Fiduciary Duties of Corporate Officers
The courts in Texas are littered with cases involving directors and corporate officers alleged to have failed to meet their obligations to the corporations they served. And while there are myriad causes of action that can be brought against corporate officers, a claim for breach of fiduciary duty has the potential to be one of the most consequential, both for the officer and the corporation.
It is imperative that corporate officers understand what their fiduciary obligations to their companies are, as well as what could happen in the event that they fail to fulfill those obligations.
It is well settled in Texas courts that officers and directors owe a corporation the fiduciary “duties of obedience, loyalty, and due care.”
Hui Ye v. Xiang Zhang, NO. 4:18-cv-4729 (S.D. Tex. May. 15, 2020)
What is a fiduciary duty?
A fiduciary duty is a duty that requires a person, called the fiduciary, to act in the best interests of another person, called the beneficiary.
A fiduciary duty gives rise to other, more specific, duties, like the duties of care and loyalty.
Fiduciary duties commonly arise in situations where one person in a relationship has an unusual degree of control or influence over another person. For example, the attorney-client relationship is one in which the attorney has a fiduciary duty to the client, while the doctor-patient relationship is one where the doctor has a fiduciary duty to the patient.
A fiduciary relationship exists when the parties are under a duty to act for or give advice for the benefit of another upon matters within the scope of the relationship.
American Medical Int’l v. Giurintano, 821 S.W.2d 331, 339 (Tex.App.—Houston [14th Dist.] 1991, no writ)
Fiduciary duties can emerge when two or more parties enter into a relationship that has been previously recognized by the courts as giving rise to a fiduciary relationship. The aforementioned examples of attorney-client and doctor-patient would qualify, as would agent-principal relationships (the type of relationship most relevant to this article) as well as trustee-beneficiary relationships or insurer-insured relationships.
They can also arise “informally,” when parties enter into a relationship that involves special amounts of trust and confidence. The fiduciary duties in these cases arise from “a moral, social, domestic or purely personal relationship of trust and confidence.” Associated Indem. Corp. v. CAT Contracting, Inc., 964 S.W.2d 276, 287 (Tex.1998).
A heightened degree of responsibility is what distinguishes fiduciary relationships from other, less exacting, relationships. In other words, fiduciaries must pay even stricter attention than they otherwise would to the interests of the beneficiary.
Fiduciary duties owed by officers to corporations
Just as the directors of a corporation owe a fiduciary duty to their company, corporate officers owe identical fiduciary duties to the companies they manage.
In Gantler v. Stephens, 965 A. 2d 695, the Delaware Supreme Court, an influential and authoritative source of corporate law in the United States, found that:
In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold.
It bears mentioning that the duty of an officer (or a director) to a corporation is not mirrored in law by a similar duty owed to an individual shareholder, whether that shareholder is in the majority or in the minority. In all respects, officer and director fiduciary duties are owed to the corporation and not to individual shareholders.
Of course, an informal fiduciary relationship may arise between an officer and a shareholder that gives rise to a particular fiduciary duty, but that duty would be specific to that relationship and determined on a case-by-case basis.
The duties owed by officers and directors to corporations can be classified into three broad categories: The duties of obedience, care, and loyalty.
Duty of obedience
The duty of obedience refers to a requirement that corporate officers act only within the scope of a corporation’s permitted activities. To determine what a corporation is or isn’t permitted to do, an officer would look to the company’s constitutional documents, including its Articles of Incorporation, as well as statute.
The duty of obedience requires a director to avoid committing ultra vires acts, i.e., acts beyond the scope of the powers of a corporation as defined by its charter or the laws of the state of incorporation.
Ubelaker, Director Liability Under the Business Judgment Rule, 35 Sw.L.J. 775, 775 n. 1.
Frequently, however, companies are formed with wide-ranging purposes that include virtually any type of profit-seeking activity. In these cases, the only limits on a corporation’s actions would be those imposed by Texas law.
Of course, any action by an officer that took a firm outside of what is permitted under Texas law could be considered a breach of their fiduciary duty of obedience.
Because of the broad scope of permissible activities in most Texas corporations, and because officers are not typically held liable for breaches of this duty unless there is a clear violation of a statute that leads to a result that is contrary to public policy, there is a dearth of case law on this subject.
Duty of care
The duty of care speaks to the level of diligence and skill a corporate officer brings to the exercise of their obligations. In Texas, a corporate officer is required to exercise the care that “an ordinarily careful and prudent person” would exercise. (See McCollum v. Dollar, 213 S.W. 259 (Tex. Comm’n App. 1919) for a description of the duties owed by a corporate director, which also apply to corporate officers.)
The duty of care doesn’t require that a corporate officer’s decisions be proven “correct,” or even wise, with the benefit of hindsight. Texas law applies the business judgment rule, which protects corporate officers from liability for informed decisions made in good faith.
There are limits to the application of the business judgment rule. Cases of self-dealing, a complete disregard of one’s responsibilities as a corporate officer, acting without the benefit of accessible information, fraud, illegality, and gross negligence would not be covered by the business judgment rule.
Put another way, the business judgment rule only protects against allegations of breaches of the duty of care (not the duties of loyalty or obedience) that relate to an officer’s honest exercise of their discretion and judgment. Sneed v. Webre, 465 S.W.3d 169 (Tex. 2015).
Duty of loyalty
The duty of loyalty requires corporate officers to act in good faith and in the best interests of the companies they manage. This means they may not act in ways that further their own self-interests in a way that is detrimental to the interests of their organization (commonly known as “self-dealing”).
The duty of loyalty would also prohibit an officer from engaging in an activity designed to benefit a third party in which they also had an interest. For example, if an officer of Company A was a shareholder in Company B, she could not act to further Company B’s interest to Company A’s detriment.
This is why it’s crucial for officers with conflicting interests, and fiduciary duties, to disclose those conflicts to the corporations they serve.
Claims for breach of the duty of loyalty tend to be more common than claims for breach of the duty of care. This may be because of the limiting role that the business judgment rule plays in actions involving the latter. It may also be that “disloyal” officers are considered more worthy of pursuit than “careless” officers.
Indemnification and authorization
Indemnification of director and officer liability is a complex issue deserving an article all to itself. Essentially, Chapter 8 of the Texas Business Organizations Code sets out instances in which a corporation must, must not, or may indemnify officers and directors.
Speaking generally – and there are plenty of exceptions – officers and directors can be indemnified for some breaches of their duties of care. Officers and directors can typically not be indemnified for breaches of their duties of loyalty. However, because breaches of the duties of both loyalty and care are so highly fact-specific, great care should be taken by officers when relying on an indemnification.
With respect to the duty of loyalty and self-dealing, Section 21.418 of the Texas Business Organizations Code sets out the procedure for authorizing officers and directors who wish to engage in transactions in which they have a personal interest. In addition to full disclosure of their personal interest to the corporation, they must typically obtain approval from the corporation for engaging in the transaction. The transaction itself must also be “fair” to the corporation.
Remedies for breaches of fiduciary duty
Remedies for an officer’s breaches of fiduciary duty can take multiple forms. A corporation can bring an action on its own, or one can be brought derivatively on behalf of the corporation. (A derivative action is one brought by a company’s shareholder to enforce a right or a claim that the corporation has failed to enforce.)
Shareholders bringing a derivative action should be alive to the requirements of these proceedings found in the Texas Business Organizations Code at Sections 21.551 to 21.560. For example, a shareholder bringing a derivative action must “fairly and adequately [represent] the interests of the corporation in enforcing the right of the corporation.” (Section 21.552(2))
Derivative actions against closely held corporations, which are defined in Section 21.563 of the Texas Business Organizations Code as corporations with fewer than 35 shareholders and that are unlisted in any national securities exchange, may be treated as a direct action with damages paid directly to the plaintiff or to the corporation, depending on the circumstances.
As we alluded to in the introduction to this article, corporate officers in Texas who fail to instruct themselves with respect to their fiduciary duties to the companies they serve do so at their own peril. A failure to live up to their extensive obligations can result in several different kinds of legal action against them personally, each of which has the potential to lead to significant damages.
This article is strictly commentary and is not a substitute for legal advice.