What happens when a director doesn't pay attention to what's going on in their company? Bad things. This case, decided by the Supreme Court of New Jersey in 1981, was one example. (For a tougher example, see Smith v. Van Gorkom.)
Facts of the case
Once upon a time, there was a corporation called Pritchard & Baird, based in Morristown, New Jersey. It was owned by a man named Charles Pritchard and his wife and two sons. In addition to being shareholders, the four also formed the board of directors of the company.
P&B was in the reinsurance brokerage business, setting up contracts between insurance companies to share their assumed risks. Reinsurance brokers generally get large payments from the selling companies, take out their commission, and forward the rest of the payment to the reinsurer, so they handle a lot of money on a regular basis.
Charles Pritchard had made a habit of lending himself money from corporate funds. This was odd, but probably legal. He made sure to pay back his loans at the end of each year, so there were no problems at the time.
Then, in 1973, the old man croaked, leaving his widow and sons to run the company. Mrs. Pritchard was not involved in the company while her husband was alive, and after his death, she became an alcoholic. The sons, who were left in charge, kept up their father's practice of borrowing money from the company... except that they weren't running the company with any degree of competence. By 1975, P&B was in bankruptcy.
The corporation's creditors filed suit against Mrs. Pritchard and her husband's estate, then administered by the United Jersey Bank, for negligence in oversight. In 1978, while the case was pending, Mrs. Pritchard died. The Superior Court hearing the case refused to exonerate her on the basis of pity for her condition, and instead found her liable for "never (making) the slightest effort to discharge any of her responsibilities as a director." Her executrix appealed, and the Appellate Division affirmed the Superior Court's ruling. The final appeal wasn't much better.
Mrs. Pritchard had never been to a board meeting in her life and had only been to P&B's corporate offices on one occasion. This, said Justice Stewart Pollock, was unacceptable:
...Directors must discharge their duties in good faith and act as ordinarily prudent persons would under similar circumstances in like positions. Although specific duties in a given case can be determined only after consideration of all of the circumstances, the standard of ordinary care is the wellspring from which those more specific duties flow.
As a general rule, a director should acquire at least a rudimentary understanding of the business of the corporation. Accordingly, a director should become familiar with the fundamentals of the business in which the corporation is engaged. Because directors are bound to exercise ordinary care, they cannot set up as a defense lack of the knowledge needed to exercise the requisite degree of care. If one feels that he has not had sufficient business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to act.
Directors are under a continuing obligation to keep informed about the activities of the corporation. Otherwise, they may not be able to participate in the overall management of corporate affairs. Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect.
Pollock said that directors could not be figureheads or dummies. "A director is not an ornament, but an essential component of corporate governance." He concluded that Mrs. Pritchard could not use her ornamentality as a defense, and affirmed the decisions from below.
- Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981)