Directors and Officer's Fiduciary Duties - California Versus Delaware

Introduction:

As discussed in our article on fiduciary duty, officers and directors of a corporation have the highest duty known to law to their stockholders and that duty includes a high degree of care and effort to the correct operation and supervision of company activities, no self dealing, full disclosure of conflicts of interest, etc.

But how a breach of that duty is defined and what level of proof is needed to prove its breach can differ from state to state and it is instructive to compare how Delaware and California take different and revealing approaches.

A typical question we are asked by prospective business owners is whether to incorporate in Delaware or California. A misconception people often have is that regardless of where one does business, if one incorporates in Delaware one can take advantage of their low tax rate. Sadly, that is seldom true.

It is where a company engages in business that determines for California the correct tax situs. If most of your business is located and performed in California, you are taxed in California whether you are a Delaware corporation or a California corporation.

So, why do companies still incorporate in Delaware?

First, if their locale and operations exist significantly outside of California, they may successfully argue that the California tax regime does not apply.

But the more usual reason is that Delaware has “company friendly” laws that allow the company to more easily avoid and/or win struggles and contest claims from minority stockholders and third parties. Put simply, California seeks to protect the minority owners in many ways far more than Delaware, and the law concerning breach of fiduciary duty is a good example. The basic differences in that area are discussed in this article.

 

California and Delaware and Fiduciary Duty

California has codified in its California Corporations Code most of its requirements for directors and officers and cases abound which discuss full interpretation of those statutes. However, when delineating fiduciary duties in corporations, Delaware prefers a common-law approach, letting substantive rules evolve from case law.

California chooses to embed the basic concepts in Section 309(a) of its Corporation Code. One result of the difference in approach affects the duty of care  placed upon the director’s and officer’s duty to investigate business activities to determine validity.  Under Section 309(a), California effectively requires that in making every major decision for the company, the officers and directors are held to a test of inquiry  to determine whether the director or officer has satisfied the requirement to inquire. By contrast, although Delaware subsumes the need to investigate into its “prudence standard,”  its  cases do not discuss this aspect of oversight as a matter of course for each and every important decision. A director or officer in Delaware is not held to the same high duty to investigate that is often imposed upon a director or officer in California..

Another potential distinction between the two states' duty-of-care standards is that Delaware case law has developed a gross-negligence standard of conduct (though it is somewhat stricter than under conventional tort rules) while California prescribes an ordinary negligence standard. Thus, in California, the director or office is liable if he or she was negligent, while in Delaware, gross (very high) negligence must be proven to establish liability. The cases in the two states have eroded that clear distinction, but the difference in levels of care remain.

Perhaps most important, each State  permits corporations to curtail the liability of officers and directors against claims based on breaches of due care (called “exculpation clauses”)  so an occasion to impose liability does not often arise if the company passed the right resolutions to protect its fiduciaries.  Nevertheless, California's and Delaware's exculpation rules, both of which are based on statute, differ. California Corporation Code Section 204(a)(10) excludes from exculpation any acts by directors demonstrating reckless disregard of duty or a persistent lack of attention (when the act poses a risk of major harm to the company or shareholders). Delaware, in GCL Section 102(b)(7), does not provide for such exclusions from exculpation, although some commentators argue that Delaware courts can still impose liability on directors under these circumstances.

Consistent with the distinctions between the states' treatment of the duty of care, California codifies its duty of loyalty and Delaware does not, but the California statute merely restates prior case law: Directors and, by common-law extension, officers must act in good faith in the best interests of the corporation and its shareholders. This standard appears the same as Delaware's. Both states also provide statutory safe harbors that immunize interested-party transactions meeting standards of full disclosure, and they allow for ratification by shareholders or disinterested directors. However, the major difference is that California requires a fairness determination when the directors ratify the transaction, but Delaware makes fairness an independent alternative grounds for validating the transaction. It therefore does not require fairness determinations for ratification by shareholders or disinterested directors. Very occasionally, it should be noted,  Delaware courts have invalidated self dealing contracts on fairness grounds despite shareholder or director ratification, although in such cases the burden of proof shifts to the transaction's challengers.

A recent important 2006 Delaware case involved the Delaware Supreme Court decision, In re The Walt Disney Company Derivative Litigation, as an important example of Delaware's view of fiduciary duties. That court rejected the idea that good faith represents a free-standing fiduciary duty and that bad faith stands in for gross negligence in duty-of-care analyses—a contrast to California's use of good faith in its duty-of-care statute. Instead, bad faith, whether of the subjective self-interested variety or the objective disregard of a director's duties, constitutes an element of the duty of loyalty. The Disney court upheld the chancery court's ruling, finding that the officers and directors who had approved an extraordinarily expensive hiring and firing of Disney's president had not acted in bad faith.

Yet, by characterizing good faith as a duty-of-loyalty issue, the court effectively removed such cases from the exculpation/indemnification provisions covering breaches of the duty of care.

 

So…California or Delaware?

Owners who are in control of an entity and do not want to be bothered with the higher duty of care standards of California are tempted to incorporate in Delaware which, in addition, has numerous other laws that allow those in control of the Company to operate it, raise capital, hire and fire and take other actions with less due care to the rights of the minority or the Company as a whole. Essentially, Delaware has made itself an attractive corporate locale by crafting a legal apparatus that those in a position of power within the company find appealing.

Such states as California or New York take a very different approach. Their approach assumes that a well run entity will protect its owners…all of them…and holds the operators of the company to high standards of due care, fiduciary responsibility and avoidance of conflict of interest. While Delaware courts, faced with often extreme wrong doing by majority owners or operators of company, often find ways to avoid the lesser standard imposed, the fact remains that in California the one who runs the company is likely to face a higher degree of both scrutiny and obligation of due care and responsibility than his or her counterpart in Delaware.

Does this matter? Only if something goes wrong. Does it matter enough to incorporate in Delaware? That depends on the plans, intentions, and role of the incorporators. Certainly any passive investor will want the protections of California while any owner not wanting the other owners to “get in the way” will be tempted to consider the usefulness of the Delaware system.

Both states easily allow out of state persons and entities to incorporate within their systems. Both incorporations are easily completed within a few weeks. The issue is which structure is more appropriate to the planned business.

One experienced businessman once told this author that New York or California could create structures that are less attractive to the operators of business because those states have sufficient economies that business owners have to come there no matter what. “Delaware sells its easy going structure for entrepreneurs who want a relatively free hand. It’s all Delaware has to sell…”  An overstatement, certainly, but with a grain of truth.