Duty of Obedience
Most jurisdictions recognize that directors have three basic fiduciary duties: the duty of care, the duty of loyalty, and the duty of obedience. The duty of obedience requires a director to act in furtherance of the business organization’s goals and mission as stated in the articles of incorporation and bylaws. The duty of obedience also prohibits a director from committing acts that are outside the scope of the business organization’s powers, i.e., ultra vires acts. Additionally, a director must comply with all applicable state and federal laws. As a component of this duty, a director is responsible for adopting and enforcing policies and procedures that will ensure the organization’s compliance with applicable laws. Periodic evaluations of the effectiveness of the board and organization may be in order.
Under most state corporation statutes, for-profit corporations are allowed wide latitude in stating the corporation’s overall goals and business mission. Thus, plaintiffs alleging that a director has breached the duty of obedience by committing an ultra vires act have a heavy burden of proof. However, certain federal laws and statutes do impose significant limitations on a fiduciary’s authority to act (for example, a bankruptcy trustee has limited authority to act pursuant to the Bankruptcy Code). Even if an ultra vires act is alleged, a director in a jurisdiction that recognizes the business judgment rule may not be held personally liable for ultra vires acts of corporate agents unless the ultra vires act was illegal or the director participated in, knew, or should have known of the ultra vires act.
Claims for breach of the duty of obedience proliferated in litigation stemming from the savings and loan scandals in the late Twentieth Century. Many states have now enacted laws that allow corporations and shareholders to ratify ultra vires acts of directors, particularly self-interested transactions. These laws have seemingly reduced the claims for breach of the duty of obedience. However, claims for breach of this fiduciary duty still frequently arise in the non-profit business organization context. Many of the claims allege that the board of directors has failed to carry out the original mission of the non-profit organization. Some courts require strict adherence to the stated mission and business goals. For example, a California court concluded that directors of a nonprofit organization that was chartered to operate a hospital violated the duty of obedience when they used corporate funds to operate medical clinics. Some courts take a more liberal and flexible approach. These courts impose liability for breach of the duty of obedience only when the directors have “substantially departed” from the organization’s stated mission.