To Whom Are Directors' Duties Owed?

To Whom Are Directors' Duties Owed?

 It is generally understood that corporate directors act in a fiduciary role in performing their board duties. But to whom do directors owe their fiduciary duties? That was the question asked in a November 8, 2013 decision from the North Carolina Supreme Court, in which the Court reversed a trial verdict and post trial motion rulings and reaffirmed that directors’ duties generally are owed to the corporation itself rather than to the individual shareholders. A copy of the Court’s opinion in the case of Green v. Freeman can be found here [an enhanced version of this opinion is available to lexis.com subscribers]. A December 20, 2013 memo by the Smith Anderson law firm can be found here

The case arose out of a failed business venture. The claimants sought to recover a total of $400,000 they had invested in the venture. At trial, the evidence showed that the various entities involved in the venture had not followed corporate forms. For example, the names of the entities were used interchangeably, there had been no shareholder or board meetings, and a corporate checking account was used to pay the personal expenses of the sole shareholder and chairperson of one of the entities.

The claimants sued the shareholder and chairperson as well as the other principals involved in the venture on a variety of theories. The jury found that the chairperson, Corinne Freeman, had controlled the entities involved in the venture and that the plaintiffs had been damaged by Freeman’s failure to discharge her duties as a corporate director or officer. The other claims against her were dismissed. Freeman appealed to the intermediate appellate court, which affirmed the lower court, and she appealed to the Supreme Court. The plaintiffs cross-appealed the dismissal of their other claims against Freeman.

In its November 8 opinion, the North Carolina Supreme Court, in a unanimous opinion written by Justice Mark Martin, reversed the lower court, holding that the claimants did not have a direct claim that Freeman had breached her fiduciary duties to them,  and remanded the case for further consideration of the dismissal of the plaintiffs’ other claims.

In reaching its decision, the Court confirmed that under North Carolina law directors are “required to act in good faith, with due care and in a manner they reasonably believe to be in the interests of the corporation.” If these duties are breached, a shareholder may sue the director – but in a derivative action only, not in a direct action. In general, under North Carolina law, shareholders and creditors “may not bring individual actions to recover what they consider their share of the damages suffered by the corporation.”

The only exceptions to these general principles are when the wrongdoer owed the claimant a special duty or the claimant suffered a special injury. The Supreme Court found that the plaintiffs were unable to bring themselves within either of these exceptions because they had never become shareholders. Even as creditors, the claimants had not produced sufficient evidence to bring themselves within these exceptions. In particular, the Court held that the plaintiffs had failed to present evidence that they had suffered an injury peculiar or personal to themselves sufficient to bring them within the persona injury exception.

The Court concluded that because the plaintiffs could not bring themselves within either of the exceptions to the rule that directors’ fiduciary duties generally are owed only to the corporation, the plaintiffs as a matter of law could not assert individual claims that belonged to the company. 

The Court did find that there was evidence sufficient to support the piercing of the corporate veil to allow the claimants to try to assert claims against Freeman. However,  the doctrine of piercing the corporate veil “is not a theory of liability” but rather “provides an avenue to pursue legal claims against corporate directors and officers” for which they would otherwise be shielded from liability by the corporate form. Because the Supreme Court had determined that the claimants breach of fiduciary duty claims were not viable, the Supreme Court remanded the case to the lower court for consideration of the issue of whether the piercing of the corporate veil would allow the claimants to recover under any of the other theories the claimants had asserted as the basis of liability.

The North Carolina Supreme Court’s decision is important (at least in North Carolina) because it confirms that, other than in exceptional circumstances, directors cannot be held liable in direct shareholder action for breaches of fiduciary duty, but can only be held liable derivatively to the corporation itself, because the directors owes fiduciary duties to the corporation, not to shareholders or creditors.

The clarification of these principles is important not only because it explainsto whom directors may be held liable, but it also clarifies the circumstances under which directors may be held liable as well. As the Smith Anderson law firm said in its memo about the case,

This distinction is important because under North Carolina law derivative claims are subject to more stringent requirements than direct claims face. Specifically, plaintiffs seeking to bring derivative claims must prior to filing suit make a demand on the company’s board of directors asking the company to assert the claim directly. Following such demand, if an independent committee of the board determines in good faith after conducting a reasonable inquiry that the claim should not be pursued, then the plaintiff cannot bring a derivative action asserting the claim.

The law firm concluded its memo by noting that the Supreme Court’s decision is “significant” because the Court, “which rarely has occasion to address corporate law issues, has reaffirmed the basic principles governing the duties of directors.”

Readers of this blog may find it useful to read the opinion in its entirety as the opinion provides a good review of the general principles governing the duties and liabilities of corporate directors. The case also underscores the importance of maintaining the corporate forms.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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