Delaware Business Law: An Explanation of Fiduciary Duties
It is essential for U.S. businesses to understand Delaware business law. Millions of businesses have incorporated in the state of Delaware. In fact, businesses outnumber the state’s population. Over 50% of all publicly traded companies have registered in Delaware. Of Fortune 500 companies, over two-thirds are incorporated in Delaware.
The Delaware Court of Chancery oversees issues related to Delaware’s corporate laws. Because it handles so many business law cases, the court has gained significant expertise in interpreting and setting standards for laws governing businesses. This familiarity with corporate law has prompted many new startups to incorporate in Delaware.
The board of directors of a publicly-traded Delaware corporation must abide by fiduciary duty rules. In simple terms, the law requires directors to act in the best interests of the corporation. This includes avoiding conflicts of interests and overseeing the corporation’s affairs with an appropriate attention level. You can learn more about the duties of a board of directors here.
Basic fiduciary duties include the duty of care, the duty of loyalty, and the duty of good faith. Delaware law provides directors with many protections to avoid fiduciary duty breaches, but directors must nonetheless conduct themselves carefully.
Duty of Care
The duty of care is a judicial standard that requires directors to act with the same level of care that an ordinarily careful and prudent person would use in a similar scenario. There are two key components of the duty of care: diligence and discussion. Directors must make informed, deliberative decisions. In order to do this, they must devote a reasonable amount of time to understanding and considering relevant issues. Deliberative discussions with other directors help ensure a director understands potential red flag issues.
Reliance on outside experts is allowed under the duty of care, provided that this reliance is in good faith. Directors must select outside experts with reasonable care and under a reasonable assumption they have expertise over such subject matter. Under the duty of care, directors must identify actual or potential conflicts of interest with the company’s best interests.
Duty of Loyalty
The duty of loyalty under Delaware law requires directors to act in good faith with the sincere belief that their actions are in the best interests of the company and its stockholders. In other words, directors should not act in a manner that causes injury to the corporation. This includes abstaining from self-dealing or using their board positions for personal gain.
Issues with adherence can arise when directors are not fully independent or fully disinterested. A director is “independent” when the director is not beholden to someone else that has a personal or financial interest in the corporate action. A director is “interested” when the director is on both sides of the transaction and stands to gain personally or financially at the expense of the company’s stockholders.
Duty of Good Faith Under Delaware Law
Delaware law holds directors to a duty of good faith. This entails not intentionally acting to harm the company or violate the law. The decision in the Caremark case clarifies that directors cannot act with conscious recklessness. Directors must act in good faith to ensure that there is appropriate oversight over corporate actions. This includes oversight over business strategy, information reporting systems, and risk management functions. Directors must routinely monitor the company’s compliance structures and play an active role in oversight.
Business Judgment Rule
The business judgment rule is a set of presumptions that afford directors who make decisions for the company. This hallmark of Delaware law is highly deferential and gives directors wide decision-making latitude.
Under the business judgment rule, the court will not substitute its judgment regarding a board decision for the judgment of the board under certain conditions. These conditions include: 1) that there was a rational basis for the decision, 2) that the director acted with due care and on an informed basis (duty of care), 3) that the director acted without personal or financial benefit and with the genuine belief that that decision was in the best interests of the corporation (duty of loyalty) and 4) that the director acted in good faith (duty of good faith).
Business Judgment Rule versus the Delaware Entire Fairness Standard
When the business judgment rule applies, courts tend to defer to the good faith judgment of the board. However, in cases where the business judgment rule does not apply, a stricter standard of review: entire fairness, kicks in.
Under the entire fairness standard of Delaware law, the board of directors must prove it conducted a thorough process to determine the corporation transaction involved both “fair price” and “fair dealing.” Courts weigh these two factors together to reach a “unitary” conclusion on entire fairness.
Other Heightened Standards of Judicial Review
In certain special situations, stricter standards of judicial review may be triggered. These heightened standards of review are named after the court cases that led to these standards.
The Revlon rule requires judicial review to involve “enhanced scrutiny” in situations where the board decides to sell the company. The Unocal rule establishes a reasonableness test when a board implements defensive measures in response to a perceived threat. Finally, the Blasius standard requires a compelling justification if the board acts with the main intention to interfere with shareholders’ election of directors.