Fiduciary Duty and the Business Judgment Rule

Brehm v. Eisner (Disney) (Golden Parachute, hefty executive termination)

- $101 million of stock options, $39 milion cash, etc - Ovitz only worked for Disney for 14 months - Sues saying corporate waste, not disinterested - Court held that this was business judgment so protected - No breach, essence of business risk - As long as informed belief - Judges assess legal risk, not business risk - Courts will review procedural business judgment, ut not substantive - P says didn't properly scrutinize; whole of Disney has inside/outside experts etc - What if Board does things quickly> (grunt work done, can work fast) - Court articulating dissent of Transunion and furthering Wrigley and Heller mindset - Bet on corporate horse, not ride it (sue) - Collective action problem - Agency costs of going over and court comes in to fix - Duty of impartiality: worry about directors engaging in in self-dealing and freezing out minority shareholders

The Corporate Opportunity Doctrine Generallly

- A corporate manager cannot usurp corporate opportunities for his own benefit unless the corporation consents - The P, typically a shareholder, has burden of proving that a corporate opportunity exists - DOctrine raises two interpretive issues - When does business opportunity belong to the corporation and qualify as a corporate opportunity? - When can it be said that the corporation has (or would have) consented to director taking opportunity?

Duty of Care

- Addresses attentiveness and prudence of managers in performing their decision making and supervisory functions - Board of directors manages and oversees corporation's business affairs - Judicial review of directors' performance of their decision making and oversight functions is governed by the duty of care, which in turn defined by the business judgment rule

Duty of Loyalty

- Addresses fiduciaries' conflicts of interest and requires fiduciaries to put the corporation's interest ahead of their own (mandatory altruism) - Corporate fiduciaries brach duty of loyalty when they divert corporate assets, opportunities, or information for person gain

Heller v. Boylan (Tobacco Case)

- Allegation of corporate waste (with bonuses) and shareholder wants to know why (exec compensation) - P owns 7 out of 62,000 shares - Arguing all gift and majority can't give without minority approval - Should court review setting fo salaries? - Argue yes: Salaries often very large with poor performance; difficult for shareholders to monitor high transactions costs; management executives in control of the accounting; rational ignorance (no incentive to determine appropriate vs. inappropriate) -If don't have court, who reels in? Salary in lieu of dividends; may be detriment of dividends of minority shareholders; makes a freeze-out (conflict of interests, self dealing, breach of duty of care) - Court says won't even view - Business judgment (not a legal question; court says don't have expertise to run business) - What would an appropriate salary be anyway? -Court has 20/20 hindsight; profit matter for corp (should reward) (if don't, can't attract/keep management) - Want court to overrule shareholders meeting (where lost) and directors meeting - Contradictory to McQuade - Can't have it both ways - PUblic Choice Theory (lose in market place and ask court to bail you out) - Business of court not revamping of social/economic order - Assuming choose to revise, no way to assess compensation - Clear standards of review or not a rule - Court has power but would be artificial, inexact, a farce - Courts ill-equipped to grapple with these problems - Courts concerned with clear laws, not ambiguous rules or standards - No reasonable or clear standard Here

Smith v. Van Gorkum (procedural; informed business judgment rule) (is it an actual uninformed rule?)

- Approved $660 million merger of TransUnion - Only 2 hours board deliberation, no crisis to justify quick approval, acted w/o information, no true valuation, assessment, independant opinion - Court says acted without informed business judgment - DUe diligence required for merger - If no knowledge supposed to hire experts such as internal and external accountants, analysts, legal, etc - Attempt to amend merger failed as well; failed to disclose all material facts which knew/should've known prior to shareholder approval - Only ran unresearched numbers - Mergers have two steps 1) board votes for merger 2) shareholders vote for or against - Bets entire corporation on merger transaction - Court says must see if participated in informed decision and if not, not protected by business judgment rule - Directors do more work before meeting, which is more of a mere formality - These people had strong business backgrounds and wouldn't just make decision lightly - Is informed business judgment rule an uninformed rule? - How much is enough information? People say unworkable; leaves to discretion - Personal wealth at risk; own personal stock - Massive incentive of directors to use best judgment substantively/proceduraly - Regulation doesn't add much but it does drive up transactions costs - Held to be gross negligence, which is standard in determining if judgment informed

Actions Lacking Rational Business Purpose- Waste

- Business judgment rule presumes directors acted (or chose not to act) with a rational business purpose - Challenges rooted in this standard focus on the merits of the board's action or inaction, compelling a substantive review of the challenged decision - Per the rational purpose test, shielded from liability so long as judgment was not improvident beyond explanation or removed from realm of reason - Typically, if courts can find some fair benefit to corporation, matter entrusted to judgment (ie Wrigley) - Situations of Board inaction present difficult questions - Dominant view is that board inaction protected only if the failure to act was a conscious exercise of business judgment (ie matter came before board and board expressly decided not to do anything about it) - View would leave unconscious action open to liability - Yet, it would seem contradictory to business judgment rule to hold directors liable for not even considering a certain action (only appears in dicta, hasn't been considered dispositive) - Any failure not to take action creates liability only in the case of a sustained failure of the director to be informed or other material failure of director to discharge oversight function

Applying Business Judgment in the Compensation Context

- Challengers to an executive's compensation must show - That the board was grossly uninformed or - That the compensation was a waste of corporate assets (ie that has no relation to value of services given and might as well be a gift)

To Whom do rules on corporate opportunity show owe duty to?

- Common Shareholders (owners) - Sometimes other stakeholders - Zahn: duty owed to holders of convertible stock and not common - Majority stock said - Inventory rise in value corporate opportunity that goes to remaining shareholders? - Idea is to pay off cheaply/majority pockets increased price of stock - Has effect of taking, without disclosure - Freeze-outs violate duty of loyalty, taking of corporate opportunity - Effect: freeze-out of preferred; legal because charter says can cut stocks in some cases

Usurping Corporate Opportunities

- Corporate fiduciary seizes for herself a desirable corporate opportunity that the corporation would likely have taken and profited from - Denies corporation to expand profitably

Old British Rule for Self Dealing (very strict)

- Corporation can always recind transaction director or officer is a party to - Trust question - May be no way to structure arm's length deals - Don't allow insiders to K w/o right to rescind - Inherently skeptical

Marciano Test (Intrinsic Fairness) for Self Dealing

- Court looks at a couple of factors - Effect of transactions (does it enhance personal interest at expensive of others?) - Motive: why did Directors do as did? Personal gain (interested) or to help corporation? (disinterested, valid)

Outs for fiduciary duties (per MBCA)

- Directors entitled to rely on outsiders to provide advice - Committees and others rely on advice by them - Do we want to second-guess management's business decisions? - Hire business people to make business decisions - If hold people liable for business decisions, what incentives created? (disincentives to take risks) - Unless fraud, illegality, or conflict of interest, no violation of substantive business judgment rule - Can limit by planning in charter, bylaws, etc

American Law Institute Test

- Disclosed to corporation (disclose opportunity) - Corporate opportunity is rejected by corporation - Either - Fair to corporation to reject - Rejected in advance, followed by disclosure, by disinterested directors - Rejection authorized in advance or ratified following disclosure by disinterested shareholders, and rejection not waste of corporate assets - Plan ahead and list classes of opportunities (waiver in by-laws; can also put in corporate charter)

Line of Business Test

- Does new venture fall in line of business being conducted by old corporation? - Was opportunity related to corporation's purpose? - Personnel, Finance - Could corporation raise money and hire personnel? - Are of natural expansion for old corp? - Evidence fight

Common Law Standards of the Duty of Care

- Duties established by judicial decisions follow much the same rubric - Ex: The Delaware test has stated that in order to claim must show the directors failed to act - In good faith - In the honest belief that the action taken was in the best interest of the company; and - on an informed basis

Three types of Fiduciary duty

- Duty of Care (Wrigley case) - Duty of Loyalty (Golf club case) - Duty of impartiality (Marciano v. Makash)

Notes on Remedies for BReaching the Duty of Care

- Each director who voted for action, acquisced in it, or failed to object to it becomes jointly and severally liable for all damage that the decision proximately caused to corporation - Record of who voted, acquiesced, etc is located in the minutes of the corporation - Presumed to have agreed to action unless the minutes of the meeting reflect a director's dissent or abstention-thus, make sure your dissent is noted - Courts may also enjoin or rescind board actions that are unprotected by business judgment doctrine

Fraud

- Elements of fraud (knowing misrep, reliance, harm suffered) - Examples of liability - Directors may be held liable for misleading shareholders in connection with shareholder voting - Knowingly disseminating false or misleading information to public trading markets - Knowingly or recklessly misrepresenting material facts tot he board on which other directors rely to corporation's detriment

Types of Diversion

- Flagrant diversion - Self-dealing - Squeeze-out (freeze-out) - Executive compensation - Usurping corporate opportunity - Disclosure to shareholders - Insider Trading - Selling Out - Entrenchment - Focus on corporate opportunity doctrine, duties to constituents other than shareholders, and self-dealing/conflicts of interest

Three Ways to Overcome the Business Judgment Rule

- Fraud, illegality, or conflict of interest - Lack of a rational business purpose (waste); or - Gross negligence in discharging duties to supervise and become informed

Notes on Executive Compensation

- IRS under tax law says if too high, can't deduct (disincentive to pay too high because more taxes) - Legislation caps salary in some environments - Securities law now allows shareholders meeting to set executive compensation

Conflicts of Interest

- If director is personally interested in a corporate action because he stands to receive a personal or financial benefit, the business judgment shields neither director from liability nor board's approval from review - Director may also be liable if a corporate action approved because he is beholden to another person interested in the action - Validity of action hinges on a fairness test

Illegality

- If directors approve illegal behavior or remain intentionally ignorant of it, business judgment rule presumption is lost, even if directors were informed and action benefitted corporation - There exists some notable tension between holding scofflaw directors liable as a matter of corporate law, not substantive law that invalidates this behavior

Delaware Approach to Self Dealing (MBCA Subchapter F)

- Interest of directors known to shareholders and shareholders approve - or Known to board and board approves - Fair to corporation - Sterilizing/sanitizing transaction - CHroneism problem: problem of powerful people having great interest in shareholder meeting, etc? - Rubber stamp on conflict of interest?

Reasonable Belief

- Involes the substance of director decision-making - Under this standard, a board decision must be related to furthering the corporation's interests - Embodies the waste standard, under which board action is invalid if lacks any rational business purpose

Remedies for Breach of Corporate Opportunity Doctrine

- Liability for profits realized by usurping manager - Liability for lost profits and damages suffered by corporation - Imposition of a constructive trust on new business or subject matter of opportunity (such as land)

Authorizing Executive Compensation

- Like any other K, officer employment and compensation contracts must be authorized by board - Shares for stock based compensation must be authorized in articles - Transactions involving corp's stock require board approval - Transactions granting options redeemable for more than 20% of voting power of shares require shareholder approval - Board may (and often does) delegate task of reviewing and approving executive pay to a compensation committee of outside directors

Statutory standards of Duty of Care

- Many states codify standards for directorial behavior - MBCA says each individual director must discharge his duties in good faith and act in a manner he reasonably believed to be in best interest of corporation - Collectively, members of board must become informed in performing their decision-making and oversight functions with the care that a person in like position would reasonably believe under the circumstances - Officers with discretionary authority are subject to similar standards

Executive Compensation, generally

- Most common form of self-dealing, but also an indispensable aspect of the corporation, thus it receives special judicial deference - When approved by disinterested directors, executive compensation subject to business judgment rule - Board must be aware of all material information related to the executive's compensation and interested executive cannot dominate board's decision-making

How to disagree with a decision for a director

- Object at time of saying and vote accordingly - Add dissent into minutes of meeting - File written consent before adjournment - Send letter immediately after adjournment - problems: - Dissent may not properly be entered or at all - May be best to try all - Who may dissent? - Only those voting against resolution; if vote yes, can't change your mind later - Try to get board as a whole to reverse resolution/take a new vote to protect self from liability

The Business Judgment Rule Generally

- Often called the golden rule of corporate law, it is a judicial "hands off" philosophy - Rebuttable presumption that directors, in performing their functions, are honest and well-meaning, and that their decisions are informed and rationally undertaken

Grounds for Special Deference

- Raises same concerns of any other self-dealing transaction, that executive will put own interests above corporations and board will likely accede to executive's wishes at expense of corporate interests - That said, treating executive pay the same as other self-dealing transactions would force courts to regularly intermeddle in matters of business judgment- specifically, placing a value on particular executive's services to the corporation - As such, judicial deference to decisions on executive compensations is prevelant - The market for talented, high-performing labor presumably keeps managers honest

Golf Course Case

- Reversed and find corporate opportunity, but saved by statute of limitations and laches - Interested officers vs. disinterested directors and officers - President of golf club purchased and developed property adjoining golf course and developed it personally - Duty of good faith action in best interest of corporation for officers - What does your state say? - 3 CL approaches: interest/expectancy test, line of business test, equity or fairness test

Duty of Impartiality (Self Dealing)

- Self dealing is possible breach of duty of impartiality - Can you K with corporation to make loan, sell property, lease jet, etc without it being a conflict of interest or self-dealing?

Operation of Business Judgment Rule

- Shields directors from personal liability - Insulates board decisions from judicial review - Breadth of operation may vary depending on whether damages or injunctive relief is sought - Rule is a presumption and burden of rebutting presumption rests on party challenging director's action or board's decision - Entitles directors to rely on information and advice from other directors, competent officers and employees, and outsider experts (like lawyers and accountants) - That said, directors remain subject to general standards of care in judging reliability and competence of the source of any information

Notes on Van Gorkum

- Stone hates this, worst case in corporate law history - Corporate world lashed out, calling decision atrocious - Finding outside directors has become more difficult since this case - Even with high paychecks/dividends, who would want to expose selves to this liability? - Further, this case has created a wave of new compliance costs in the form of financial experts and cumbersome record keeping, all in the name of covering one's butt in event of procedural challenge - This case is an anomaly; very rare to find directors liable - Delaware enacted a law since then as a pushback - Enacted a statute to limit director liability that supersedes Van Gorkum - Allows to K to limit liability of directors - Recent case says can pass along legal costs/fees people make whether business judgment rule (shareholders who file suit) - Director/ Operator (D&O) liability insurance - People invest, not for social reasons, but to maximize wealth - When do we have liability for a particular director? - Under Van Gorkum, must be informed before decision - Protect people by honorary chairman - Law protects uninformed directors (ie scientist/expert) advise from inside corporation can rely unless known/should've known untrue - How does producing world really work?

Reasonable Care

- The informed basis and ordinary care standards involve procedures of decision-making and oversight - In dual capacities of decision making and oversight, directors must have at least minimal levels of skill and expertise -The like position formulation designed to establish an objective standard that recognizes that risk-taking positions are central to director's role - The under similar circumstances language has been understood to allow a court to take into account the complexity and urgency of the boards functions

Squeeze Out

- The ultimate form of preferential dealing - Majority (or parent company) squeezes out the minority in a merger or similar transaction and forces minority to accept unfair consideration for their shares

Actions Constituting Gross Negligence (Procedural Review)

- To claim a business judgment presumption in a decision making context, directors must make reasonable efforts to inform themselves in the decision - The focus is on procedure, and courts assume the diligent board deliberations (procedure) ensure rational board decisions (substance) - Recent courts moved away from MBCA model of holding directors liable if not informed about a decision to an extent directors reasonably believed appropriate in the circumstances and toward a model of finding liability based on a finding of gross negligence

Marciano v. Nakash

- Two families in gas corp, each has 50% interest and P's upset D's loaned $2.5 million - Don't want D's loan to be seen as debt - Arguing that it is self-dealing - Approved loan and lent it (interested party on both sides of deal) - No majority since 50/50 split - Trial court: no self dealing - Intrinsic Fairness Test: fair, best under circumstances? - What is fairness? - Effect of activities/does it advance personal interest at expense of others? - Motive (why did D's do as D's did? All for personal interest or also to help corp?) - Is this oppression? - Directors and officers are presumed tphave best interests of corporation at mind; wearing two hats (owe duty to corp and using own funds, incompatible, can't serve two masters)

Good Faith

- Typically understood to require the directors - Be honest; - Not have conflict of interest; - Not approve or condone illegal activity - Interested or fraudulent action is subject to scrutiny under rules that enforce duty of loyalty - COrporate illegality, which generally not protected by business judgment rule, is subject to heightened judicial scrutiny

Equity or Fairness Test

- Was opportunity presented to officer/director in personal capacity or fiduciary capacity? - Was there full disclosure by director/officer to old corporation?

Schlensky v. Wrigley

- Wrigley decides not to have night baseball games for cubs - P says has caused loss of money for shareholders - Says breached duty of care by not allowing and not giving good business judgment - Personal bias against night baseball has hurt them - Court says do have duty of care, but the test is to weigh the best business judgment - Business people run corps, not judges, so won't look at unless fraud, illegality, or conflict of interest - Directors make business decisions; judges not equipped to make these decisions and can only use hindsight to gauge while directors must decide immediately - Role of business person is to assess business risk with the knowledge they have at the time - Model Act: used to say good faith, care of ordinary prudent person in loike position, best interests of corporation - Now, good faith, reasonably believes best interest of corporation in care like person in similar situation would use - Wrigley is majority; majority rules (unless against best interests) - Is this a substantive tort negligence standard? - Was it really lights causing low attendance? - Did Wrigley do a cost-benefit analysis of night vs. day and make business judgment call? - Standard is business judgment of particular business and its characteristics (risk analysis) - Courts make legal judgments - Standard of old MBCA? - Does it matter what kind of business? (ie would a bank director be held higher standard than baseball?) - But, all are directors who manage others; money (assets, not liquidity or non-liquidity; would be inefficient to have different standards for every type - Bottom line is profit and maximizing shareholder wealth - Duty of care = protect assets - Recession: should bank directors be responsible for bad decisions/loans or was it business judgment? (or fed gov't?)

Selling OUt

A corporate official who accepts a bribe to sell out corporation breaches duty of loyalty

Boeing

Bondholders are respondents who gave insufficient disclosure of paying off of bonds (early pay off) - Notice buried in 113 page document of redemption and court holds not adequate - Read your K? Should read all of it - Would lead to document not being used as rules

Disclosure to SHareholders

Corporate officials who provide false or deceptive information, on which shareholders then rely to their detriment undermine corporate credibility and transparency and also frustrate shareholders' expectations of fiduciary honesty and accountability - Duties of disclosure arise when corporate officials communicate to stock trading markets

Interest/Expectancy Test

Does coproration have interest or expectancy in the development of a new opportunity? (past actions, etc)

Entrenchment

Manager who uses corporate governance machinery to protect his incumbency

Executive Compensation

When a director or officer sells his executive services to the corporation, diversion can occur if compensation exceeds fair value of services

Insider Trading

When a fiduciary knows of confidential corporate information such as impending acquisition of another company, and buys the target's stock, diversion can occur if the acquisition price to the corporation rises because of these purchases

Self Dealing

When fiduciary enters into transaction on unfair terms, the operational effect is the same as if he had appropriated the difference between transaction's fair value and transaction's actual value

Test for Business Judgment Rule

Won't look at a business judgment outside of fraud, illegality, or conflict of interest