What potential liability could Directors + Officers of a California Corporation have?

⚖️ Potential Liability of Directors + Officers

1️⃣ Losses caused by Ultra Vires Acts;

2️⃣ Improper distributions (see discussion below);

3️⃣ Breach of Director/Officer Duties;

 4️⃣ Improper loans - OK only if it is reasonably expected to benefit the Corporation.

💡 Sarbanes-Oxley Act (Federal Law) generally forbids loans to executives in large, publicly traded ("registered") Corporations.

It requires the Board of such a large Corporation to establish an audit committee and to oversee work of registered public accounting firm.

Chief executive and financial officers must certify accuracy and completeness of financial reports.

⚖️ Which Directors are liable?

⚖️ Defences

✅ Dissenting members: A Director is presumed to concur with Board action unless their dissent or abstention is noted in writing in corporate records.

In writing means:

1️⃣ Recorded in the minutes; or

2️⃣ Delivered in writing to the presiding officer at the meeting; or

3️⃣ Written dissent, delivered to the Corporation immediately after the meeting.

❌ A Director cannot dissent if they voted for the resolution at the meeting.

✅ An absent Director is not liable for Board action done at the meeting they missed.

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✅ Reliance on others: It is not unreasonable for a Director to rely in good faith on information (including financial information) presented by an officer, legal counsel, committees (where the Director was not a member), or professional reasonably believed competent.

💡Point of comparison: This ability to rely on the information from others is in direct contrast to the position of directors in Australia, who must exercise their own independent judgment + cannot rely blindly on the advice/information of officers/experts.

For a more detailed discussion please refer to my blog article: The Business Judgment Rule for Directors [Australia v. U.S.A.]

⚖️ Indemnification

💡The Articles of Incorporation can provide for indemnification of a Director or Officer for liability while acting in their role UNLESS they are:

❌ Held liable to the Corporation;

❌ Held to have received an improper financial benefit; or

❌ Committed intentional wrongful acts or crimes.

Mandatory Indemnification

The Corporation must indemnify the Director or Officer if they have prevailed in defending the proceeding against them.

Permissive Indemnification

The Corporation may indemnify the Director or Officer if the case is settled, or in any other situation not covered above.

Eligibility standard: Must show they acted in Good Faith and with a reasonable belief that their actions were in the Corporation's best interest.

Same standard as Duty of Loyalty.

Who determines eligibility?

Disinterested Directors or Shareholders or Independent Legal Counsel.

The Court may order reimbursement in its own discretion

Where a Director or Officer is sued, a Court may decide to order reimbursement if it is justified in view of all of the circumstances.

If they are held liable to the Corporation, this reimbursement is limited to costs and attorney's fees (cannot include judgment).

Important decision to make when drafting the Articles:

⚖️ Whether or not to add an exculpation clause?

Articles can include a clause which eliminates Director liability to the Corporation for damages, but not for intentional misconduct, usurping corporate opportunities, unlawful distributions, or improper personal benefit.

Can exculpatory provisions apply to Officers as well?

Split authority: Some states Yes, some No.

⚖️ Federal Securities Laws

Debt Securities: The investor lends capital to the Corporation, to be repaid (usually with interest) as specified in the agreement.

The debt holder is a creditor.

➲ Secured by corporate assets (bond)

➲ Unsecured (debenture).

Equity Securities: The investor buys stock from the Corporation, which generates capital for the business. Investor is an owner.

⚖️ Insider Trading Rule 10b-5

Federal law prohibits fraud or misrepresentation (or nondisclosure) in connection with the purchase or sale of any security (debt or equity).

Possible Plaintiffs

✅ Securities and Exchange Commission (SEC)

✅ Private action for damages by buyer or seller of securities. If didn't buy or sell, then no cause of action.

Possible Defendants - any person (including entities)

❌ Company that issues misleading press release.

❌ Buyer or Seller of securities who misrepresents material information.

❌ Buyer or Seller of securities who trades on material inside information

(when there is a duty to disclose - again, comes from relationship of trust and confidence with shareholders of the Corporation).

❌ Tipper or Tippee.

Financial Benefit - clear

Still liable if you only get a personal benefit, but personal benefit is broadly defined.

Enhancing reputation is enough.

💡 Note: When there is no tipper, there cannot be a tippee.

Elements:

1️⃣ At some point the deal must use "instrumentalities and channels of interstate commerce".

This means the facilities enabling the movement of goods and people in interstate commerce or used for interstate communications.

2️⃣One of the following transaction types

❌ Misrepresentation of material information

❌ Insider trading: Trading securities on the basis of material inside information. This is only a problem for someone high enough in the business hierarchy that they have a duty to abstain or ensure disclosure so that everybody's on the same footing.

Who has this duty?

Someone with a relationship of trust and confidence with Shareholders.

Generally this would include:

Directors;

Officers:

Employees of the insurer with access to confidential information.

❌ Misappropriation: Under the misappropriation doctrine, a person who owes a duty of trust and confidence to the source of the information has a duty to abstain or disclose (e.g., a lawyer in a law firm who discovers confidential information about a firm client who is engaging in a merger; the lawyer owes a duty of trust and confidence to his firm, which has been held, along with the client, to be the source of the information).

❌ Tipping: Here, an insider passes along material inside information for a wrongful purpose.

3️⃣ Materiality

The misrepresentation or omission must concern a "material" fact. One a reasonable investor would consider important in making an investment decision.

4️⃣ Scienter / Intent

D must have an intent to deceive, manipulate, or defraud.  Recklessness may suffice.

Negligently holding a confidential conversation in a public space is not enough for 10b-5 liability.

5️⃣ Reliance

Said to be a separate element, as in fraud cases, but is presumed in public misrepresentation (e.g., a misleading press release) and nondisclosure cases.

6️⃣ Damages

Generally determined by an out-of-pocket measure.

⚖️ Short-Swing Profits Rule 16(b) - Strict Liability

Federal law provides for the recovery by the Corporation (or its shareholders via a derivative suit) of "profits" gained by certain insiders from buying and selling the company's stock.

If, within 6 months before or after any sale, there was a purchase at a lower price, there is a profit.

The sequence of the buy and sell does not matter.

⚖️ Applied to public companies or "Reporting" Corporation

✅ Listed on a national exchange;

at least 2,000 Shareholders; or

500 Non-Accredited Shareholders; and

✅ $10 million in assets.

Accredited Investor is a defined term meaning, in general, an investor who can handle risk, such as an institutional investor or wealthy individual.

Types of Defendants:

👉 Director (either when they bought or sold); or

👉 Officer (either when they bought or sold); or

👉 Shareholder who owns more than 10% (both when they bought and sold).

Type of transaction:

Short-swing trading: Buying + Selling stock within a single 6 month period.

No fraud or inside information is needed.

⚖️ Sarbanes-Oxley Act sets Standards for Publicly Traded Companies

Board oversees public accounting firms that perform audits and create rules pertaining to corporate financial reporting

Enhanced Reporting Requirements, including:

✅ Audit Board;

✅ Senior executives;

✅ If a filing is inaccurate.

Criminal Penalties:

❌ Destroying or altering corporate documents and/or audit records is punishable by ➲ A $5million fine + up to 20 years in prison;

❌ Securities Fraud ➲ Up to 25 years in prison;

Statute of Limitations is the later of 2 years after discovery or 5 years after the action accrued.

Whistleblowers are afforded protection.

Credits:

This FAQ was prepared by James D. Ford GAICD | Principal Solicitor, Blue Ocean Law Group℠.

Important Notice:

This FAQ is intended for general interest + information only.

It is not legal advice, nor should it be relied upon or used as such.

We recommend you always consult a lawyer for legal advice specifically tailored to your needs & circumstances.