Duty of loyalty - Definition | What is a breach of the duty of loyalty?

Duty of loyalty is about making sure that the company's best interests are given priority over personal interests. Learn more about Fiduciary Law and examples of when the duty of loyalty has been breached

TABLE OF CONTENTS

1. What does the duty of loyalty mean?

2. Duty of Loyalty Key Components

3. Breach of the Duty of Loyalty

4. Example of Breach of Duty of Loyalty

What is the duty of loyalty?

The duty of loyalty is one of the key fiduciary duties for the board of directors of a company that requires them to ensure all decisions are taken in the utmost good faith and in the best interest of the company. 

The duty of loyalty is an important obligation of the employee towards the employer. It requires a party to be loyal to the entity that he is associated with. The duty of loyalty also requires the person to be honest with the entity and not to take any action that harms the interests of the entity. 

The duty of loyalty prohibits the officer or director from benefiting the officer or director at the expense of the corporation. This includes gaining an unfair advantage for the officer or director or any of his family members. This also includes the officer or director taking actions that will impair or be prejudicial to the corporation.

A fiduciary duty is the highest standard of responsibility that applies to any relationship between two parties. It is required for activities like financial planning, real-estate broker, stockbroker, insurance/pension salesman, etc. These activities require a measure of trust between two parties. It is the fiduciary duty that ensures trust between the two parties.

Duty of loyalty as a legal term refers to a situation where the agent, as the subordinate, is not permitted to do anything which benefits himself at the cost of the principal. 

In a non-legal context, a duty of loyalty means an ethical duty that requires a person to be loyal to the entity the person is associated with. 

 

Duty of Loyalty Key Components

A director's duty of loyalty has three main components. A director should:

  • Not take advantage of corporate opportunities for personal gain.
  • Avoid having a personal interest in transactions between the company and another party.
  • Keep the corporation's information confidential.

 

Breach of the Duty of Loyalty

Breach of the duty of loyalty can occur in a variety of ways. A breach of the duty of loyalty occurs when an employee or director uses the business to further his personal interests. For example, an employee might breach his duty of loyalty by using confidential information for his own purposes. 

This is known as an "interested director transaction". A fiduciary is a person who acts on behalf of another and is expected to carry out their duties with the highest of standards. A breach of loyalty is when a fiduciary betrays the trust held by the principal. 

To put it simply, if a director or a person is benefitting himself, while the other such as stakeholders, employees, other directors are losing value out of that action, then the director is in violation of the duty of loyalty.

In the event of a director breaching the duty of loyalty, the courts, upon shareholder suit, may set aside the transaction unless the director can demonstrate that the transaction was fair and equitable. 

If the court is to determine whether or not a transaction was fair, it is likely to consider the following:

  • A shareholder vote approving the transaction
  • Board approval of the transaction by a strong vote that does not include the votes of interested directors
  • A unanimous vote by the uninterested directors if interested directors are necessary for a quorum

In the absence of any of the above, the court will act to undo the transaction or otherwise nullify its effects. Finally, here is an example of a breach of duty of loyalty.

 

Example of Breach of Duty of Loyalty

Max is the director of Titan Motors, a car manufacturer based in Detroit. The company has been doing well in sales ever since it began shipping its latest model last quarter. Upon preliminary investigation, it was discovered that the airbags were not functioning properly, and the cars had to be recalled.

An official press release announcing this unfavorable news will be released the next day after the market closes. In response, Max places an order to sell a majority of his shares at the current market price, since the stock price will slump after the news comes out.

Thus, Max has misused confidential information for his personal gains, opening himself up to insider trading charges and violating the duty of loyalty.