When Director Fiduciary Duties Are Actually Tested
A company runs into trouble after its board approves a material transaction with a company owned by a director's relative, without meaningful due diligence and without full disclosure. When the deal collapses, investors ask one question: where was the board? This is precisely where director fiduciary duties are tested — not in quiet times, but when something goes wrong.
The Companies Law, 5759-1999, imposes two central duties on directors: the duty of care and the duty of loyalty. These are not theoretical obligations — breaching them can expose a director to personal liability, even when the company itself becomes insolvent. For technology companies and startups, where many directors are investors or fund representatives, this issue carries particular sensitivity.
This article reviews the current legal framework, explains how Israeli courts apply the business judgment rule, and presents practical tools for reducing the personal exposure of directors and officers.
The Duty of Care: What a Reasonable Director Must Do
Section 252 of the Companies Law provides that an officer owes the company a duty of care equivalent to the standard applied under the tort of negligence in the Torts Ordinance. In practice, the test is how a reasonable director, possessing similar skill and experience, would have acted under the same circumstances.
The duty of care does not require a director to be a specialist in every field, but it does require the director to:
- Stay informed and understand material information presented before making a decision
- Ask questions and demand clarification when information is missing or inconsistent
- Actively participate in board meetings rather than serve as a "rubber stamp"
- Seek professional advice when a matter falls outside the director's own area of knowledge
Israeli courts have repeatedly emphasized the importance of documentation — detailed minutes showing that the board reviewed alternatives and asked relevant questions serve as important evidence in defending directors against a future claim.
The Duty of Loyalty: Acting Solely in the Company's Interest
The duty of loyalty, set out in Section 254 of the Companies Law, requires a director to act in good faith for the benefit of the company and to refrain from any act involving a conflict between the director's role in the company and personal interests. This is a stricter duty than the duty of care, since it concerns not merely the quality of a decision but the purity of the motives behind it.
Obligations flowing from the duty of loyalty include:
- An immediate duty to disclose any personal interest in a transaction or matter before the board
- A prohibition on diverting a corporate business opportunity for the director's personal benefit
- A prohibition on competing with the company's business
- A prohibition on using information obtained by virtue of the director's position for any other purpose
Where a director has a personal interest in a transaction, Section 278 of the Companies Law requires disclosure of the existence and nature of that interest to the board as soon as reasonably possible after the director becomes aware of it. Failure to disclose, even if done in good faith, may constitute a breach of the duty of loyalty.
The Business Judgment Rule as Protection for Business Decisions
One of the key tools protecting directors is the business judgment rule, codified in Section 253 of the Companies Law. The rule provides that a court will not second-guess a business decision made in good faith, on a reasonable informational basis, and free of conflict of interest — even if, in hindsight, the decision turns out to have been mistaken.
In practical terms, courts examine the quality of the process that led to the decision, not its outcome. A board that obtained professional advice, held a substantive discussion, and considered alternatives will generally be protected even if the decision itself later proves commercially unsuccessful.
The rule does not apply, however, where there is a suspected conflict of interest, where the decision was made with gross negligence, or where material information was not presented to the board. For this reason, documenting the decision-making process is no less important than the substance of the decision itself.
Approving Related-Party and Extraordinary Transactions
The Companies Law establishes a tiered approval mechanism for transactions involving a conflict of interest, under Sections 268 through 275. The more material the transaction, or the more significant the personal interest, the more layers of approval are required — from board approval, through audit committee approval, up to shareholder approval for extraordinary transactions with a controlling shareholder.
Many technology companies encounter this issue when an institutional investor holding shares in the company also serves as a director and is involved in a transaction between the company and an entity affiliated with that investor. In such cases, companies should ensure:
- Full and timely disclosure of the personal interest
- The interested director's abstention from the discussion and vote, as required by law
- Accurate documentation of the approval process in the minutes
- An assessment of whether audit committee or general meeting approval is required, based on the nature of the transaction
Disregarding the proper approval process may result in the transaction being voided or in personal liability exposure for directors — even where the transaction itself was economically fair.
D&O Insurance, Indemnification, and Exemption from Liability
The Companies Law allows a company to grant directors three types of protection, subject to the conditions and approvals set out in Sections 258 through 259: advance exemption from liability for breach of the duty of care (a director cannot be exempted from breach of the duty of loyalty), a commitment to indemnify against certain expenses and liabilities, and directors and officers liability insurance (D&O).
These mechanisms are not a substitute for careful conduct — they are a safety net, not a license to act negligently. A D&O policy, for example, typically does not cover intentional breaches of the duty of loyalty or criminal conduct. Companies in fundraising rounds are frequently required by investors to obtain D&O coverage as a condition to closing, reflecting the weight investment bodies place on this protection.
It is advisable to review the scope of insurance coverage, the policy exclusions, and the exemption and indemnification provisions in the articles of association on an ongoing basis — not only when onboarding a new director.
Enforcing Fiduciary Duties and Derivative Actions
When the company itself fails to act against a director who breached fiduciary duties — for instance, because the board itself is implicated in the same breach — the Companies Law allows shareholders to bring a derivative action on the company's behalf, subject to court approval. This mechanism, set out in the third part of the Companies Law, is designed to prevent serious breaches from going unaddressed due to a structural conflict of interest within management.
In addition, the Israel Securities Authority is empowered to act against officers of public companies in cases of serious violations, and may in some cases impose personal liability. Even in private companies, a creditor or shareholder may sue a director personally under general tort law principles in particularly severe cases.
As a rule, the more a company invests in an orderly corporate governance culture — documented board meetings, active audit committees, and clear procedures for disclosing conflicts of interest — the lower the risk of legal proceedings against directors personally. Growing technology companies, especially those planning funding rounds or an IPO, should invest in corporate governance infrastructure early rather than postpone it to a later stage.
The information contained in this article is general in nature and does not constitute legal advice. For advice tailored to the specific circumstances of your company, we invite you to contact our firm.
