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This blog post discusses the Duty of Loyalty. A previous blog post discussed the duty of care and subsequent blog posts will discuss special circumstances regarding fiduciary duties.

While this blog post refers to the company as a “Corporation” and the fiduciaries as “Directors” or “Officers” of the Corporation, the same principles are in effect for limited liability companies or limited partnerships. The actors may be called Managers or Members, but share in many (if not most) of the same obligations to act in another party’s interests.

Duty of Loyalty

The Duty of Loyalty requires Officers and Directors of a Corporation to act in good faith for the benefit of the Corporation and its stockholders, and not for the Officer/Director’s own interest. It may seem obvious, but Officers and Directors may not engage in fraud, use their position with the Corporation for personal gain or advantage, or take opportunities from the Corporation.

Violations of the duty of loyalty include:

  • A conflict of interest (where the Director has an interest in the “other party” in a transaction);
  • Usurping a corporate opportunity (where the Director uses an opportunity for his or her other company, instead of recommending the opportunity to the Corporation);
  • Personal benefit to the Director (golden parachute, promise of employment);
  • Fraud upon the Corporation; and
  • Misappropriating corporate assets (where a corporate asset – say a jet – is used for non-corporate purposes).

Standard

In contrast to the duty of care, there is no business judgment rule shield for Officers or Directors. Instead, once the mere existence of a personal benefit or other allegation of displaced loyalty is established, the Directors and Officers must show that their actions were entirely fair to the Corporation: a very high standard to prove.

To balance this high standard, states have enacted statutory procedures for transactions involving a conflict. Virginia’s Stock Corporation Act provides that a conflict of interest transaction is not voidable by the Corporation solely because of the Director’s interest in the transaction if (i) the material facts of the transaction and the Director’s interest were disclosed or known to the board of Directors and the board of Directors authorized the transaction; or (ii) the material facts of the transaction were disclosed or known to the shareholders and the shareholders authorized the transaction, or (iii) the transaction was fair to the Corporation.

How to Avoid Breaching the Duty of Loyalty

In order to avoid breaching their duty of loyalty, Directors should always disclose any personal benefit they have in a transaction and have the transaction approved by either the non-conflicted Directors or the shareholders. If a Director has any reason to suspect they might have a conflict of interest, such Director should bring it to the attention of the board so that the board can consider appropriate actions. The conflicted Director can then abstain from voting upon the subject transaction.

Things can get a little more complicated when there is not a majority of non-conflicted Board members. That would occur when there is only one director or two directors (with one having a conflict) of the Corporation. In that case, it may make sense to appoint an independent director to the Board in order to obtain the necessary approvals, or to request shareholder consent. The statutory provisions allowing for shareholder approval to “cure” any conflicts do not exclude conflicted shareholders from the approval process. In that case, the shareholders are considered to be wearing their “shareholder” hats and they can approve transactions that are in their best interests – not just the Corporation’s best interests.

Officers and Directors of a corporation can avoid liability for a breach of the duty of loyalty by disclosing any possible conflict of interest to the Board and then obtaining consent of the non-conflicted Board.