A fiduciary is an individual (or business) that pledges to prioritize the beneficiary’s interest by avoiding any conflicts of interest that arise in the duty of good faith, trust, and loyalty towards the beneficiary.
Fiduciary relationships are characterized by the beneficiary’s vulnerability and the fiduciary’s knowledge and control. Fiduciaries must act in the beneficiaries’ best interest. Relationships such as lawyer and client, doctor and patient, investment advisor and client, trustee and beneficiary, director and corporation are fiduciary in nature.
Fiduciary relationships are formed when a beneficiary relies on the expertise of a fiduciary and is at the mercy of their control or discretion.
Fiduciary duty requires that a fiduciary avoid all conflicts of interest; they must act with honesty, integrity, loyalty, and in good faith to serve the best interest of the beneficiary.
A director acts as a fiduciary to a company. They must disclose all conflicts of interest and preserve the confidentiality of company information. A director should avoid transactions with the company, must not intercept corporate opportunities, or compete with the company.
How to Determine a Fiduciary Relationship?
A fiduciary relationship can be determined as follows:
The fiduciary commits to act in the beneficiary’s best interest.
The beneficiary is vulnerable to a fiduciary’s discretion or control.
The fiduciary can exercise its power to harm the legal and practical interest of the beneficiary.
Breach of Fiduciary Duty
A breach of fiduciary duty occurs if a fiduciary puts its own interests above that of a beneficiary. Instances include withholding information, obtaining secret benefits, or profiting at the beneficiary’s expense.
Example – Director and Company
Let’s consider an example of a director and a company. Directors have fiduciary duties towards companies.
A director is elected by shareholders to act in the company’s best interest. They must ensure the company’s long-term success over making decisions that temporarily increase profits and share value. Directors are not expected to act in the best interest of all stakeholders, but customers, suppliers, employees, and creditors must be treated fairly. Directors can go against the wishes of majority shareholders if they are acting in the company’s best interest.
To act in the company’s best interest, a director must disclose all conflicts of interest that interfere with their duties towards the company. It is possible that a director’s agreements with third parties threaten their independence in corporate affairs. Such information must be revealed to the board.
Directors are entrusted with ensuring the confidentiality of company information. Even after a director resigns from the board, they cannot disclose information about the company. The duty to keep the information confidential is lifelong and continues after the director’s departure from the company.
Responsibilities of a Director
A director must fulfill four kinds of responsibilities as a fiduciary to the company:
1. Duty of care
A director should exercise care and sound business judgment in decision-making. Sound business judgments are made by conducting thorough due diligence and carefully evaluating business options.
Directors must exercise reasonable prudence by ensuring that business practices are comparable to what another expert with the same experience and knowledge will practice in a similar situation. The business judgment rule protects directors in situations where unexpected circumstances lead to unfavorable outcomes as opposed to the lack of care in following industry best practices.
2. Duty of loyalty
Directors must put the company’s interests above all else. They must not participate in discussions or transactions that put their self-interest or the interest of other stakeholders above that of the company. Doing so can create conflicts of interest which would constitute a breach of loyalty.
3. Duty to act in good faith
A director must genuinely believe that his/her decisions are in the company’s best interest. Decisions based on self-interest, after thorough due diligence and evaluation of business options, breach a directors’ duty to act in good faith towards the company.
4. Duty to act lawfully
A director’s actions must always comply with the law to ensure trust and reliability.
Examples of a Breach
In some circumstances, directors breach their fiduciary duty to the company. The most typical scenarios in which it occurs are:
1. Transactions with the company
A director selling goods or services to the company will sell them at the highest price. However, as the director of the company, they must buy goods and services at low prices. Historically, such transactions were considered voidable due to the direct conflict between the interests of directors and companies. However, over time, some transactions between directors and companies have been allowed.
Transactions are allowed where:
The director gives the company a notice. A director meeting must record that a notice has been given.
Shareholders and other directors approve the transaction.
The transaction is fair to the company.
In some cases, a transaction may be allowed even if the above requirements are not fulfilled. Specifically, the interest of the director must be disclosed to shareholders in detail, the transaction should be approved by shareholders through a special resolution, and the transaction should be just to the company at the time of approval.
If none of these requirements are met, then the director will have breached his/her fiduciary duty by engaging in a transaction with the company. In cases of violation, profits must be disgorged.
2. Interception of corporate opportunities
A breach of fiduciary duty will occur if a director takes an opportunity away from the company. Often, the director enters a contract for personal gain, preventing the company from entering that contract. Therefore, the company’s best interest is compromised.
3. Competing with the company
Directors are not permitted to engage in activities that compete with the company’s line of business. If a director competes with a company, they will be required to pay the profits earned through the venture back to the company.
Thank you for reading CFI’s discussion about Fiduciary. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: