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The business judgment presumption presumes, among other things, that directors act “in the best interests of the corporation.” When a plaintiff can plead facts to suggest that director does not act in the best interests of the corporation, then the defendant director will lose the deferential business judgment presumption and will be required to prove at trial that notwithstanding the facts pleaded by the plaintiff that the challenged decision was nevertheless entirely fair to the corporation (the entire fairness standard).
Factual situations that commonly call into question whether a director acted in the best interests of the corporation include some of the following factual scenarios:
In each of these factual situations, a plaintiff can reasonably plead that a director's decision was not in the best interests of the corporation and the director can lose the presumption of business judgment.
Unlike violations of the duty of care, violations of the duty of loyalty are not exculpable. That is to say, if a director violates her duty of loyalty to the corporation, the director may be personally liable to the corporation and its stockholders for damages. Violations of the duty of care, as you will remember, are exculpable on the other hand. The availability of a monetary remedy consequently draws the attention of plaintiffs' counsel who can be expected to engage in a high degree of scrutiny of interested director transactions.EDIT PLAYLIST INFORMATION DELETE PLAYLIST
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|1||Show/Hide More||Dweck v. Nasser|
|2||Show/Hide More||Entire Fairness|
When fiduciaries of the corporation lose the business judgment presumption, they will have to justify to the court that their actions were entirely fair to the corporation. A defendant director who bears the burden of proving its actions were entirely fair to the corporation has to bear a heavy burden. Unlike the business judgment presumption, which can a defendant can rely on to have a claim dismissed on the pleadings, when a defendant must bear the burden of proving the entire fairness of transaction, the defendant can only do that after a full trial. Consequently, losing the presumption of business judgment and being forced to prove at trial that the actions of the defendants were entirely fair to the corporation is often outcome determinative. Defendant directors will often seek to settle litigation rather than go to trial under the entire fairness standard.
In older cases, the “entire fairness” standard is also known as the “intrinsic fairness” standard or the “inherent fairness” standard.
|2.1||Show/Hide More||Weinberger v. UOP, Inc.|
In Weinberger, the court deals with a common loyalty problem. What are the fiduciary duties of a controlling stockholder in dealing with minority stockholders. In such situations, the controlling stockholder, because of her ability to control and direct management decisions of the corporation, has fiduciary obligations to deal with minority stockholders fairly. Transactions between the controller and the corporation will not receive the protection of the business judgment presumption.
Rather, the controlling stockholder bears the burden of proving the fairness of its dealings with the corporation. The entire fairness standard requires the court to examine two aspects of the board's dealings with the corporation: whether the board dealt fairly with the corporation and whether the challenged transaction was at a fair price to the corporation.
As you read Weinberger, consider the facts and ask yourself if you were advising the controller how, if they were able to do things all over again, they might change things to make sure the actions of the controller and the board comported with the entire fairness standard as described by the court.
|2.2||Show/Hide More||Sinclair Oil Corporation v. Levien|
Stockholders do not normally have fiduciary duties with respect to other stockholders. This principle makes sense for a number of reasons. Stockholders with small stakes have no ability to influence the board of directors and therefore should be free from restrictions in their dealings with other stockholders.
However, this principle is subject to an exception. When stockholders can, through their ownership position influence and control the direction of the corporation, then those stockholders have fiduciary obligations with respect to minority stockholders. As a result, in such circumstances, controlling stockholders will bear the burden of proving entire fairness when they engage in self dealing with the corporation.
|2.3||Show/Hide More||In Re Cornerstone Therapeutics|
|3||Show/Hide More||Sec. 144 Safe Harbor and Interested Director Transactions|
During the 19th century, transactions between the corporation and its directors were commonplace. Such transactions often worked to the advantage of the interested director at the expense of the stockholder. The pernicious effect of such transactions caused legislatures to strictly regulate relationships between corporations and their directors. Through the early 20th century, transactions between a corporation and a director were considered void. Over the years, policy with respect to interested director transactions has loosened, but such transactions are still, rightly, looked at with suspicion.
Such transactions are no longer void per se. Section 144 provides for a statutory safe harbor for interested director transactions. Interested director transactions that comply with the requirements of Section 144 will not be considered void or voidable.
Compliance with the requirements of Section 144 provides a board with a safe harbor only against attacks for voidability. Interested director transactions are still subject to attack for potential violations of the duty of loyalty. So, while the challenged transaction might not be void, it could still be unfair and boards may be required to defend the transaction for violations of the duty of loyalty.
The procedures for insulating interested director transactions from attack for purposes of Section 144 provide a partial roadmap for the related doctrine of stockholder ratification. Interested director transactions that comply with the requirements of stockholder ratification doctrine will not be subject to attack for potential violations of the duty of loyalty and will receive the benefit of the business judgment presumption.
|3.1||Show/Hide More||DGCL Sec. 144 - Interested director transactions|
|3.2||Show/Hide More||Benihana of Tokyo Inc. v. Benihana Inc.|
Section 144(a)(1) provides that when a board member's interest is disclosed to or is known by disinterested directors and a majority of the disinterested directors approve the challenged transaction, the board's decision to enter into the transaction will receive the benefit of the §144 safe harbor protection from challenges for voidness and voidability.
Benihana raises a couple of important issues. First, does the disclosure of the director's interest need to be accomplished formally? Or, is it sufficient that the director's interest be common knowledge to the disinterested directors? Second, to the extent a majority of disinterested directors approve the transaction does such an approval provide the interested director and the transaction any additional protection beyond merely protection against the transaction being deemed void or voidable? If a transaction is approved by a majority of disinterested directors who are fully informed about the transaction should that transaction get the protection of the business judgment presumption?
|3.3||Show/Hide More||Fliegler v. Lawrence|
Section 144 provides alternate methods to insulate interested director transactions from attack for voidness. In addition to seeking the approval of a majority of the disinterested directors, a board can seek the approval of the stockholders. Notice that the statute requires only that the challenged transaction is approved by a majority of the stockholders in order to gain the protection of the statutory safe harbor and not necessarily a majority of disinterested stockholders.
Remember the protections of §144 extend only to the question of void or voidability of an interested director transaction and not further. One can see how there would be many situations where one might not want stockholder approval of an interested director transaction to do much more than simply rescue a transaction from voidness. Where a controlling stockholder approves a transaction with itself (as a director) we may be okay with that transaction not being void, but we might still want the interested director/stockholder to be required to prove the transaction is nevertheless entirely fair to the corporation.
The court in the following case, Fliegler, recognizes this problem and makes it clear that for directors who are seeking the additional protection of the business judgment presumption, they would have to do more than just comply with §144(a)(2). For those directors, they will have to take the additonal step of complying with the requirements of common law stockholder ratification doctrine and seek informed approval of a majority of disinterested stockholders.
|4||Show/Hide More||Stockholder Ratification Doctrine|
For anyone with more than a passing familiarity with the law of agency, stockholder ratification doctrine will sound very familiar. As you remember in the Restatement (3rd) of Agency, §8.06 conduct by an agent that would otherwise constitute a breach of a fiduciary duty does not constitute a breach of duty if the principal consents to the conduct, provided that the agent acts in good faith, discloses all material facts that the agent knows, has reason to know, or should know would reasonably affect the principal's judgment, and the agent otherwise deals fairly with the principal. Full and adequate disclosure of an agent's actions followed by knowing and uncoerced assent by the principal in effect cleanses the otherwise disloyal acts of an agent.
In the context of the corporate law, common law courts have adopted a very similar approach to the unauthorized acts of boards, or agents of the corporation. For example, self-dealing by a board will, upon a stockholder challenge, be subject to the stringent entire fairness standard with the board bearing the burden of proving that it dealt fairly with the corporation. However, where the material facts about those acts are fully disclosed to the stockholders and stockholders have an uncoerced opportunity to vote ‘yay or nay' on those actions, board actions so approved by the stockholders will be granted the deference of business judgment rather than be subject to entire fairness review.
Although in a successful ratification case, the board is not required prove entire fairness, in order to establish that the ratification is effective, the board is required to bear the burden of proving that it disclosed to stockholders all the material facts related to the challenged transaction available to it at the time.
Once a board has successfully established that stockholder ratification the effect of such ratification is to shift the substantive test on judicial review of the act from one of fairness to one of “corporate waste”.
|4.1||Show/Hide More||Corwin v. KKR Financial Holdings LLC|
|4.3||Show/Hide More||Calma v. Templeton|
Because directors have a statutory right to set their own compensation (See DGCL §122(15)), director compensation plans are neither void nor voidable. However, the ability of boards to set their own compensation is not without limits. Director compensation is a quintissential “interested director” transaction. In these cases, directors are deciding the amounts and nature of their own compensation and naturally have at least implicit biases in favor of larger amounts. It is no surprise then that director decisions to set their own compensation are subject to entire fairness review upon a stockholder challenge.
In the case that follows, the Chancery Court addresses whether disinterested stockholder approval of a compensation plan for non-employee directors subjects affords the plan the protection of the business judgment presumption rather than the more exacting entire fairness standard.
This discussion in the case relates to director compensation, not compensation of corporate executives. Decisions by the board of directors to compensate corporate executives, like the CEO and other C-level executives who are not simultaneously directors of the corporation, are typically treated like arms-length transactions and granted the protection of the business judgment presumption. Absent a successful attack under the waste standard, claims that the board violated their duty of loyalty to the corporation by approving executive compensation plans typically fail.
|5||Show/Hide More||Corporate Opportunity Doctrine|
Remember that directors have an obligation to act in the best interests of the corporation. However, that charge can sometimes be difficult for even well-meaning directors to operationalize. For example, directors are often experienced business-people with their own relationships and their own business ventures. A common challenge facing directors comes in the form of business opportunities that come to them while they are directors. Which of the opportunities that come to directors properly belong to the corporation and which of them properly belongs to the director can be a vexing question.
If the director gets the answer to that question wrong, she may well find herself on the wrong end of a lawsuit alleging violations of the duty of loyalty for wrongfully benefitting from an opportunity that properly belonged to the corporation. On the other hand, the director may also mistakenly forego personal business opportunities for fear that her duty to the corporation prohibted her from pursuing them. The courts have developed a doctrine with respect to corporate opportunities that directors may come across in their capacities as directors of the corporation.
|6||Show/Hide More||Duty of Good Faith|
The ubiquity of exculpation provisions in charters as well as precedent like Malpiede v. Townson have made it extremely difficult – if not impossible – for shareholder plaintiffs to succeed on claims that simply allege violations of the duty of care. In response to foreclosing that avenues, shareholder plaintiffs have brought other theories to court in attempts to generate monetary liability for otherwise disinterested directors when their decision-making process has fallen short of the mark.
Duty of good faith claims are just one such theory. In the good faith claims, plaintiffs argue that otherwise disinterested directors inaction or decision-making was so poor that it exceeds gross negligence – the standard of a duty of care claim – and rises to the level of a violation of the duty of good faith.
The object of these theories is to work around the limitations of exculpation provisions. To the extent they are successful, such theories might be able to generate monetary liability for disinterested directors.
Courts have heard these theories and have responded by narrowing the possible set of circumstances of a successful good faith claim.
|6.1||Show/Hide More||Oversight Claims|
It is not uncommon that when a corporation makes a decision that results in a loss for the corporation that stockholders will be unhappy. In some cases, stockholders may well sue the board for the lack of propriety of the decision leading to the loss. However, absent some indicia of a violation of the duty of loyalty, such claims are a very thin reed upon which to rest one's litigation hopes. Oftentimes, plaintiffs will advance a theory that directors violated their duty of good faith due to inadquate oversight of the corporation leading to a nonexculpable loss. In one such case, Caremark, the court noted the good faith theory advanced by the plaintiffs “is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”
Following the financial crisis of 2008, plaintiffs brought a series of claims against the major banks alleging directors failed in their oversight obligations of the banks leading to catastrophic losses. Citigroup demonstrates just how difficult it is for plaintiffs to win on this legal theory.
|6.1.1||Show/Hide More||Stone v. Ritter|
|6.1.2||Show/Hide More||In re Citigroup Inc. Shareholder Derivative Litigation|
In the wake of the Financial Crisis of 2008, stockholders were rightly upset. Boards of corporate America took what in hindsight appear to have been excess risk and helped push the entire economy to the brink of collapse. The case that follows, Citigroup, is typical of the derivative claims brought following the financial crisis. In essence, the plaintiffs argument is that the defendant board mismanaged the company and missed obvious signs (‘red flags') that things were heading in the wrong direction.
Stockholders seek to hold directors accountable for the resulting failure in corporate performance. These claims are a version of “Caremark” oversight claims. Though rather than charging directors with missing misconduct of corporate officers, plaintiffs are charging directors with taking on excessive business risk. Remember, such claims must take the form of derivative claims. Consequently, plaintiffs must plead demand futility. This opinion is an opinion on a Rule 23.1 motion to dismiss.
|8||Show/Hide More||Duty of Candor|
June 14, 2016
Brian JM Quinn
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