North Carolina Business Court Clarifies Corporate Director Duties of Care

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Smith Anderson

[co-author: Bree Koegel]

The North Carolina Business Court recently issued a lengthy opinion discussing the duties of corporate directors. Key points include:

  • Directors comply with their duty to exercise adequate oversight if the board makes a good faith effort to put into place a reasonable board-level system of monitoring and reporting, even if that system ultimately fails to detect illegal or harmful company activities.
  • Directors may be personally liable for excessive compensation paid to corporate officers, if the compensation is completely out of proportion to the value received by the company for the officers’ services.
  • Directors may be personally liable if they make corporate decisions that benefit themselves at the expense of other shareholders.

In Lee v. McDowell, 2022 NCBC 28 (May 26, 2022), the plaintiffs were investors in a North Carolina company called rFactr, Inc. The company ultimately went out of business, and the plaintiffs lost their investments. The plaintiffs, asserting claims derivatively on behalf of the company, sued members of the rFactr board of directors.

The directors exercised adequate oversight over the company’s officers.

The plaintiffs claimed that the company’s failure resulted from corporate mismanagement and malfeasance by the CEO and COO, including failure to provide complete and accurate financial information to the board and failure to pay payroll taxes to the IRS. The plaintiffs asserted that the directors, by failing to supervise adequately the CEO and COO, had breached their fiduciary duties to the company and thus were liable for the company’s losses.

In assessing plaintiffs’ claim, the Business Court began by reiterating the general statutory standard applicable to directors of North Carolina corporations, namely, that directors are required to perform their duties: (1) in good faith, (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and (3) in a manner they reasonably believe to be in the best interests of the corporation. (N.C. Gen. § 55-8-30(a)) The Court then noted that there is “limited guidance” from North Carolina courts regarding how this standard applies to a director’s duty to monitor and oversee a corporation’s business affairs.

The Court therefore looked to Delaware law for guidance, embracing Delaware’s Caremark standard, named after In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). In that opinion, the Delaware Court of Chancery held:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation . . . only a sustained or systematic failure of the board to exercise oversight––such as an utter failure to attempt to assure a reasonable information and reporting system exists––will establish the lack of good faith that is a necessary condition to liability.

Id. at 971. Thus, so long as the board attempts to put into place “a reasonable board-level system of monitoring and reporting,” board members will not be liable for alleged failures of oversight. The Court characterized this as a “minimal burden” on directors to satisfy their duty of loyalty to the corporation.

Having thus defined the standard, the Court readily held that the directors had met the standard in this case. For example, the directors repeatedly requested financial information from the CEO and COO. The Court recognized that the directors could have done more, “but Caremark does not require that directors do very much to meet their duty of loyalty in this context—they simply must do something.” Accordingly, the Court granted summary judgment for the directors on this claim.

The directors could be liable for the officers’ allegedly excessive salaries.

The plaintiffs also claimed that the CEO and COO received excessive compensation and that the directors failed to act to reduce their compensation.

The Court explained that the directors’ judgment regarding compensation decisions is subject to the business judgment rule. The business judgment rule generally prevents a court from interfering with managerial decisions by the board. If there is no proof of bad faith, conflict of interest or disloyalty, the business decisions of directors will not be second-guessed by a court so long as the directors engaged in a rational decision-making process, availed themselves of all material and reasonably available information and honestly believed they were acting in the best interests of the corporation.

The Court added, however, that board decisions that “approve compensation amounting to corporate waste are not protected by the business judgment rule.” In this case, there was evidence that the CEO and COO were receiving compensation up to 4.5 times higher than what was typical for executives in similarly situated companies. Furthermore, there was evidence that the directors were concerned about the executives’ compensation, but nevertheless chose not to act. The Court therefore held that the directors were not entitled to summary judgment on this issue, leaving it as an issue to be resolved at trial.

The directors were not liable for acting in their own self-interest, but only because plaintiffs could not show any harm.

The plaintiffs further claimed that the directors breached their fiduciary duties by rejecting a potential sale of the company to a third party. The directors rejected the sale on the grounds that the value of the tax write-off from the company’s losses was more valuable than the price of a potential deal. But the tax write-off would benefit only certain shareholders (including the directors); other shareholders would have benefitted more from a sale.

The Court explained that directors “must strive to advance the best interests of the corporation,” and are prohibited from using their position for personal gain to the detriment of the corporation or its shareholders. In this situation, the decision not to sell the company was self-interested, and thus the directors were not protected by the business judgment rule.

The Court nevertheless granted summary judgment for the directors on this claim, on the grounds that the plaintiffs were unable to prove any injury. The evidence showed that, for funding reasons, the contemplated third-party sale would not have gone forward regardless of whether the board of directors had pursued the transaction.

Most of the plaintiffs’ remaining claims were dismissed.

In addition to the derivative claims against the directors for breaches of fiduciary duty to the company, the plaintiffs also brought direct claims against one of the directors for breach of fiduciary duty and securities fraud. The breach of fiduciary duty claims were dismissed on the grounds that the director’s fiduciary duties were owed to the company, not to the investors individually. The plaintiffs’ securities fraud claims were mostly dismissed based on the lack of a duty to disclose and a failure to prove reasonable reliance on the alleged misrepresentations. A fraud claim did, however, survive based on a director’s failure to disclose that he would receive compensation if the plaintiffs invested in the company.

Key takeaways.

The Business Court’s recent decision in the Lee case provides helpful guidance to directors of North Carolina companies, reminding them of (among other things) their responsibility to oversee company affairs, their obligation to carefully consider executive compensation and their need to take appropriate steps to ensure the fairness of actions that are or appear to be self-interested.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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