duty of care

The duty of care is a fiduciary duty requiring directors and/or officers of a corporation to make decisions that pursue the corporation’s interests with reasonable diligence and prudence. This fiduciary duty is owed by directors and officers to the corporation, not the corporation’s stakeholders or broader society.

The American Law Institute’s Principles of Corporate Governance defines the duty of care as the duty by which a corporate director or officer is required to perform their functions in good faith; in a manner that they reasonably believe to be in the best interests of the corporation; and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances (negligence standard).

Courts analyze the duty of care by applying the business judgment rule and examining the processes by which the directors and officers made decisions. Generally, courts do not subject these decisions to judicial review so long as the decision constitutes a valid business judgment. A valid business judgment is one that is made by financially disinterested directors or officers who have become duly informed before exercising judgment, and who exercise judgment in a good-faith effort to advance corporate interests that a reasonably prudent person would make.

If the court finds bad faith, gross negligence, or bad processes, the court will subject the directors’ decision to judicial review to analyze whether there was a breach of duty of care.

Generally, however, there is a lower negligence standard for directors and officers for many reasons. Courts want directors and officers to use their expertise to take risks and exercise discretion without the fear of liability, and courts do not want to conduct judicial review of every business decision. Moreover, directors possess greater expertise regarding business decisions than courts. And, it is difficult to objectively review decisions beforehand when the court has already seen its consequences in the present.

Limiting exposure to the duty of care:

Corporations can limit their exposure to the duty of care through indemnification, directors and officers insurance (D&O insurance), and waivers of liability.

Indemnification is explicitly allowed by some corporate statutes. Indemnification authorizes corporations to reimburse any agent, employee, director, or officer for reasonable expenses for losses of any sort arising from any actual or threatened judicial proceeding or investigation so long as the losses result from actions undertaken on behalf of the corporation in good faith and do not arise from a criminal conviction.

D&O insurance allows corporations to insure fiduciaries for anything (including crime and bad faith). Generally, however, the insurance market will limit what is actually covered (i.e. criminal activity) and typically only covers losses stemming from good faith decisions.

Waivers of liability can limit and/or extend the Board of Directors’ liability through the corporation’s charter. A corporate charter can extend and/or limit personal liability for director fiduciary duty unless it pertains to a breach of duty of loyalty; acts or omissions in bad faith; intentional misconduct/violation of law; or any transaction from which a director has received an improper personal benefit.

[Last updated in January of 2022 by the Wex Definitions Team]