Toward a Horizontal Fiduciary Duty in Corporate Law

Asaf Eckstein is Lecturer on corporate law and securities law at Ono Academic College; and Gideon Parchomovsky is Robert G. Fuller, Jr. Professor of Law at University of Pennsylvania Law School and Professor at Bar Ilan University Faculty of Law. This post is based on their recent article, forthcoming in the Cornell Law Review.

The duty of care and the duty of loyalty are the twin pillars on which corporate law is constituted. Together, they form the fiduciary duty that guides and binds every corporate officer and director. The duty of care requires directors and officers to exercise the level of care that a prudent person would use under similar circumstances. The duty of loyalty requires directors and officers to refrain from benefiting themselves at the expense of the corporation that they serve. Critically, though, both duties are one-dimensional. They only apply vertically in the relationship between the duty-bearers and the corporation. They do not avail horizontally in the relationship among corporate officers and directors inter se.

This article calls for the recognition of a horizontal duty of care and a duty of loyalty among directors and corporate officers inter se. The new duty we envision is supposed to complement, not replace, the duties directors and officers owe to the corporation.

To understand the motivation behind our proposal, one need to understand that although boards are often portrayed as monolithic entities comprised of equal peers, this ideal portrayal is a far cry from the real world, where boards are comprised of members with different skill sets, experiences, leverages, and personalities. Board decisions are the product of the interaction among directors. And, although individual directors can disagree with each other, it is a well-known fact that there is strong pressure on boards to acquiesce and play along. This is especially true when the decision at hand falls within the domain of expertise of a particular board member and the board operates under conditions of exigency.

Furthermore, in discharging their duties toward the firm, directors must invariably depend on other corporate officers. Directors usually do not have access to independent information sources and they normally do not engage in specific fact finding about the day to day operations of the firm. Typically, the board rests its decisions on information it receives from the other organs of the firm. The successful operation of boards, therefore, necessitates an environment of trust within the firm. The same is true, albeit to a lesser degree, of other corporate officers. Corporate officers possess expertise in certain areas, such as business, engineering, accounting or law, but they, too, must rely on their peers in matters that fall outside of these areas or in making decisions that depend on factual predicates that they cannot independently verify.

This, of course, raises the question whether liability for breaches of fiduciary duty is assigned individually or collectively? Surprisingly, extant law on the nature of civil liability of directors and corporate officers is unclear. A careful perusal of the caselaw reveals a nuanced picture under which the choice between collective and individual liability is largely case specific, depending on the legal context and the claims involved. As a result of the uncertainty that surrounds directors’ liability, all directors are potentially exposed to the liability for breaches of fiduciary duty even if they were not actively involved in the problematic conduct or omission. Indeed, liability may even be assigned to absentee directors, and dissenting directors whose dissent has not been recorded in the minutes. Worse yet, even board members who choose to resign in response to a decision they opposed are not immune from liability.

The tendency to view board members collectively is much more pronounced in administrative and criminal actions. When launching an investigation against a corporation for suspected illicit activities, the Department of Justice (DOJ), the Securities and Exchange Commission (SEC) and other law enforcement agencies approach the board as a single entity and do not distinguish among individual board members in terms of their responsibility. Many investigations end up in plea agreements and pretrial diversion agreements, specifically deferred prosecution and non-prosecution agreements that assign blame to the board as a whole without apportioning it among its members. Individual board members who wish to dissociate themselves from the failures of their colleagues and clear their names have no means of legal redress. Under current law, there is no cause of action they can assert.

To address the plight of individual directors and corporate officers, and to improve corporate governance more generally, we call for the recognition of a fiduciary duty among directors and corporate officers vis-à-vis one another. Directors, by virtue of their shared responsibility, must rely on each other and trust one another to carry out their duties successfully. Failure by one director to dutifully perform her tasks is liable to affect other directors. The successful operation of boards is predicated, in other words, on a system of trust. It stands to reason, therefore, that directors should owe each other a fiduciary duty. The implementation of our proposal would have enabled the passive directors in Van Gorkom and In re Disney to seek legal recourse against the directors who breached their trust and led them astray. Similarly, it would allow directors, whose companies were implicated in criminal and regulatory violations, to prove that they were not involved in the wrongdoing and seek recompense from board members who suppressed information from them or misled them for the reputational and other harms they have suffered.

The introduction of a horizontal fiduciary duty among corporate officers and directors would have four salutary effects. First, the fiduciary duty we propose would firm up the incentives of corporate officers and directors to be diligent in the performance of their duties. This, in turn, would lead to improved information-sharing and decisionmaking on boards. Second, the independent cause of action we seek to create would enable individual board members to vindicate themselves and restore their reputation if they were led astray or misled by their peers. Third, it would attract more capable individuals to serve on boards, at a lower cost to the corporation itself. Giving individual directors an independent cause of action that protects their reputation should increase the willingness of skilled individuals to act as directors and reduce the compensation they require. Fourth, and most importantly, empowering individual directors to sue for breach of fiduciary duty is liable to improve corporate management across the board. Corporate officers and directors have superior information about the corporation and can bring to light evidence that other plaintiffs may not be able to produce. The threat of being sued by a fellow officer or director would consequently improve the diligence and heighten the loyalty exercised by all board members and corporate officers. Importantly, our proposal would give corporate officers and directors who were harmed by the misdeeds and omissions of their colleagues an independent cause of action exercisable irrespective of harm to the corporation itself.

One may argue that the availability of directors and officers insurance as well as exculpatory clauses renders our proposal superfluous. This argument is flawed for several reasons. First, directors’ and officers’ insurance is not available in all corporations. Second, cases of recklessness, gross negligence and intent are generally excluded from coverage. Relatedly, a judicial determination of directors’ way of acting is not an exact science and even directors that were not reckless or grossly negligent are exposed to the risk of judicial mistakes. Third, liability findings affect directors’ future insurance premiums. Fourth, insurance does not offer adequate coverage for reputational harms and lost future opportunities to serve on boards resulting therefrom. Fifth, and finally, insurance is costly. It exists to address cases of failure. Policymakers should therefore strive to improve the mechanisms of corporate governance, and not increase reliance on insurance.

The complete article is available for download here.

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