What is a Duty of Care
Duty of care is a fiduciary responsibility for company directors that requires them to make decisions in good faith and in a reasonably prudent manner. The duty of care requires directors to make business decisions after taking all available information into account, and then act in a judicious manner that promotes the company's best interests. Directors are required to exercise the utmost care in making business decisions in order to fulfill their fiduciary duty. The other main fiduciary duty is the duty of loyalty.
Breaking Down Duty of Care
Duty of care can be summed up in the requirement that a director should be present, informed, engaged, use good and independent judgment, utilize expert advice and trusted information, refer to meeting minutes, and seek to stay abreast of legal developments, good governance, and best practices. Directors should also schedule and be prepared to discuss and review of budget issues, executive compensation, legal compliance, and strategic direction.
Failure to uphold the duty of care may result in legal action being brought against the board of directors by shareholders. However, the courts will not rule on whether or not a business decision was a sound one (known as the business judgment rule, in which courts defer to the judgment of corporate executives). Instead, their main focus is on assessing whether the directors:
- Fulfilled their duty of care by acting in a reasonably prudent manner when making the decision (in the best interest of the corporation)
- Conducted an adequate degree of due diligence (otherwise known as ordinary care)
- Acted in good faith
- Have not wasted corporate assets or resources on overpaying for goods, property or labor.
Duty of Care Example
Assume a public company PubCo makes a large acquisition of rival firm ABC Holdings that effectively doubles its size. The market reaction, judging by the decline in PubCo's share price after the acquisition is announced, is that PubCo paid too much for ABC Holdings. PubCo's management is initially very confident that the acquisition will be accretive to earnings. But a few months after the deal closes, PubCo announces that ABC's management had been engaged in accounting fraud that grossly inflated its revenue and profitability. Despite PubCo's management asserting that they had no inkling anything was amiss at ABC, PubCo's shares plunge 30% and shareholders launch a class-action lawsuit against PubCo's directors.
In such a situation, if the case does go to trial (most such cases are settled out-of-court), the court would not rule on whether PubCo paid too much for ABC. Rather, it would assess whether PubCo's board of directors conducted their due diligence on ABC and acted in good faith. The fact that the directors failed to detect the accounting fraud at ABC does not necessarily constitute a breach of the duty of care. But if PubCo's directors were aware of it and chose to go ahead with the acquisition anyway, this could be construed as a breach of duty.
Duty of Care Criticism
Given that the courts tend to defer to the judgment of executives, it can be exceptionally hard to prove a duty of care breach. In fact, in Brehm v. Eisner, the Delaware Supreme Court found that the business judgment rule protected The Walt Disney Co. board after it awarded $150 million in pay to Michael S. Ovitz for just 14 months of work as part of a no-fault termination of his employment agreement. The court found that Disney's board had exercised bad business judgment but was covered under procedural requirements by the fact that they had consulted an expert before allowing Ovitz's severance. The decision reinforced the belief that there is little shareholders can do to hold directors accountable.