Thursday, September 29, 2011
A Corporate Director’s Duty of Loyalty Is Owed to the Corporation
A Corporate Director’s Duty of Loyalty Is Owed to the Corporation
In 1400 Willow Council of Co-Owners, Inc v. Ballard, 2010 WL 2010521, 2010 Ky. App. LEXIS 94, No. 2008-CA-001155-MR (Ky. App. 2010), the Court of Appeals considered a case primarily involving the degree to which a condominium association would be responsible for certain costs of maintenance to a unit’s windows. For our purposes, the interesting point of the case is an allegation that the directors owed an individual duty of loyalty to the plaintiff as distinct from the duty of loyalty to the entity. Specifically, the Court reversed a determination that fiduciary duties had been violated, finding the following jury instruction to have not properly set forth the law:
Is the duty of the Council, acting through its Board of Directors to exercise good faith and loyalty in conducting the business of the Council which includes an obligation to exercise good faith and loyalty in making decisions with respect to all co-owners, including co-owner Patricia Ballard. If you find, from the evidence, that the Council, acting through its Board of Directors, failed to comply with this duty and that such duty was a substantial factor in causing loss to Patricia Ballard, you shall find for Patricia Ballard. Otherwise, you shall find for the Council.
Turning to the language of the statute (more on that below), the Court noted that:
KRS 273.215 specifies the standards to be followed by directors of a nonprofit corporation. Of particular relevance to this case is KRS 273.215(1) which states:
A director of a nonprofit corporation subject to the provisions of KRS 273.161 to 273.387 shall discharge his duties as a director, including his duties as a member of a committee:
(a) in good faith;
(b) on an informed basis; and
(c) in a manner he honestly believes to be in the best interests of the corporation.
It was the Court of Appeals that italicized “corporation” in its recitation of the statute. Interpreting this provision, the Court wrote:
We read KRS 273.215(1) to mean directors in Kentucky owe their allegiance to the corporation (or in this case, the Council) as a whole, and not to individual members/shareholders (or in this case, co-owners like Ballard). This is a reasonable interpretation since co-owners could have competing agendas, none of which may be in the best interests of the Council.
A pair of thoughts follow from this direction. First, if the duty of loyalty is owed exclusively to the corporation, and there exists no duty of loyalty to the members, as individuals, of the nonprofit corporation, it would follow that a suit complaining of a breach of loyalty must be derivative, and not direct, in nature. Second, in that KRS § 273.215(1) is identical in terminology to KRS § 271B.8-300(1) (and it bears noting that the two statutes were adopted in the same 1988 General Assembly), presumably this holding is equally applicable in the context of a business corporation.
As to the Court actually referencing and discussing the particulars of the statutory formulation of the fiduciary duty, such is too often missing from decisions of this nature. Rather, the typical formula is a bland conclusion that the actor was subject to and violated a duty of loyalty. As I have elsewhere observed:
A simple statement that a person is a fiduciary and therefore owes a duty of loyalty is misleading because it is incomplete. The duty of loyalty is not a monolithic, self-defined and self-effective rule or series of rules; rather, different duties of loyalty are applicable under different circumstances. A bare declaration that a person is a fiduciary subject to a duty of loyalty and that his conduct violated the duty ignores the crux of the question; that is, the nature of the duty of loyalty as relating to particular facts and circumstances. The only way the duty of loyalty can be properly evaluated is by making an inquiry that includes interpretation of the applicable agreement and of the particular governing statute and applying the same to the unique facts and circumstances of the case.
Thomas E. Rutledge & Thomas Earl Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Ark. L. Rev. 473, 499-500 (2010). These requirements, I posit, are consistent with the direction of the United States Supreme Court:
But to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?
S.E.C. v. Chency Corp., 318 U.S. 80, 85-86 (1943).
It should be noted that the Kentucky Supreme Court, on September 14, 2011, granted discretionary review in this case, and that the application for discretionary review included this point of the Court of Appeals’ opinion. Essentially, Ballard seeks a determination that common law fiduciary duties of “candor and good faith” are individually owed by the directors to the members. Motion for Disc. Review at 2, 13. 1400 Willow’s response is that “The legislature settled this question clearly when it enacted KRS 273.215(1).” Response to Motion for Disc. Review at 10. The argument continued with “The legislature explicitly and clearly defined the ‘duties’ of a director of nonprofit corporations that are organized under Chapter 273,” noting that a broad statute addresses the subject matter of the common law, the statute suspends the common law.” Id. at 11, 12, citing Aetna Ins. Co. v. Comm., 51 S.W. 624 (Ky. 1899).
My view is (no surprise here) that 1400 Willow has what must be the prevailing argument. The various formulae employed in our business entity statutes define the existence of duties, who owes those duties, to whom are those duties owed, and the standards required for holding one culpable for breach. The legislature well knows how to leave the duties openended (e.g., KRS § 362.1-401(1) (“includes”)).
If the General Assembly is not able to make determination as to the rules in corporations, then there cannot be proxy voting (at common law proxies were forbidden), approval of a merger by majority vote (at common law a merger required the approval of all shareholders), a heightened standard of culpability (see KRS § 271B.2-020(2)(d); id. § 271B.8-300(5)) for violation of the duty of care or a near elimination of the doctrine of ultra vires (KRS § 271B.3-040; id. § 273.173). Besides, isn’t setting the rules for corporations what section 190 of the Kentucky Constitution says the General Assembly is to do? At a practical level, if the statutes are not going to be applied as written, who will even know what are their rights and who will even know what is expected of them?