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Fiduciary Duties and the Business Judgment Rule

The duties of care and loyalty that directors, officers, managers and controlling owners owe the business, the rule that protects honest decisions that turned out badly, and the derivative suit that enforces them.

Informational only - this is not legal advice. These definitions explain general legal vocabulary in plain English. They are not advice about your situation, reading them creates no attorney-client relationship, and the law differs from state to state and changes over time. For advice you can rely on, speak to a lawyer licensed in your state.

What it means

The people who run a corporation or LLC owe it fiduciary duties. The duty of care requires them to inform themselves and act with the diligence a reasonably prudent person would use; the duty of loyalty requires them to put the company's interests ahead of their own - not to take a business opportunity that belongs to the company, not to deal with it on unfair terms, not to compete with it, and to disclose conflicts. Controlling shareholders and LLC managers owe versions of the same duties to the entity and, in some situations, to the minority owners.

The business judgment rule is the courts' answer to the obvious problem that every business decision can look wrong in hindsight. It presumes that a decision made by disinterested directors, on an informed basis, in good faith and in the honest belief that it served the company, will not be second-guessed, however badly it turned out. The presumption is lost when a decision-maker was conflicted, acted in bad faith, or made no real effort to be informed; then the burden shifts and the transaction is tested for fairness. Many states also allow a corporation's charter to exculpate directors from personal liability for breaches of the duty of care, but not of loyalty or good faith.

These duties are enforced mostly through the derivative suit, in which an owner sues on the company's behalf because the people who would ordinarily decide whether to sue are the defendants. LLC statutes in several states allow the operating agreement to narrow, and in a few to eliminate, fiduciary duties, leaving only the implied covenant of good faith and fair dealing - which is why the LLC agreement, not the statute, is the first place to look.

Where this comes from

Fiduciary duties and the business judgment rule are state corporate and LLC law, most developed in Delaware: Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (duty of care), Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939) (corporate opportunity), and 8 Del. C. § 102(b)(7) (charter exculpation for the duty of care). Model Business Corporation Act §§ 8.30 and 8.31 state the standards of conduct and liability for directors adopted in many states. For LLCs, Delaware Limited Liability Company Act, 6 Del. C. § 18-1101(c), permits the agreement to modify or eliminate duties other than the implied covenant, and Revised Uniform Limited Liability Company Act § 409 states the default duties in the states that adopted it.

When people hire a lawyer for this

A minority owner who believes those in control are diverting opportunities, paying themselves unfairly or dealing with the company on the side should consult a lawyer before demanding anything, because the derivative route has procedural prerequisites - typically a demand on the board or an explanation of why demand would be futile - that are easy to get wrong. Directors and managers facing a conflicted decision should get advice on process before deciding: recusal, independent approval and a documented record are what keep the business judgment rule available.

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Part of the LawyerLand plain-English legal glossary. Definitions are written from primary sources - statutes and court rules - and each entry states the authority it rests on, or says plainly when the doctrine is state law with no national rule.

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