Corporate law in a modern state has to deal with an issue that defines the subject of corporate governance. The issue is that control of companies has passed from the hands of the owners – the shareholders – to the managers. On the one hand, separation of ownership and control is beneficial to the owners of the company who are willing to give control to a centralised management, which is likely to be more expert and more rapid in decision-making. On the other hand, the assumption that the directors of the company are qualified to manage the company's affairs and will act in the best interests of shareholders is not always correct. Here the law must ensure that those (directors) who undertake to act on others' (shareholders') behalf do so in prudent and fair manner.

Since 1990 the Baltic States – Estonia, Latvia and Lithuania – have built their law on principles of a free market, which cannot be imagined without the modern regulation of corporations.

Estonia

The basis of the regulation regarding duty of care of a management board member in Estonia is Article 35 of the General Part of the Civil Code Act, which provides that the members of a directing body shall perform the obligations arising from law or the articles of association with the diligence normally expected of a member of a directing body. The rule of diligence lies on the principle of good faith, which is the general principle of Estonian private law.

In Article 306.2 of the Commercial Code the legislator stipulated that a management board must act in the most economically purposeful manner.

Duty of care

In addition to the abstract rules mentioned previously, the Supreme Court of Estonia has ruled that the legal relation a member of the management board has with the company is a relation similar to a contract for provision of services. Therefore Article 619.1 and 619.2 of the Estonian Law of Obligations Act applies when assessing the duty of care of a member of the management board.

This article provides that individuals must, on performance of their mandate, exercise the necessary level of diligence commensurate with the nature of the mandate; they must perform the mandate to the maximum benefit of the mandator in the light of and according to their knowledge and abilities, and shall prevent any damage to the property of the mandator. In addition, individuals acting for the purposes of their economic or professional activities shall apply the skills generally recognised in their profession.

The rather abstract statutory norms provide a standard of duty of care, which must be assessed from the point of reasonableness. To clarify the issue of the reasonableness when assessing the duty of care of a member of the management board, it must be noted that under the established practice of the Supreme Court of Estonia the standard of care is higher than the normally applicable standard. However, it must be noted that the standard of care can differ in each separate case, as the level of diligence has to be commensurate with the nature of the obligations under the statutory norms.

In Estonian legal literature it is established that the standard of care also means a person's obligation to be sufficiently active in the activities of the management board, have the necessary skills and education as well as the obligation to involve third persons – mainly experts – in the decision making process if necessary.

Levels of education

As mentioned above the Estonian regulation also considers an economic element as part of the standard of care. The Supreme Court has stated in its rulings that the obligation to act in the most economically purposeful manner means that management board members are obliged in their activities to be diligent and sufficiently informed to take the necessary decisions and not to expose the company to unreasonable risks.

According to case law, this concept is sufficiently broad and allows a board member to make economic decisions that do not necessarily guarantee a positive outcome without fearing liability for decisions – for example, the selling of the assets of a company under the market price cannot automatically be regarded as an infringement of the board member's obligation of diligence. Also, the selling of assets to a person that is insolvent without getting immediate remuneration does not necessarily constitute an infringement of the obligation of diligence, unless the board member knew about the insolvency.

In addition to the objective elements of the standard of care described previously, the subjective element must be taken into account. The law provides that management board members must fulfil their obligations with their knowledge and abilities. Therefore, the standard of care varies in the case of each member of the management board. If members of the management board are well educated, for example, in the field of finance management, they must apply those skills. Otherwise the obligation of diligent management is breached.

To sum it up, management board members are only liable for breaching their duty of care when they are culpable for infringing the obligations under the standard of care. Therefore, even though a member of the management board has a higher standard of duty than normally expected from average people in their everyday activities, a board member is protected from liability when adopting decisions in an unpredictable environment.

Corporate social responsibility

The management board of a company is regarded as a tool of shareholders in taking care of the company's everyday business. Therefore the main obligation of the management board is to follow the instructions of the shareholders. But this concept, established in mandatory rules, does not entail corporate social responsibility (CSR).

At present, the concept is not stipulated as such in any mandatory or soft law rules applicable to Estonian companies. Even the Code of Corporate Governance, which is an elaboration of the mandatory rules cited above establishing a higher standard of care and duties for the listed companies in Estonia, is silent regarding CSR. The rules on CSR can be found in legislative acts of labour and environmental law, but they do not establish a basis for CSR.

However, the concept of CSR is not unknown in Estonia. Several NGOs promote CSR and cooperate with big players in the Estonian economy. There have been many projects in which the big energy companies finance public sporting facilities or organise events aiming to help disabled persons, for example.

The concept of CSR as a deviation from the shareholders' interests is admissible only if the shareholders themselves have made obedience to CSR an obligation of the members of the management board. If the management board has not received a mandate to act in accordance with CSR that damages the interests of the shareholders, a member of the management board has no other valid ground to rely on CSR and argue that there is no breach of duty of care by making decisions against the interests of the shareholders, unless the deviation could be justified on the grounds of duty of care. Taking the recent success of CSR projects in Estonia into account, it must be said that CSR has a prosperous future in Estonia, and the shift will probably also affect legislation.

Latvia

The standard of care for the management of commercial entities in Latvia has evolved since the 1930s, when the codified Civil Law was enacted stating the basic duties of members of commercial societies. A commercial law reform has taken place in the past decade, and the legal environment is divided between the original Civil Law and the newly drafted Commercial Law, which meets the EU company directives. These are considered a source of business-specific legal norms that take priority over general civil law.

The overall rule states that each member of the management board must exercise such care as to act as a prudent and diligent manager. This duty of care is not further expanded in the law, and interpretation often leads to grammatical and systemic analysis of what elements of diligence would normally be covered. The management board must first observe the company interests; it also needs to act in accordance with shareholder instructions.

Uncertainties

It is generally accepted that managers' duty of care extends at least to the standard of proper custody for their own matters. Nevertheless, this standard is not a stand-alone test suitable for all cases or businesses. It must be assessed in relation to general industry practice and the habits of reasonable businessmen. By taking the general duty of care in the civil law-based principal-agent relationship further to the level of prudent manager, the lawmaker has imposed additional criteria. Managers must not only take care of business at the level of their personal abilities but to a professional degree, having generally accepted skills.

Daily court practice has not yet provided clearance on the issue whether the commercial law requirement for the management board to run the company affairs collectively places less individual liability on each board member for questionable collective decisions. The practice of having detailed management board rules and procedures is far from regular in daily business, thus calling into question the delegation of authority and duties among board members.

Uncertainties are present when assessing the management board's responsibilities in leveraged buyouts of companies. Latvian law does not forbid the passing of shareholder debt to the company by way of upward reorganisation. Thus, the management board often faces a liquidity challenge, when the company undertakes a shareholder loan uses its assets as collateral to secure its indebtedness. If the target company goes into negative equity, the management board would be required under insolvency law to file for protection. This is seldom done in practice: the current regulation is not precise enough to distinguish true insolvency circumstances from short-term liquidity shortage upon share takeover, thus forcing the board members to take the financial risk.

Boom and bust

One of the core elements in the duty of care assessment in Latvia is Article 169.4 of the Commercial Law. This states that members of the management board are not responsible for any loss by the company if it is proved that they acted in good faith pursuant to a lawful shareholder decision. Practitioners struggle with the dilemma of whether management board members should at all times analyse shareholder decisions regarding their compliance with law in all respective jurisdictions, and if the decision proves unlawful, whether managers acted in good faith when implementing the decision; this would release the management board from liability.

The Latvian economy has boomed in the past 15 years. This has resulted in the establishment and termination of a large numbers of companies. It is estimated that about 50,000 active companies are registered in Latvia, each of which has at least one level of management consisting of at least one member. Pursuant to the Company Register information about 100,000 people (roughly 10% of all economically active citizens) are registered members of management.

Language barriers

Although they are junior on the global business arena and in corporate culture, members of management boards in Latvia have had to comply with strict regulations regarding the duty of care while needing enough incentive to carry out business in the changing Baltic commercial environment. Needless to say, most individual entrepreneurs managing limited liability companies registered for daily operations lack comprehensive legal and business education. It could be expected that with the slow-down of economics and potential closures of companies the corporate management liability will be imposed more strictly than before.

Another element of concern is the otherwise desirable foreign investment and direct management of investment by foreign directors. Most have inadequate language skills to comprehend company operations. Moreover, they are often not residents of Latvia. The current legislation allows management decisions to be taken at a distance but one may question whether resolutions taken without the manager's presence in a company or without the right supporting information are within the highest duty of care for the purpose of commercial law. Because a large number of foreign-owned subsidiaries operate in Latvia, and management board members are appointed and rotated on a global scale, the implementation of local corporate responsibility is a challenging task.

The Commercial Law reform in Latvia must undergo further development to be modern and to guarantee the shareholder and creditor interests affected by management decisions in commercial entities. One ironic fact illustrating the current combination of flexible yet inappropriate regulation is the ability of newly elected board members to register their own position with the Company Register by producing all derivative documents, but having no ability to resign from their position in the absence of shareholder will.

The package of risks and potential liabilities has led to impressive board remuneration packages, which cannot be traced directly to performance results of the particular company. As the lawmakers consider just another means of strengthening the corporate responsibility standard in commercial law one may wonder whether a new breed of professional board members will arrive to fill those challenging positions.

Lithuania

The system of general duties of members of management bodies of legal persons is dealt with in the Lithuanian Civil Code adopted in 2000. Article 2.87 provides that members of legal persons' management bodies are subject to duties of good faith and reasonableness, loyalty and confidentiality, and a duty to avoid conflict of interest. It further establishes some specific rules of management bodies' conduct.

Reasonableness

The Civil Code states: "A member of a legal person's body shall have to act in good faith and a reasonable manner in respect of the legal person and members of other legal person's bodies." Indeed, principles of justice, fairness (good faith) and reasonableness are the general principles established in the first book of the Civil Code as criteria for deciding cases without an explicit solution adopted in laws, as well as fundamental guidance for courts and parties to civil relations in interpreting and complying with statutory provisions. According to the commentaries on the Civil Code, reasonableness is the general principle of law specifying the duties of persons involved in civil relations to act cautiously, carefully, justly and in good faith. Objectively, good faith is a notion consisting of prudent, careful and just conduct.

Thus the Lithuanian law is inspired by Roman legal tradition and its standard of bonus pater familias. What does this mean for members of management bodies (directors) of a firm? The standard implies objectivity – that is, the conduct of the director should be assessed by the question how another person would act in the same circumstances. Further, Lithuanian scholarship is homogeneous in arguing that the director should be confronted not merely with the standard of ordinary people but with that of a prudent director.

A manager is a special figure in a company under Lithuanian laws, who can be compared to a CEO or a director. A prominent Lithuanian academic has claimed that when it comes to civil liability, courts should consider whether a careful, cautious, prudent manager in an analogous situation would have acted in the same manner. If so, then the standard is that of a qualified director. However, directors are not necessarily professional within the meaning of attorney or notary; therefore they cannot be confronted with the same standard of duty of care as attorneys or notaries. It is argued that objective standards also imply other criteria, such as the size of a company and its field of activities.

Notably, the Lithuanian courts' practice affirms scholars' considerations. In one case the Lithuanian Supreme Court gives obiter dictum that: "The position of the chairman of the board requires thorough sophistication..." In another case the Supreme Court observes that the director must act: "Carefully, in good faith, cautiously, in a qualified manner". The reference to the qualified manner could be argued to imply a higher standard of behaviour than that of an ordinary person.

A subjective standard

The standard of bonus pater familias implies an objective assessment according to a conceivable prudent person (in company law, a director). Such a standard cannot be diminished due to subjective criteria, such as the director's qualification, age, management experience, health conditions or other personal or professional characteristics. But directors cannot escape liability for negligent actions that they should not have conducted with their personal or professional characteristics. This follows from both statutory provisions and Lithuanian case law.

From the legislation point of view, a member of the management bodies must not only be reasonable but also act in good faith. Commentaries on the Civil Code observe that fairness (good faith) contains a subjective element: subjective fairness is a person's attitude to a particular situation. Subjective fairness is determined by considering whether a person could have done or omitted doing something taking into account age, education, sophistication and life experience. In other words, directors are to be held liable if they took reasonable actions, but did not do their best. Lithuanian case law adopts this view clearly by stating that directors must pass both objective and subjective tests to avoid liability for negligent performance of their functions.

Corporate objectives

Even though Lithuanian corporate law states that directors should adopts a high standard of care in exercising their managerial functions, case law is not rich with hard cases where a director's care faced a thin red line. Instead, most cases have been based on direct or indirect self-dealing, with the standard of care constituting a subsidiary question only. Indeed, the corporate paradigm of favouring shareholders' interests is more frequently at stake than the diligence of a particular director. The classic paradigm of taking decisions in the best interests of shareholders is, however, challenged by the concept of CSR.

There is much debate about CSR and the way it would amend the principles based on unrestricted profit-seeking in both legal and economic scholarship and practice. However, corporate law must answer a question whether the introduction of the concept of CSR could by any means affect the basic paradigm of corporate law to increase shareholders' value. Can the directors decrease the shareholder value by practising CSR?

Lithuanian Company Law explicitly states that the management bodies of a company must act for the benefit of shareholders and the company. A recent document, the Code of Corporate Governance, which applies to Lithuanian listed companies on the comply-or-explain basis, provides that listed companies should adhere to the imperatives of CSR.

CSR is understood as the need to respect the rights and interests of persons other than the company's shareholders (for example, employees, creditors, suppliers, clients and the local community). However, reference to stakeholders is declaratory and is confined to paying respect to the stakeholders' rights already established in other laws, such as employee protection and possible participation in share capital of the company and creditors' involvement in insolvency proceedings. Still, in practice company managers tend to declare their respect for CSR values and publish information on relevant projects implemented by the company.

However, nothing in the Lithuanian corporate law suggests that CSR might seriously challenge the classic imperatives of corporate law which provide for prevalence of shareholders' interest.

Such a conclusion cannot deny a convergence of shareholders' and other stakeholders' interests. In the end, a company's reputation of being socially responsible and the related PR create value for shareholders in terms of increased sales and other economically measurable properties. One might argue therefore that a diligent director in Lithuania should not fear being held liable for failed CSR projects, which could reasonably have been thought to benefit the company and its shareholders. However, hard cases are to come yet, and the courts are yet to give their judgment as to what the law is.

Author biographies

Sander Kärson Glimstedt Straus & Partners Sander Kärson joined Glimstedt Straus & Partners' corporate practice group in 2007 after completing a Master's at the University of Tartu. Before joining the firm Kärson worked for a year at the Ministry of Justice in the private law department as a legal adviser, where he obtained valuable experience in general private law. In addition to full-time work in the corporate practice group he also supervises a contract law seminar at the University of Tartu and has been responsible for the University's Willem C VIS International Commercial Arbitration moot team. Kärson spent a year in Münster, Germany, studying German language and law. Andrius Ivanauskas Glimstedt Straus & Partners Andrius Ivanauskas joined Bernotas & Dominas Glimstedt in 2004 during his studies at Vilnius University Faculty of Law. After obtaining a Master of Law diploma he practised as a corporate lawyer and has worked constantly with the firm's teams in M&A deals, advising clients on corporate governance and capital issues. Afterwards he spent a year at Amsterdam University where he improved his knowledge of M&A-related fields such as European and comparative contract law, and competition law and corporate law. He was granted an LLM cum laude in European Private Law. Ivanauskas is works on corporate practice and real estate-driven transactions.