Foreign nationals are frequently asked by international parent companies to serve as officers or directors of California-based wholly-owned subsidiaries. Often these individuals are reluctant to take such a position, given their perception of the litigiousness of Americans. That concern, however, is misplaced because wholly-owned subsidiaries avoid the most common risk associated with serving as an officer or director, that of actions that might be brought by minority shareholders. There remain, however, some minimal risks the individual should consider before accepting the position. These risks arise most commonly from judicial interpretation of the whether the director or officer complied with his or her "duty of loyalty" and "duty of care" and are largely abated by the protections afforded by the "Business Judgment Rule."
In California, like many other states, directors and, by common-law extension, officers owe a "duty of care," which duty requires competency, diligence and exercise of good faith in their decision-making and supervisory functions. Directors also owe the corporation a "duty of loyalty," which prohibits the directors from serving their own interests at the expense of the corporation.
Directors have a strong defense to any claim for breach of duty of care based on what is known as the Business Judgment Rule. That rule protects directors from being second guessed by shareholders and the courts on a particular business decision if the director acts on an informed basis, in good will, and in the honest belief that the decision was in the corporation’s best interest.
As a threshold matter, to invoke the Business Judgment Rule the director must demonstrate that he or she (a) was not interested in the subject of business judgment; (b) was properly informed regarding the subject of the business judgment as appropriate under the circumstances; and (c) rationally believed that the business judgment is in the best interest of the corporation. To ensure that the directors are sufficiently informed, the directors may rely on advice of management and experts in making decisions, provided that they exercise the necessary oversight and inquire into the information upon which their advice is based.
The "duty of loyalty" arises in (a) transactions directly between the corporation and one of its directors or officers, (b) corporate opportunity situations, (c) corporate control contests, (d) transactions between corporations and interlocking boards of directors, (e) executive compensation arrangements, (f) situations in which a director or officer competes with the corporation, and (g) defective disclosure to shareholders. The duty of loyalty arises even when the interested director may not have personally profited. California law provides that a transaction in which a director is interested is not void or voidable if it is approved by the shareholders and the material facts concerning the director’s interests are fully disclosed, and shares held by the interested directors are not entitled to vote, or if it is approved by disinterested directors. These safe harbor provisions do not protect a transaction that involves the lack of good faith, waste, or fraud.
There are certain situations where a director or officer could face personal liability for what are essentially corporate obligations and that are not derived from recalcitrant shareholders. The following are the most common:
- If the corporation does not pay over to the state or federal government payroll taxes.
- If the corporation is actually insolvent, directors owe creditors the duty to avoid diversion, dissipation, or undue risk to assets that might be used to satisfy creditors’ claims. (That said, in most cases, the presumption created by the Business Judgment Rule discussed above will provide a strong defense).
- If the board of directors declares an illegal dividend or other distribution (even to the parent company), the directors may have personal liability to third party creditors who are hurt by such action.
Even though the risks of serving as a director or officer of a wholly-owned subsidiary are minimal, an individual considering whether to so serve should (a) confirm that the parent and possibly the subsidiary have agreed to indemnify the individual, and (b) confirm that the subsidiary corporation has adequate directors and officers liability insurance. In addition, the individual should confirm that the subsidiary is authorized by its Articles of Incorporation to provide the maximum indemnification allowed under California law, and to eliminate each director's liability for monetary damages to the corporation itself to the maximum extent permitted under California law.
As should be obvious from the preceding discussion, in the case of a wholly-owned subsidiary, the above duties are very unlikely to be problematic.