Fiduciary duties of directors of privately held companies The duties of directors and officers of publicly held companies have attracted increased attention because of recent highly publicized corporate scandals and regulatory responses such as the Sarbanes-Oxley Act. But a federal court opinion, Pereira v. Cogan, holds that directors and officers of privately held companies carry many of the same responsibilities and, in fact, may be subject to even greater scrutiny and liability. This is especially true if ownership is concentrated in a single shareholder or CEO. Self-dealing A private holding company declared bankruptcy in 1999, and the bankruptcy court appointed a trustee to oversee the company’s liquidation. The trustee sued Marshall S. Cogan — who was founder, CEO, controlling shareholder and chairman of the board — and several directors and officers. The trustee alleged they breached their fiduciary duties to the company’s creditors by engaging in self-dealing and by authorizing: o Excessive compensation without recommendations from the compensation committee, o Loans to Cogan, his family members and other insiders, o Inappropriate dividend payments, o His wife and daughter’s employment, and o His extravagant birthday party. The directors argued they couldn’t be held liable for expenditures the board hadn’t voted on and that board action during the time in question had been accomplished by written consent. Rejected arguments The court found that the directors had breached both their duty of due care and their duty of loyalty. It dismissed their argument that they couldn’t be held liable in the absence of board action because — if this argument were adopted — directors could shield themselves from liability by holding their noses, closing their eyes and avoiding all board meetings. This surely wouldn’t satisfy a director’s fiduciary duties to the corporation. The court based the breach of loyalty on the board’s failure to exercise diligence in the performance of their duties, combined with their close relationship with Cogan. As for liability of nonboard company officers, the court held: o They could be held liable for damages because they had discretionary authority in a relevant functional area and the ability to cause or preclude inappropriate conduct, o The general counsel was liable for violating his insider-loan obligations by failing to inform the board about the loans’ statutory requirements, and o The officer acting in the role of chief financial officer was liable because his review of daily cash reports put him in a position to prevent the loans by informing the board or taking other action. The court held these persons personally liable. The insolvency zone Generally under corporate law in every state, directors and officers also owe a fiduciary duty to a corporation’s creditors when it is “in the vicinity of insolvency.” Here, the court found that the company was in the vicinity of insolvency for four years before it filed for bankruptcy. The court applied two tests to determine when a company enters the insolvency zone: 1. The balance-sheet test finds insolvency when a company’s liabilities exceed its assets, and 2. The cash-flow test finds insolvency when a company can’t meet its financial obligations as they come due while maintaining a reasonable cushion for business fluctuations and uncertainties. Companies may qualify as insolvent under one test but not the other, and the courts haven’t established a single standard. The court concluded that Cogan and some of the directors and officers violated their fiduciary duties to the corporation and its creditors. So they were personally liable for more than $40 million of unlawful corporate expenditures. Implications for private companies Although privately held companies aren’t subject to Sarbanes-Oxley and its rules, they may nonetheless come under scrutiny in litigation — especially over bankruptcy. As Pereira noted, given the lack of public accountability, officers and directors of privately held companies arguably owe a greater duty to the corporation and its shareholders to keep a sharp eye on the controlling shareholder. “At the very least, they must uphold the same standard of care as required of officers and directors of public companies.” Board members can’t ignore corporate officers’ actions. Officers and directors must vigilantly exercise their duties of due care and loyalty because abstaining from board action or lack of self-interest won’t protect them. When they suspect their company has entered the insolvency zone, they would be well-advised to consult their legal advisors — not company attorneys — to avoid individual liability. Sidebar: Satisfying your fiduciary duties As Pereira v. Cogan shows, private-company directors and officers can’t afford to take their fiduciary duties lightly. When seeking to fulfill their duties while avoiding liability, they should pay particular attention to: Board meetings. The directors should meet regularly, even in states that allow boards to act by unanimous written consent. They should use written consent sparingly and only for noncritical decisions. Regular, in-person meetings show a heightened level of deliberation and care. Individual directors also must actively participate in meetings. As noted in Pereira, inaction won’t shield a director from liability. Finally, the board should appropriately record its meetings in minutes. Procedures and codes. A company should establish formal reporting procedures to allow board members and officers to regularly review financial and operational reports. And the board should develop conduct and ethics codes, including a formal procedure for handling internal complaints. Audit committees. Sarbanes-Oxley requires publicly held companies to form audit committees composed of independent directors charged with reviewing financial reports and overseeing external audits. Privately held companies should follow suit. Conflicts of interest. Directors and officers must go out of their way to avoid conflicts of interest and even the mere appearance of conflicts. They should fully disclose any personal interests they may have in company transactions and abstain from participating in any decisions regarding the transactions. Further, companies should limit or eliminate loans to directors and officers. If a company opts to allow loans, it should formulate an approval process to verify that loan terms represent an objectively acceptable business risk. Contact | Legal Disclaimer