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As company ombudsman,your task is to investigate complaints of wrongdoing on the part...

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berty63 | (Level 1) Salutatorian

Posted March 15, 2014 at 5:55 PM via web

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As company ombudsman,your task is to investigate complaints of wrongdoing on the part of corporate directors and officers, decide whether there is a violation of the law, and deal with the wrongdoers accordingly. Jane, a shareholder of Goodly Corperation, alleges that its directors decided to invest heavily in the firm's growth in negligent reliance on its officers' faulty financial reports. This caused Goodly to borrow to meet its obligations, resulting in a drop in its stock price. Are the directors liable? Why?

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Stephen Holliday | College Teacher | (Level 1) Distinguished Educator

Posted March 15, 2014 at 8:32 PM (Answer #1)

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In your scenario, the directors of Goodly Corporation have engaged in "negligent reliance" on the corporation's financial officer's financial report.  This negligence has caused the corporation to borrow heavily to make certain investments and, because the investments have lost money, the corporation itself has lost money, resulting in a drop in stock price.  The issue is whether the directors are personally liable to the corporation's shareholders.  The key to the answer is whether or not the directors are guilty of "negligent reliance."  If they have truly been negligent, they may be liable.  But if the directors rely on the financial report, with no reasonable way of knowing that it is "faulty," they will most likely never be found to be liable for the bad decision.

Most states in the United States require that directors of a corporation perform their duties diligently and prudently.  In fact, most corporate governance laws in the U. S. require that that directors act in the interest of the corporation in the same manner as they would act in their own interests, using the same care and deliberation in the corporation's financial well-being that they would in their own investments.

Further, corporation law in the U. S. requires that financial reports be audited by an independent third-party auditing firm, which is usually chosen by the Board of Directors (the "BOD").  If, in your scenario, the BOD makes its decision on the basis of audited financial statements, the auditing firm and/or the corporation's officers who provided the financial information to the auditing firm are in trouble, not the BOD.  If the BOD relys on information provided by a duly appointed officer of the corporation, then that officer, not the BOD, is responsible for the information and the decisions made on the basis of the information.

Except in very rare cases, if a BOD acts in good faith and without corrupt motives, the board cannot be held liable for decisions that hurt the corporation's interests.  If, however, your scenario is to be taken literally--that is, the BOD is negligent in its reliance on the corporation's financial report-- then the BOD may be liable because it has failed to act diligently and prudently. 

From a practical standpoint, proving that a BOD has acted negligently is very difficult, almost impossible, because most BODs exercise some level of due diligence in their investment decisions.  As long the BOD exercises reasonable care in its decisions, it can be wrong without incurring personal liability.

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