parent nodes: appraisal | business judgment | corporation law | derivative suit | directors | duty of loyalty | fiduciary duty | Smith v Van Gorkom
duty of loyalty
As with the fiduciary duty of care that directors owe to their shareholders, directors are protected by the business judgment rule only where directors have undivided loyalty to the corporation, especially where directors personally transact with their corporations. Duty of loyalty claims may be easier for courts to rule on than duty of loyalty problems; conversely, shareholders may be in a better position to judge duty of care violations than duty of loyalty violations. Unlike monitoring the fiduciary duty of care, judicially monitoring duty of loyalty violations won't inhibit effective board functioning; self-deaing is evidence of a dysfunctional team of directors, so courts are less concerned about interfering.
Duty of loyalty claims are also more appropriate because, unlike duty of care violations, they are more likely to be one-shot occurrences, so that a liability rule rather than a property rule is more appropriate. (Note that the business judgment rule reinforces the conception of shareholders' interests as a property rule, given that their main recourse to mismanagement is to sell their interest.) Similarly, duty of loyalty abuses are harder to detect, justifying harsher judicial treatment to support deterrence.
Directors owe firms "the duty of constant and unqualified fidelity." (cardozo, Globe Woolen Co v Utica Gas & Electric) At common law, a corporation's transactions with directors were voidable by the firm without regard to fairness of approval. Such a rule could prevent mutually beneficial transactions since firms can always walk away if the deal goes badly. Under the Globe Woollen liberalized rule, self-interested transactions would not be voidable only if approved by a disinterested majority of the board and the transaction was fully fair.
"Fairness" typically means that the defendants must show that (1) the terms of the deal were within the range of 'fair' options and (2) the firm wouldn't have gotten a materially better deal if the self-interest wasn't present.
Now, self-interested transactions are not voidable if the decision is fully ratified by a fully informed and disinterested majority of the board, or if a majority of shareholders approves the deal, or if the transaction was fully fair to the corporation. Note that in order to survive a motion to dismiss, shareholders must show a "clear case," rather than mere "speculat(ion)," that a self-interested transaction took place. [Kamin v American Express Co].
Statute
(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director's or officer's votes are counted for such purpose, if:
(1) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or
(2) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the shareholders; or
(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.
(b) Common or interested directors may be counted in determining the presence of a quorum at a meeting of the board of directors or of a committee which authorizes the contract or transaction.
DGCL § 144(a)
Note that a violation of the fiduciary duty of care or the duty of loyalty is sufficient to rebut the presumption of the BJR; the directors must then show that the transaction was "entirely fair" in order to avoid liability. [Cede II]. The plaintiff need not show that he was injured by the duty's breach. [Cede II]. (allowing derivative suit against corporate sale where corporation violated fiduciary duty of care and the duty of loyalty, but transaction actually caused a gain to shareholders).
Transactions with interested parties
Self-interested transactions are not voidable if the decision is fully ratified by a fully informed and disinterested majority of the board, or if a majority of shareholders approves the deal, or if the transaction was fully fair to the corporation. Note that in order to survive a motion to dismiss, shareholders must show a "clear case," rather than mere "speculat(ion)," that a self-interested transaction took place. [Kamin v American Express Co].
See DGCL § 144(a) above, listing the three defenses against voiding self-interested transactions:
- § 144(a)(1): material facts are disclosed to the board, who authorizes the transaction by a majority of the disinterested directors
- § 144(a)(2): material facts are disclosed to shareholders, who duly ratify the transaction
- note that § 144(a)(2) applies if a majority of interested shareholders ratify, but on equity grounds, the plaintiff can still prevail if he shows that the transaction was waste [Fliegler v Lawrence]
- § 144(a)(3): the transaction is fair to the corporation
- if facts aren't disclosed under § 144(a)(1) or § 144(a)(2), the defendant must then show that the transaction was within the range of fair deals, and the firm couldn't have otherwise gotten a better deal [HMG Cortland Properties v Gray]; see also [Bayer v Beran] (holding that no proof had been made that some other singer would do better than the president's wife, who was hired to do radio ads)
- likewise, if the conflict isn't ratified, § 144(a)(3) places the burden on directors to show fairness
- other factors informing 'fairness:'
- whether the contract process was unusual; cf [Bayer v Beran] (no DOL liability for interested transaction in part where signed on form contract)
- whether compensation matches the work; cf [Bayer v Beran] (no DOL liability for interested transaction in part where president's wife paid less than other performers)
Corporate opportunities
"If there is presented to a corporate officer or director a business opportunity which the corporation is financially able to undertake, is, from its nature, (1) in the line of the corporation's business and is of practical advantage to it, (2) is one in which the corporation has an interest or a reasonable expectancy, and, (3) by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of the corporation, the law will not permit him to seize the opportunity for himself." [Broz v Cellular Information Systems]. Note that the corporation must also be financially able to capture the opportunity. [Broz v Cellular Information Systems] (no director liability for purchasing cellular license where firm not capable of doing so). However, the financial ability test may cause moral hazard by encouraging directors to cause the parent firm to perform badly.
The "line of a corporation's business" can be vague, especially where involving financial deals that all corporations use to operate. [In re Ebay Shareholders Litigation] (corporate opportunity violation where investment bank gave IPO allocations in other companies to eBay directors as incentive for further business with them, where eBay had large amount of its holdings invested in shares, etc.)
Note that disclosure to other directors typically creates a safe harbor, although it is not necessary to escape liability. [Broz v Cellular Information Systems]. If the "material facts as to an (interested party's) relationship or interest . . . are disclosed or are known to the board of directors or te committee," and a majority of disinterested shareholders ratifies the transaction, the transaction will not be voidable. [Fliegler v Lawrence].
Other factors that may be relevant to the Broz test include:- whether there were prior negotiations with the firm regarding the opportunity
- whether the director concealed the opportunity from the firm
- whether the director used firm funds to pursue the opportunity
- whether the opportunity will create competition for the firm
- whether the firm has non-money resources (ex. HR, technology) sufficient to capture the opportunity
Refusal to deal
A director may defend against a corporate opportunity claim if he shows that the other party would have refused to deal with the parent firm, at least if such refusal to deal is disclosed. [Energy Resources Corp v Porter] (allowing defense for scientist who moved to new firm to make grant proposal when other scientists on the project refused to deal with the original firm because of the owners' race)
Ratification
Ratification of a duty of care problem by shareholders (that is, independent and fully-informed shareholders) kills the claim; in comparison, ratification of a director loyalty problem shifts the burden to the plaintiff but keeps the standard at waste, unless the transaction involves a controlling shareholder (see below).
At common law, shareholders were entitled to vote their shares without regard to the interests of other shareholders. This is still the law today generally; notice the different standard for shareholders than the standard for directors, since directors have to represent the firm as a whole, while shareholders represent only their own interests. Controlling shareholders owe a fiduciary duty to minority shareholders. Now, ratification of an interested transaction involving a controlling shareholder shifts the burden to the plaintiff, who must show that the deal was not entirely fair. (Note that if the plaintiff does make this showing, the defendant can still survive the deal by showing intrinsic fairness.)
Courts will use a "intrinsic fairness" standard to review a parent's control of a subsidiary when the parent has received a benefit "to the exclusion and at the expense of the subsidiary." [Sinclair Oil v Levien] (applying intrinsic fairness standard where parent allowed one subsidiary to breach contracts with another subsidiary, where the injured subsidiary also had 3% minority shareholders). Otherwise, courts will apply the business judgment rule (applying BJR to parent's use of subsidiary to issue dividends in excess of profits because the minority shareholders received a pro rata distribution)
A court may require that a controlling shareholder have its decisions ratified by a 'majority of the minority' shareholders, [In re Wheelabrator Technologies]; [Flieger v Lawrence]. Such ratification can shift the burden of proof to show lack of intrinsic fairness to the plaintiff. [Flieger v Lawrence]. Otherwise, the burden of proof is on the controlling shareholder to show that the entire transaction was fair.
For example, a controlling shareholder may be held liable if it acts on the basis of private information not available to the minority shareholders. See, for example, [Zahn v Transamerica] (finding controlling parent subsidiary for decision to reedeem class of stock held by minority, where minority could have converted stock to other class that would have guaranteed dividends, and controlling parent held information that the subsidiary's assets were more profitable than publicly known).
Note that agency law can constrain controlling shareholders, since they have voting rights and thus can be liable for fiduciary breaches of their agents (that is, the directors).
(Also note that the securities laws define "controlling shareholders" at 10%, which triggers all kinds of new duties.) Other jurisdictions have varying definitions of what counts as a "controlling shareholder" (ranging from 10% to 51%). However, bright line rules really don't work here, given that there will be different distributions of shares, so the real issue is typically whether a shareholder controls the firm's decisionmaking.
Cases
Cases finding breach of loyalty duty
[Lewis v SL and E Inc] (placing burden of proof on directors of SLE corporation, who also controlled LGT corporation, to show that rent that LGT paid to SLE, whose only asset was building leased to LGT, was fair, where SLE did not hold regular meetings, where SLE allowed LGT to use building without formal rent for a period of time, and where SLE shareholders were to be required to sell their shares to LGT after a specified period)
[In re Ebay Shareholders Litigation] (corporate opportunity violation where investment bank gave IPO allocations in other companies to eBay directors as incentive for further business with them, where eBay had large amount of its holdings invested in shares, etc.)
[Sinclair Oil Corp v Levien] (finding that Sinclair did engage in self-dealing when it caused Sinven, a subsidiary, to contract with another Sinclair subsidiary, then had the other subsidiary breach the contract, then failed to have Sinven seek any remedy)
[Zahn v Transamerica] (finding breach of duty of loyalty where corporation recalled shares of subsidiary in order to liquidate the subsidiary's tobacco, about which they had private information that the tobacco was more valuable than publicly realized, where the holders of the recalled shares had a right to convert their shares to a different share type if they had had the information, and where the board of directors for the subsidiary was controlled by the directors of the parent corporation, who held a large amount of the non-recalled stock)
Cases finding no breach of loyalty duty
[Bayer v Beran] (no duty of loyalty violation where corporation hired president's wife to sing for company-sponsored radio musical program, where the program was not "designed to foster or subsidize" the wife's career, where the advertising "served a legitimate and useful corporate purpose and the company received the full benefit thereof," where the cost of the program was not "disproportionate" to the usual cost of advertising, where the wife received no "undue prominence," and where the popularity of the program had increased; note also that the court absolves the president inaugarated the program without formally consulting the whole board of directors, given that the directors were in close working relationship with one another, and where the individual directors each approved the move)
[Broz v Cellular Information Systems] (finding no breach of loyalty duty where director, who owned a competitor company, used his own company to outbid potential purchaser of the company on which he served for FCC license, where the company on which he served was not financially able to make viable bid for the license, where the company he served was divesting itself of its cellular license holdings, where the director owed no duty to the potential purchaser of the company, and where the director individually consulted other directors, even if he did not convene full meeting of the board)
[Beam v Stewart] (no corporate opportunity violation where Martha Stewart sold shares to institutional investors, on grounds that MSO was not in business of making profit by selling shares, and that MSO had no expectancy since it had no need for additional capital)
[Sinclair Oil Corp v Levien] (no violation where Sinclair had a subsidiary, Sinven, of which Sinclair owned 97% of shares, issue dividends in excess of its profits when Sinclair was in need of cash on grounds, holding that because Sinven and Sinclair shareholders both received a dividend that Sinclair did not engage in self-dealing, so that business judgment rule applied; likewise finding that Sinclair did not usurp corporate opportunities of Sinven by purchasing its own oil fields where no opportunity really appeared to Sinven; however finding that Sinclair did engage in self-dealing when it caused Sinven to contract with another Sinclair subsidiary, then had the other subsidiary breach the contract, then failed to have Sinven seek any remedy)
[Fliegler v Lawrence] (refusing to protect company by ratification for its purchase of mining company formed by individual directors where only a minority of the minority shareholders voted, but then finding the transaction 'entirely fair' where the properties had "substantial value" and minority shareholders' company received valuable business opportunity from transaction)