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In this post Sarbanes-Oxley environment directors and officers of public companies are under greater scrutiny to maintain their independence and exercise the requisite duty of care and loyalty to the corporations they serve. This heightened scrutiny has now spilled over into the world of private companies. In a May 2003 court decision based on Delaware corporate law — Pereira v. Cogan , 1:00 Civ. 619 — U.S. District Judge Robert Sweet of the Southern District of New York applied the same standard of fiduciary responsibility used for the directors and officers of public companies to the directors and officers of a closely held corporation. The result was a judgment in which the directors and officers of the private corporation could be required to pay a total of $44 million. Judge Sweet found the directors and officers liable for breach of the duty of care and loyalty through their inactions in allowing the controlling shareholder to use the corporation for his own personal financial gain. Under general corporate law principles, directors and officers of public companies owe a fiduciary duty to the corporation. They are generally bound by a duty of care, good faith and a duty of loyalty. The duty of care requires directors to exercise the diligence of a reasonable, prudent person in similar circumstances when making decisions pertaining to the corporation. Decisions involving the duty of care are protected by the business judgment rule. The rule — which is designed to ensure that courts do not, in hindsight, reverse the managerial decisions of corporate directors and officers — presumes directors and officers have acted in good faith and in the best interest of the company. As such, if the directors and officers of a corporation can demonstrate an informed, procedurally careful decision-making process, with the ultimate decision being made in good faith, their decision will most likely withstand a challenge even if it was a poor one or the corporation suffered monetary loss. The duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the shareholders generally. Normally, a court will find a breach of loyalty where a director has received some personal benefit from a transaction. However, a breach of the duty of loyalty can also be found in an abdication of directorial duty or where an interested director controls or dominates the board as a whole or if the interested director fails to disclose his or her interest in a transaction to the board. In Pereira v. Cogan , the Chapter 7 trustee of Trace International Holdings Inc. initiated an action against the controlling shareholder, Marshall Cogan, also the CEO, and seven former directors and officers. Among others allegations, the trustee alleged that the CEO engaged in self-dealing and that all of the defendants breached their fiduciary duty of due care stemming from their failure to carry out their duties in the best interest of the corporation and their subordination of those duties to the personal interests of Cogan. The trustee also alleged that the director-defendants breached their duties of due care, loyalty and good faith to the corporation by illegally approving payment of dividends and redemption of the corporation’s stock when the corporation’s capital was impaired. The court agreed with the trustee and found the defendants liable for breach of fiduciary duty. The court addressed the novel issue of the role directors and officers should play when confronted by, or at least peripherally aware of, the possibility that a controlling shareholder (who also happens to be their boss) is acting in his own best interest and not those of the corporation. The court held that, at the very least, directors and officers must uphold the standard of care as required of directors and officers of public companies or private companies not so dominated by a founder/controlling shareholder. The judge denied the defendants the protection of the business judgment rule on his finding that the directors subordinated their duties to the corporation to the personal interests of Cogan and simply rubber-stamped his requests rather than acting with the requisite level of due care necessary in such situations. The judge also found that the officers and directors breached their duties of care and loyalty through their inaction. Even though in this situation the directors did not personally benefit from the transactions, the court imposed the burden of proof on them to demonstrate the “entire fairness” of the transactions in order to avoid personal liability. In his ruling, he not only applied the same standard of care typically reserved for public companies, but he also noted that the standard of care applied to closely held corporations should be even greater, given the lack of public accountability in such corporations. Unlike the private sector, in the public sector, the oversight of the Securities and Exchange Commission, shareholders and the public market in general creates a checks and balance system for directors of public companies, leaving them less opportunity to acquiesce to the whims of management or other directors without exercising the proper level of diligence. This decision has far-reaching ramifications for those involved in the management of closely held corporations. Directors of private companies cannot approach their duties in a lax manner. The Pereira decision requires directors and officers of private companies to be independent and to exercise an appropriate level of diligence to ensure that the actions taken by management and others are in the best interests of the corporation. Board inaction will not be a defense against the charge of breach of fiduciary duties. Directors will be subject to liability if they knew about the matter at issue and unreasonably failed to take action or, if they did not know, should have taken steps by which they would have been informed of it. The court’s decision may make it harder for private companies to find qualified directors and officers willing to undertake director positions because of the possible imposition of large financial liabilities, and the relative rarity of directors’ and officers’ insurance coverage for private companies. However, while the decision does subject the directors of private companies to a higher level of scrutiny — and may initially strain working conditions between the board and management or a controlling shareholder — it should produce heightened performance by directors. In order to protect themselves from liability and in keeping with the standard of care, directors and officers of closely held corporations must take an active role in the management of the corporation and not simply acquiesce to the wishes of the controlling shareholder. Directors who carry out their duties on an informed basis — and in a manner that they, in good faith, believe is in the best interests of the corporation — will still be protected from personal liability by the business judgment rule. John Duncan is a senior member of the Venture & Technology and the Mergers & Acquisitions teams in Nixon Peabody’s Business Practice Group in San Francisco. He can be reached at [email protected] peabody.com or 415-984-8271. • Practice Center articles inform readers on developments in substantive law, practice issues or law firm management. Contact News Editor Candice McFarland with submissions or questions at [email protected]or go to www.therecorder.com/submissions.html.

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