Corporate officers and directors owe a fiduciary duty to the corporation that they serve, and they can be held liable if they breach that fiduciary duty. Fiduciary duties are not codified in the Texas Business Organizations Code (BOC),[1] but instead have developed through Texas case law and generally include the duty of loyalty, duty of care, and duty of obedience (also known as the duty to follow the law).[2] Directors must use their unbiased business judgment for the sole benefit of the corporation.[3]
What is the Business Judgment Rule?
The business judgment rule may protect a corporation’s officers or directors from liability for a breach of fiduciary duty claim by the corporation. Under the rule, a director acting in good faith is not liable for mistakes in business judgment that damage the corporation’s interests.[4] The rule protects directors from liability for actions within the honest exercise of a director’s business judgment and discretion, even if the actions are negligent, unwise, inexpedient, or imprudent.[5]
The Texas Supreme Court has stated that “courts will not interfere with the officers or directors in control of the corporation’s affairs based on allegations of mere mismanagement, neglect, or abuse of discretion.”[6]The business judgment rule, however, does not protect fiduciaries from liability for acts that are dishonest, fraudulent, or self-dealing.
When Does the Business Judgment Rule Apply?
Texas case law specifically addressing which fiduciary duties are subject to protection from the business judgment rule is limited. It seems fairly clear that the business judgment rule will protect a director from liability arising from a claim of breach of the duty of care, which involves general mismanagement. The U.S. District Court for the Western District of Texas has joined the majority of federal district courts in finding that Texas courts would, however, hold a director liable for breach of the duty of care if the director causes the corporation harm through gross negligence.[7] The business judgment rule would not likely protect against liability for actions considered to be required under a duty of loyalty.[8] Likewise, the business judgment rule is not likely to provide any protection from liability for failure to obey the law or the duty of obedience, as actions required by law are not within the discretion of directors. The Texas Supreme Court recently confirmed that the business judgment rule applies to closely held corporations.[9]
Although the business judgment rule is described as a defense to a breach of fiduciary duty claim, it is a substantive rule requiring the plaintiff to plead and prove that the director’s conduct is outside of the rule’s protection.[10] Notably, however, the Texas Supreme Court has held that a shareholder of a closely held corporation is not required to plead and prove that the board of directors acted outside of the protections of the business judgment rule in deciding not to pursue the corporation’s cause of action.[11]
Need assistance in managing the business planning processes? Freeman Law advises clients with corporate and other entity formations and reorganizations. Restructuring entities—through conversions, mergers, and liquidations—can involve particularly complex tax and regulatory considerations. Freeman Law provides experienced tax and business counsel, helping our clients achieve their organizational goals in a tax-efficient manner. Schedule a consultation or call (214) 984-3000 to discuss your corporate structuring or business and tax planning concerns.
[1] Tex. Bus. Orgs. Code Ann. §§ 1.001 et seq.
[2] See Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707, 719-23 (5th Cir. 1984) (addressing Texas law); see also Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014); Loy v. Harter, 128 S.W.3d 397, 407 (Tex. App.-Texarkana 2004, pet. denied).
[3] See In re Westec Corp., 434 F.2d 195, 202 (5th Cir.1970)
[4] See Gearhart, 741 F.2d at 721.
[5] Sneed v. Webre, 465 S.W.3d at 178.
[6] See Sneed v. Webre, 465 S.W.3d 169, 186 (Tex. 2015) (citing Cates v. Sparkman, 11 S.W. 846, 859 (Tex. 1889)).
[7] In re Life Partners Holdings, Inc. Shareholder Derivative Litigation, 2015 WL 8523103 (W.D. Tex. 2015).
[8] Id.
[9] See Sneed v. Webre, 465 S.W.3d at 179.
[10] See Matter of Estate of Poe, 591 S.W.3d 607, 640-41 (Tex. App.-El Paso 2019, pet. filed).
[11] Sneed v. Webre, 465 S.W.3d at 193.
