Chapter 11 - Duty of Loyalty

Two major categories:

(1) Area of self-dealing - Example: buying something from corporation; can be indirect, to family and/or friends. (2) Common directors/shareholders in different entities and entities are dealing with each other

Fairness Standard

- An objective test; director must show that the transaction is in the "range of reasonableness" within which conflict-of-interest transactions may be sustained. - The court may take into account the process by which the transaction was shaped and approved and any relevant objective indicators of fairness of price. - Fairness will only be judged as of the time a transaction is entered into.

Analysis

- Court can start with a substantive review (unlike the duty of care) (ex: review of price of rent) - Facts matter!

Qualified versus Nonqualified Stock Options

- Example of a Compensation Committee that did not act in good faith: - The Compensation Committee had the authority to issue stock options at any price it chose. However, it was not permitted to disguise a non-qualified option as an incentive option at the current share price. The company provides shareholders with only minimal information about the issuance of the options. - Rule: Where facts suggest that directors have concealed the nature of a stock option after the grant, directors are not entitled to business judgment rule protection against a claim for breach of fiduciary duty.

Intrinsic Fairness Test

- If no safe harbor is available, courts can look to the substantive part of the transaction and apply the intrinsic fairness test. - Rule: If you can't prove that it is procedurally fair, you can use the intrinsic fairness test and argue that it is substance is fair. - Intrinsic Fairness Test: It will apply where shareholder deadlock prevents ratification. - Directors who engage in self-dealing are required to establish the additional element that they acted in good faith, honesty, and fairness. - Even if the procedure/process was fair and correct, the court should still look at the substantive fairness.

Doctrine of Waste

- In Delaware, to recover on a claim of corporate waste, the plaintiffs must shoulder the burden of proving that the exchange was so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration. - Very high standard; it is nearly impossible to win a waste claim.

Compensation Agreements

- Must show what the compensation (how much) proposal is. - "Say on pay" - vote yes or no; power is limited; saying "no" shows that the shareholders are not happy with the compensation amount. - Courts generally give Board of Directors authority to determine the form, amount, and timing of executive compensation and determination of associated conditions; - The determinations are clearly within the statutory authority and duty that the Board has to manage a corporation's business and affairs.

Lowered Standard re: Reporting System

- Rule: Directors will be liable for failure to engage in proper corporate oversight where (1) they fail to implement any reporting or information system, or (2) having implemented such a system, consciously fail to monitor or oversee its operations. - Court lowered the Caremark standard: --The standard for such a determination is whether the directors knew that they were not fulfilling their oversight duties and thus breached their duty of loyalty to the corporation by failing to act in good faith. --This is a forward-looking standard and hindsight may not be used to determine whether directors exercised their corporate oversight responsibilities in good faith.

Common Law Standard

- Rule: The business judgment rule does not apply when directors cause the corporation to enter into transactions in which the directors have an interest other than as directors of the corporation. When such self-interested transactions are challenged, they will be set aside unless the directors can show that they are fair and reasonable. - Burden of proof: First, the plaintiff must prove there is a conflict (usually easy to show). Then, the burden shifts to the defendant, who has to prove that the transaction was fair and reasonable.

Corporate Opportunity Doctrine

- Sometimes directors and officers pursue economic opportunities on their own behalf. For example, they buy property, start a new company, or offer consulting services in their individual capacities. In response, the corporation may argue that the opportunities really belong to it and that the directors or officers violated their duty of loyalty by taking the opportunities. - Much more common in small, closely held corporations than in large, publicly held companies. *Rule: Must present opportunity to the Board collectively, not individual members. *Analysis: Spot the duty first, then look at what the actor did.

Standard for Good Faith

- The concept of intentional dereliction of duty and a conscious disregard for one's responsibilities is an appropriate standard for determining whether fiduciaries have acted in good faith. - A form of fiduciary bad faith that is not intentional, but "is qualitatively more culpable than gross negligence."

A corporate officer or director may not take a business opportunity for his own if:

- The corporation is financially able to exploit the opportunity; - The opportunity is within the corporation's line of business; - The corporation has an interest or expectancy in the opportunity; and - By taking the opportunity for his own, the corporate fiduciary will thereby be placed in a position inimicable to his duties to the corporation.

General Information

- The duty of loyalty requires directors to exercise their powers in the interests of the corporation and not in the directors' own interest or in the interest of another person (including a family member) or organization. - Directors should not use their corporate position to make a personal profit or gain or for other personal advantage. - The duty of loyalty is implicated when a conflict between the director's individual pecuniary interests and the corporation's interest exists. - Conflicts arise when the directors and officers enter into transactions with their corporations, i.e., they are on both sides of the deal, or when two corporations with common directors enter into transactions.

A director or officer may take a corporate opportunity if:

- The opportunity is presented to the director or officer in his individual and not his corporate capacity; - The opportunity is not essential to the corporation; - The corporation holds no interest or expectancy in the opportunity; and - The director or officer has not wrongfully employed the resources of the corporation in pursuing or exploiting the opportunity.

Safe Harbor Statutes

- Under the majority position, if directors can demonstrate that the statutory requirements were met, then the transaction enjoys a safe harbor from judicial review as to the claim concerning the interested person's conflict of interest. - It does not extinguish other claims that shareholders may be able to assert to challenge the transactions, such as: gross negligence, other duty of loyalty breaches that the interested person may have committed plus waste, fraud or lack of board authority. - It doesn't absolve liability; some courts will shift the burden to the plaintiff to also prove that the transaction was unfair.

Reliance

- When the Board relies on other people's opinions for its business decision and the other people were not disinterested people! - Disney Case directors relied on two people: CEO Eisner & General Counsel (which is almost always acceptable) **Rule: For reliance issues, legal training is taken into account, so the standard is: reasonable lawyer person.

Three tests for "line of business"

1. Narrow Interpretation 2. Expansive Interpretation 3. Expectancy Interpretation

Safe Harbor Rule

A transaction involving an interested director is valid if: - The material facts as to the director's interest are disclosed or known to the board of directors and - The board in good faith authorizes the transaction by an affirmative vote of the disinterested directors.

Good Faith

An element of the two doctrines: duty of care and duty of loyalty; it is not an independent element; courts look at it as part of both duties. - Delaware Cases: not consistent; mainly in the area of executive compensation **General rule: Director must be (1) informed and (2) act in good faith.

Backdating Stock

Deliberately back-dating stock options in violation of a stock option plan constitutes bad faith action that is not shielded by the business judgment rule.

Expectancy Interpretation

Does the corporation have a protectable expectancy to the opportunity? - "Expectancy" may require that the corporation has an express contractual right to the opportunity (such as an option to buy); or may be more broad, allowing the corporation to claim opportunities for which it has no contract, but for which it had some prior interest and dealings. - Not a question of what they don't currently do.

How to Safe Harbor:

Have disinterested directors vote; or if there are not enough disinterested directors, have disinterested shareholders ratify the decision; or have disinterested shareholders vote (ones not on the Board).

Narrow Interpretation

Only precludes fiduciaries from pursuing opportunities that would put fiduciaries in direct competition with the corporation. - Whether the service/product is the same and market is the same; direct competition.

Expansive Interpretation

Precludes fiduciaries from any opportunities to which the corporation could possibly adapt itself. Corporations would be entitled to a broad range of opportunities and directors and officers would likely be found liable unless the opportunity was completely unrelated to the corporation's activities. - Tangential relationship/competition; could adopt/transform to enter that line of business.

"Spring-loaded" options

Rule: Under Delaware law, corporate directors who use inside information not known to shareholders and circumvent shareholder-approved procedures to enrich employees, officers, or directors act in bad faith and breach the duty of loyalty. - Seeking stockholder authorization of the stock incentive plan and then awarding those options in a way that contravenes its requirements is "inconsistent" with the duty of loyalty. - Although spring-loading options is not as clearly dishonest as backdating, the practice may be misleading if done without full knowledge and approval of the shareholders. - If shareholders are hurt economically, indirectly, because company loses money when officers and products get paid too much and have to pay fines.

Model Act Approach to "line of business"

When the director of a corporation is presented with a business opportunity closely related to a business in which the corporation is engaged, the director must fully disclose the opportunity to the corporation prior to taking advantage of it himself. - Only after the corporation has formally rejected the opportunity may the director take advantage of the opportunity himself.