Chapter 34: Corporate Directors, Officers, and Shareholders 23

Chapter 34: Corporate Directors, officers, and Shareholders 23

Chapter 34

Corporate Directors, Officers,

and Shareholders

Introduction

Sometimes, actions that benefit a corporation as a whole do not coincide with the separate interests of the individuals making up the corporation. In considering those situations, it is important for your students to be aware of the rights and duties of the participants in the corporate enterprise.

This chapter focuses on the rights and duties of directors, managers, and shareholders and the ways in which conflicts between and among them are resolved. The duty of care and duty of loyalty owed by directors, the business judgment rule and the immunity it provides directors from honest mistakes, and the duty owed by majority shareholders to the corporation and minority shareholders are among the topics.

Chapter Outline

I. Directors and Officers

• Directors are the ultimate authority in a corporation with responsibility for corporate policy. Each director has one vote. The board—

Selects and removes corporate officers.

Determines the firm’s capital structure.

Declares dividends.

• Directors act for and on behalf of their corporation, but no individual director can act as an agent to bind the corporation, and directors collectively control a corporation in a way that no agent can control a principal.

• A corporation may require a director to be a shareholder. Otherwise, there are few, if any, qualifications.

A. Election of Directors

• The number of directors is stated in the articles or bylaws. Close corporations may eliminate the board altogether. The incorporators appoint the first board, which serves until the first shareholders’ meeting. A majority vote of the shareholders elects subsequent directors. Directors typically serve for a year or more.

• A director can be removed for cause (and usually not without cause).

B. Compensation of Directors

There is no inherent right to compensation, but many states permit the articles or bylaws to authorize it, and in some cases the board can set its own. Directors may set their own compensation [RMBCA 8.11]. A director who is also a corporate officer is an inside director. A director who does not hold a management position is an outside director.

C. Board of Directors’ Meetings

The dates for regular board meetings are set in the articles and bylaws or by board resolution, without further notice.

• A quorum is generally a majority of the number of authorized directors [RMBCA 8.24].

• Ordinary matters require majority approval—certain extraordinary matters may require more.

Enhancing Your Lecture—

 The Timing of Directors’ Actions

in an Electronic Age 

Corporate directors can hold special board meetings to deal with extraordinary matters, provided that they give proper notice to all members of the board. If a special meeting is called without giving sufficient notice to all of the directors, are the resolutions made at that meeting invalid? If so, can the directors validate these resolutions by holding a second special board meeting with proper notice? In today’s electronic age, matters of timing can be complicated and can affect a variety of other issues, including the effective date of a director’s resignation and the validity of a resolution appointing a new director. These were the central issues presented by In re Piranha, Inc.a
The Issue of Proper Notice
In May 2001, Edward Sample, the chairman of the board of directors of Piranha, Inc., called a special meeting for May 25 to consider restructuring Piranha’s management in response to serious financial problems. The four members of the board of directors at that time were Sample, Richard Berger, Larry Greybill, and Michael Steele. Berger objected to the lack of notice of the May 25 meeting and refused to attend, claiming that the meeting was invalid. The other directors held the meeting without him and, among other things, voted to accept the resignations of two of the directors, Greybill and Steele, and appoint a new director, Mike Churchill.
After the meeting, Greybill submitted his written resignation, but Steele did not, fearing that Berger might be correct about the lack of notice rendering the meeting invalid. Nonetheless, the corporation’s legal counsel filed a form with the Securities and Exchange Commission (SEC) on May 25 indicating the changes made to the board of directors. The SEC form stated that Steele had resigned as director and contained Steele’s electronic signature.
The Second Meeting
By early June, Piranha’s legal counsel concluded that insufficient notice had probably rendered the May 25 meeting—and the resolutions made at that meeting—invalid. The attorneys informed the directors that, to effect the changes to the board, they would need to call another special meeting and provide sufficient notice. A second special meeting was held on June 15 with proper notice (to Berger, Sample, and Steele), and Churchill was voted in as a director. Steele, now confident that Churchill was validly appointed as a director, submitted his written resignation the following day.
Berger, however, contended that Churchill was not truly a corporate director because Steele had no right to vote at the second board meeting. At issue was whether the SEC filing of May 25 bearing Steele’s electronic signature meant that Steele had effectively resigned on that date. If Churchill was not a valid director, then his subsequent vote that the corporation should file for bankruptcy would be invalid.b
The Court’s Conclusion
Ultimately, a federal appellate court held that Steele’s electronic signature on the SEC filing did not operate as his formal resignation. Under the Uniform Electronic Transactions Act (UETA), a signature may not be denied legal effect solely because it is in an electronic form. Section 107(a) of the UETA, however, also allows a person to disavow the signature. Here, Steele claimed that he did not authorize his signature on the form submitted to the SEC. Therefore, the court found that Steele had not resigned until he submitted his written resignation following the second meeting. Thus, Churchill was a corporate director and could vote for the corporation to file bankruptcy.
For Critical Analysis
What would the legal consequences have been if Berger had attended the first special board meeting despite the lack of sufficient notice?
a. 2003 WL 22922263 (5th Cir. 2003).
b. After the June 15 meeting, the directors voted that the corporation should file a petition for bankruptcy. Berger originally filed an action requesting that the court dismiss the bankruptcy petition because Churchill was not a valid director at the time of the vote. The bankruptcy court rejected this contention and Berger appealed, resulting in the decision discussed here.

D. Committees of the Board of Directors

• Most states permit a board to elect an executive committee from among the directors to handle management between board meetings. The committee is limited to ordinary business matters.

• The audit committee selects, compensates, and oversees independent public accountants who audit the firm’s financial records under the Sarbanes-Oxley Act of 2002.

E. Rights of Directors

• Directors’ basic right is to participate in management, which includes a right to be notified of board meetings.

• Directors have access to all corporate books and records.

• Most states (and RMBCA 8.51) permit a corporation to indemnify a director for costs, fees, and judgments in defending corporation-related suits.

F. Corporate Officers and Executives

The board normally hires officers. Qualifications are set in the articles or bylaws. Rights are defined by employment contracts. One person can hold more than one office and be both an officer and a director. Officers’ duties are the same as those of directors.

II. Duties and Liabilities of Directors and Officers

Directors and officers are corporate fiduciaries.

A. Duty of Care

The duty of care includes acting in good faith and in the best interests of the corporation, and exercising the care that an ordinarily prudent person would use in similar circumstances [RMBCA 8.30(a), 8.32(a)]. Breach of the duty may result in liability for negligence.

1. Duty to Make Informed and Reasonable Decisions

Directors must be informed on corporate matters and act in accord with their knowledge and training. A director can rely on information furnished by competent officers, or others, without being accused of acting in bad faith or failing to exercise due care.

2. Duty to Exercise Reasonable Supervision

Directors must exercise reasonable supervision when work is delegated.

3. Dissenting Directors

Directors must attend board meetings; if not, he or she should register a dissent to actions taken (to avoid liability for mismanagement).

4. The Business Judgment Rule

Directors and officers are immune from liability for a bad business decision as long as—

• The decision is within managerial authority.

• The decision complies with management’s fiduciary duties.

• Acting on the decision is within the powers of the corporation.

• There is no evidence of bad faith, fraud, or a clear breach of fiduciary duties.

The rule applies when—

• The director took reasonable steps to become informed about the matter.

• The director had a rational basis for the decision.

• There was no conflict of interest between the director’s personal interest and the interest of the corporation.

B. Duty of Loyalty

Directors and officers must subordinate their self-interest to the interest of the corporation.

1. Situations Involving Duty of Loyalty

Directors should not—

• Compete with the corporation.

• Usurp a corporate opportunity.

• Have an interest that conflicts with an interest of the corporation.

• Use information that is not public to make a profit trading securities.

• Authorize a corporate transactions that is detrimental to minority shareholders.

• Sell control over the corporation.

Case Synopsis—
Case 34.1: Guth v. Loft, Inc.
Loft, Inc., made and sold candies, syrups, beverages, and food in Long Island City, New York. Loft operated 115 retail outlets in several states and also sold its products wholesale. Charles Guth was Loft’s president. Guth and his family owned Grace Co., which made syrups for soft drinks. Guth acquired the trademark and formula for Pepsi-Cola and formed Pepsi-Cola Corp. but neither Guth nor Grace could finance the venture. Without the knowledge of Loft’s board, Guth used Loft’s capital, credit, facilities, and employees to further the Pepsi enterprise. Guth also made Loft a Pepsi customer. Eventually, losing profits at its stores as a result of switching from Coca-Cola, Loft filed a suit in a Delaware state court against Guth and others, seeking their Pepsi stock and an accounting. The court entered a judgment in the plaintiff’s favor. The defendants appealed.
The Delaware Supreme Court upheld the judgment. The state supreme court was “convinced that the opportunity to acquire the Pepsi-Cola trademark and formula, goodwill and business belonged to [Loft], and that Guth, as its President, had no right to appropriate the opportunity to himself.” The court cited the principle that a corporate officer owes “the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation.” Thus “if there is *** a business opportunity which the corporation is financially able to undertake [that] is *** in the line of the corporation's business and is of practical advantage to it *** and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of his corporation, the law will not permit him to seize the opportunity for himself.”
......
Notes and Questions
How could this case have been brought before courts in Delaware? Grace and Pepsi were both incorporated in Delaware.
After the decision in the Guth case, the rule applied with respect to corporate transactions involving interested directors was that, when a matter in which they had an interest came before their board for a vote, their vote was not counted. Courts could therefore hold the transactions voidable. (Under that rule, of course, Guth’s vote on Pepsi’s use of Loft’s resources could have voided the deal even if he had proposed it to Loft’s board.
Is this still the rule? No, at least not in Delaware, where Guth was decided. In 1967, Delaware altered this rule with the enactment of Section 144 of the Delaware General Corporation Law:”
(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 his or their votes are counted for such purpose, if:
(1) The material facts as to his 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 his 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..
Under the more recent rule, with full disclosure, an interested director might even vote on a matter without that vote effectively voiding a board’s approval. In that situation, had Guth set out in full detail a proposal for Pepsi’s use of Loft’s facilities, and Loft’s board had approved, there might have been no case.:”
In taking advantage of Loft’s capital and facilities, Pepsi-Cola was utilizing resources that arguably might otherwise have gone unused. Why did the court rule against this “resourcefulness”? The principal reason that the court would not accept this argument is that Loft’s resources belonged to Loft, not Guth, who used them without Loft’s permission. Guth referred to it as “borrowings.” The court was “certain it is that borrowing is not descriptive of them. A borrower presumes a lender acting freely. Guth took without limit or stint from a helpless corporation ... without the knowledge or authority of the corporation's Board.”. He “commandeered for his own benefit and advantage the money, resources and facilities of his corporation and the services of its officials. He thrust upon Loft the hazard, while he reaped the benefit. ... A genius in his line he may be, but the law makes no distinction between the wrong doing genius and the one less endowed.”
Additional Cases Addressing this Issue —
Duty of Loyalty
Cases conflicts between a corporate official’s personal interest and his or her duty of loyalty include the following.
• NCMIC Finance Corp. v. Artino, 638 F.Supp.2d 1042 (S.D. Iowa 2009) (a company vice president violated his fiduciary duty to the company when, without his employer’s knowledge, he entered into an agreement with his employer's competitor to divert business to the competitor and expended time and effort to establish a competing business).
• Gundaker/Jordan American Holdings, Inc. v. Clark, __ F.Supp.2d __ (E.D.Ky. 2009) (corporate directors who attempted to remove their president to preserve their employment after they learned the president intended to downsize the company to save money acted in wanton disregard for the best interests of their firm and in breach of their fiduciary duty).
• Auburn Chevrolet-Oldsmobile-Cadillac, Inc. v. Branch, __ F.Supp.2d __ (N.D.N.Y. 2009) (a company president breached his fiduciary duty by issuing a check to himself without advising the company's board, particularly absent evidence the check was payment for a purported loan).
• Brewer v. Insight Technology, Inc., __ Ga.App. __, __ S.E.2d __ (2009) (the president of a company breached his fiduciary duties toward his corporate employer by establishing, with the owner of a competitor, a firm that competed with one of his employer’s divisions, making the president liable for misappropriation of a corporate opportunity).
• Patmon v. Hobbs, 280 S.W.3d 589 (Ky.App. 2009) (the managing member of a limited liability company (LLC) that was having difficulty securing financing for its projects breached his fiduciary duty to the other members of the LLC by diverting the projects to his own company without informing the other members).
• Yates v. Holt-Smith, 319 Wis.2d 756, 768 N.W.2d 213 (App. 2009) (a director of a corporation was motivated by self-dealing in pressuring a shareholder to sell her shares and was not entitled to the protection of the business judgment rule on the shareholder's claim of a breach of the director’s fiduciary duty).

2. Disclosure of Conflicts of Interest