Directors on the hook

Amid the increasing scrutiny of how corporations are conducting their business, considerable focus is falling on the corporate boards of directors and the oversight — or lack thereof — provided by the members of these boards.

Under most conditions, a director is obligated to act in the best interests of the corporation and its shareholders. As a fiduciary of the corporation, a director must act in good faith and owes two basic duties to the company and its shareholders: care and loyalty. The duty of care requires directors to be diligent — to inform themselves of any material information reasonably available to them before making a business decision. Second, the duty of loyalty prohibits directors from putting their own self-interests ahead of corporate or shareholder interests.

Under the "business judgment rule," directors ordinarily are shielded from personal liability for the actions of the board, provided that the directors are exercising their best "business judgment" in taking these actions. Under this rule, directors are presumed to have acted in good faith, on an informed basis and in the honest belief that their actions were in the best interests of the company and its shareholders.

In a 1985 Delaware case, however, directors were held personally liable for failing to exercise proper care in a corporate transaction. As a result of this court decision, many people were concerned that highly qualified individuals would be reluctant to serve on boards. In response, many states passed laws to further insulate directors from personal liability.

In times of corporate financial distress, however, a director's fiduciary duties encompass not just the corporation and its shareholders, but all of the company's creditors as well. This occurs some time before the company is actually insolvent, when it is operating "in the vicinity of insolvency." In such conditions, the directors have the obligation to protect what remains of the company's assets for the benefit of all interested parties, including the company's creditors.

Moreover, a director's duty of care, in particular, will expand in such circumstances. Directors must devote sufficient time and attention to the company's business to make prudent decisions. Directors will be held accountable for failing to grasp the meaning of important information and for failing to make reasonable inquiry into pertinent matters. Furthermore, a director may not escape this responsibility by resigning at the first sign of trouble, especially if doing so would leave the board without sufficient members to tend to the needs of the company. Rather, the director must take affirmative steps to meet the obligations of membership on the board.

Directors must also take special care to ensure that a distressed company complies with certain federal laws, including federal labor protection laws, environmental laws, tax laws, bankruptcy laws and security laws. Directors can be held personally accountable for a company's failure to follow those and other laws even if they were not personally involved in committing the violation.

Being asked to serve on a company's board of directors can be a great honor. However, no one should accept that invitation without giving it appropriate consideration beforehand.

Peckinpaugh is corporate counsel for DynCorp in Reston, Va. This column represents his personal views.