Corporate Fiduciary Duties in Texas
“Corporation officers and directors are fiduciaries.” “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions.”
Traditional Formulation of Fiduciary Duties
Under the traditional formulation, corporate fiduciary duties constitute three separate duties. “Corporate officers and directors owe three distinct duties to the corporations they serve: obedience, loyalty, and due care.”
“The duty of obedience requires a director to avoid acting beyond the scope of their enumerated powers (also referred to as ultra vires acts).” The duty of obedience also requires the directors to comply with the law, the governing documents of the corporation, and any limits on their authority.
The duty of loyalty requires that that a director act in good faith and not allow his or her personal interests to prevail over the interests of the corporation. The duty of loyalty is concerned with self-dealing—whether or not a director is “interested” in the transaction. “A director is considered ‘interested’ if he or she (1) makes a personal profit from a transaction by dealing with the corporation or usurps a corporate opportunity; (2) buys or sells assets of the corporation; (3) transacts business in his director’s capacity with a second corporation of which he is also a director or significantly financially associated; or (4) transacts business in his director's capacity with a family member. “Transactions involving an interested director are subject to strict judicial scrutiny but are not voidable unless they are shown to be unfair to the corporation.” “[T]he burden of proof is on the interested director to show that the action under fire is fair to the corporation. A challenged transaction found to be unfair to the corporate enterprise may nonetheless be upheld if ratified by a majority of disinterested directors or the majority of the stockholders. An interested director who is also a shareholder is entitled to vote his shares to ratify his challenged act.”
And finally, the duty of care “requires a director to be diligent and prudent in managing the corporation’s affairs.” The duty of care is basically a negligence standard. It concerns “mismanagement” and is based on the negligence standard of conduct that the director must use ordinary care in the management of the corporation’s business.
Ritchie Formulation of the Duty of Loyalty
The Texas Supreme Court in Ritchie v. Rupe formulated the duty of loyalty in a particular way: “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions, and this duty ‘includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.’” The Court makes clear from its citation of Gearhart Industries v. Smith that this statement of the duty is not exclusive. Fiduciary duties “include” the duty to dedicate uncorrupted business judgment for the sole benefit of the corporation, but the duties continue to include duties of obedience and care. This formulation of the duty of loyalty is taken from International Bankers v. Holloway. However, the Ritchie Court reiterates this same formulation of the duty of loyalty five times on a variety of topics. The following year the Texas Supreme Court again used the same formulation in Sneed v Webre: “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions, and this duty ‘includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.’” Going forward the standard for the duty of loyalty is clearly whether the fiduciary utilized his uncorrupted business judgement for the sole benefit of the corporation.
The Ritchie formulation of the duty of loyalty is not really novel but the emphasis seems to be different from the traditional formulation. “Uncorrupted” business judgment seems clearly to point to the need for a disinterested status, but the further requirement of “sole benefit of the corporation” takes this concept much further. A director could be disinterested personally and yet still not be acting for the sole benefit of the corporation. The example emphasized in Ritchie is that a director may not act for the benefit of the majority shareholder over that of the corporation. A director may not act for non-business reasons. Also the Ritchie formulation makes no reference to harm to the corporation or the concept of fairness. It is easy to imagine a transaction—for example executive compensation—which is not harmful to the corporation but is not done for the sole benefit of the corporation. What about a self-dealing transaction that is otherwise fair to the corporation, such as leasing property from the majority shareholder at market rates? Such a transaction is almost certainly not for the sole benefit of the corporation. It is difficult to conceive that the Texas Supreme Court would hold that a fair transaction would violate the duty of loyalty, but the emphasis on avoiding divided loyalties under the Ritchie formulation certainly makes such a result possible.
This post is taken from HCWD, PLLC recently published White Paper, The Duty of Loyalty and the Business Judgment Rule in Texas. Download the full article with complete legal analysis of the issues and case citations.