Recently, a commercial creditor attempted to rely upon dictum from a 1976 Minnesota Supreme Court decision to claim that directors should be liable to the creditor based on negligence principles for failing to detect or prevent torts committed by corporate employees. But to hold directors liable in such circumstances would dangerously expand the traditional rule that directors are not liable to third party commercial creditors in negligence for torts they did not commit.
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Several years ago the president of a company forged the signatures of our director clients on personal guarantees as part of a scheme to defraud a bank into making a loan to the president's company. Our clients were also defrauded into investing in the president's corporation, and became shareholders and directors just three weeks before the bank made its loan. After the bank had issued the loan, our clients discovered the fraud and promptly notified the bank. Unfortunately, by this time, the loan proceeds had been used by the corporation and there were insufficient funds or assets to re-pay the loan. The president was indicted for bank fraud and alas had no assets. The bank sued our clients, alleging that their negligence in supervising the president's performance was a proximate cause of the bank's loss.
Our clients were not negligent in the performance of their director duties. Nonetheless, to permit a commercial creditor to sue a director for negligence in the performance of his or her duties would radically expand the law on director liability. Traditional hornbook law is that that "[a]n officer or director of a corporation is not personally liable for torts of the corporation or of its other officers and agents, . . . but can only incur personal liability by participating in the wrongful activity." [1] The Minnesota Court of Appeals has followed this approach. [2] In our case, the bank urged a much more liberal rule of director liability, relying upon dictum from a 1976 Minnesota Supreme Court case, Morgan v. Eaton's Dude Ranch, which states that a corporate officer or director is liable to third parties for harm caused by the torts of other officers or employees if he either "participated in, directed or was negligent in failing to learn and prevent the tort.'"[3] To permit a commercial creditor to sue a director for negligence would significantly expand the potential liability of Minnesota directors. In the recent post Enron wake of corporate scandals, expansion of director liability may seem attractive to more than just the plaintiff's bar. But why should a director owe a commercial creditor any duty in the first place? This article discusses the current state of the law in Minnesota on directors' liability to commercial creditors and concludes that directors should not be subject to claims of negligence by commercial creditors for torts the directors did not participate in.
A. Under the Common Law, Corporate Directors Owe No Duty to Third Parties.
The premise that directors owe no duties to commercial creditors is based on venerable agency principles. Under the common law, an agent of the corporation is not liable for harm to someone other than his principal unless physical harm results to the third-party from reliance upon performance of the agent's duties to the principal. [4] The rule restricting director liability to third party commercial creditors is based on this rule. [5] Stated otherwise, the director owes his or her duty only to the corporation (as principal), not to creditors generally. [6]
Sound policy reasons support this limitation of director liability. After all, the commercial creditor voluntarily extends credit to the corporation and "[i]t is fair to assume that [it] looked to the corporation's ability to pay, not the directors'" when it did so. [7] Moreover, the commercial creditor has the opportunity to structure its transaction in a way that will protect it against the economic risks of non-performance, through such mechanisms as acceleration clauses, remedies upon default, and personal guarantees. A personal injury claimant does not have such an opportunity. In addition, because the commercial creditor did not elect the directors, or contract for the right of recovery against them, it should have no right of recourse against the directors if the corporation does not pay its debt. [8]
The exception at common law for cases involving personal injury makes sense too. Unlike the commercial creditor, the personal injury victim cannot structure his transaction with the corporation to prevent or minimize the risk of personal injury. The patron of an amusement park, for example, depends on the directors of the corporation to ensure an inspection program is in place to guarantee that the rides are safe. If the law did not potentially subject directors to liability for personal injuries suffered by foreseeable victims, then a director could escape liability behind the shield of his or her representative character, even though the corporation might be insolvent. [9]
In contrast, in a commercial context the law has been far more protective of directors who are negligent in the performance of their duties. [10] Thus, Section 352 of the Restatement (Second) of Agency provides:
An agent is not liable for harm to a person other than his principal because of [the agent's] failure adequately to perform his duties to his principal, unless physical harm results from reliance upon performance of the duties by the agent, or unless the agent has taken control of land or other tangible things.
Section 357 of the Restatement further provides:
An agent who intentionally or negligently fails to perform duties to his principal is not thereby liable to a person whose economic interests are thereby harmed.
Comment a. to Section 357 explains that the reason for this rule is that "[w]hen merely economic interests are involved, the courts have been slow to create liabilities even for negligent or intentionally wrongful breaches of duty to one person which affect the economic interests of others."
B. Minnesota Courts Have Narrowly Construed When Directors May Be Liable to Commercial Creditors.
The only recognized exception to the rule that directors do not owe a duty to commercial creditors has arisen in the insolvency context (in the case of corporations operating at or near insolvency), where directors engage in self-dealing. Even this exception, however, has been narrowly construed by Minnesota courts. For example, in St. James Capital Corp. v. Pallet Recycling Associates of North America, Inc.,[11] the Minnesota Court of Appeals refused to expand the recognized duty of directors of insolvent corporations to third party creditors beyond self-dealing. The creditors in St. James asserted claims against directors of an insolvent corporation alleging, in part, that they were negligent in failing to complete a public offering of debt or equity securities necessary to recapitalize the corporation and that they failed to liquidate the company's assets in a commercially reasonable manner. The St. James court affirmed the district court's dismissal for failure to state a claim, noting that the plaintiff's inappropriately "seek to impose a general negligence duty of care upon directors" and concluding that "[t]o extend the duty of due care to cover Directors in this case would seriously erode the limited liability protection granted by the corporate structure." [12]
Similarly, in Helm Financial Corp. v. MNVA R.R. Inc, the Eighth Circuit rejected an attempt to hold directors liable under Minnesota law for selling off an insolvent corporation's most valuable asset—its stock of a subsidiary—to the parent's shareholders. [13] The Eighth Circuit held that no breach of duty occurred because the directors did not engage in self-dealing or prefer themselves to other creditors. Moreover, the court explained that the duty to creditors arose "only to the limited extent that [directors] are prohibited from securing for themselves, as creditors, a preference over other creditors." [14] These decisions demonstrate that, in the insolvency context, courts applying Minnesota law adhere to very narrow exceptions to the rule that directors are generally not liable to commercial creditors.
C. The Morgan Decision.
In Morgan, the plaintiff suffered a serious personal injury as a result of a tree branch jutting into the path of her hayride. She obtained a jury verdict against both the ranch and its president. The president appealed from the verdict against him, noting it was "settled that a corporate officer is not liable for the torts of the corporation's employees unless he participated in, directed, or was negligent in failing to learn of and prevent the tort." [15] The Supreme Court reversed the jury's verdict because there was no evidence the president "knew or should have known of the dangerous condition which existed or that he directed [the driver] to proceed in the face of danger." [16] As authority for its negligence standard, the Morgan court cited to Preston-Thomas Construction, Inc. v. Central Leasing Corp. ("Preston"), a decision from the Oklahoma Court of Appeals. [17]
Preston is a case involving rather egregious facts that are more fairly characterized as intentional wrongdoing than negligence. In Preston, the two defendants were involved in soliciting funds for the purchase of a root beer manufacturing company with a third officer who was not a party to the case. The non-party officer had promised investors their money would be returned if the root beer company was not acquired. Predictably, the root beer company was not acquired, and the investors were neither told, nor given their money back. To add insult to injury, the directors paid themselves $ 1,000 each from the investor proceeds. Not surprisingly, a jury verdict was returned against both defendants for converting money held by the corporation in trust for the investors. The Oklahoma Court of Appeals affirmed, noting that:
Appellant's first proposition—that corporate officers are not liable for wrongful acts of the corporation—is but a partial rule of law. The rest of the rule . . . is that an officer or director of a corporation is personally liable for the wrongful use of funds entrusted to it if (1) he receives any of the money; (2) if he participates in the wrongful asset distribution; (3) or, being ignorant of the wrongdoing, he is negligent in failing to learn of and prevent it. The law will not permit an officer or director to escape personal responsibility for his corporation's intentional malfeasance by preserving a state of ignorance through a gross or willful neglect of duties. [18]
It is significant that virtually the entire discussion of the director liability issue in Preston is predicated on a discussion of the rule about when "an officer or director of a corporation is personally liable for the wrongful use of funds entrusted to" the corporation. [19] The existence of funds held in trust is a factor that significantly increases a director's chance of being found liable to a creditor whose trust funds are converted or misapplied. As the New Jersey Supreme Court noted in Francis v. United Jersey Bank, "[t]he distinguishing circumstances in regards to banks and other corporations holding trust funds is that the depositor or beneficiary can reasonably expect the director to act with ordinary prudence concerning the funds held in a fiduciary capacity." [20]
D. What is the Rule After Morgan?
Although Morgan arose in a personal injury context, nothing in the decision explicitly limits the articulated negligence standard to personal injury cases only. Further, its citation to Preston, a commercial case, certainly raises a question as to the intended scope of the negligence standard. Interestingly, in two commercial cases, Universal Lending Corp v. Wirth Cos.,[21] and Holzer v. Tonka Bay Yachts & Marine Sales, Inc.,[22] both decided ten years after Morgan, the Minnesota Court of Appeals did not even discuss the Morgan case, and ruled without comment that director or officers are not liable for torts of other employees unless they actively participate in them. On the other hand, an unreported Minnesota Court of Appeals case does cite to Morgan's general negligence standard in a commercial context, but found no negligence. [23] Consequently, the Minnesota Court of Appeals has issued inconsistent rulings as to the applicable legal standard governing director or officer liability for torts committed by other employees and has never squarely addressed whether or not the Morgan standard applies in a commercial context.
No sound policy reasons support giving commercial creditors the right to sue officers or directors in negligence for torts they did not commit. Officers and directors should not, by virtue of their office, be held vicariously liable for torts of others. An economic creditor has the ability to protect its interests through contract law. It also has additional protections provided by both fraudulent conveyance and bankruptcy law. It should have no recourse against directors because it has not bargained for the additional shareholder right of being able to intervene in management or to enforce a director's duties to the corporation. [24] To give commercial creditors such a right would unnecessarily interfere with corporate governance.
We can imagine situations in which a director's willful ignorance of wrongdoing could be construed as tantamount to "actual knowledge" or "authorization." But recklessness or intentional conduct does not amount to mere negligence. Absent such extreme facts, to impose a negligence standard on a corporate director would effectively make them insurers of the honesty and integrity of corporate employees. Directors should not have to face a trial every time an employee or officer unforeseeably commits wrongdoing based on a creditor's claim that if the director had just done his or her job, the tort might have been prevented.
Notably, courts have been unreceptive to arguments that directors had an obligation to ferret out fraud, which would greatly expand a director's liability, as exemplified by the Delaware Supreme Court in Graham v. Allis-Chalmers Manufacturing Co.:
The precise charge made against these director defendants is that, even though they had no knowledge of any suspicion of wrongdoing on the part of the company's employees, they still should have put into effect a system of watchfulness which would have brought such misconduct to their attention in ample time to have brought it to an end. . . . On the contrary, it appears that directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong.[25]
Indeed, the Minnesota Business Corporations Act statutorily codifies a director's right to rely on reports, statements and information prepared by officers and employees whom the director reasonably believes to be reliable and competent. [26]
To the extent courts do extend the negligence standard to directors in a commercial context, care must be taken not to undermine a director's right to rely on subordinates. As a practical matter, most courts faced with commercial creditor claims against directors have tended to be extremely deferential to a director's right to rely on others, absent egregious conduct by the director. [27]
Conclusion
The Morgan court's dicta suggesting directors might be liable to creditors for negligence in failing to detect or prevent torts committed by other corporate employees should be confined to the personal injury context. At a minimum, the doctrine must be very cautiously applied, so as not to undermine the right of directors to rely on reports from corporate subordinates. Corporate creditors have any number of ways to negotiate protection for payment of corporate obligations. They should not be entitled to involuntarily make directors the insurers of the integrity of all corporate employees.
Recently, the Hennepin County district court granted summary judgment in favor of our clients, ruling that Morgan and Preston were inapplicable to claims against directors in a commercial context. The district court ruled that absent active participation by the directors in the president's fraud, of which there was absolutely no evidence, vicarious liability could not be imposed on the directors. The district court also ruled that the directors had reasonably relied upon the president, whom they had no reason to suspect was engaging in criminal activity. Since the bank has chosen not to appeal the district court's decision, a definitive appellate decision on the scope of director liability to commercial creditors will have to await another day. When that day arrives, the appellate court should not expand the traditional rule that directors cannot be held liable to commercial creditors in negligence for torts they did not commit.
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Alain Baudry is a partner at Maslon Edelman Borman & Brand, LLP, where he practices in the areas of unfair competition, franchise and distribution litigation and general commercial litigation.
Nicole Narotzky is an associate at Maslon Edelman Borman & Brand, LLP, where she practices in the areas of intellectual property, product liability, and general commercial litigation.
[1]3A William Meade Fletcher, et al., Fletcher Cyclopedia Corporations (hereinafter "Fletcher") § 1137 at 209 (perm. ed., rev. vol. 2002) (emphasis added).
[2]See Universal Lending Corp. v. Wirth Cos., 392 N.W.2d 322, 326 (Minn. Ct. App. 1986); Holzer v. Tonka Bay Yachts & Marine Sales, Inc., 386 N.W.2d 285, 287 (Minn. Ct. App. 1986).
[3]239 N.W.2d 761, 762 (Minn. 1976) (emphasis added).
[4]Restatement (Second) of Agency § 352 (1958).
[5]See, e.g., Speer v. Dighton Grain, Inc., 624 P.2d 952, 958 (Kan. 1981).
[6]See, e.g., Marin v. Calmenson, 197 N.W. 262, 264 (Minn. 1924) ("Directors do not stand in the same relation to general creditors of a corporation as they occupy when the rights of the corporation or its stockholders are involved"); Jones v. Dist. VIII Planning Council, 492 F. Supp. 143, 146, n.3 (D. Minn. 1980).
[7]Flip Mortg. Corp. v. McElhone, 841 F.2d 531, 534 (4th Cir. 1988).
[8]McGivern v. AMASA Lumber Co., 252 N.W.2d 371, 377 (Wis. 1977) (quoting 20 Cal. L. Rev. 426, 430, 431 (1932)).
[9]Frances T. v. Village Green Owners Ass'n, 723 P.2d 573, 581 (Cal. 1986).
[10]See, e.g., Shay v. Flight C Helicopter Servs., Inc., 822 A.2d 1, 17 (Pa. Super. 2003).
[11]589 N.W.2d 511 (Minn. Ct. App. 1999).
[12] Id. at 516.
[13] 212 F.3d 1076, 1081 (8th Cir. 2000).
[14]Id. at 1081.
[15]Morgan v. Eaton's Dude Ranch, 239 N.W.2d 761, 762 (Minn. 1976).
[16]Id.
[17]518 P.2d 1125 (Okla. Ct. App. 1973).
[18]Id. at 1127 (emphasis added).
[19]Id.
[20]432 A.2d 814, 825 (N.J. Sup. Ct. 1981).
[21]392 N.W.2d 322, 326 (Minn. Ct. App. 1986).
[22]386 N.W.2d 285, 287 (Minn. Ct. App. 1986).
[23]Emery v. Ryland Group, Inc., No. C7-02-22, 2002 WL 1277037 (Minn. Ct. App. June 11, 2002).
[24]See Zipora Cohen, Director's Negligence Liability to Creditors: A Comparative and Critical View, 26 J. of Corp. L. 351, 358 (2001).
[25]188 A.2d 125, 130 (Del. 1963) (emphasis added).
[26]Minn. Stat. § 302A.251, subd 2(a).
[27]See, e.g., Wolf Designs, Inc. v. DHR & Co., 322 F. Supp. 2d 1065, 1072 (C.D. Cal. 2004) ("[M]ere knowledge of tortious conduct by the corporation is not enough to hold a director or officer liable for the torts of the corporation absent other 'unreasonable participation' in the unlawful conduct by the individual."); Air Traffic Conference of Am. v. Marina Travel, Inc., 316 S.E.2d 642, 645 (N.C. Ct. App. 1984); Rowen v. Le Mars Mut. Ins. Co. of Iowa, 282 N.W.2d 639, 652-53 (Iowa 1979).