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Business Organizations
University of Connecticut School of Law
Kwak, James Y.

DUTIES:

· Duty of care

· Duty of loyalty

· Obligation of good faith

Duty of Care – Insiders must do their jobs with the effort and diligence a reasonable person would use under the circumstances.

For example:

· Directors must inform themselves properly before making a decision. See Smith v. Van Gorkum.

· Directors must exercise reasonable supervision over the corporation. See Francis v. United Jersey Bank.

In Delaware, a violation of the duty of care generally requires gross negligence (although there is some contrary authority).

Duty of Loyalty

Insiders must act in the best interests of the corporation; they cannot use their position to benefit themselves at the expense of the corporation.

For example:

· Insiders cannot enrich themselves or their relatives at the expense of the corporation. See Bayer v. Beran.

· Insiders cannot use the corporation’s confidential information for their own benefit. See Benihana of Tokyo, Inc. v. Benihana, Inc., p. 345.

· Insiders cannot take action with the purpose of entrenching themselves in power. See Benihana, p. 345.

· Insiders cannot appropriate opportunities that belong to the corporation (like Meinhard v. Salmon; see below).

If an insider has an interest (usually financial) in a transaction with the corporation, it presents a potential breach of the duty of loyalty. Ordinarily, such a transaction will be evaluated by the court under the standard of entire (or intrinsic) fairness: the transaction must be shown to be completely fair to the corporation. See DGCL § 144(a)(3). However, the transaction may be ratified (see below).

Corporate Opportunities

A corporate opportunity is an opportunity that by right belongs to the corporation. The duty of loyalty dictates that an insider may not take for herself a corporate opportunity.

Whether an opportunity is a corporate opportunity depends on four factors:

· financial capacity to undertake the opportunity

· in the corporation’s line of business

· interest or expectancy in the opportunity

· whether the opportunity would bring the insider into conflict with the corporation

See Broz v. Cellular Information Systems, Inc., p. 349; In re eBay, Inc. Shareholders Litigation, p. 353.

Dominant Shareholders Controlling shareholders can owe fiduciary duty to minority shareholders.

Ordinarily these duties apply to directors and officers, not shareholders. However, if a shareholder effectively controls a corporation, it has a duty of loyalty to the corporation. Note that whether a shareholder has control is fact-specific; it does not always require a 51% ownership stake.

If a transaction favors the controlling shareholder at the expense of other shareholders, it must meet the test of entire fairness. See Sinclair Oil Corp. v. Levien.

The use of the intrinsic fairness test shifts the burden to D to demonstrate the fairness of a particular transaction, but in order to invoke the test and to shift the burden, the P must, in addition to demonstrating the existence of a fiduciary duty, show self-dealing on the part of the D.

Self-dealing – where the parent company receives some benefit to the detriment or exclusion of the minority shareholders of the subsidiary.

§ Excessive dividend payments from the sub corp caused by the parent corp were not self-dealing and BJR applied because the parent corp received nothing to the exclusion of the minority shareholders

· Breach of contract claim: Sinclair caused Sinven to contract with Sinclair to sell its oil at specified prices the failed to abide by the terms — This is CLEARLY “self dealing”

o Minority shareholders were not able to share in any of the benefit that accrued to SinclairBecause Sinclair could not show that its actions under the contract were intrinsically fair to Sinven’s minority shareholders, it was required to account for damages under that claim.

Ratification

The general rule is that if an insider has a conflict of interest in a transaction, that transaction must meet the entire fairness test, with the burden of proof on the defendant. However, the transaction may be ratified.

If one or more directors has a conflict, ratification may be achieved by:

· Disclosure of the conflict and approval by a majority of the disinterested directors. See Benihana, p. 344; DGCL § 144(a)(1).

· Disclosure of the conflict and approval by a majority of the disinterested shareholders. See In re Wheelabrator Technologies, Inc., p. 372; DGCL § 144(a)(2).

If a controlling shareholder has a conflict:

· If the transaction is approved by a majority of the disinterested shareholders, the transaction must still meet the entire fairness test, but the burden of proof shifts to the plaintiff. See Wheelabrator, p. 373; Weinberger v. UOP, p. 700.

Ratification is not effective, however, if it is not fully informed. See Weinberger v. UOP, p. 708.

Obligation of Good Faith

Insiders have the obligation to deal in good faith with the corporation. This obligation can be violated by actual intent to do harm to the corporation or conscious disregard for one’s responsibilities. See In re The Walt Disney Co. Derivative Litigation, pp. 386–87. Acting unlawfully is also a violation of the obligation of good faith. Directors did not breach their duty of good faith in approving Ovitz’s lavish payout and casual and sloppy review of the package

Board’s practices fell significantly short of best practices and was at most ordinary negligence

Court decided that enticing Ovitz to leave his position in Hollywood required making significant financial assurances if he were ever terminated

BJR will protect executive compensation decisions so long as they are rational, informed, approved by disinterested and independent directors, and made in good faith – and not waste.

Standard for bad faith corporate fiduciary conduct — intentional dereliction of duty, a conscious disregard for one’s responsibilities.

Categories of bad faith:

1) Subjective bad faith: conduct motivated by an actual intent to do harm

2) Lack of due care: fiduciary action taken solely by reason of gross negligence and without any malevolent intent

a. Gross negligence, without more, cannot constitute bad faith

3) Intentional dereliction of duty. Conduct that fells bw the 1st and 2nd: (1) conduct motivated by subjective bad intent and (2) conduct resulting from gross negligence

a. Acting with a purpose other than that of advancing the best interests of the corporation

b. Fiduciary fails to act in the face of a known duty to act

For example:

· Directors have the responsibility to oversee the corporation. A “sustained or systematic failure” to do so constitutes a lack of good faith. See Stone v. Ritter, pp. 398–99. (The responsibility to monitor itself comes from Caremark.)

Note that the Delaware Supreme Court said that the obligation of good faith is part of the duty of loyalty, not a third duty on the level of the duties of care and loyalty. Stone v. Ritter, p. 400. It’s not clear what practical difference this makes.

Court held directors were not liable for a deficient security system in their bank that failed to catch scoundrels running a panzi scheme since they had not engaged in a deliberate failure to exercise oversight. The bank had a system that failed, this was not enough to establish a sustained or systematic failure of the board to exercise oversight

No Waste: Courts will strike down self-dealing transactions that are so unfair that they are waste or fraud on the corporation :

Waste is found when an exchange is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration (Brehm v. Eisner)

Only where directors irrationally squander away corporate asset

Business Judgment Rule – courts will not question business decisions made by directors (because directors must be able to use their business judgment without fear of judicial second-guessing) unless the plaintiff can prove a good reason to do so.

Another way to put it is that courts will not evaluate the substance of a business decision unless one of the following is present:

fraud,

illegality,

conflict of interest,

(gross) negligence,

or waste.

The fiduciary duties above matter because:

· (Gross) negligence is a breach of the duty of care. (“Gross” is in parentheses because, while some courts say the standard is negligence, in practice it seems to be closer to gross negligence.) So a breach of the duty of care gets a plaintiff past the business judgment rule.

· A conflict of interest is not always a breach of the duty of loyalty, but it gets the plaintiff

P fails to post security for the corporation cost.

Court holds suit as representative (direct) action since P and other shareholders were personally deprived of their voting rights as a result of the company’s reorganization, even though it may also have been a fiduciary breach.

The Demand Requirement

Because of the general principle that corporations are governed by the board of directors, the shareholder should in theory first request that the board of directors cause the corporation to file suit. This is the “demand requirement.”

If a shareholder makes demand, the corporation can refuse to file suit. In that case, in filing a derivative suit, the shareholder must claim that demand was wrongfully refused. If demand is rejected by the Board, Board is given presumption of business judgment. This constitutes a concession that the board could make an independent decision on the demand, so the shareholder cannot then claim that demand is excused for futility. So to win on this claim, P is required to plead with particularity to show failure to inform itself, conflict, or lack of good faith on the part of the board. (allegations which would raise a reasonable doubt that the Board’s decision to reject the demand was wrongful =not the product of a valid BJR). See Grimes v. Donald, p. 230. (P claimed the employment agreement was bad, directors wasted corporation’s money (excessive compensation), abdication claims – directors abdicated their responsibilities to shareholders.)

Alternatively, the shareholder can file suit without demand and claim that demand is refused because of futility. To win on this claim (in Delaware), the shareholder must show grounds for reasonable doubt that the board could make an independent decision whether or not to sue. These grounds can be:

· A majority of the board is conflicted, or is dominated by someone who is conflicted.

· The underlying transaction at issue is not the product of valid business judgment.

See Grimes v. Donald, p. 228.

Special Litigation Committee

After a shareholder derivative action is initiated, a board may create a special litigation committee (SLC) composed of directors who are free of any conflict (typically new board members). The board can delegate its power to deal with the lawsuit to the SLC (under DGCL § 141(c)(2)). The SLC may investigate the situation and decide that it would be in the interests of the corporation to terminate the lawsuit (essentially taking control back from the shareholder).

Directors may not delegate duties which lie at the heart of the management of the corporation.” However, “an informed decision to delegate a task is as much an exercise of business judgment as any other […] [and] business decisions are not an abdication of directorial authority merely because they limit a board’s freedom of future action.” Grimes v. Donald .

When assessing a special litigation committee’s motion to dismiss a derivative action, a court must:

1. Determine whether the committee acted independently, in good faith, and made a reasonable investigation; and

2. Apply the court’s own independent business judgment on the question — is continuing the suit good for the corporation.

See Zapata Corp. v. Maldonado (Delaware)

(Delaware law here is somewhat easier and P friendly than NY– Imposes a heavy burden on the corp to show that its committee is independent.)

NY – made it difficult for a derivative action to survive a special litigation committee’s decision to terminate it