In their oversight of the business and affairs of a Virginia corporation, directors owe the corporation and its shareholders a fiduciary Duty of Care which requires that the directors perform their oversight duties in good faith and in a reasonably prudent manner and a fiduciary Duty of Loyalty which requires that directors refrain from benefitting personally at the expense of the corporation.
Although there is some uncertainty as to whether directors owe a Duty of Care and/or a Duty of Loyalty to creditors, the Virginia Stock Corporation Act (VSCA) expressly grants to creditors a right of action against directors that approve Unlawful Distributions that render a corporation “insolvent.”
The Bottom Line: To avoid liability to the corporation and its shareholders for breaches of the Duty of Care and/or the Duty of Loyalty and liability to creditors for Unlawful Distributions, directors of “financially distressed” Virginia corporations should: increase management oversight through frequent, regularly scheduled board meetings; retain and rely upon experts; ensure that any “self-dealing” conduct is approved by “disinterested” directors or “disinterested” shareholders; and maintain detailed consents and minutes of meetings.
The Duty of Care, a common law construct, requires that directors perform their oversight duties in good faith and in a reasonably prudent manner. The VSCA sets forth a threshold test for the Duty of Care, stating that “a director shall discharge his duties as a director, including his duties as a member of a committee, in accordance with his good faith business judgment of the best interests of the corporation.”[i] Any director who satisfies this standard will not be liable for any action taken (or not taken) as a director.[ii]
The VSCA expressly provides that, in making business judgments, a director may rely upon “opinions, reports and statements” of officers or employees of the corporation, legal counsel and public accountants unless the director has knowledge or information that makes such reliance unwarranted.[iii]
The Duty of Loyalty, also a common law construct, prohibits directors from benefiting personally at the expense of the corporation. Common circumstances where Duty of Loyalty issues arise include transactions between a director and the corporation and situations where the director usurps for the director’s personal benefit a “business opportunity” that might otherwise have benefited the corporation.
The VSCA provides “safe harbor” statutory language setting forth steps that can be taken to preclude a claim that a director has breached the Duty of Loyalty. Specifically, transactions between a director and the corporation will not be voidable where the material facts of the transaction are fully disclosed and approved by the “disinterested” directors or by “disinterested” shareholders.[iv] A director’s taking advantage of a “business opportunity” will not result in proceedings being brought against the director where such opportunity is first offered to the corporation or where such opportunity is “disclaimed” by the “disinterested” directors or the “disinterested” shareholders.[v]
Proceedings against directors for purported breaches of the Duty of Care and/or the Duty of Loyalty may be brought by the shareholders on behalf of, and in the name of, the corporation. The provisions of the VSCA governing so called “derivative proceedings” explicitly limit the right to initiate such proceedings to “shareholders.”[vi] Courts in some jurisdictions (including, most notably, Delaware) permit creditors of insolvent corporations to bring “derivative proceedings” on the theory that such creditors are, in effect, equity holders.
Virginia courts have not afforded to creditors of insolvent Virginia corporations the right to initiate “derivative proceedings.” However, the Supreme Court of Virginia has intimated that creditors of insolvent Virginia corporations may enjoy a direct right of action against directors where directors have approved distributions of funds from an insolvent corporation to themselves. Although the leading case on this point, Marshall v. Fredericksburg Lumber Company,[vii] dates back to 1934, the Supreme Court of Virginia made reference to such a possible direct right of action by creditors as recently as 2009 in Luria v. Board of Directors of Westbriar Condominium Owners Association.[viii]
The current version of the VSCA contains a provision that makes directors personally liable to “the corporation and its creditors” for any Unlawful Distribution[ix] including any distribution resulting in the corporation not being able to “pay its debts as they become due in the usual course of business” or resulting in the corporation’s “total assets” being “less than total liabilities.”[x] This provision of the VSCA would appear to obviate the need for creditors to bring a direct action against directors in reliance upon the case law cited in the immediately preceding paragraph.
To ensure that a distribution is not an Unlawful Distribution, directors may rely upon “accounting practices and principles” and “fair valuations” that are, in each case, “reasonable in the circumstances.”[xi]
How should directors of “financially distressed” Virginia corporations proceed to ensure that they fulfill their fiduciary Duty of Care, fulfill their fiduciary Duty of Loyalty and do not authorize an Unlawful Distribution? The first step for such directors should be the engagement of legal counsel.
With the assistance of legal counsel, the directors should then undertake a comprehensive review of: the VSCA; the corporation’s Articles of Incorporation, By-Laws and board and shareholder resolutions; any “stand-alone” Indemnification Agreements; and any applicable D&O insurance policies, in each case with the goal of understanding the scope of potential liability for such directors and the circumstances under which such directors may have a right of indemnification and/or expense advancement. If necessary, additional D&O insurance coverage should be arranged, provisions of applicable corporate documents pertaining to indemnification and/or expense advancement should be revised and “stand-alone” Indemnification Agreements should be entered into.
Although the precise course of conduct recommended to be taken by the directors of a “financially distressed” Virginia corporation will depend upon the specific circumstances of each such corporation, as a general matter, such directors should:
· Increase Management Oversight. Increase management oversight through frequent, regularly scheduled board meetings featuring presentations and reports by officers and employees of the corporation.
· Retain and Rely Upon Experts. Retain and rely upon experts such as public accountants and appraisers.
· Utilize Statutory “Safe Harbor” Provisions. Utilize statutory “safe harbor” provisions when entering into a transaction with the corporation or usurping a “business opportunity” that might otherwise benefit the corporation by ensuring approval and/or disclaimer by “disinterested” directors or “disinterested” shareholders.
· Detailed Board Records. Ensure that detailed consents and minutes of the meetings of the directors are maintained and that such consents and minutes include complete and accurate summaries of all matters addressed and all “opinions, reports and statements” of officers or employees, public accountants, appraisers or other experts relied upon.
Faithful adherence to the foregoing should significantly enhance the position of the directors of “financially distressed” Virginia corporations in arguing that such directors have fulfilled their fiduciary Duty of Care, have fulfilled their fiduciary Duty of Loyalty and have not authorized an Unlawful Distribution.
Should you have any questions regarding the contents of this Client Note, please contact Steven G. Thompson by e-mail at sthompson@sgthompsonlaw.com or by telephone at (757) 253-5711 (Office) or (917) 817-2720 (Mobile).
