Legal Liability:

The Board of Directors

Cindy A. Schipani, George J. Siedel
As director liability problems increase, it becomes increasingly
tant for directors to understand their legal
responsibilities.

impor-

N i n e t y percent o f the c h i e f e x e c u t i v e officers i n A m e r i c a n c o r p o r a t i o n s

believe that the l i a b i l i t y p r o b l e m s of directors a n d officers are d a m a g i n g
the q u a l i t y o f c o r p o r a t e g o v e r n a n c e , a c c o r d i n g to a survey released i n
1987 by Peat M a r w i c k . T h e survey o f a l m o s t e i g h t t h o u s a n d c h i e f e x e c u tives i n b o t h the c o r p o r a t e a n d n o n p r o f i t sectors is believed to b e the
m o s t c o m p r e h e n s i v e l i a b i l i t y survey ever c o n d u c t e d . A p p r o x i m a t e l y o n e
third o f the executives overall a n d o n e h a l f o f those from s m a l l e r corp o r a t i o n s c o n c l u d e d that the l i a b i l i t y p r o b l e m h a d already r e a c h e d a
crisis stage, a n d o n e fourth of the executives reported that their directors
h a d b e e n i n v o l v e d i n l i t i g a t i o n r e l a t i n g to director l i a b i l i t y ( " D & O
L i a b i l i t y , " 1987).
T h e c o n c e r n over liability illustrated by this survey has led the owners
of family businesses to q u e s t i o n the role o f the b o a r d o f directors. W h a t
is the general legal f u n c t i o n o f the board? H o w m i g h t this f u n c t i o n be
different i n a family-owned c o r p o r a t i o n ? H o w does the board's legal
f u n c t i o n translate into liability? H o w can directors prevent liability or at
least protect themselves from the consequences of liability? T h i s article
addresses these questions.
I n m o s t states, general c o r p o r a t i o n law is based o n a model act develo p e d by the A m e r i c a n B a r Association. T h e latest version of this act is
the Revised M o d e l Business C o r p o r a t i o n Act o f 1984 (Revised Model. . . ,
1985). W h i l e the general principles o f c o r p o r a t i o n law apply to all types
of c o r p o r a t i o n s , several states have adopted specific provisions for family
a n d other close c o r p o r a t i o n s . T h e Model Statutory C l o s e C o r p o r a t i o n

Note: T h e authors wish to thank Philip M. Dawson, a partner in the law firm of
Calfee, Halter & Griswold, Cleveland; Brian Sullivan, a partner in the law firm
of Dykema, Gossett, Spencer, Goodnow & Trigg, Detroit; and Joel D. Tauber,
president of Key International Manufacturing, Inc., Southfield, Michigan, for
their helpful comments.
F A M I L Y BUSINESS R E V I E W , V O L . I , NO. 3, F A L L 1 9 8 8

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S u p p l e m e n t (Revised Model . . . , 1985) adopted by the American B a r Assoc i a t i o n assembles these provisions. I n this a r t i c l e we will discuss b o t h
general principles of c o r p o r a t i o n law, w h i c h we will refer to as the Model
Act, a n d specific family business provisions, w h i c h we will refer to as the
Close Corporation
Supplement.
T h e Board's L e g a l F u n c t i o n
I n the classic corporate m o d e l , the directors have u l t i m a t e m a n a g e m e n t
responsibility. A c c o r d i n g to S e c t i o n 8.01 o f the Model Act, " a l l c o r p o r a t e
powers shall be exercised by or under the a u t h o r i t y of, a n d the business
a n d affairs o f the c o r p o r a t i o n m a n a g e d u n d e r the direction of, its b o a r d
of directors." I n practice, boards c a n delegate powers to b o a r d c o m m i t tees, subject to e x c e p t i o n s , s u c h as a m e n d i n g articles o f i n c o r p o r a t i o n
a n d bylaws. T h e board can also delegate to officers the authority to implem e n t b o a r d policies.
T h e classic m o d e l frequently breaks d o w n i n the family c o r p o r a t i o n
setting for two reasons. First, even w h e n the c o r p o r a t i o n has adopted the
classic legal structure, the structure is often i g n o r e d in practice because
the founder o f the firm, s o m e t i m e s aided by other family members, makes
all decisions. Under these circumstances, boards are little m o r e than paper
or r u b b e r - s t a m p boards (Dyer, 1986).
S e c o n d , the family c o r p o r a t i o n m a y c h o o s e to adopt a n o n t r a d i t i o n a l
legal structure. T h e C l o s e C o r p o r a t i o n S u p p l e m e n t provides that a family
c o r p o r a t i o n c a n operate w i t h o u t a board o f directors, i n w h i c h case the
responsibilities a n d l i a b i l i t i e s that n o r m a l l y fall o n directors are placed
instead o n the v o t i n g shareholders.
F u r t h e r m o r e , even if the c o r p o r a t i o n has a b o a r d o f directors, the
shareholders c a n agree to transfer m a n a g e m e n t responsibilities from the
directors to the shareholders. T h e effect of s u c h a n agreement is that the
business c a n be operated as if it were a partnership.
W h e n a family c o r p o r a t i o n decides to sterilize the b o a r d of directors
t h r o u g h a shareholder agreement or to e l i m i n a t e the b o a r d completely,
the c r e a t i o n o f a n advisory b o a r d is often r e c o m m e n d e d . T h i s b o a r d
counsels owners o n matters h a n d l e d by a t r a d i t i o n a l b o a r d o f directors,
s u c h as corporate policy, l o n g - r a n g e p l a n n i n g , capital expenditures, a n d
e m p l o y e e c o m p e n s a t i o n . B u t , p e r h a p s m o r e i m p o r t a n t , the advisory
b o a r d plays a c r i t i c a l role i n succession p l a n n i n g . D a n c o does n o t overstate the case w h e n h e notes (1982, p. 137) that " t h e single m o s t i m p o r tant j o b o f the b o a r d o f directors i n the family c o r p o r a t i o n s h o u l d be . . .
to provide for the profitable continuity of the firm. It m u s t p r o m o t e p r o p e r
m a n a g e m e n t development to a l l o w for the 'passing o f the t o r c h ' from the
founder g e n e r a t i o n to the successor g e n e r a t i o n . "
W h i l e n o legal requirements govern selection o f the advisory board,

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c o m m o n sense dictates that the b o a r d should i n c l u d e m e m b e r s w i t h professional legal or a c c o u n t i n g experience a n d business experience. Advisory b o a r d m e m b e r s s h o u l d also c o m e from outside the c o m p a n y . A n
attorney or a c c o u n t a n t retained as a professional by the c o m p a n y m i g h t
be less w i l l i n g to provide a c r i t i c a l assessment than a n outside professional. W h i l e the outsider does n o t provide the firm w i t h actual services,
h e or she c a n offer an independent second o p i n i o n that is n o t available
w h e n the a c c o u n t a n t or attorney is b o t h retained by the firm a n d serves
o n the advisory board.
Directors' Liability
Directors' liability is generally based o n the director's duty of care a n d
fiduciary duty. I n the family c o r p o r a t i o n , two other theories o f liability
are also i m p o r t a n t : p i e r c i n g the corporate veil a n d liability for p e r s o n a l
a c t i o n s . I n this section, we discuss these four types o f liability.
Duty of Care. Directors are required by statute to exercise due care. I n
the words o f S e c t i o n 8.30 of the Model Act (Revised Model. . . , 1985) a
director m u s t act " w i t h the care a n ordinarily prudent person i n a like
p o s i t i o n w o u l d exercise under s i m i l a r c i r c u m s t a n c e s . " State c o r p o r a t i o n
laws also list specific types of liability from w h i c h the exercise o f ordinary
care is n o protection. F o r e x a m p l e , these laws h o l d directors personally
responsible for distribution of an illegal dividend, losses r e s u l t i n g from
activities b e y o n d its lawful powers, a n d contracts made i n states where
the c o r p o r a t i o n has n o t o b t a i n e d a certificate o f authority to c o n d u c t
business.
T w o factors m i t i g a t e the duty of care. First, directors are entitled to
rely o n reports, o p i n i o n s , f i n a n c i a l data, a n d other i n f o r m a t i o n supplied
by c o m p a n y employees, professionals (legal c o u n s e l , a c c o u n t a n t s ) , or
b o a r d committeesprovided that directors have n o reason to be suspicious of this i n f o r m a t i o n .
S e c o n d , a n d perhaps m o r e i m p o r t a n t , courts have adopted a handsoff p h i l o s o p h y k n o w n as the business judgment rule w h e n r e v i e w i n g
directors' decisions. I n the words o f the Delaware S u p r e m e Court, the
business j u d g m e n t rule "is a p r e s u m p t i o n that i n m a k i n g a business
decision the directors of a c o r p o r a t i o n acted o n a n informed basis, i n
g o o d faith, a n d i n the h o n e s t belief that the a c t i o n taken was i n the best
interests o f the c o m p a n y " (Aronson v. Lewis, 1984). T h i s m e a n s that the
party w h o challenges a business decision faces a difficult burden o f proof.
As a result, absent fraud o r self-dealing, directors are rarely found l i a b l e
for errors, mistakes, or s i m p l e b a d j u d g m e n t ( B l o c k , B a r t o n , a n d R a d i n ,
1987).
I n a d d i t i o n to these legal factors, there are p r a c t i c a l considerations
that protect directors o f a family c o r p o r a t i o n from liability. W h i l e it has

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been asserted that a lawsuit filed by shareholders is the most serious risk
that corporate executives face ( B i s h o p , 1982), i n m a n y family corporations all shareholders serve o n the board. I n cases where these shareh o l d e r - b o a r d m e m b e r s u n a n i m o u s l y agree o n a p a r t i c u l a r c o u r s e of
a c t i o n , there are n o shareholders left w h o c a n later assert that the b o a r d
failed to exercise due care. Similarly, a l t h o u g h a c t i o n s seeking recovery
from directors c h a r g e d with v i o l a t i n g securities law m a y be the fastestg r o w i n g area o f personal liability ( B i s h o p , 1982), m o s t family corporations do n o t have or seek p u b l i c f i n a n c i n g . T h u s , the exposure o f their
directors under securities l a w is reduced.
T h i s is n o t to say, however, the a director m a y i g n o r e the business
affairs o f the c o r p o r a t i o n w i t h o u t risk o f p e r s o n a l liability. T h e r e is case
a u t h o r i t y for h o l d i n g a director personally liable for losses suffered by
the c o r p o r a t i o n w h e n those losses have been caused by the director's
failure to discharge the duty o f care. F o r instance, i n Francis v. United
Jersey Bank (1981), the S u p r e m e C o u r t o f N e w Jersey h e l d a director
personally liable for the losses o c c a s i o n e d by the fraudulent acts of others.
T h e director k n e w n o t h i n g a b o u t the c o r p o r a t i o n ' s affairs a n d h a d n o t
even read f i n a n c i a l statements that allegedly disclosed o n their face the
m i s a p p r o p r i a t i o n of trust funds.
Fiduciary Duty. Directors owe a fiduciary duty to the c o r p o r a t i o n . As
a result, contracts between a director a n d the c o r p o r a t i o n s h o u l d be fair
to the c o r p o r a t i o n , a n d a director s h o u l d never personally enter i n t o a
business t r a n s a c t i o n in w h i c h the c o r p o r a t i o n m i g h t be interested.
Directors a l s o owe a fiduciary duty to shareholders. I n o n e case, a son
w h o was the majority shareholder i n a l u m b e r c o m p a n y operated the
c o m p a n y after the death of his father. W h i l e i n the process o f n e g o t i a t i n g
a sale o f the c o m p a n y to B o i s e Cascade, he purchased shares held by his
sister a n d b r o t h e r w i t h o u t d i s c l o s i n g the p e n d i n g sale to them. A court
later h e l d h i m liable for damages o n the g r o u n d s that " a director has a
fiduciary responsibility to b o t h the c o r p o r a t i o n a n d to s h a r e h o l d e r s "
(Weatherby v. Weatherby Lumber Co., 1972).
Piercing
the Corporate
Veil. T h e c o r p o r a t i o n represents a veil
designed to protect its owners from personal liability. I n the words of
attorney G i l b e r t (a partner i n G i l b e r t a n d S u l l i v a n ) in Utopia, Ltd.:
T h o u g h a R o t h s c h i l d y o u m a y be i n your o w n capacity,
As a c o m p a n y you've c o m e to utter sorrow
B u t the liquidators say, "Never m i n d , you needn't pay,"
S o you start a n o t h e r c o m p a n y tomorrow.
However, i n family businesses there is a risk that courts will pierce
the corporate veil a n d h o l d family m e m b e r s w h o serve as directors, shareholders, or employees personally liable i f they have failed to treat the

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c o r p o r a t i o n as a separate entity. T h i s is especially true w h e n the corporat i o n h a s a p a p e r or rubber-stamp board.

As a result, close attention s h o u l d b e paid to legal formalities. Courts
are especially i n c l i n e d to pierce the corporate veil w h e n directors do n o t
meet o n a r e g u l a r basis, a n n u a l reports are n o t filed w i t h the state, the
c o r p o r a t i o n is undercapitalized, corporate assets are c o m m i n g l e d w i t h
personal assets, a n d corporate funds are used for personal purposes.
Personal Actions. Even w h e n the corporate veil is preserved, individuals are liable for their o w n a c t i o n s w h e n n a m e d as defendants i n a civil
lawsuit. T h i s is a special c o n c e r n in family c o r p o r a t i o n s , where family
m e m b e r s are active o n several fronts as directors, officers, a n d employees.
If, for e x a m p l e , a family m e m b e r serving i n these roles causes a n autom o b i l e accident w h i l e o n c o m p a n y business, there is personal liability;
the corporate veil provides n o protection, a l t h o u g h the c o r p o r a t i o n itself
m i g h t also be liable.
Individuals also face p o t e n t i a l c r i m i n a l liability for their o w n a c t i o n s .
I n recent years, for instance, l o c a l p r o s e c u t i n g attorneys have perceived a
decline in federal safety i n s p e c t i o n s of businesses a n d as a result have
b e c o m e m o r e aggressive i n filing c r i m i n a l charges. I n o n e well-publicized
case, a c o m p a n y president, plant manager, a n d f o r e m a n were sentenced
to twenty years i n p r i s o n after a worker died as a result o f unsafe w o r k i n g
c o n d i t i o n s at their c o m p a n y ' s plant (Tasini, 1986).
Liability Prevention
It is possible to m i n i m i z e director liability o n b o t h a structural a n d a
p e r s o n a l level. O n a structural level, the c o r p o r a t i o n s h o u l d agree to
indemnify directors for expenses r e s u l t i n g from l i t i g a t i o n . However, the
c o r p o r a t i o n ' s ability to indemnify is frequently l i m i t e d by law (for e x a m ple, i n cases where the c o r p o r a t i o n itself is s u i n g a director) a n d by the
c o r p o r a t i o n ' s f i n a n c i a l ability to pay. Consequently, a n i n d e m n i f i c a t i o n
agreement s h o u l d be c o m p l e m e n t e d by liability insurance. I n a family
b u s i n e s s where the b o a r d has been e l i m i n a t e d or where the p o w e r o f
a b o a r d h a s b e e n diluted by a shareholder agreement, the shareholders
are the o n e s w h o need to b e p r o t e c t e d by i n d e m n i t y a n d i n s u r a n c e
arrangements.
L i a b i l i t y i n s u r a n c e has been p r o b l e m a t i c i n recent years b e c a u s e it
has b e c o m e very expensive or even unavailable. As a result, Delaware a n d
several o t h e r states have enacted l e g i s l a t i o n a l l o w i n g c o r p o r a t i o n s to
e l i m i n a t e the personal liability o f outside directors to the c o r p o r a t i o n o r
its shareholders for f a i l i n g to exercise due care.
T h e use of a b o a r d of advisers has been r e c o m m e n d e d as an alternative
to the b o a r d o f directors as a way o f preventing directors' liability. W h i l e
courts have n o t yet determined the extent to w h i c h a n advisory b o a r d

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m e m b e r m a y be held liable, this r e c o m m e n d a t i o n is h i g h l y suspect for

two reasons. First, if the advisory board does i n fact perform the functions
of the b o a r d o f directors, then it is possible that the advisers will be held
j u s t as liable as they w o u l d if they were directors. I n other words, courts
will p r o b a b l y place m o r e e m p h a s i s o n the substance o f the a r r a n g e m e n t
t h a n o n the n a m e that it assumes.
S e c o n d , i f the b o a r d is indeed o n l y advisory, the m e m b e r s are i n effect
a c t i n g as consultants. A l t h o u g h they may avoid the liability i m p o s e d o n
directors by statute, they still face liability if they give b a d advice. F o r
e x a m p l e , o n e executive w h o lost his outside directors was advised n o t to
stay i n t o u c h w i t h them. H i s lawyers c o n c l u d e d that the former directors
c o u l d b e held liable merely for providing advice ( B l u m e n t h a l , 1986). T h e
risk o f liability is c o m p o u n d e d by the fact that the usual m e c h a n i s m s
designed to protect directorssuch as the business j u d g m e n t rule, indemn i f i c a t i o n , a n d charter provisions l i m i t i n g personal l i a b i l i t y m a y be
u n a v a i l a b l e to advisory b o a r d m e m b e r s w h o are a c t i n g as consultants.
A n d , even w h e n advisory b o a r d m e m b e r s are n o t held liable, the cost of
l i t i g a t i o n c a n be substantial.
B e y o n d these structural a p p r o a c h e s , directors s h o u l d be able to avoid
l i a b i l i t y o n a personal level by a c t i n g i n a c c o r d a n c e w i t h the two b r o a d
rules o f t h u m b i m p l i c i t i n the business j u d g m e n t rule a n d in the c o n c e p t
of fiduciary duty: First, all decisions s h o u l d be m a d e o n an i n f o r m e d
basis, w i t h d o c u m e n t a t i o n sufficient to withstand a c h a l l e n g e i n court.
S e c o n d , the interests of the c o r p o r a t i o n s h o u l d always c o m e before pers o n a l interests.
T o these general g u i d e l i n e s s h o u l d be added o n e piece of procedural
advice: A director w h o c o n c l u d e s that the b o a r d is m a k i n g an i m p r u d e n t
or illegal decision s h o u l d dissent a n d m a k e certain that the negative vote
is recorded. Otherwise, silence will be construed as consent to the a c t i o n ,
a n d this i n turn c a n lead to liability.
Conclusion
M o r e t h a n twenty-five years a g o , L o r d B o o t h b y described the duties of a
director ("Soft B o a r d s , " 1962, p. 96) as follows: " N o effort of any k i n d is
called for . . . Y o u g o to a m e e t i n g o n c e a m o n t h i n a car supplied by the
c o m p a n y . Y o u l o o k b o t h grave a n d sage, a n d o n two o c c a s i o n s say 'I
agree,' say 'I d o n ' t t h i n k so' o n c e , and if all goes well, y o u get $ 1 , 4 4 0 a
year. I f y o u have five o f them, it is total heaven, like h a v i n g a p e r m a n e n t
hot bath."
T i m e s have c h a n g e d . Over the past two decades, increased c o n c e r n
over liability has led directors to b e c o m e m u c h m o r e involved i n c o m p a n y o p e r a t i o n s . W h i l e this trend is positive, it has c o m e at a steep price
i n terms o f p e r s o n a l liability. However, the price c a n be reduced or even

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avoided if certain measures are taken. T h e benefits of these measures over

the l o n g r u n g o far b e y o n d k e e p i n g the director o u t of court. A n active,
i n f o r m e d b o a r d c o m p o s e d o f m e m b e r s w h o place c o m p a n y interests
before self-interests is the key to developing a s o u n d organization that
will benefit succeeding generations.
References
Aronson v. Lewis, 437 A.2d 805, 812 (Del. 1984).
Bishop, J . W., Jr. The Law of Corporate Officers and Directors Indemnification
and
Insurance. Wilmette, 111.: Callaghan, 1982.
Block, D. J . , Barton, N. E., and Radin, S. A. The Business Judgment Rule: Fiduciary Duties of Corporate Directors and Officers. Englewood Cliffs, N.J.: PrenticeHall, 1987.
Blumenthal, K. "Board Members Confront Loss of Outside Help." Wall Street
Journal, June 2, 1986, p. 19.
"D&O Liability Seen as a Crisis in the Making." Journal of Accountancy, July
1987, pp. 32, 34.
Danco, L. A. Beyond Survival: A Business Owner's Guide for Success. Cleveland,
Ohio: University Press, 1982.
Dyer, W. G., Jr. Cultural Change in Family Firms: Anticipating and Managing
Business and Family Transitions. San Francisco: Jossey-Bass, 1986.
Francis v. United Jersey Bank, 432 A.2d 814, 826 (1981).
Revised Model Business Corporation Act. New York: Law 8c Business, Inc./Harcourt Brace Jovanovich, 1985.
"Soft Boards." Time, October 5, 1962, p. 96.
Tasini, J . " T h e Clamor to Make Punishment Fit the Crime: Local Prosecutors
Are Taking Up Business Cases Once Relegated to Civil Suits." Business Week,
February 10, 1986, p. 73.
Weatherby v. Weatherby Lumber Company, 492 P.2d 43, 45 (1972).

Cindy A. Schipani and George J. Siedel are professors at the

School of Business Administration,
University of Michigan.