Duty of Loyalty: What it is, How it Works, Example

What Is Duty of Loyalty?

Duty of loyalty is a director's responsibility to act at all times in the best interests of their company. The duty of loyalty is one of the two primary fiduciary duties required to be discharged by a company's directors, the other being the duty of care.

The duty of loyalty requires a director to be completely loyal to the company at all times. It also imposes the responsibility to avoid possible conflicts of interest, thereby precluding a director from self-dealing or taking advantage of a corporate opportunity for personal gain.

The violation of the duty of loyalty may expose the director to a court order to pay restitution and stiff fines.

Understanding Duty of Loyalty

The duty of loyalty imposes a number of additional responsibilities upon the directors of a company. They are required to keep confidential, and not disclose or misuse, any information that they come across in their official capacity as directors.

They also have to report all conflicts of interest, whether actual or potential, real or perceived, to the board of directors. They may also have to obtain legal advice when the potential for conflicts of interest is unclear. In cases where conflict does exist, the director should be fully transparent about it and disclose all relevant information.

Duty of Loyalty Key Components

A director's duty of loyalty has three main components:

  1. They must not usurp corporate opportunities for their own personal gain.
  2. They must avoid having a personal interest in transactions between the corporation and another party.
  3. They must keep the corporation's information private.

While these may seem like onerous requirements, a director who is completely loyal to the company will have no problem in adhering to the duty of loyalty. But problems will arise when directors place their own interests above those of the company or have an undisclosed conflict of interest.

Example of Duty of Loyalty

Assume the director of a pharmaceutical company learns in advance that one of its most promising drug candidates has failed to meet the primary endpoints of a pivotal Phase 3 trial. The press release about this negative development is scheduled to be released after the market closes the next day. The director immediately places an order to sell his substantial shareholdings at the current market price, as the stock price is bound to slump when the news is released.

By doing so, the director has used confidential information for his own enrichment, opening himself up to insider trading charges and violating the duty of loyalty.

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