What Is Duty of Care?
Duty of care refers to a fiduciary responsibility held by company directors which requires them to live up to a certain standard of care. This duty—which is both ethical and legal—requires them to make decisions in good faith and in a reasonably prudent manner. These people are required to exercise the utmost care in making business decisions to fulfill their fiduciary duty.
- Duty of care is a fiduciary responsibility held by company directors which requires them to live up to a certain standard of care.
- The duty requires them to make decisions in good faith and in a reasonably prudent manner.
- The duty of care also applies to other roles within the financial industry including accountants, auditors, and manufacturers.
- Failure to uphold the duty of care may result in legal action by shareholders or clients.
Understanding Duty of Care
Duty of care is often an implicit responsibility that comes with being a company director, but it may also be part of a written contract. This duty requires them to make decisions that are financially, ethically, and legally sound. These decisions should be made after taking all available information into account. Directors must act in a judicious manner that promotes the company's best interests.
Duty of care can, therefore, be summed up as the requirement that directors be present, informed, and engaged. They should use good and independent judgment, consult experts for their advice and trusted information, refer to meeting minutes. They must also stay abreast of legal developments, good governance, and best practices that affect their companies. Directors should also schedule and be prepared to discuss and review things such as budget issues, executive compensation, legal compliance, and strategic direction.
Along with the duty of care, the other main fiduciary duty is the duty of loyalty. This duty requires company directors to put the fiduciary interests of the company before their own, and to expose any conflicts of interest.
The duty of care also applies to other roles within the financial industry. Accountants and auditors are bound to and responsible for the best interests of their clients. Manufacturers are held accountable for the safety of consumers with the products they make and market.
The duty of care also applies to others within the financial industry such as accountants, auditors, and manufacturers.
Failure to uphold the duty of care may result in legal action being brought by shareholders or clients for negligence. Courts generally do not rule on whether a business decision was a sound one or not in the case of company directors. This is known as the business judgment rule, meaning courts normally 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.
Given that 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 Walt Disney's 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 the company's board exercised bad business judgment but was covered under procedural requirements by the fact that they consulted an expert before allowing Ovitz's severance. The decision reinforced the belief that there is little shareholders can do to hold directors accountable.
Example of Duty of Care
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 was 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.
Most cases are settled out of court. But in such a situation, if the case does go to trial, the court would not rule 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.