Duty of Loyalty vs. Duty of Care - Corporations Fiduciary Duty Law on the UBE / MEE

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The Duty of Loyalty vs. The Duty of Care - How to Best Distinguish the Two


The subtopic of fiduciary duties within the confines of corporate law is a heavily tested subject on the MEE.  If we receive a corporations essay in our MEE essay six-pack, it is likely that a duty of loyalty and/or a duty of care issue (or perhaps more than one issue!) may be present.  It is VERY common to muddy the waters with the definition(s) of these duties, muddy the waters with respect to the remedies available for a breach of each, and muddy the waters concerning how the fact finder determines whether a breach of one of these aforementioned duties occurred.

Duty of Loyalty - Overview

The duty of loyalty requires a fiduciary to act for the best interests of their corporation and in good faith. Thus, there are in a sense, two different means of violating one's duty of loyalty and they include (1) a failure to act in good faith and (2) acting even though a true conflict of interest exists.
In a duty of loyalty analysis involving a conflict of interest and not good faith, the directors usually have the burden of proof as to the fairness of their decision and, thus, the courts scrutinize the process and the substance of the decisions with a greater possibility of liability.
The classic duty of loyalty scenario is the interested director transaction; that is, defendant is a fiduciary who contracts or transacts unfairly with her own corporation, receiving a benefit that is not equally shared with the shareholders and thereby creating a conflict of interest. There are a variety of circumstances in which such self-dealing can occur.  For example, an officer or director may sell personal property to the corporation or buy corporate property.  A conflict of interest would also arise where a fiduciary's corporation contracts with another corporation or business entity in which the fiduciary has a significant financial interest. For example, Corporation A sells property to Corporation B and a director of A is the controlling shareholder of B.   Another example is when a parent corporation contracts with its subsidiaries (that it controls) and the subsidiary has other shareholders.
There may also be conflicts of interest issue when two corporations have common directors (also called "interlocking directors") but they have no significant interest in either. These transactions (which will be called "disinterested director transactions") can involve a variety of exchanges such as loans to or form the corporation or purchases and sales of property or services

Duty of Loyalty – Standard and Definition
Definition: A director must act in good faith and with the conscientiousness, fairness, morality, and honesty that the law requires of fiduciaries.
Courts focus on the fairness of the process of approval and the substance of the transaction. The process often would require full disclosure and approval by either disinterested directors or shareholders. The contract itself would need to be fair and the burden of proof would generally be placed on the fiduciary.
Duty of Loyalty – Remedies
If self dealing is found, the usual remedy is restitution in nature with rescission of the unfair contract or seeking the gains made by the fiduciary. Breach of the duty of loyalty claims also allows the courts to fashion broad, discretionary and equitable remedies. This general approach to interested director transactions (as well as other conflicts of interest) varies depending upon the circumstances and the availability of a relevant statutory provision.
            Interested director transactions will be set aside UNLESS the director shows either that: (1) the deal was fair and reasonable to the corp when approved OR (2) the directors interest(s) were disclosed or known AND the deal was approved by either (a) shareholder action OR (b) board of director approval by a sufficient vote NOT counting those interested director(s) OR (c) a unanimous vote of disinterested director if the disinterested directors are insufficient to take a board of director act or action.

Duty of Loyalty – Typical Scenarios on the UBE / MEE
We may see a duty of loyalty issue arising from the following scenarios: (1) Self-dealing that may involve controlling shareholders; (2) Conflicts of interest in tender offers; (3) Insider trading also raising an issue of conflict of interest; (4) director(s) failing to disclose transactions; (5) competing ventures.
Interested director transactions are very heavily tested.  If a director will benefit from a transaction, he must disclose this to the board or to the shareholders.  Disinterested directors or the shareholders must then approve the transaction.  If no disclosure, the transaction can be set aside unless it is fair to the corporation and alternatively, the corporation can recover damages equal to the interested director(s) profits.

Duty of Care – Overview -

The duty of care stands for the principle that directors and officers of a corporation in making all decisions in their capacities as corporate fiduciaries, must act in the same manner as a reasonably prudent person in their position would.

Duty of Care – Standard and Definition
A director must discharge her duty in good faith and with that degree of diligence, care, and skill that an ordinary prudent person would exercise under similar circumstances in like position(s), in a manner the director(s) reasonably believed to be in the best interest of the corporation.

Duty of Care – Consequences of a Breach of the Duty of Care

Nonfeasance, aka the director(s) does nothing.  This is a state standard of care.  Generally, an ordinarily prudent director would do (X) and (Y). Here, they did not do X and Y.  They will liable IF: the breach caused a loss to the corp. This is a very tough standard to win a nonfeasance case.  The difficulty in a “nonfeasance” situation is equating the failure to act with a specific liability. However, certain circumstances might be imagined where the director’s failure to act, such as failure to attend a meeting, might result in a direct injury to the firm.

Misfeasance, aka the board of directors engages in activity that HURTS the corporation.  Here, causation is clear!  In a nonfeasance scenario, the causation is murky but with misfeasance? The causation is clear as it is obvious the corporation was harmed.  Misfeasance is also a state standard of care.  Here, the director(s) decision caused the corporation to lose money.

Keep in mind, however, that the director will not be liable is she meets the Business Judgment Rule (hereinafter “BJR”).  In short the BJR protects prudent director(s) who do appropriate homework, deliberate and analyze a potential corporate action.  Thus the BJR might save that director(s) actions. It also means that a court will not second guess a business decision if it was made in good faith, was reasonably informed, and had a rational basis surrounding it.

Misfeasance enters the equation when the director has failed to fully inform herself of the nature or effects of the decision, and has therefore acted rashly and without proper regard to the consequences of her action. In such a situation, or in a case where the director has committed outright fraud, the court will likely dismiss the protection of the BJR and hold the director liable in misfeasance for her actions.

Difference between Duty of Loyalty and Duty of Care

In short, the duty of loyalty is different from the duty of care because it seeks to prevent directors from acting against the best interests of the corporation or self dealing in such as way as to reap a personal benefit unavailable to other shareholders. The duty of care involves poor decision making or lack of attention, but no personal benefit.

Your task is to know the difference between the two duties, understand the rules surrounding each, and be precise with your definition(s) of each on the exam, as well as being precise with your analysis (use of the facts) of and for each duty.

Should you have any additional questions about fiduciary duties in general, other areas of corporations law or another area of the UBE, please do not hesitate to contact us at PassYourBarExam@gmail.com
GOOD LUCK!


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