Question 2: Torts

Question

Beth, Charles and David are the directors of Web, Inc. (Web), a corporation that is in the business of creating Web sites.

Adco, Inc. (Adco), a corporation that markets computer advertising, had an urgent need for a complex Web site that would cost thousands of dollars to create. Adco approached Web about creating the Web site. Adco explained that it did not have the cash to pay for the work but claimed that it was a well-established corporation and asked Web to extend credit for the work.

Beth, Charles and David unanimously agreed to take on the work, conditioned upon a prior review of Adco's financial statements and a determination of Adco's credit-worthiness. After learning this, Adco contacted David and told him that the sooner Web could start on the Web site, the sooner Adco would be able to pay Web.

David was anxious to obtain Adco's business. He falsely told Beth and Charles that he had obtained and reviewed Adco's financial statements and that, based on his review, "we should proceed with the work." Beth and Charles, without further inquiry, agreed, and Web created the costly Web site. Adco is unable to pay Web.

Beth, Charles and David have now learned that Adco's shareholders have regularly taken its funds for their personal use.

In an unrelated transaction, Charles received a call from his friend Sam who wanted Web to create a new game Web site. Charles told Sam that the new game Web site was such a small job that he could do it at home for less money than Web.

Charles told Sam to send the payment for the game Web site to Charles at his home. Sam was pleased with the work and sent the check to Charles as requested. Shortly afterward, Beth and David learned of this transaction.

  1. What duties to Web, if any, have been breached by Beth, Charles and David regarding the money lost on the Adco job? Discuss.
  2. What rights, if any, does Web have against Adco's shareholders for Adco's failure to pay for the Web site? Discuss.
  3. What rights, if any, does Web have against Charles regarding the contract with Sam? Discuss.

Answer

1. What duties to Web, if any, have been breached by Beth, Charles and David regarding the money lost on the Adco job? Discuss.

A. Fiduciary Duty of Care (Conditional Acceptance of the Project) — Beth, Charles and David
Directors have a duty of care to manage and discharge their duties in good faith with the care a prudent person in their position would exercise, and in a manner the directors reasonably believe is in the best interest of the corporation. Here Beth, Charles and David recognized that producing a website for an organization such as Adco would not only bring income into their company, but that it had the potential to promote their services. Beth, Charles and David unanimously agreed as lucrative as the Adco project was they needed certain assurances payment would be received for the work performed. This determination appears to have been in good faith, because Web had not previously performed work for Adco and Adco stated it was only able to make payment at the conclusion of the project. The directors' decision to proceed only after reviewing the financial statements of Adco was reasonable. Thus, at this point Beth, Charles and David met their duty of care as directors of Adco.

B. Fiduciary Duty of Care (Delegation of Review) — Beth and Charles
Directors are justified in entrusting certain matters of business to officers of the corporation or delegating certain tasks to a single director. Moreover, Directors are justified, in the absence of grounds for suspicion, in trusting that officers and directors of the corporation will perform their duties honestly and in good faith. Here, Beth and Charles delegated the task of obtaining financial information from Adco to David. There would be no reason for each director to separately seek Adco's financial information. Nor would each be required to conduct separate review of the documentation. Thus, Beth and Charles did not breach their fiduciary duty by permitting David to act alone on their behalf.

C. Fiduciary Duty of Care (Independent Review of Data) — Beth and Charles
A director is expected to conduct the business of the corporation with the same diligence as if it were his/her own personal business. This duty may be satisfied by full consideration of all appropriate material and on the advice of professionals, where appropriate. Here, Beth and Charles were anxious to begin work on the project. They accepted David's determination of Adco's credit worthiness without question. Although it may have delayed the start of the project, it would have been reasonable for Beth and Charles to inquire into the documentation that David based his determination on and to generally ask what he had learned. Such inquiry may not have revealed the falsity of David's statements, but likely would have insulated Charles and Beth from liability. Thus, Beth and Charles will likely be held liable to have breached their duty of care for failing to review David's determination of Adco's credit-worthiness.

D. Business Judgment Rule
Under the Business Judgment Rule, directors are not liable if they act: (1) in good faith; (2) with the care of an ordinary prudent person in a like position would exercise under similar circumstances; and (3) in a manner they reasonably believe to be in the best interests of the company. If directors meet this standard, they are not liable even if their decisions are erroneous. Further, directors are entitled to rely on information or advice provided to them by other directors, officers, employees, and outside experts. Here, there are no facts that Beth or Charles acted in bad faith or in a manner they believed not to be in the best interest of Web. However, Beth and Charles relied on David's statements that he had obtained Adco's financial data and found it sufficient to extend credit to Adco. Beth and David relied on these representations without asking any questions to determine what information David reviewed or how he reached his conclusion. Thus, the business judgment rule will not shelter Beth or Charles from liability.

E. Fiduciary Duty — David
David as a director owed a fiduciary duty to Adco. As stated above, David was obligated to act in the best interest of the corporation. Here, David actively misrepresented his actions by stating he had reviewed Adco's financial documentation and found Adco to be credit worthy. This statement was made in bad faith. Thus, David's actions breached his fiduciary duty to Adco.

F. Misrepresentation — David
Misrepresentation occurs where there is a knowing misrepresentation of a material fact made with the intent to induce reliance, the misrepresentation induces reliance and results in damages. Here, David knowingly lied to Charles and Beth when he stated that had he reviewed Adco's financial documentation and found Adco credit worthy. David had not received any documentation or conducted any such review. He made the statement to Beth and Charles anticipating that as a fellow director they would rely upon it. In fact, Charles and Beth did accept David's statement as truthful and proceeded to work on the website based on his statement. After the work was completed, Adco suffered damages when Adco was unable to make payment for the work. Thus, David appears to be liable for misrepresentation.

2. What rights, if any, does Web have against Adco's shareholders for Adco's failure to pay for the website? Discuss.

Piercing the Corporate Veil — "Alter Ego"
A corporation is a separate entity that alone is obligated to meet its debts, except in extraordinary circumstances. However, courts will pierce the corporate veil and hold the individual owners liable where the corporation is believed to have inadequate assets to cover its liabilities and the corporation is not really a distinct entity, but merely an extension or "alter ego" of its shareholders, which being used to advance their private interests or to perpetrate a fraud. Three factors are considered when piercing the corporate veil: 1) whether corporate formalities were observed; 2) whether the principals maintained financial individual control of corporation; and 3) whether the principals used the corporation to advance their own interests. Here Adco's directors would regularly take Adco's funds for their personal use. In doing so, the Adco's directors appeared to have maintained individual control of the finances of Adco and use the corporation to advance their own interests. Thus, the corporate veil will likely be pierced and the Adco's shareholders will be held individually liable to Web.

3. What rights, if any, does Web have against Charles regarding the contract with Sam? Discuss.

A. Duty of Loyalty — Conflict of Interest
Directors owe a fundamental duty of loyalty to the corporation and its shareholders. A director's self-dealing or advancing his/her self-interest ahead of a corporation's interest demonstrates a breach of this duty for loyalty. Where a director's self-dealing results in a material financial benefit to the director, the transaction is evaluated by whether it was just and reasonable to the corporation. Here, Charles performed work for Sam, which was the very type of work Web co performed. Charles was a director at the time he advised Sam that he (Charles) could perform the work. Charles owed Web a duty of loyalty with respect to this transaction. Thus, as a director Charles breached his duty of loyalty to Web.

B. Duty of Loyalty — Corporate Opportunity Doctrine
The Corporate Opportunity Doctrine prevents directors from usurping an opportunity in which their company has an interest for their personal gain. A director may not divert a business opportunity from their corporation without first giving the corporation an opportunity to act. After making the opportunity available to the corporation, the director may engage in such activity when the corporation rejects the opportunity. Here, Web had an expectancy interest in the project, because Sam had intended to give the work to Web. The project was within the line of work performed by Web. Charles withheld information about the project with the intention to divert the potential profits Web could have realized. The facts do not suggest that Web could not or would not have accepted the project. Rather, Charles did not give Web an opportunity to accept the project. In total, Charles's actions did not demonstrate fairness to Web. Thus, Charles would be guilty of usurping a business opportunity in violation of his duty of loyalty.

C. Web's Recovery — Breach of the Duty of Loyalty
An interested director may be required to divest himself of profits realized as a result of a breach of his duty of loyalty. Here, Charles usurped Web's opportunity to create the game website. Charles intended for Sam to pay him directly for the work he performed. This arrangement would have meant that Charles alone would have profited from the arrangement. The facts do not indicate the amount of profit Charles realized as a result of this transaction. Thus, to the extent any profits were realized as a result of this transaction, Web can require that Charles be divested of that profit.

D. Web's Recovery — Usurped Corporate Opportunity
Where a director is found to have usurped a corporate opportunity, the corporation may recover damages equal to the losses it suffered as a result of the lost opportunity or the profits it would have made had it been allowed to pursue the opportunity. Here, the facts are insufficient to ascertain the profits that would have been realized by Web. Thus, it is likely that Web would be able to recover the losses it suffered as a result of Charles's action.