Chapter 17Duty of Loyalty
Outline
(last update 08 Nov 06)
Chapter 17Duty of Loyalty
- Introduction: Conflicts of Interest
- definition and dangers of self-dealing
- director on two sides of transaction with corporation
- director predictably prefers self-interest
- balance
- director prefers own over corporate interests
- director provides corporation additional flexibility
- Overview of the Issues
- standards of judicial review
- flat prohibition
- shareholder ratification or approval
- disinterested director validation
- fairness review
- Evolving Standards of Review
- The common law standard: 1880 – 1960
- Contemporary Statutory Approaches
- Traditional analysis: Remillard Brick v. Remillard-Dandini
- Interpreting interested Director Statutes
- MBCA Subchapter F
- Company Codes: the European approach
- Entire Fairness: Fair Dealing and Fair Price
- Fair dealing (Procedural fairness)
- In Re the Walt Disney Company Derivative Litigation
- In Re Oracle Corp. Derivative Litigation
- Lewis Vogelstein
- Harbor Finance Partners v. Huizenga
2.Fair price (Substantive fairness)
- Corporate Opportunities
- Traditional corporate opportunity doctrine
- Farber v. Servan Land Company
- What is a corporate opportunity?
- Interest or expectancy
- misappropriate assets
- misappropriate information
- interfere with expansion plans
- Line of business
- current operations
- anticipated operations
- Fairness
- When can a manger take a corporate opportunity?
- corporate consent
- rejection / acquiescence
- corporate incapacity
- ALI § 5.05
- mandatory rejection
- definition: expectancy + line of business
- Remedies for usurping a corporate opportunity
Class notes
B. Overview of the IssuesHow might corporate law deal with a director's conflict of interest transaction?
- Flat prohibition: The corporation cannot enter into any transaction with any person or entity in which a director has a conflicting interest.
- Shareholder ratification. The corporation can enter into conflicting-interest transactions if the shareholders validate -- ratification or approval.
- Director ratification. The corporation can enter into conflicting-interest transactions if the uninterested directors approve.
- Fair. The corporation can enter into conflicting-interest transactions if a judge says the transaction was fair.
C. Evolving Standards of Review
Remillard Buick Co v. Remillard Dandini Co
(Calif App 1952)
Stanley and Sturgis were in the brick business. They owned a majority of Brick Corp, a brick manufacturing firm. Stanleyand Sturgis also owned all of Sales Corp, which contracted with Brick Corp to sell the bricks.
- What's the problem? Who sued?
- Wasn't the relationship with Sales Corp approved by the board of Brick Corp?
- Didn't the stockholders of Brick Corp approve, as well?
".. if the majority directors and stockholders inform the minority that they are going to mulct the corporation [and this were] an impervious armor against attack on the transaction ... it would be shocking reflection on the law of California"
"The point is that large profits that should have gone to the manufacturing companies were diverted to the sale corporation.
Del. G. Corp. L. § 144 [edited a little]
(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:
(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors
(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders
(3) The transaction is fair as to the corporation as of the time it is approved. / California court:
"If the conditions provided for in the section appear, the transaction cannot be set aside simply because there is a common directorate."
"But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply because there has been a disclosure and approval by the majority of the stockholders"
Even though the requirements of section 820 are technically met, transactions that are unfair and unreasonable to the corporation may be avoided. ... It would be a shocking concept of corporate morality to hold [otherwise]
Hypothetical
Is there any way for Brick Corp to delegate the sales function to an outside company owned by Stanley and Sturgis? Advise. / Delaware Supreme Court (Marciano v. Nakash -Del 1987)
"... approval by fully-informed disinterested directors under Section 144(a)(1) or disinterested stockholders under section 144(b)(2) permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof on the party attacking the transaction."
Consider the result under NC Bus Corp Law § 8.31
Overly v. Kirby
(Del 1991)
The FM Kirby Foundation is a Delaware non-stock charitable corporation. The foundation's largest asset was a 15% stake in Alleghany, a large publicly-traded conglomerate with holdings in American Express. But federal tax laws forced the foundation to divest itself of its Alleghany holdings. Faced with the prospect of the foundation selling its ALleghany stock to the market, Alleghany management considered redeeming it (buying it back) and learned it could so by using its American Express stock as consideration. (In this way Alleghany would not have to pay capital gains tax on its appreciated AmEx stock - and realize tax savings of $26 million!) The problem to a tax-driven deal made in tax-heaven was that Fred Kirby was both a Kirby Foundation director (along with his siblings, Allan, Grace and Ann) and the Chief Operating Officer of Alleghany. So the Foundation’s attorney sought to negotiate a deal with Alleghany. What were Alleghany's options?Who might it sell its AmEx stock to? What is SEC Rule 144? What are the transaction costs in a registered securities offering? What were Alleghany's options in selling its AmEx stock? What did the Foundation’s investment banker opine?
The Delaware attorney general challenged the sale. On what grounds? What standard applies? Why is "legally irrelevant" that the interlocking directors, Fred and Allan Jr., absented themselves from meetings involving the transaction? Why were the other Foundation directors interested? Would it have made a difference if only non-interested directors approved the transaction for the Foundation? Why does the court have the "sole" role to determine intrinsic fairness? How did the court determine the transaction was fair? / Del. G. Corp. L. § 144 [edited a little]
(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:
(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors
(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders
(3) The transaction is fair as to the corporation as of the time it is approved.
D. Entire Fairness: Fair Dealing and Fair Price
Shlensky v. South Parkway Building Corp.
(Illinois 1960)
Building Corporation owns a 3-story commercial building in Chicago. Its majority shareholder Englestein, who also sits on the board, is an entrepreneur. Englestein also owns two other corporations that do business with Building Corporation:
- Store (a tenant) sold $100,000 of fixtures to Building Corporation
- the lease with Store was modified to eliminate all percentage rents (a 40% reduction) and waive accrued rent of $24,316
In any event, Englestein did not deal personally with Building Corporation. Instead it was Store. Is Englestein really on both sides of the transactions?
Who sued? Why?
Who has the burden of showing fairness? What is fairness? What is entire fairness? Wasn't this transaction approved by the outside director - Bernstein, Englestein's lawyer? Who is liable? What are damages? / Illinois Supreme Court:
"The directors of a corporation .... are subject to the general rule ... that they cannot in their dealings with the business or property of the trust, use their relation to it for their own personal gain."
"dealing with the corporation ... will be subject to the closest scrutiny. .... a director may deal with the corporation of which he is a member provided he acts fairly and for the interest of the company ..."
"transactions between corporations with common directors may be avoided only if unfair, and ... the directors [must] sustain the challenged transaction have the burden of overcoming the presumption against the validity of the transaction by showing fairness ..."
"courts have stressed factors
- full value in commodities purchased
- corporation's need for the property
- whether transaction was at market price
- detriment to the corporation
Hayes Oyster Co. v. Keypoint Oyster Co.
(Wash Sup Ct 1964)
Coast Oyster Company was in bad financial shape and to solve its cash flow problems sold its valuable oyster beds to Keypoint Oyster Company. What was the problem with this arrangement -- from the standpoint of Coast Oyster shareholders? One Verne Hayes had multiple allegiances -- president, manager, 23% SH of Coast Oyster / co-signor of note to Engman for start-up / capital in Keypoint shareholder in Hayes Oyster, which became 50% shareholder of Keypoint
What do we know about human nature? Verne Hayes got a promise from Joe Engman (the owner of Keypoint) that Hayes Oyster would receive a 50% interest in Keypoint, if Verne lent Joe $15,000 in start-up capital for Keypoint. The issue for the court: who owns this 50% interest (249 shares) -- Hayes Oyster or Engman or Coast Oyster? What was the argument of Hayes Oyster?The argument of Coast?
Coast lost no money in its transaction with Keypoint. All agree that the oyster beds were worth $250,000 -- the purchase price. How could Coast claim that the transaction was unfair? What is the remedy for self-dealing? What remedy did Coast pursue? / Washington Supreme Court:
"... nondisclosure by an interested director or officer is itself unfair ... [Coast shareholders and directors] had the right to know of Hayes' interest in Keypoint in order to intelligently determine the advisability of retaining Hayes as president and manager."
"... direction to order Keypoint Oyster Company to issue a new certificate for 250 shares of its stock to Coast Oyster ..."
Fliegler v. Lawrence
(Del. 1976)
Silvergold Mines (known as Agau) is thinking of getting an option to buy US Antimony in an exchange of stock. Problem is that US Antimony is mostly owned by directors and officers of Agau. You represent Agau's management. Assume there are no problems with the way US Antimony was set up. Advise. What should Agau's board do? What if, as happened, the Agau shareholders vote on and approve the transaction? Do you see a conflict? What did the Delaware Supreme Court say was the standard of review?
What does fairness mean? What about the statute!!
HYPOTHETICAL
Agau's management also owns US Platinum. Agau agrees to buy platinum from USP over the next ten years at a fixed $700 an ounce. The outside directors of Agau approve the deal, though never learn that USP would have sold cheap at $650. The non-management shareholders of Agau approve the deal, on the strength of the outside director's recommendation. Judicial review, anyone?
/ Del. G. Corp. L. § 144 [edited a little]
(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:
(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors
(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders
(3) The transaction is fair as to the corporation as of the time it is approved.
Fliegler v. Lawrence:
"... the individual defendants stood on both sides of the transaction in implementing and fixing the terms of the option agreement.
"Accordingly, the burden is upon them to demonstrate its intrinsic fairness."
"... objectively, was [800,000 shares] a fair price for Agau to pay for USAC as a wholly-owned subsidiary?
Regarding the question at the class today, I would like to try to explain how self dealing is treated under Japan Commercial Code.
1, The self dealing by a corporate director must be reported to and approved by the board of directors. The matter should be discussed and ratified only by disinterested directors.
2. This approval does not indemnify interested directors. Furthermore, the disinterested directors who agreed to the transaction -- together with the interested director -- have responsibility to shareholders.
3. The self-dealing must be reported to shareholders in the annual report. Although it is very rare case in Japan, the liability of interested and disinterested directors can be discussed at shareholders' meeting and released only by supermajority (3/4) share approval.
4. Nothing in the Code prevents an interested shareholder from voting, but the Code says interested shareholders may also be liable to the corporation.
5. Given that it is almost impossible to release liability at the shareholders' meeting, I think such liability will be usually be challenged through the derivative suit brought by a shareholder. Usually, D&O insurance in Japan does not cover such liability.
6. I heard that recently that the new Commercial Code enables corporations to set forth the indemnification clause in the article of corporation. But it is not clear to me what extent of liability can be indemnified. I need to study this!
Kazuya Shiki (LLM 2004)
Director conflict of interest transactions
ALI Principles of Corporate Governance
Gries Sports Enterprises v. Cleveland Browns Football Co
(Ohio 1986)
The corporation that owned the Cleveland Browns football team purchased the company owning Cleveland Stadium. Modell, the Cleveland Browns CEO, owned 53% of the Browns and 80% of the stadium company.
When Gries, a 43% Cleveland Browns shareholder, challenged the purchase price as excessive, the question was whether an independent majority of directors had approved it:
- Gries - the victim
- Modell - the culprit
- Modell's wife
- Bailey (full-time general counsel of Browns)
- Berick (outside counsel and 1% owner)
- Cole (full time Brows employee)
- Wallack (full time Browns employee)
Assume that the sale of the stadium company to the Browns was based on outside appraisals. What more is required? Is approval of the by the Browns board sufficient? What if Modell had absented himself? What if the bylaws permitted a quorum of one director and Berick had approved the purchase? Is Berick independent? How do you know?
What are the ALI Principles of Corporate Governance? / ALI Principles of Corporate Governance
§ 1.23 Interested defined
(a) A director ... is "interested" in a transaction if:
(1) The director ... is a party to the transaction ...
(2) The director ... has a business, financial or familial relationship with a party to the transaction .... and that relationship would reasonably be expected to affect the director’s judgment with respect to the transaction in a manner adverse to the corporation.
(3) The director .... has a material pecuniary interest in the transaction (other than usual and customary directors' fees and benefits and that interest .. would reasonably be expected to affect the director's ... judgment in a manner adverse to the corporation .
(4) The director ... is subject to a controlling influence by a party to the transaction ..... and that controlling influence could reasonably be expected to affect the director's ... judgment with respect to the transaction ... in a manner adverse to the corporation.
How does this case come out under the ALI Principles? Is this relevant to the non-voidability statutes?
/ ALI Principles of Corporate Governance
§ 5.02 Transactions with Corporation
(a) General rule. A director... who enters into a transaction with the corporation (other than compensation) fulfills the duty of fair dealing with respect to the transaction if:
(1) disclosure concerning the conflict of interest and the transaction is made to the corporate decision-maker ....
(2) either
(A) the transaction is fair to the corporation ...
(B) the transaction is authorized in advance, following disclosure .... by disinterested directors .... who could reasonably have concluded that the transaction was fair to the corporation ....
(C) the transaction is ratified, following such disclosure, by disinterested directors ....
(D) the transaction is authorized in advance or ratified, following such disclosure, by disinterested shareholders and does not constitute a waste of corporate assets ....
(b) Burden of proof. A party who challenges a transaction between a director ... and the corporation has the burden of proof, except that if such party establishes (B), (C), or (D) is not satisfied, the director ... has the burden of proving the transaction was fair to the corporation.
How does the approach of the ALI Principles change the statutory approach? / Del. G. Corp. L. § 144 [edited a little]
(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:
(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors
(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders
(3) The transaction is fair as to the corporation as of the time it is approved.
Lewis v. Vogelstein
(Del. Ch. 1997)
Shareholders of Mattel challenged the board's stock option compensation plan for directors, which had been ratified by shareholders.Under the plan directors received: (1) 15,000 one-time options with an exercise price equal to market price on the date granted, and exercisable for up to ten years, (2) 5,000 (or 10,000 for longer-serving directors) annual options that vest over a four-year period, with an exercise price equal to market price when granted, and exercisable for up to ten years. What were the issues? What is the effect of shareholder ratification?
What choices did Chancellor Allen have, as he saw it, in giving effect to the shareholder ratification?
- complete defense
- shift review from fairness to waste
- shift burden to plaintiff to show unfairness
- no effect
What is the meaning of "waste"? How is it different from the BJR?
Del. G. Corp. L. § 144 [edited a little]
(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:
(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors
(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders
(3) The transaction is fair as to the corporation as of the time it is approved. /
Chancellor Allen:
... it has long been held that shareholder may not ratify a waste except by a unanimous vote. .... IN all events, informed, uncoerced, disinterested shareholder ratification of a transaction win which corporate directors have material conflict of interest has the effect of protecting the transaction from judicial review except on the basis of waste.
Roughly, a waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade.
In this age in which institutional shareholder have grown strong and can more easily communicate, however that is, I think a more rational means to monitor compensation than judicial determination of the "fairness" or sufficiency of consideration, which seems a useful technique principally, I suppose to those unfamiliar with the limitations of courts that their litigation processes.
I cannot conclude that no set of facts could be shown that would permit the court to conclude that the grant of these options particularly upon the one-time options, constituted an exchange to which no reasonable person not acting under compulsion and in good faith could agree.
E. Corporate Opportunities