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Chapter 20 Director Conflicts

Module VII – Fiduciary Duties. Chapter 20 Director Conflicts. Bar exam. Corporate practice. Law profession. Self-dealing transactions Definition: director on both sides History: void  process + substance  substance only  process enough (DGCL 144)

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Chapter 20 Director Conflicts

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  1. Module VII – Fiduciary Duties Chapter 20Director Conflicts Bar exam Corporate practice Law profession Self-dealing transactions Definition: director on both sides History: void  process + substance  substance only  process enough (DGCL 144) Subchapter F: statutory safe harbor Process Disinterested/independent directors Shareholder ratification Collective action problems Effect: validates or shifts burden? Corporate opportunities Compare to self-dealing Definition: expectancy / line of business ALI Principles Disclosure + process Distinguish: officers / directors Citizen of world Chapter 20 Director Conflicts

  2. Director self-dealing Shareholder X Corporation A owns and leases a number of commercial buildings. Corporation A leases one of its buildings to Store X. Any problems? When Store X faces financial difficulties, Corporation A agrees to waive “bonus rents” and past arrearages – to help Store X get back on its feet. Any problems? X is a significant shareholder and member of the board of directors of Corporation A. X is also the owner of Store X. Any problems? Board Lease Rent Corp A Store X Waive How should corporate law respond to director self-dealing? Chapter 20 Director Conflicts

  3. Possible Approaches • Flat prohibition: The corporation cannot enter into any transaction with any person or entity in which a director has a conflicting interest. • Shareholder ratification. The corporation can enter into conflicting-interest transactions if the shareholders validate -- ratification or approval. • Director ratification. The corporation can enter into conflicting-interest transactions if the disinterested directors approve. • Fair. The corporation can enter into conflicting-interest transactions if a judge finds the transaction was fair. Chapter 20 Director Conflicts

  4. Common law Procedure AND Substance Evolving common law Substance only Judicial review Modern common law Procedure OR Substance 1900 1950 2000 Chapter 20 Director Conflicts

  5. Common law in age of statutes … Chapter 20 Director Conflicts

  6. Stanley and Sturgis were in the brick business. They owned a majority of Brick Corp, a brick manufacturing firm.  Stanley and Sturgis also owned all of Sales Corp, which contracted with Brick Corp to sell the bricks.  What's the problem?  Who sued?  Wasn't the deal approved by Brick Corp board?  Didn't the Brick Corp stockholders approve, as well? Remillard Brick Co v. Remillard Dandini Co (Calif App 1952) Shareholders Stanley / Sturgis Minority 100% Majority Brick Corp Dealings Sales Corp Chapter 20 Director Conflicts

  7. Del. G. Corp. L. § 144 [edited a little] (a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if: (1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors OR (2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders OR (3) The transaction is fair as to the corporation as of the time it is approved. Is the statute a safe harbor? Chapter 20 Director Conflicts

  8. "But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply because there has been a disclosure and approval by the majority of the stockholders" Even though the requirements of section 820 are technically met, transaction that are unfair and unreasonable to the corporation may be avoided. ... It would be a shocking concept of corporate morality to hold [otherwise] Remillard Brick Co v. Remillard Dandini Co (Calif App 1952) California Appeals Court Chapter 20 Director Conflicts

  9. Common law in age of statutes in Delaware … Chapter 20 Director Conflicts

  10. Delaware cases Fliegler v. Lawrence (Del 1976) DGCL 144 “merely removes an “interested director” cloud when its terms are met … nothing in the statute removes the transaction from judicial review” Marciano v. Nakash (Del 1987) - dicta "... approval by fully-informed disinterested directors under Section 144(a)(1) or disinterested stockholders under section 144(b)(2) permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof on the party attacking the transaction.” Benihana of Tokyo v. Benihana, Inc (Del 2006) DGCL Section 144 provides a safe harbor for interested transactions, like this one, if "[t]he material facts as to the director's . . . relationship or interest and as to the transaction are disclosed or are known to the board of directors ... and the board ... in good faith authorizes the transaction by the affirmative votes of a majority of the disinterested directors...." After approval by disinterested directors, courts review the interested transaction under the business judgment rule. Chapter 20 Director Conflicts

  11. Benihana (Del 2006) Benihana in middle of family imbroglio and needs capital. Bank loan not attractive. Board approves issuance of $20 mm preferred stock to finance company, in which Abdo (Benihana director) is 30% shareholder and director/vice chair. Board knew that Abdo was negotiating for finance company. “Abdo did not use confidential information, set the terms deceive the board, dominate any directors.” Chapter 20 Director Conflicts

  12. MBCA Subchapter F - Hypothetical Fred, the favorite cousin of Director A and principal legatee of A’s estate, sells Blackacre to Corporation XYZ. The board approves and shareholders ratify. How does Subchapter F handle this transaction? What if Fred is Director A’s son? How does that change things? Chapter 20 Director Conflicts

  13. Subchapter F • § 8.60 Definition • “DCIT”? • direct interest • indirect interest • § 8.61(b) • Safe Harbor • not challenge DCIT • if (1) or (2) or (3) • § 8.62 • Board approval • maj “qualified Ds” • required disclosure • review: manif unfav ? Yes • (2) § 8.63 • SH action • maj “qualified shs” • notice / req’d discl • review: no substance No • § 8.61(a) • Exclusive • can’t challenge tx • if not DCIT • (3) “fair” (Note) • review: tx terms + • corp benefit • BOP on defendant Chapter 20 Director Conflicts

  14. Pop quiz Chapter 20 Director Conflicts

  15. B owns Blackacre and also sits on the board of Corp X. If B sells Blackacre to X, the transaction is: Insider trading Director self-dealing Usurpation of corporate opportunity B’s sale to Corp X is: Void (or voidable) OK, if approved by independent directors OK, if approved by majority of shareholders OK, if judge determines to be “fair” • 3. “Fairness” means: • Transaction is within corporation’s line of business • Transaction reflects market price / terms • Transaction reflects director’s “reservation price” • 4. In shareholder suit challenging Corp X’s purchase of Blackacre: • Burden in on shareholder to show unfairness • Burden is on shareholder to show inadequate approval • Burden is on Corp X (and B) to show fairness – process or substance 1–b / 2-d / 3-b / 4-c Chapter 20 Director Conflicts

  16. 5. DGCL 144: Simply prevents automatic voidability of DCIT Requires fairness showing even if board/Shs approve Applies BJR if defendant shows proper board approval 6. When Benihana Inc raised capital from director, Del Sup Ct said DGCL 144: Did not apply because director did not explain his role Did not apply because court must determine fairness Provided safe harbor since “qualified” directors OK’d deal • 7. Under DGCL 144: • BJR applies if DCIT approved by informed directors • BJR applies if DCIT approved by disinterested directors • BJR applies if DCIT approved by independent directors • 8 . MBCA Subchapter F: • Covers all situations of DCIT • Ensures judicial review of DCIT under fairness standard • Creates BJR safe harbor, beyond judicial scrutiny 1–c / 2-c / 3-abc / 4-a Chapter 20 Director Conflicts

  17. Board “cleansing” When are directors – disinterested? independent? Effect of such approval Chapter 20 Director Conflicts

  18. Contexts“Disinterested” and “independent” director Board reviews DCIT (Cullman v. Orman) SLC reviews Sh lawsuit (Oracle Corp) Board reviews Sh demand(Disney I) Chapter 20 Director Conflicts

  19. What is “disinterested”and “independent”? Chapter 20 Director Conflicts

  20. “Cleansing” DCIT If a plaintiff alleging a duty of loyalty breach is unable to plead facts demonstrating that a majority of a board that approved the transaction in dispute was interested and/or lacked independence, the entire fairness standard of review is not applied and the Court respects the business judgment of the board. Chancellor William Chandler(Delaware Chancery Court) Chapter 20 Director Conflicts

  21. “Cleansing” DCIT Disinterested: “… directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self- dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally." Independent: … a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.“ Plaintiff must show particularized facts manifesting 'a direction of corporate conduct in such a way as to comport with the wishes or interests of … persons doing the controlling.' Chapter 20 Director Conflicts

  22. Apply to law professor … Chapter 20 Director Conflicts

  23. Is “independence” same in SLC as “demand” cases … Chapter 20 Director Conflicts

  24. “Allegations that Martha Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends” even when couple with Stewart’s 94% voting power, are insufficient without more, to rebut the presumption of independence.” Martha Stewart MS Living Omnimedia Director independence in board-demand case: Chapter 20 Director Conflicts

  25. “Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife” -- above reproach.” Delaware Supreme Court Supreme Court distinguishes Oracle: Chapter 20 Director Conflicts

  26. Can directors be truly “independent”? Chapter 20 Director Conflicts

  27. Charles Elson Director – Delaware Center Corporate Governance A solution … Chapter 20 Director Conflicts

  28. Shareholder ratification Shareholders ratification? Effect of ratification? “Waste” standard as safety valve? Chapter 20 Director Conflicts

  29. Lewis v. Vogelstein (Del Ch 1997) • What are stock options? • Why grant to directors? • Why need shareholder ratification? Chapter 20 Director Conflicts

  30. Stock options “in money” Expire Grant Exercise price Vest “out of money” Chapter 20 Director Conflicts

  31. Stock options “in money” Expire Grant Exercise price Vest Back-date “out of money” Chapter 20 Director Conflicts

  32. Lewis v. Vogelstein (Del Ch 1997) Effect of informed ratification? • Complete defense • Shift burden to Pl to show waste • Shift burden to Pl to show unfairness • No effect Problems w/ ratification • Inability to negotiate – “take or leave” • Collective action problems Chapter 20 Director Conflicts

  33. Lewis v. Vogelstein (Del Ch 1997) What is “waste”? • “consideration so disproportionately small as to lie beyond range at which any reasonable person might be willing to trade” • “such a transfer is in effect a gift” Why not dismiss complaint? Chapter 20 Director Conflicts

  34. “Safety valve” review …(who wins argument – Allen or Strine?) Chapter 20 Director Conflicts

  35. Harbor Finance Partners v. Huizenga (Del Ch 1999) Shareholders • What was transaction? • Why interested? • Effect of ratification? merger Chapter 20 Director Conflicts

  36. Harbor Finance Partners v. Huizenga (Del Ch 1999) Waste • “I question utility of this equitable safety valve” • “presumes stockholders are, as a class, irrational and that they will rubber stamp outrageous transactions” • “the corporation is not personal property of the stockholders” • “If fully informed, uncoerced, independent stockholders approve, they have decided the tx is “fair exchange” Chapter 20 Director Conflicts

  37. Corporate Opportunities “Corporate opportunity”? The rule? “Corporate expectancy” vs “line of business”? “Rejection” vs “acquiescence”? Disclosure necessary? Chapter 20 Director Conflicts

  38. Entrepreneurship Corporate expansion potential Competing spheres "Every corporation has the power to .... renounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in ... specified business opportunities ... that are presented to the corporation ...  Fairness Line of Business Acquiescence Expectations (actual / inferred) Rejection / Renunciation Contract Contract / Property Inability to finance Del GCL § 122(17) Chapter 20 Director Conflicts

  39. Traditional - Focus on corporation “expectancy” “line of business” “ability to finance” Balance - Focus on fiduciary Rejection (implied) Acquiescence Procedure - ALI Principles Different levels: directors vs. executive officers Require presentation and disclosure Formal rejection by disinterested directors, shareholders, court Approaches – corporate opportunity Chapter 20 Director Conflicts

  40. Farber v. Servan Land Co. (5th Cir 1981) Servan Land owns a 180-acre golf course and country club. Third-party Farquhar offers to sell the corporation an abutting 160-acre tract.  This idea is presented at the 1968 annual shareholders' meeting, but nothing happens. Then, within a year, Servan's principals (Serriani and Savin - majority shareholders and principal officers) buy the tract for themselves. Four years later the country club and S&S sell the golf course and 160 acres as a $8.3 MM package: $5 MM to the club, $3.3 to S&S. Scoundrels or entrepreneurs? Issues? Chapter 20 Director Conflicts

  41. Farber v. Servan Land Co. What is the definition of "corporate opportunity"?  • what is the expectancy test?  • what is the line of business test?  Internal decision-making / notice and rejection?  • must the fiduciary have offered the opportunity to the corporation?  • what constitutes corporate rejection / ratification?  • is the corporation's financial ability to take the opportunity relevant?  Remedy:  what is "constructive trust"?  • how are profits computed? less net purchase price?  • causation defense: would corporation have realized same profits?  By the way, “majoritarian” or “tailored”? Chapter 20 Director Conflicts

  42. Acquiescence - hypothetical The Horns and Burgs are friends in Brooklyn. The Horns had invested in low-price real estate, and they urged the Burgs to "get their feet wet" too. A slumlord venture! Lillian Burg became a one-third shareholder with Max and George Horn in Darand Realty, an incorporated landlord operating tenements in Brooklyn. Max and George run the business. When Lillian learns that Max and George bought 9 other tenements for themselves, she is upset.  What are the arguments? Chapter 20 Director Conflicts

  43. Second Circuit ... a person's involvement in more than one venture of the same kind may negate the obligation which might otherwise be implied to offer similar opportunities to any one of them, absent some contrary understanding. Judge Hays (dissent): ... the Horns were under a fiduciary duty imposed by law not to take advantage for themselves of corporate opportunities, it is irrelevant that ... there was no agreement under which the Horns would ... offer every property they located to Darand. Burg v. Horn (2d Cir 1967) Aren’t fiduciary duties mandatory? Chapter 20 Director Conflicts

  44. ALI Principles … Chapter 20 Director Conflicts

  45. ALI Principles of Corporate Governance  “Corporate Opportunity”? § 5.05 Taking of Corporate Opportunities by Directors SeniorExecutives (a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless: • the director or senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity; • the corporate opportunity is rejected by the corporation; and • (A) the rejection of the opportunity is fair to the corporation; or (B) the rejection is authorized in advance following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, authorized in advance by a disinterested superior, in a manner that satisfies the standards of the business judgment rule; or (C) the rejection is authorized in advance or ratified following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets. Fiduciary offers to corporation • Corporation rejects • Judge: “fair” • Disinterested Ds • (subject BJR) • Disinterested Shs • (not waste) Chapter 20 Director Conflicts

  46. ALI Principles of Corporate Governance  Director or Senior executive (b) Definition of a Corporate Opportunity. For purposes of this Section, a corporate opportunity means: (1) any opportunity to engage in a business activity of which a director or senior executive becomes aware, either: (A) in connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or (B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or (2) any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage. • Offeror expects • to corporation OR • Fiduciary expects • corporate interest Senior executive Fiduciary aware closely related to actual/expec business Chapter 20 Director Conflicts

  47. 4. If fiduciary usurps corporate opportunity, the remedy is … • Damages for opportunity costs • Damages for revenues realized by fiduciary • Constructive trust as though corporation had taken opportunity • 5. If the parties in a CHC understand that the corporate managers have other outside interests … • COD is waived completely • COD is waived as to those interests • Cannot be waived because COD is mandatory • Under ALI Principles… • Corporate directors and officers have same COD duties • Any “corporate opportunity” must be disclosed to corporation • COD is defined as “expectation” • A corporate opportunity is one in which … • Corporate fiduciary deals with corporation unfairly • Corporate fiduciary deals with outside party on market terms • Corporate fiduciary deals with outside party unfairly • A business opportunity is a “corporate opportunity” when … • Corporation has resources to take opportunity • Corporation has made plans to take opportunity • Corporate insider learns of it through corporation • Corporate opportunities … • Must be offered to corporation • Can be taken by fiduciary if disclosed to corporation • Can be taken by fiduciary if corporation rejects Answers: 1-b / 2-b / 3-c / 4-c / 5-b / 6-b Chapter 29 Planning in CHC

  48. The end Chapter 20 Director Conflicts

  49. Disney I Shareholders of The Walt Disney Company claim that executive compensation package to Michael Ovitz was “waste.” Ovitz received stock options and severance payments totaling $140 million – after 14 months of inept service. What must a shareholder do to bring a derivative suit in Delaware? The Michaels (in better days) Chapter 20 Director Conflicts

  50. Demand Requirement Shareholders Shareholder Plaintiff • Demand requirement. “To proceed with their derivative claims, Plaintiffs must set forth in their complaint particularized facts that create a reasonable doubt that • a majority of the members of Disney's board of directors are disinterested and independent or • the challenged transaction was otherwise the product of a valid exercise of business judgment.” Pre-suit demand Board of directors Corporation Chapter 20 Director Conflicts

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