Chapter 8 Fiduciary Duties

Chapter 8 Fiduciary Duties • Introduction: One Controversial Case • John v. Robinson (Del 1985) • The charter stated that under any circumstance, the shareholders shall waive the right to hold all directors liable for mismanagement or any wrongdoing. • Robinson, one of the directors, was involved in an interest-conflict transaction causing great damages to the shareholders. • Q: Could shareholders be entitled to hold Robinson liable?

Classification of Corporate Rules Enabling Rules Distributional rules & Structure Rules Supplemental Rules • Mandatory Rules: Fiduciary Rules • A case recently heard by court in Shanghai Mike is a managing director and CEO of a real estate company. Price of the house in Shanghai was increasing from 2002-2006, then dropped at the 2006 year end.

Framework of Fiduciary Duties • Theoretical Framework 1930s, A.Berle & G.Means Modern Company and Private Property Separation of Ownership and Management • Regulatory Framework duty of care Fiduciary duties duty of loyalty • Who shall undertake duties of fiduciary? Directors, officers, controlling shareholders, actual controller

General Provision in Chinese Corporate Law • Article 148 • Directors, supervisors and senior management personnel shall comply with the provisions of laws and administrative regulations and the articles of association of the company and bear fiduciary duties towards the company. • Directors, supervisors and senior management personnel shall not abuse their rights to receive bribes or other illegal income and shall not convert company assets.

Chinese Regulations of Fiduciary Duties Fiduciary Duties General Regulations — Article 148 Detailed Regulations — Article 116 — Article 117 — Article 149 Item 1 (1)~(8) — Article 151 Damages — Article 149 Item 2 — Article 150 Remedies Derivative Suit — Article 152 Suit Direct Suit — Article 153

Section One: Duty of Care Definition and Standards of Care the Business Judgment Rule Overcoming Business Judgment Presumption Remedies for Breaching the Duty of Care

The Structure of Duty of Care decision making oversights function the board B J R the duty of care judicial review

Standards on Duty of Care Statutory Standards MBCA§8.30 (1997 revised)(directors) ~in good faith ~reasonably believes to be in the best interests of the Co. ~become informed in performing their decision-making and oversight functions with the care a person in like position would reasonably believed appropriate under the circumstances.

Standards on Duty of Care Common Law Standards The Delaware Supreme Court has stated a party challenging a business decision must show either the directors failed to act: ~in good faith ~in the honest beliefthat the action taken was in the best interest of the company ~on an informed basis ALI Principles§4.01(a) specifying ordinarily prudent person standard. In general, these judicial standards also apply to officers.

Facets of Duty of Care Good Faith require directors: (1)honest; (2)not have a conflict of interest; (3)not involved in illegal activity. Reasonable Belief substance of decision-making: furthering Company’s interest Reasonable Care procedures of decision-making and oversight: “Informed basis” ,“ordinary care” ,“like position” , “under similar circumstances” rarely held liable for mere mismanagement

B.J.R (safe harbor) • B.J.R：rather than a prescription of standards of behavior, but a judicial “hands off” attitude——a golden rule of Company law • B.J.R： a rebuttable presumption——directors’ performance are honest and well-meaning, decision are informed and rational undertaken. • B.J.R：not statutorily codified but continues to be developed by the courts, dilute the statutory standards.

Operation of B.J.R • B.J.R. operates at two levels: (1) It shields directors from personal liability; and (2) it insulates board decisions from review. • The burden of rebutting the business judgment presumption rests on the party challenging a director’s actions or board decision.

Justification for the BJR • Encourages risk-taking “nothing ventured, nothing gained” • Avoids judicial meddling Judges are not business experts, and plaintiffs have incentives that may be odds with the company and body of shareholders. So corporate statutes specify uniformly that corporate management is entrusted to the board. • Market Pressure Alternative Mechanism poorly managed—stock price falls and hard to raise new capital—vulnerable in proxy fight or takeover—managers replaced—manager less attractive in the executive job market.

Reliance Corollary: Delegation of Inquiry and Oversight Functions • Reliance Corollary:Directors cannot be expected to learn and know about the full range of the corporation’s business. • Statutes: MBCA§8.42(c)-(e) : directors can rely on information and advice from proper persons. MBCA§8.42(b) under some statutes, it also extends to officers Persons can be relied on: (1) other directors [committees of board] (2) competent officers (3) employees (4) outsider experts [lawyers and accountants]

Reliance Corollary: Delegation of Inquiry and Oversight Functions • Requirements & Limitations on Reliance Corollary • -To claim reliance, directors must have become familiar with the information or advice and have reasonably believe that it merited confidence. • -Directors remain subject to general standards of care in judging reliability and competence of source of information (MBCA §8.30). Directors cannot hide their heads in the sand and claim reliance if they have reasonable suspicions that make reliance unwarranted. • -Management directors have a correspondingly greater duty to independently verify information.

Overcoming B.J. Presumption fraud, illegality or a conflict of interest the lack of a rational business purpose gross negligence burden The court ~action not in good faith ~decision not reasonably believed to be Company’s best interests ~decision not adequately informed ~action from lack of objectivity or independence ~a sustained failure to be informed in oversight function ~receipt improper financial benefit Revised MBCA ~charter provision limiting liability ~the statutory safe harbor for conflict interest transactions MBCA§8.31

Overcoming B.J. Presumption • Not in Good Faith • Irrational Decision—Waste • Gross Negligence • Inattention

Not in Good Faith—Fraud, Illegality, or Conflict of Interest Fraud Directors knowingly or recklessly misrepresent a material fact on which the board relies to the corporation’s detriment can be held liable under a tort deceit theory. Conflict of Interests Director’s liability and action’s validity is dependent on fairness standards that apply to interest-conflicted transactions. Illegality Breach of duty of loyalty

Irrational Decision—Waste Rational basis: how much of a business justification is sufficient? • Rational purpose test: even board decision that in hindsight seem patently unwise or imprudent are protected from judicial review so long as the business judgment was not- ~improvident beyond explanation…Del ~removed from the realm of reason…ALI.P

Gross Negligence • Directors must make reasonable efforts to inform themselves in making decisions. • Trans Union(Smith v. Van Gorkom)del.1985 • A CEO (Van Gorkom) who initiated, negotiated and advocated a merger agreement whose terms may have favored the acquirer (Prizker) • Shareholders brought a class action challenging the board’s failure to become sufficiently informed.

Gross Negligence • Trans Union(acquired) Prizker (acquirer) • Board of Directors (5 managing directors & 5 outside directors) $ 55 • Van Gorkom (CEO) • Roman (CFO)

Gross Negligence • Errors by a board composed of five management directors and five eminently qualified outside directors, according to the court, directors had: • -failed to inquire into Van Gorkom’s role in setting the merger’s terms: • -failed to review the merger documents; • -not inquired into the fairness of the $55 price, and the value of the company’s significant, but unused, investment tax credits; • -acted without inquiry the view of the company’s CFO (Roman) that the $55 was within a fair range. • -not sought an outside opinion from an investment banker on the fairness of the $55 price; and • -acted at a two-hour meeting without prior notice and without there being an emergency.

Gross Negligence • Directors asserted they had been entitled to rely on Gorkom’s oral presentation outlining the merger terms, but the court held no reliance was warranted: • -Van Gorkom did not explain that he, not Pritzker, suggested the $55 price; • -Van Gorkom had not read the merger documents; • -Directors did not inquire about senior management, who strongly objected to aspects of the agreement, including the price; • -Directors never questioned Romans about the basis for his opinion;

Who can be relied on? • Shall it be at any circumstance, the director seek outside opinion? ——Decision Making Process • Shall it be at any circumstance, the directors’ liabilities are the same? —— Discrimination on the Liabilities of directors Two directors, One specialized in architecture, the other in finance. ——Allen v. Roydhouse,232 F 1010, P.1015. • Other directors are entitled to trust the colleague with the qualification of CPA(UK)。 ——Re Cladrose Ltd.(1990) BCLC204, p.208.

Inattention • Oversight Functions of directors: (1) go beyond decisions making (2) requires directors to inquire into managers’ competence and loyalty • Judicial review has varied depending on whether the director is inattentive to mismanagement, management abuses or illegality.

Inattention • Inattention to mismanagement: • Case: A director whose “only attention to the affair of the company consisted of talks with the president [who was a friend] as they met from time to time” was sued after the business failed because of the president’s poor business judgment. • Learned Hand: • (1)The passive director, though he had technically breached his duty of care, could not be liable because nothing indicated he could have prevented the business failure. • (2) It would be impossible to know whether the director could have saved the business or how much he could have save.

Inattention • Inattention to management abuse • Court have been less forgiving when a director fails to supervise management defalcations. • Directors turned on a blind eye to managers with their hands in corporate till. • Liability hinges on whether the director knew or had reason to know of the management abuse.

Inattention • Inattention to illegality • The court held that business judgment rule shields directors who had failed to detect antitrust violations (price-fixing or bid-rigging) by midlevel executives. • The MBCA care standards regarding directorial oversight functions also reflects this view: “the director may depend upon the presumption of regularity, absent knowledge or notice to the contrary.” ——Official Comment, MBCA §8.30 (b)

Remedies for Breaching the Duty of Care • 1. Personal Liability of Directors • Most Courts: vote for/acquiesced/failed to object • MBCA§8.24(d) :Attending shall be assumed to have agreed to the action, unless minutes of the meeting reflect the director’s dissent or abstention. • Somecourts: challenger to show D’s action/inaction • 2. Enjoining Flawed Decision • enjoin/rescind action/unprotected by the BJR

Duty of Loyalty Self-dealingtransaction(自我交易) Executive compensation (管理者报酬) Flagrant diversion (转移公司资产) Usurping corporate opportunity (滥用公司机会) Parent-subsidiary dealings (母子公司交易) Selling out (权钱交易) Promoter’s early dealings with the corporation (公司发起人与公司的早期交易) Entrenchment (巩固地位的交易)

Chinese Regulations of Fiduciary Duties Fiduciary Duties General Regulations — Article 148 Detailed Regulations — Article 116 — Article 117 — Article 149 Item 1 (1)~(8) — Article 151 Damages — Article 149 Item 2 — Article 150 Remedies Derivative Suit — Article 152 Suit Direct Suit — Article 153

Nature of Self-dealing A simple contrasting example: CorporationA is selling a house worth $102,000 B is a business man C is a business man and a director of corporation A

Nature of Self-dealing Question: Why the purchasing price of the house is only $ 2,000 in a self-dealing transaction? Answer: DirectorC——(Seller) a director of corporation A ——raise the price ——(Buyer) a business man ——lower the price Conflict of Interest —Reason

Nature of Self-dealing Definition of Self-dealing ﹡The conduct of a fiduciary in a transaction ﹡that consists of taking advantage of his or her position ﹡and acting for his or her own interests ﹡rather than for the interests of the corporation. conflict of interest

Nature of Self-dealing Two broad categories of Self- Interest Direct Interest Self- Interest Indirect Interest

Nature of Self-dealing Two broad categories of Self- Interest Direct Interest —corporation & director e. g. ①sale & purchase of property ②loan to & from ③furnishing of services

Nature of Self-dealing Two broad categories of Self- Interest Indirect Interest ——corporation & person or entity (in which director has a personal or financial interest) e. g. ①with director’s close relatives ②with an entity in which the director has a significant financial interest ③between companies with interlocking directors

Judicial Suspicion of Self-dealing Transactions Two basic assumptions Historicaldevelopmentoffairnesstest

Judicial Suspicion of Self-dealing Transactions Two basic assumptions: Assumption1: human nature ——advance their own interest rather than the corporation’s interest ——Judicial suspicion of substantive fairness Assumption2: group dynamics ——identify with their interested directors even if they don’t have an interest in the transaction ——Judicial suspicion of procedural fairness

Judicial Suspicion of Self-dealing Transactions Historical development of fairness test Late 1800s: rule of voidability ——regardless of fairness ——flatly prohibited ——voidable at the request of the corporation Since early 1900s: Safe harbor test ——substantive and procedural fairness tests ——abandon the flat prohibition ——be valid if properly approved

Statutory “safe harbors” “Safe harbor tests” in four statutes: ①Delaware GCL § 144 ②1984 MBCA § 8.31 ③1989 MBCA § 8.61 (Subchapter F) ④ALI Principles of Corporate Governance

Statutory “safe harbors” Statutory “safe harbors” in four statutes Three basic principals of “Safe harbor tests”: ①disinterested directors’ approval, or ②disinterested (qualified) shareholders’ approval, or ③fairness

Statutory “safe harbors” Analysis of similarities and differences of the four statutes in details ﹡Analysis of similaritiesof the four statutes in details ★ Burden of provein the litigation

Statutory “safe harbors” ★ Two aspects ofSubstantive Fairness Standard Objective test: terms of the transaction—principally the price Corporate value:corporation’s needs and scope of its business

Statutory “safe harbors” ﹡Analysis of differencesof the four statutes in details ★ Interested personsin a self-dealing transaction:

Statutory “safe harbors” • Disclosurein a self-dealing transaction ☆ Content of disclosurein a self-dealing transaction: ﹡Existence and nature of conflict of interest ﹡Material information ☆ Disclosure requirements in a self-dealing transaction:

Statutory “safe harbors” • Quorum requirements in the directors’&shareholders’approval ☆ Quorum requirements in the directors’ approval ☆ Quorum requirements in the shareholders’ approval Majority of disinterested or qualified shareholders

Statutory “safe harbors” • Judicial review of the directors’ & shareholders’ approval • Judicial review of the directors’ approval • Judicial review of the shareholders’ approval

Remedies for self-dealing General Remedy Exceptions to Rescission

Remedies for self-dealing General Remedy ——— Rescission（废除） Rescission: Returns the parties to their position before the transaction Exceptions to Rescission ——— Damages（赔偿） Damages: The profit made by the director in the self-dealing transaction

Chapter 8 Fiduciary Duties