmonization without any hassle in the internal affairs of the company. For this to be achieved there should be corporate governance which controls the internal regulation of the companies. The shareholders are the owners of the company as they have invested their money in the corporation but it would be difficult for the shareholders to regulate the company’s affairs themselves as they are large in number. To make their job easier and for proper regulation of the company they jointly appoint the directors and executives who governs the company and to take major decisions for the welfare of the company. As the work is being divided between the shareholders and directors it can be termed as separation of ownership and control. Due to this separation of ownership and control, problems may arise with regard to day to day management of the business. Disclosure of important information with regard to the welfare of the company by the directors to the shareholders is one of the important components for the corporate governance to be conducted in a transparent way. Though external mechanism also plays a role in corporate governance, much focus is given to internal mechanisms with regard to the rights of the shareholders and the structure of the board. The duties/obligations of the directors play an important role in Corporate Governance. The primary responsibility of the directors is to act in a bonafide manner without abusing the powers granted to them. The directors have to protect the right of the shareholders. The directors should take decisions in the interest of the company. While taking any decision on behalf of the company they should ensure that the company’s/shareholders interest is protected and under no circumstances personal interest should weigh over shareholders interest. The directors owe certain responsibilities to the shareholders with regard to proper accounts and disclosure of major decisions.

This paper will explain about Professor Eisenberg’s thesis with regard to the fiduciary duty which prevails in the English Law and American Law. It will examine whether the English and American approaches suggest a social rather than a political or legal differences. It will further debate upon the difficulty in achieving harmonization and whether it is an important objective in the field of corporate Law. To start with, it would be appropriate to first explain about the fiduciary duty.

Fiduciary duty

In the corporate world, there is separation of ownership and control. The owners of the corporation are the shareholders however the directors who may have a small share or no share in the capital fund of the company are vested with substantial discretionary powers which provides them the required authority to take risk on behalf of the company. Exercising of such authority should be to the benefit of the company/shareholders. The obligation of the directors to act in the best interest of the shareholders is called as Fiduciary duty. To detail further about the fiduciary duty, it is important to see about the American and English Law approach.

American Approach

In the United States (US) the corporations are bound by the Law of the State in which they are incorporated. It can exercise the powers conferred upon it under the general corporation law of the state and the articles of incorporation. The statutes in the corporation Law are incomplete in the sense that it does not cover all the factual activities of the day to day management. To make the statutory Law complete, to redress the wrong which are not covered by the words of the statutes but within the purpose of the statute, there should be courts available and a standard to judge whether the complaint is actionable. The standard which was developed in the United States was "fiduciary duty". This duty is owed by the management and board of directors to the shareholders. As the United States follow the Law of the State in which the corporation is being incorporated, the fiduciary duties of the corporation would be different in different States. But, most of the publicly traded corporations are incorporated in Delaware as Delaware provides modern and flexible corporate laws. The Delaware court is often called as the "Mother court of Corporate Law". Delaware’s fiduciary duty forms as the backbone of the Corporate Law. The Delaware Corporate Law follows both statutory and common Law. It has been formulated as a modern corporate code which is easy and flexible for the corporate sector. It is known as the Delaware General Corporation Law (DGCL). It has been amended many a times to achieve and make the corporate transactions easier.

In United States the fiduciary duties are often referred as the "triad fiduciary duties". The three main fiduciary duties are duty of Loyalty, duty of care and good faith. These duties are basically derived from the common Law of Delaware. The duties of the directors keep changing according to expectations and changes which are evolving in the corporate sector. To evaluate the activities of the director, the court needs a standard or process of evaluation which is known as the "Business Judgment Rule". Duty of care and Business judgment rule are both judicial concepts which are related to govern the activities of the directors.

Duty of care

To manage the corporation the directors have to act in good faith, to take decisions with care which an ordinary man would take in the same position, to decide matters in the best interest of the company. The director to act with duty of care should have adequate knowledge about the corporation’s business, should act in good faith, to obtain plausible information, to adequately debate about the relevant issues and to understand the importance of each decision which the director takes and its impact on the company’s performance. The Delaware Law requires procedural due care and substantive due care for the courts to review the decisions taken by the directors. The plaintiff has to prove that the procedural due care was not observed by the director and the facts produced by the plaintiff should overcome the business judgment rule and prove that there was negligence on part of the director. If the plaintiff proves that the directors were negligent and overcome the presumption, then the burden moves on to the director to prove that he performed his duties with necessary degree of care. If the plaintiff is not able to prove then the decisions taken by the directors are protected under the presumption rule and the claim by the plaintiff is dismissed.

The directors are empowered with the right to delegate certain functions to the board committee, to the corporate officers and advisers. The directors rely upon them to carry out the given functions. Section 141 (e) of Delaware General Corporation states that

"(e) A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation." [1] 

The provision requires the board of directors to act with utmost due care in selecting the officers, employees and advisers. The directors are not given the right to delegate certain functions which are very important which is the heart of the corporation management. These functions are to be performed by the directors themselves as required by the statutes, by laws and articles of incorporation. The directors have the responsibility to investigate the wrong doing which is being committed by the officers. If the director has any suspicion he may act reasonably on the information gained. The extent to which the directors can inspect the fraud done by the officers are not yet expressly given or settled under any case law. To avoid such problems the directors can install systems to monitor and govern the fraudulent activities of the corporation. If the directors do not act reasonably even after the information received of fraudulent activities, they can be charged for the losses caused to the corporation. Section 102 (b) (7) of the Delaware General corporation Law limits the personal liability of the director for any breach of fiduciary duty as a director. The section states that

"A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit. No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective. All references in this paragraph to a director shall also be deemed to refer to such other person or persons, if any, who, pursuant to a provision of the certificate of incorporation in accordance with S 141(a) of this title, exercise or perform any of the powers or duties otherwise conferred or imposed upon the board of directors by this title." [2] 

This section protects only directors and not officers. It protects the directors from the liability of breach of duty and not any activity involving breach of duty of loyalty, acts which are not done in good faith, unlawful payments and purchases, transactions by which the director earned unlawful benefit.

The Duty of Loyalty

The duty of loyalty is imposed on persons who possess the fiduciary relationship with the corporation. The person who posses such authority has to work for the best interest of the company and not for personal benefit. If the person is engaging in activities by misusing corporate assets, conflict of interest and gaining profits in any transactions which is not fair for the corporation are termed as breaches of duty of loyalty. The director who has the power to control over the board and who takes major decisions, owe duty of loyalty to the corporations and shareholders. The duty of loyalty is carried out by the director in transactions where he or she is not independent and the acts are of self interest which is not for the interest of the company. The duty of loyalty is bound by two concepts which are independence and interestedness. Independence means, the director should take decisions for the merit of the company and his acts should not be influential and external consideration should not be taken into account for a decision to be made by the director. The director’s independent decisions should not affect the welfare of the company. Interestedness means, where the director shows any personal interest and gains financial benefits out of it which is not shared by the shareholders.

The duty of loyalty involves duty of candor, where the director has to disclose his or her interest in the given matter and restrict themselves from voting in the discussion when the matter is brought in the meeting. The directors are allowed to share information regarding corporation and at the same time the directors should keep certain information confidential until it is made public.

English Approach

Present legislation does not define or explain the term director. The Companies Act 1985 has a general provision which explains the term director as any person who holds the position of a director by whatever name called. Any person who acts as a director even though not appointed officially can be termed as director. The main aim to impose fiduciary duty on the director is to control their utilization of the advantages and to work with a duty for the best interest of the company. The fiduciary duty ensures that the directors work for the company’s objective. Board of directors fulfills the interest of the shareholders by performing their fiduciary duties. The duties are to maintain a level between the director and the shareholder who have invested their assets to gain profits from the corporation. The concepts of fiduciary duties are taken from the common Law. The role of the director is compared with the role of an agent where the director enters into a contract with other parties but he or she does not take the liability on themselves with the condition that they work within their power and does not misuse it. Further, there are similarities between the role of director and trustees. It is not really equivalent to the role of a trustee as the trustees own the trust property. But it is important to note that the directors play the fiduciary role.

According to the statutory provisions the Law makes it clear that the directors owe fiduciary duty to the company. They are not owed to any subsidiary company or a holding company, they are also not owed to persons to whom the company has any obligations. The duties are not owed to any individual as such but they are owed to a company as whole (shareholders). In certain circumstances creditors and employees interest are also taken into account according to the Companies Act 1985 and Insolvency Act 1986. According to section 309 of Companies Act 1985 the directors owe certain duties in their performance to the employee’s of the company and the interest of the members. The section also states that the duty is owed to the company as a whole and not directly to the employee. If a director has any interest in another company and if the said interest collides with the fiduciary duty of company in which he or she works has to disclose to the shareholder about the interest in a meeting. [3] 

Section 317 of the Companies Act 1985 was reenacted and explains that the directors of the company have to disclose their interest directly or indirectly at a full board meeting. The disclosure of the interest should be before the board for consideration and it’s approval. It should not be for mere formality. Section 317 of the Companies Act 1985 cannot be nullified by any other provision of the Company’s Act or by a special resolution. It is the duty of the director not to make any secret profit from the company. If any profit is made, it should be accounted to the company. These are the main fiduciary duties which form the major part of the Companies Act in United Kingdom.

The fiduciary duties of the American approach and the English approach are based on how they are read in statutes and how they are approached and adopted in day to day life. Both the approaches are dealt in a legal manner. The Legal norms are brought as provisions and explained in each approach. It is important to note and review about Eisenberg’s theory which explains about the social norms. The paper will further debate about Eisenberg’s theory with regard to the social norms about the fiduciary duties.

Eisenberg’s theory- a way to social norms rather than a legal or political approach

Corporate Law performs to regulate and simplify the conduct of the corporate enterprise. As far as regulation is concerned it provides incentives and disincentives to the directors, shareholders and officers. They are made to work as a menace to liability. The directors, shareholders and officers do not work to avoid the liability but to gain financial benefits from the company and to work for social norms. To make the actors work, efforts have been taken to work and improve on the financial benefit but less effort has been exercised on social norms. The ignorance of social norm reflects the law in general. In recent times, the ignorance has been noted and measures have been taken by some to remedy the problem. The measures taken have made some changes by connecting the Law with the social norms. Various attempts have been made to work on the social norms such as forming communities on various fields to communicate their social norms rather than Law in particular.

The important fiduciary duties in a corporate enterprise are duty of care and duty of loyalty. The duty of care is imposed on corporate actors who are free of self interest. In the thesis, it tries to explain that the care taken by the actors are mainly based on social norms rather than the financial benefit or liability. In recent times, there has been more care on the social norms which requires more efficient care when compared to last ten years. These have brought important changes in the belief systems which have added more weightage to the social norms.

Duty of care

In recent years, the observers believe that there has been great improvement in directorial care. The directors work with great responsibilities, set targets and work harder to achieve their goal. The company is ready to replace directors who are inefficient and appoint persons who are more efficient in working towards the goal set forth by the company. The thesis emphasize that, the greater directorial care was not achieved due to the threat of liability or financial gain. It tries to explain, Delaware Law provides an opportunity to the plaintiff to prove the facts of the case which should overcome the presumption of the business judgment rule. The Law allows inquiry for the duty not done by the director. The court proceeds with the notion that the directors perform their duties unless the facts are proved by the other party. Section 102 (b) (7) allows personal liability for the director for the breaches of duty of care. This rule applies only to the directors and the officers are not benefited directly. The statute does not apply even to officers who work in that capacity. The statute shields only liability but not the validity of the actions of the director. There are certain exceptions to the rule of personal liability which has been enumerated in section 102 (b) (7) of Delaware General Corporation Law. The exceptions are acts which are not performed in good faith, acts which involve intentional misconduct. These terms have to be interpreted in a judicial manner. In, In Re RJR Nabisco case the court held that, the actions of a director are not in good faith if he or she has acted for his personal benefit, taken revenge or hatred before the welfare of the company. [4] In spite of the protection of personal liability available to the directors, the directorial care has risen in the last ten years, where the threat of liability has not been considered as a reason for the rise in the directorial care.

Eisenberg’s theory also puts forth a point which explains that the rise of the directorial care is not due to the incentives or individual gains which is provided to the director. The directors are paid on uniform basis and extra care by the director to the corporation does not provide incentives of greater amount to the directors. The value of the directorial care increases the number of directorship but not the incentives to the director. The level of increased directorial care is not due to threat of liability nor prospect of gain, the threat of liability has been reduced substantially. The determination of the increase in directorial care is because of social norms concerning the directorial role. It is important to know the reason which has lead to the shift in the directorial care. Media plays an important role and is one of the reasons for the shift, the press makes note of the shortcomings of the directors and officers and they make it public and it makes the directors and officers feel disgraced, it affects their esteem and reputation in the corporate field. This action by the media makes the directors work more efficiently and thoughtfully. The other important factor is the critical observation by the institutional investors who investigate the actions of the director by producing source of bad notoriety.

There is something else operating in the social norm- that is the change in belief system in the business community. First, they receive information about the inefficiency of the director in the take over process. Second, contribution of Law in the director’s belief system. There are some statutes which provide personal liability for directors for the breach of duty of care. The court tries to interpret and clarify by dividing the duty of care into standard of conduct and standard of review. The standard of conduct explains how a director or an officer has to perform or conduct his functions in a proper manner. Standard of review is where the court tests or reviews the actors performance and decides on judgment whether to grant relief or impose liability. The standard of review is based on the business judgment rule. The director’s standard of conduct is not affected by the elimination of liability under the statutes but the liability of failure to cling to the standard. Legal rules are often based on social norms. Adoption of any legal rule with the social norm will be appreciated with great significance. The legal rule includes the standard of obligation which in general is the obedience to law. Obedience to law is one of the powerful social norms in the society. Sometimes, legal rules may clarify a social norm. This has been clearly related to duty of care, in a directorial context the directors were satisfied by performing minimal care to the corporation which safeguards the interest of the company. The legal rule which contains a social norm indicates the court to order the directors to perform their functions more effectively by some adjustments made in their conduct. The adoption social norms with regard to the directorial care made the directors to perform more effectively in the recent years.

Duty of Loyalty

The duty of loyalty is an expression for the duties performed by the directors, officers and the shareholders for the fair dealing of the money which has been invested in the corporation. An important article, written by Jonathan Macey and Geoffrey Miller explains about the relationship between the Law and social norm in this particular area. This article was based on a case Basic, Inc v. Levinson where the court held that, while a transaction takes places with regard to mergers or negotiations the directors, officers have to act in loyalty by not giving wrong information to the public. But, this point has been criticized by Jonathan Macey and Geoffrey Miller. They try to explain their point which allows a director or an officer to make false statement during transactions involving merger negotiation, if the false statement is made in good faith for the benefit of the corporation and shareholders. There are some problems which prevail in Macey and Miller rule. If this rule is being followed, there would be drawback in the business community where the investors would think before investing their money due to false statements and would discount the statements made by the corporation which would lead to an inefficient market.

If the corporation follows the rule it would not commit itself to honesty. The main duty of the corporation is to maintain honesty in the business. The investors would assume that all the statements made by the corporation are false and would not believe the corporation. If the directors do not act in honesty it would diminish the social norm of truth-telling. Loyalty could be achieved through legal sanctions. This process is expensive and it is difficult to detect the breaches of loyalty and has limited effectiveness. Installation of intracorporate monitoring system is another way to achieve loyalty which is effective and expensive. Legal sanctions can be made through the operations of social norms which are very inexpensive and effective. The duty of loyalty through social norm will make the directors fear reputational sanctions and the problems could be detected significantly. The expressive function through legal rules of loyalty makes the rules meaningful and operational through concretization.

Eisenberg’s theory speaks about the social norms in connection with duty of care and duty of loyalty. It is important to consider about harmonization of fiduciary duties in connection with the English and American approach. Eisenberg’s theory of social norms is connected more with the United States approach. Harmonization would be easier to achieve in the United States as it has the mother court of corporate law- Delaware. As the Eisenberg’s thesis also talks more about the social norms which can be correlated with the American approach it would be possible to achieve harmonization in that part. But, it is important to note whether harmonization could be achieved when it crosses the border and enters English Law. Harmonization is not easy to achieve in English Law as the fiduciary duties are more connected in Legal manner. It would be better to achieve harmonization when both the approaches are brought together but at the same time it should be considered that it is not an easy task. Many compromises have to be made for this to be achieved. Harmonization can be an objective in certain cases to bring a uniform approach.

Conclusion

Corporate governance is the key factor in corporate Law. For a company to run in an efficient manner it is important to govern the company properly. The fiduciary duties of the actors of a company play an important role in the corporation. In United States, duty of care and duty of loyalty are the prime factors for determining the fiduciary duties of the director. Eisenberg’s thesis stresses more on social norms which can be connected with the American approach. Inclusion of Social norms in the statutes would make the society and the corporate sector achieve their goal more effectively. It would be more efficient if harmonization is taken as a objective and uniforms the law between the fiduciary duties of English Law and American approach.