Corporations and LLC's Flashcards
Summary
Amy and Bill, as a majority of the corporation’s board of directors, had the authority in their role as directors to approve the corporation’s payment of their travel expenses to Belgium, even though the transaction was a director’s conflicting interest transaction (DCIT).
Under the Model Business Corporation Act (MBCA, rev’d 2016), a DCIT is a corporate transaction in which a director has a personal financial interest, raising the question whether they violated their duty of loyalty. By voting to have the corporation pay for their entire trip to Belgium, which included personal sight-seeing, Amy and Bill voted for a DCIT because they had a personal financial interest in the transaction. However, even if the transaction was not approved by disinterested directors or shareholders, payments of the travel expenses would not breach their duty of loyalty because these payments were “fair to the corporation.” There is a strong argument that these payments were fair to the corporation. They served a reasonable business purpose (enabling corporate employees to learn about ingredients and brewing techniques) and were comparable to expenses incurred by other competing craft breweries for similar purposes. Furthermore, the payment for Amy’s and Bill’s visits to museums and historic sites was merely incidental
Assuming that BC’s payment of Amy’s and Bill’s travel expenses to Belgium was a breach of their duty of loyalty, Sharon may not recover those expenses personally because her suit would vindicate a wrong to the corporation, not to herself.
Even assuming that Amy and Bill violated a duty with respect to the corporation’s payments of their prior travel expenses to Germany, Sharon was not a shareholder when these payments occurred, and thus she does not have standing to bring a derivative claim against Amy and Bill related to these payments.
[NOTE: The following analysis is based on the Model Business Corporation Act, as revised in 2016. This revision continues a safe-harbor approach for director self-dealing transactions, one first introduced to the MBCA in 2005. The analysis, however, would be the same under the earlier 2005 version and even the original 1984 version of the MBCA. Thirty-one states have modeled their corporate statute on the MBCA.]
As directors of BC, did Amy and Bill have the authority to approve their trip to Belgium at corporate expense?
Amy and Bill, as members of the corporation’s board of directors, had the authority to vote to have the corporation pay their travel expenses to Belgium.
Rule
Generally, the corporation’s board of directors makes decisions for the corporation. According to § 8.01 of the Model Business Corporation Act (MBCA, rev’d 2016), “Except as provided in a [proper shareholders’ agreement], and subject to any limitation in the articles of incorporation . . . , all corporate powers shall be exercised by . . . the board of directors” of the corporation. MBCA § 8.01(b). Among the powers of the corporation is the power to “make contracts [and] incur liabilities.” MBCA § 3.02(g). Further, the corporation’s board of directors acts by “the affirmative vote of a majority of directors” present at a meeting where there is a quorum present. MBCA § 8.24(c) (board quorum is generally majority of corporation’s directors).
Application
Here, all three directors of the corporation were present at a meeting, and a majority of the directors (Amy and Bill) voted to authorize the corporation’s payment of their travel expenses to Belgium. Thus, Amy and Bill had the authority to vote to have the corporation pay these expenses. Although this payment constituted a director’s conflicting interest transaction (see Point Two(a)), the nature of the payments does not affect Amy’s and Bill’s directorial authority to vote to have the corporation pay their travel expenses.
Did Amy and Bill violate the duty of loyalty by having the corporation pay for their Belgium trip over Sharon’s objection?
The corporation’s payment of Amy’s and Bill’s travel expenses for the trip to Belgium was a “director’s conflicting interest transaction” (DCIT).
Rule
The MBCA addresses a director’s duty of loyalty in corporate transactions where directors have a conflicting financial interest (“director’s conflicting interest transaction” or DCIT). See Alan R. Palmiter, Frank Partnoy & Elizabeth Pollman, Business Organizations: A Contemporary Approach 587 (3d ed. 2019) (the “duty of loyalty” is “the duty a director owes when he or she enters into a transaction with the corporation.”) A DCIT is any corporate transaction “respecting which . . . the director had knowledge and a material financial interest.” MBCA § 8.60. A “material financial interest” means “a financial interest in a transaction that would reasonably be expected to impair the objectivity of the director’s judgment” when authorizing the transaction. Id.
Application
Here, the corporation’s payment of Amy’s and Bill’s travel expenses for the trip to Belgium, including any expense for touring museums and historic sites, constituted a DCIT. Amy’s and Bill’s financial interest in the corporation’s payment of their travel expenses to Belgium—of which they were both aware—was a “material financial interest” under the statute given that there is a reasonable assumption that their objectivity about the payment was likely impaired when they approved it. Although they might argue that this travel was not personal, the corporation’s payment of their travel expenses to a place that they wanted to visit (“to take in nearby museums and historic sites”) would reasonably be expected to impair their objectivity. See MBCA § 8.60, Official Comment 4 (materiality of financial interest measured under objective standard).
Note
[NOTE: Answers describing the payment by the corporation of Amy and Bill’s travel expenses as directorial “self-dealing” should receive full credit. A similar analysis would apply in a jurisdiction with an “interested director” statute. See former MBCA § 8.31; Del. GCL § 144 (defining director self-dealing to include “transaction between a corporation and 1 or more of its directors”). Further, under the common law, a transaction with the corporation in which a director has a personal, material financial interest is treated as a self-dealing transaction and subject to heightened judicial scrutiny. See, e.g., Globe Woolen Co. v. Utica Gas & El. Co., 224 N.Y. 483 (N.Y. 1918) (Cardozo, J.) (holding that corporation may void a contract entered into between the corporation and a separate corporation owned by one of its directors, given the directorial conflict of interest).
An answer that analyzes the corporation’s payment of Amy’s and Bill’s travel expenses as a form of “executive or director compensation” should also discuss fairness. Whether characterized as compensation or as a non-compensation transaction with the corporation, the corporation’s payment is subject to analysis as a DCIT. See MBCA § 8.61, Official Comment [Note on Directors’ Compensation] (explaining that directors’ compensation practices “do involve a conflicting interest” and must be acted upon by disinterested shareholders or be shown to be fair to the corporation). That is, the fairness of this payment does not depend on whether it was a form of compensation or merely an “ordinary and necessary” business expense.]
Assuming that Amy and Bill violated the duty of loyalty by having the corporation pay for their Belgium trip, can Sharon personally recover from Amy and Bill all the expenses for that trip paid by BC?
Amy and Bill violated the fiduciary duty of loyalty to the corporation by having the corporation pay their travel expenses to Belgium, unless they can show that the corporation’s payment of these expenses was fair to the corporation. Here a strong argument exists that payment of their expenses was fair to BC.
Rule
Under the safe-harbor approach of Subchapter F of the MBCA, a DCIT is not subject to a judicial remedy because of the director’s conflicting interest if the transaction was approved by informed, qualified directors or informed, qualified shareholders, or, alternatively, is shown to have been fair to the corporation. MBCA § 8.61(b). The MBCA defines a “qualified director” for purposes of a DCIT as a director without a material conflicting financial interest in the transaction and not related to the conflicted director (MBCA § 1.43(a)(4)) and defines “qualified shares” as shares not held by a conflicted director or related person (MBCA § 8.63(c)(ii)). Further, the MBCA defines “fair to the corporation” to mean that the challenged transaction “as a whole was beneficial to the corporation, taking into appropriate account whether it was (i) fair in terms of the director’s dealings with the corporation, and (ii) comparable to what might have been obtainable in an arm’s length transaction, given the consideration paid or received by the corporation.” MBCA § 8.60.
Application
Here, the corporation’s payment of Amy’s and Bill’s travel expenses to Belgium was not approved by Sharon, the only director and shareholder who did not have a conflicting financial interest in the transaction. Thus, the procedural safe harbors for a DCIT approved by informed, qualified directors (MBCA § 8.62) or by informed, qualified shareholders (MBCA § 8.63) do not apply in this case.
Nonetheless, Amy and Bill can show that the corporation’s payment of their travel expenses was “fair to the corporation” even though at some level they personally benefited from the payment as well. They could argue that
1. The primary purpose of this travel was similar to the purpose of their earlier travel to Germany at corporate expense, which arguably was reasonable and contributed to the success of their craft brewing business.
2. At a board meeting, they presented their idea for a trip to Belgium at corporate expense and gave Sharon a chance to note any objections, though it is unclear whether Sharon knew of this practice when she became a shareholder.
3. Paying for personnel to travel to Europe to learn about the latest in craft brewing is entirely consistent with the practices of BC’s competitors.
4. BC, if for no other reason than being competitive, would have paid these expenses for these purposes regardless of who was employed by BC.
5. While the travel also allowed Amy and Bill to visit museums and historic sites located near the breweries, this benefit was mostly incidental to the other benefits of the trip and most likely benefited BC as well.
These points strongly suggest that Amy and Bill could establish that their dealings with BC were fair and that the corporation’s payment of their travel expenses would have happened in an arm’s-length transaction.
Note
[NOTE: Examinees who make a well-reasoned argument to the contrary should receive full credit.]
[NOTE: Generally, directors who engage in self-dealing with their corporation violate their duty of loyalty, unless they can prove that the self-dealing transaction was procedurally or substantively fair to the corporation. See Palmiter, et al., supra, at 594 (under modern corporate statutes, “an interested-director transaction will not automatically be void or voidable if either there has been informed, disinterested board approval or informed shareholder approval or the transaction is fair to the corporation”). Thus, absent a showing of procedural or substantive fairness, the presumption of the business judgment rule does not apply to a director self-dealing transaction, and the court “may take such remedial action as it considers appropriate.” MBCA § 8.61, Official Comment [Introduction].]
Assuming that Amy and Bill violated the duty of loyalty by having the corporation pay for their prior trips to Germany, can Sharon bring a derivative claim to recover from Amy and Bill the expenses paid by BC that related to their prior trips to Germany?
Although Sharon could bring a derivative suit on behalf of the corporation claiming that Amy and Bill violated their duty of loyalty, any recovery would be to the corporation and not to Sharon personally.
Rule
Generally, a shareholder may bring a derivative suit to vindicate corporate rights when directors have breached their fiduciary duties to the corporation. See Palmiter, et al., supra, at 503. “[A] derivative suit is an action on behalf of the corporation [that] has historically been the principal method of challenging allegedly illegal action by management.” Introductory Comment, Subchapter D (Derivative Proceedings), MBCA §§ 7.40–7.47 (as amended in 1989); see 44 Bus. Law. 543, 548 (1989).
Because a derivative suit is brought on behalf of the corporation to enforce duties owed to the corporation, recovery in a derivative suit generally “inures to the corporation, with the proceeds becoming a part of the corporate assets.” James D. Cox & Thomas Lee Hazen, 3 Treatise on the Law of Corporations § 15:4 (3d ed. 2018); see also Keenan v. Eshleman, 2 A.2d 904 (Del. 1938); Wolf v. Rand, 685 N.Y.S.2d 708, 710 (N.Y. App. Div. 1999); Outen v. Mical, 454 S.E.2d 883 (N.C. Ct. App. 1995).
Application
Here, although Sharon could bring a derivative suit claiming that Amy and Bill breached the duty of loyalty that they owed to the corporation with respect to the corporation’s payment of their travel expenses to Belgium, any recovery in such a suit would be paid to the corporation and not to Sharon personally.
Note
[NOTE: There are, nonetheless, special circumstances when courts have allowed pro rata recovery by shareholders, thus directly distributing corporate funds to complaining shareholders. These circumstances include when the corporation is in liquidation, when corporate control has been sold, and when the wrongdoers retain control and returning funds to their control would be inequitable. See Cox & Hazen, supra, § 15:4 (summarizing cases). Thus, a complaining shareholder in a derivative suit may be entitled to receive a direct pro rata payment for the damage done to the corporation, rather than participate indirectly in any corporate recovery, when corporate recovery would be inequitable to the shareholder. And, even if there were justification for an exception to the corporate-recovery rule, Sharon’s direct recovery would be pro rata based on her 40% ownership stake. That is, there is no basis for Sharon to personally recover all of the damages resulting from any breach of duty by Amy and Bill.]
[NOTE: Discussions of matters such as Sharon’s contemporaneous and continuing ownership, the requirement of a demand on the board, or the possibility of the corporation’s seeking dismissal of the suit should receive no credit. Although all these matters related to derivative litigation may be relevant under other facts, none were raised by the call in the question. The question asked only that the examinee address what recovery would be appropriate in a derivative suit brought by Sharon against Amy and Bill. Therefore, there is no need to address the issues raised in this Note.]
Assuming that Amy and Bill violated the duty of loyalty by having the corporation pay for their prior trips to Germany, can Sharon bring a derivative claim to recover from Amy and Bill the expenses paid by BC that related to their prior trips to Germany?
Even if Amy and Bill violated the duty of loyalty, Sharon does not have standing to bring a derivative claim with respect to Amy’s and Bill’s travel expenses to Germany. She was not a contemporaneous owner when the corporation paid these expenses.
Rule
Under the MBCA, to maintain a derivative suit on behalf of the corporation, the plaintiff-shareholder must be a contemporaneous owner. MBCA § 7.41 (requiring plaintiff in derivative suit have been shareholder “at the time of the act or omission complained of”). The purpose of the rule is to “align the plaintiff’s economic interests with the corporate interest to be advanced by the diligent prosecution of the suit.” Cox & Hazen, supra § 15:9. Further, as the Official Comment to MBCA § 7.41 explained when the section was first added, “The Model Act and the statutes of many states have long imposed a “contemporaneous ownership” rule.” See Changes to MBCA, 44 Bus. Law. 543, 548 (1989). Although a few state statutes have relaxed this rule for subsequent purchasers “in limited circumstances,” the MBCA’s retention of the contemporaneous-ownership rule “was based primarily on the view that it was simple, clear, and easy to apply” and exceptions to the rule might encourage the acquisition of shares to bring a lawsuit. Id.
Application
Here, Sharon was not a shareholder in the corporation when Amy and Bill had the corporation pay their travel expenses to Germany. Thus, even if these payments violated the duty of loyalty to the corporation, Sharon cannot enforce that duty in her derivative suit.
Note
[NOTE: An answer that asserts that Amy and Bill, as sole shareholders, cannot have violated any duties to the corporation at the time of the corporation’s payment of their travel expenses to Germany should receive no credit for this point. The question asked the examinee to assume there was a violation, and such payments might have constituted unlawful distributions if they would have rendered the corporation insolvent. See MBCA § 6.40(c) (no distribution permitted if “the corporation would not be able to pay its debts as they become due in the usual course of business”).]
