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Duties of Care, Good Faith and Loyalty

Professor Jesse W. Markham, Jr. Corporations Spring 2011

Discussion Problem #1
What are some of the dynamics of a corporation that affect the ability of the Board to act in the best interest of the company when presented with a transaction in which one or more Board members are interested? Whose side are they on? Put yourself in their position what would affect your judgment?

Cal. Corp. Code Section 310


(a) No contract or other transaction between a corporation and one or more of its directors is either void or voidable because such director[is a party to the transaction], if (1) The material facts as to the transaction and as to such director's interest are fully disclosed or known to the shareholders and such contract or transaction is approved by the shareholders in good faith, with the shares owned by the interested director or directors not being entitled to vote thereon, or (2) The material facts as to the transaction and as to such director's interest are fully disclosed or known to the board or committee, and the board or committee authorizes, approves or ratifies the contract or transaction in good faith by a vote sufficient without counting the vote of the interested director or directors and the contract or transaction is just and reasonable as to the corporation at the time it is authorized, approved or ratified, or (3) As to contracts or transactions not approved as provided in paragraph (1) or (2) of this subdivision, the person asserting the validity of the contract or transaction sustains the burden of proving that the contract or transaction was just and reasonable as to the corporation at the time it was authorized, approved or ratified.

Hypo #1
Abel, a Director of Intell Corp., owns a patent on technology that could be valuable to the company. CEO Charles negotiates a license from Abel and presents it for Board approval. Abel explains the technology and its value to Intell and then leaves the room while the remaining 4 Board members approve the deal. What rule applies and how would a shareholder challenge turn out? (A) Challenge would void the transaction. (B) Transaction upheld if corp. proves it is fair.

Notes on Hypo #1

First, one member of the BOD has a direct interest in the transaction Approval by a distinterested majority by itself does not automatically clear the conflict If a transaction is unfair, ratification alone does not render it enforceable So (B) is the better answer (A) is wrong because a self-interested transaction is not automatically voidable or void

Discussion Problem #2

BOD of ABC Corp votes to move headquarters to a city that is also a Board members hometown. The town will benefit from the prestige and business activity. May the Board member from that town participate in the vote? Any difference if she neglects to disclose her residency?

HYPO #2
Same facts as Hypo #1 but the patent that Intell wants is owned by another company, Darthvader Corp., in which all Intell Directors are shareholders. Can Intell obtain the patent rights at a fair royalty without the Board violating any duty to the company and its shareholders? (A) No because all BOD members are substantially interested in Darthvader. (B) Yes, if either the BOD members holdings in Darthvader are small or the Intell SHs ratify the license. (C) Yes, but the SHs must ratify in any case.

Notes on Hypo #2

This may not be a self-dealing transaction if the holdings in Darthvader are insubstantial If any of their holdings are significant enough, then shareholder ratification would still clear the transaction (given that it is assumed to be fair) So B is the best answer

Hypo #3

Forest Corp. appointed Mary Hart as CEO. Her husband Hava founded the company and has always sat on the Board. Marys three-year compensation is set at a staggering sum of $20 million. Hava did not vote but spent three hours at the meeting pressing each member to commit to him that they would approve.
(A) Marys contract is voidable by a shareholder challenge because it is unfair to the company (B) Marys contract is voidable because the disinterested vote was under pressure (C) (A) and (B) are both correct

Notes on Hypo #3

This is a self-interested transaction because Hava has a substantial, if indirect, interest The lobbying obliterated the process protection for the fairness of the transaction by pressuring the disinterested vote In any case, an unfair transaction is voidable in many jurisdictions (including California) Note that statutory rules may be otherwise

You are a director in a small company that needs legal advice on a matter on which you are expert. The four other disinterested directors learn of your knowledge in the field and it is voted to retain you for $400/hour to look into the matter and give advice. This transaction: A. Violates your duty of loyalty if you vote on it. B. Does not violate the duty of loyalty because it does not concern a matter of substantial significance to the company C. Does not violate the duty of loyalty if it is fair. D. Violates the duty of loyalty only if you dominate the Board in any way.

Hypo #4

Notes on Hypo #4

Note the precise question is not whether the transaction is voidable, but whether by entering it you violate the fiduciary duty of loyalty. Ratification of the transaction is a separate matter The best answer is (A) because you violate the duty immediately and without any doubt if you vote for the company to enter into a transaction by which you personally profit. A matter of substantial interest? Sounds good; does not mean anything

Summary

Old rule: self-interested transactions were not allowed at all. Common law evolved to allow them, provided the Board could establish fairness

Business judgment rule does not apply to selfinterested transactions

Statutes allow for approval by disinterested majority of Board, or for shareholder approval

Must be full disclosure of the conflict Some states still insist on fairness, but burden on this may differ state to state.