9 Nov 2014

One of the two primary fiduciary duties required to be discharged by directors of a company. The duty of care requires directors to make business decisions after taking all available information into account, and then act in a judicious manner that promotes the company’s best interests. Directors are required to exercise the utmost care in making business decisions in order to fulfill their fiduciary duty. The other main fiduciary duty is the duty of loyalty.

Failure to uphold the duty of care may result in legal action being brought against the board of directors by disgruntled shareholders. However, the courts will not rule on whether or not a business decision was a sound one. Instead, their main focus is on assessing whether the directors:

1. Fulfilled their duty of care by acting in a reasonably prudent manner when making the decision

2. Conducted an adequate degree of due diligence

3. Acted in good faith

For example, assume a public company PubCo makes a large acquisition of rival firm ABC Holdings that effectively doubles its size. The market reaction, judging by the decline in PubCo’s share price after the acquisition is announced, is that PubCo paid too much for ABC Holdings. PubCo’s management is initially very confident that the acquisition will be accretive to earnings. But a few months after the deal closes, PubCo announces that ABC’s management had been engaged in accounting fraud that grossly inflated its revenue and profitability. Despite PubCo’s management asserting that they had no inkling anything was amiss at ABC, PubCo’s shares plunge 30% and shareholders launch a class-action lawsuit against PubCo’s directors.

In such a situation, if the case does go to trial (most such cases are settled out-of-court), the court would not rule on whether PubCo paid too much for ABC. Rather, it would assess whether PubCo’s board of directors conducted their due diligence on ABC and acted in good faith. The fact that the directors failed to detect the accounting fraud at ABC does not necessarily constitute a breach of the duty of care. But if PubCo’s directors were aware of it and chose to go ahead with the acquisition anyway, this could be construed as a breach of duty.

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