It is common in the ebb and flow of business for corporate directors to move in and out of corporations for a variety reasons. Therefore, it is critical for directors to understand the duties and obligations they have to the companies they serve. This article will focus on a director’s duty not to compete with a company for which he is a director.
Kentucky courts have long recognized that corporate directors owe a corporation they serve fiduciary duties that arise from the common law. Baptist Physicians Lexington, Inc. v. New Lexington Clinic, P.S.C., 436 S.W.3d 189 (Ky. 2013). These fiduciary duties are generally limited to that of care and loyalty. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). The duty of loyalty essentially requires directors to always put the corporation’s interests above their own interests. This duty is the one implicated when a director decides to compete. In Kentucky, part of that duty is that the director must not acquire an interest in a competing business. Id.
Kentucky case law has many examples where a director of one company set up a competing business at the same time he was still a director of the company he was about to leave. In Aero Drapery of Kentucky, Inc. v. Engdahl, 507 S.W.2d 166 (Ky. 1974), Engdahl, an officer, director and shareholder of Aero Drapery, recruited key employees to start a competing business, shared confidential information with them, and loaned them money to purchase stock in the new competitor. All of this occurred in an eight-week period prior to Engdahl’s resignation. Needless to say, the Court determined that he violated his duty of loyalty to Aero Drapery. In its holding, the Kentucky Court of Appeals (then the state’s highest court) indicated that Engdahl could not have an antagonistic interest without full disclosure, and that he should have terminated his relationship when he first began his preparations to compete. Id.
Although this seems like a common-sense legal principle, in some circumstances, a person is a director of a number of companies that may compete in some manner. For example, business associates may own multiple companies that own commercial or residential real estate. Certainly circumstances arise where two people own Company A and one of those two is also an owner with a third person of Company B. It is possible that Company A and B might want to bid on the same property at a foreclosure auction. What should the director of both Company A and B do? This circumstance would put the director involved in both companies at risk to violate his duty of loyalty to one or both companies.
The best solution may be found in the Baptist Physicians Lexington case. There, a group of physicians resigned from New Lexington Clinic to join the nearby Baptist Physicians Lexington. The Kentucky Supreme Court analyzed the facts and looked favorably on physicians who left to compete because they had agreements that permitted them to leave and compete under certain circumstances.
This review of the law provides two good recommendations for those who serve as directors of a corporation. The first is to have a written agreement that protects both the company and the director should the director choose to leave to compete. Such an agreement can provide reasonable guidance to both parties. The second is, absent an agreement, to resign before starting a plan to compete; or at a minimum, fully disclose the plan to compete and obtain the consent of the corporation. These recommendations seem like common sense, but it is nevertheless smart to understand these duties and incorporate that understanding into the decision-making process.
Todd V. McMurtry is a Member at Hemmer DeFrank Wessels, PLLC. He is a commercial trial attorney and Harvard trained mediator. Todd has been married to his wife, Maria C. Garriga, for 32 years. They have three adult children.