Founders Beware: Fiduciary Obligations of Officers

by Scott Edward Walker on May 30th, 2013

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Many founders do not realize that officers of a corporation have the same fiduciary obligations as directors.  This post briefly explores this issue and its ramifications.

 What Are the Fiduciary Obligations of Directors?

Directors have two basic fiduciary obligations to the corporation and its stockholders: the duty of care and the duty of loyalty.  The extent of these obligations varies from state to state; however, since most companies are incorporated in Delaware, we will focus on Delaware law.

Under Delaware law, the duty of care requires a director to exercise the care that a reasonably prudent person in a like position would exercise under similar circumstances.  The duty of loyalty requires a director to act in good faith and to refrain from putting his personal interests ahead of the interests of the corporation and/or its stockholders.

Directors have historically been protected under the so-called “business judgment rule” – which is a presumption that a director’s decision has been made on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation. This presumption is rebuttable; however, as a result of the business judgment rule, a court will not substitute its own views for those of a director or second-guess the outcome of a decision.

What About Officers?

Prior to 2009, the duties of officers were unclear.  In 2009, however, the Delaware Supreme Court held in the Gantler case that: “[O]fficers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and…the fiduciary duties of officers are the same as directors.”

In the Hampshire Group case in 2010, the Delaware Chancery Court expressly noted that officers are “expected to pursue the best interests of the company in good faith (i.e., to fulfill their duty of loyalty) and to use the amount of care that a reasonably prudent person would use in similar circumstances (i.e., to fulfill their duty of care).”

Officers are also protected by the business judgment rule; however, due to a significant gap in the Delaware statute, if officers breach their fiduciary obligations, the consequences of the breach will not necessarily be the same as for directors.  Why?  Because pursuant to Section 102(b)(7) of the Delaware General Corporation Law, a corporation may adopt a provision in its certificate of incorporation exculpating its directors from monetary liability for an adjudicated breach of their duty of care.  There is no similar statutory provision relating to officers.

Who Is an “Officer”?

There is no definition of “officer” in the Delaware General Corporation Law.  Section 142(a) thereof merely provides that: “Every corporation organized under this chapter shall have such officers with such titles and duties as shall be stated in the bylaws or in a resolution of the board of directors which is not inconsistent with the bylaws . . . .”  That section further provides that: “Officers shall be chosen in such manner and shall hold their offices for such terms as are prescribed by the bylaws or determined by the board of directors or other governing body.”

Moreover, Delaware case law suggests that while the title of the position is an important factor in determining whether a particular individual is an officer, the term “officer” would apply to those individuals to whom executive functions have been assigned pursuant to the bylaws or by Board resolution and who have discretion as to corporate matters.  Similarly, Rule 501(f) of the Securities Act of 1933, as amended, defines “executive officer” as “the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function, or any other person who performs similar policy making functions for the issuer.”

What Does This All Mean?

It means every founder must be very careful whom he or she chooses as a co-founder or an investor.  As I discuss in my post “What Are the Rights of Minority Stockholders?”, any stockholder may sue an officer or director for breach of their fiduciary duties.  We live in litigious society – and this is a significant potential problem.

This is also the dark side of crowdfunding.  The more stockholders a startup has and the less sophisticated they are (e.g., a dentist, a neighbor, a stranger), the more likely officers and directors will get sued.  Indeed, this is another reason why I recommend that startups issue convertible notes instead of preferred stock in a seed investment – i.e., because noteholders are lenders, not stockholders, and thus have no right to sue officers or directors for breach of their fiduciary duties (unless perhaps the company is insolvent or in the “zone of insolvency”).

So How Can Founders Protect Themselves?

Again, the best protection is adequate due diligence: know thy co-founders and investors!  Additional protections include certificate-of-incorporation provisions that eliminate directors’ personal liability to the corporation and its stockholders (as discussed above), indemnification provisions contained in the corporation’s certificate of incorporation and/or bylaws, contractual indemnification agreements, and directors’ and officers’ insurance policies.  Bottom line for founders: discuss the foregoing with experienced legal counsel.

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