Lecture 4 - Board of Directors: Roles and Duties

Question 1

Directors - Overview Who?

Answer 1

o Natural persons elected by the stockholders
of the corporation
o No requirement that they be stockholders of the corporation, unless specified in charter or bylaws

Question 2

Directors - Overview Powers?

Answer 2

o To manage or direct the management of the business and affairs of the corporation

Question 3

Directors - Overview Roles/Functions?

Answer 3

o Decision-making

o Oversight

Question 4

Directors - Overview Procedures?

Answer 4

o Act only as a group
o Meetings, with notice and quorum requirements
o Proxy voting not allowed, but participation by telephone, teleconference, etc. allowed
o Majority vote unless charter or bylaws provide a higher requirement
o May create, and delegate decision-making over specified topics to, committees of the board

Question 5

Fiduciary Duties analysis questions

Answer 5

“To say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. [1] To whom is he a fiduciary? [2] What obligations does he owe as a fiduciary? [3] In what respect has he failed to discharge these obligations? [4] And what are the consequences of his deviation from duty?”

Question 6

Derivative lawsuit (Consequences of Breach of Fiduciary Duties )

Answer 6

o A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation.
o Shareholder can only sue on behalf of a corporation when the corporation has a valid cause of action, but has refused to use it. This often happens when the defendant in the suit is someone close to the company, like a director or a corporate officer.
o If the suit is successful, the proceeds go to the corporation, not to the shareholder who brought the suit.

Question 7

Fiduciary duty definition

Answer 7

A fiduciary duty is a legal duty to act solely in another party’s interests.

Question 8

Stone v. Ritter

Answer 8

This case said that directors are not responsible for ensuring the legality of every act by the corporation’s personnel, even if the illegal conduct would have been discovered if there hadn’t been a failure of the corporate compliance program.

Question 9

Directors – Duty of Care Definition

Answer 9

Duty to proceed on a fully-informed basis in making business decisions.
- Managers must “discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” (MBCA §830(b))

Question 10

Smith v. Van Gorkom (Duty of Care)

Answer 10

o The issue is whether the business judgment by the Board to approve the merger was an informed decision. The court noted that a director’s duty to exercise an informed business judgment is a duty of care rather than a duty of loyalty. Therefore, the motive of the director can be irrelevant, so there is no need to prove fraud, conflict of interests or dishonesty.
o Gross negligence standard - Managers have “an affirmative duty to … proceed with a critical eye in assessing information.”

Question 11

Business Judgment Rule (Smith v. Van Gorkom)

Answer 11

The rule itself “is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” … Thus, the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one.

Question 12

directors’ duty of disclosure

Answer 12

corporate directors must disclose all facts germane to a transaction that is subject to a shareholder vote (not an independent duty, but derives from the duty of care and loyalty)

Question 13

Delaware Exculpatory Statues - General Corporation Law §102(b)(7) (Smith v. Van Gorkom aftermath)

Answer 13

Permit Delaware companies (with shareholder approval) to adopt charter amendments that exculpate directors from personal liability for breaches of the duty of care → continuous erosion of the duty of care

Question 14

Duty to speak

Answer 14

a director would only have a duty to speak if he possessed special knowledge of future plans and deliberately misled a stockholder who is ignorant of those plans.

Question 15

Standard of review (Directors – Duty of Care)

Answer 15

o Gross negligence: “Reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason.” (Delaware Court of Chancery)
o As long as business decisions are based upon reasonable information and are not irrational, managers making those decisions are not liable even if those decisions turn out to be disastrous.

Question 16

Directors – Diminished Personal Liability

Answer 16

o Exculpatory statutes, provisions in articles of incorporation
o Indemnification provisions in articles of incorporation
o Directors and Officers (D&O) insurance

Question 17

Directors – Extra-Legal Sanctions

Answer 17

o Reputation (of individual directors)
o Capital Markets (share price)
♣ Decline in attractiveness of corp. as investment (sell-off, no new investment)
♣ Decline in ability to raise capital (debt or equity)
♣ Increased risk of contest for corporate control

Question 18

Directors – Duty of Loyalty Definition

Answer 18

A director must discharge his duties “in a manner [he] reasonably believes to be in the best interest of the corporation.” (MBCA §830(a))

Question 19

Classic cases of breach of Duty of Loyalty

Answer 19

o Self-dealing
o Stolen business opportunities
o Competing ventures

Question 20

A transaction is not automatically voidable if the fiduciary proves one of following (Basic Self-Dealing)

Answer 20

o “Safe harbor” approach
o Delaware approach
In either case, failure to obtain disinterested approval means the transaction’s fairness to the corporation is subject to “entire fairness” review.

Question 21

“Safe harbor” approach (Basic Self-Dealing)

Answer 21

Disinterested approval cleanses the transaction

Question 22

Delaware approach (Basic Self-Dealing)

Answer 22

Disinterested approval permits transaction to
benefit from BJR. The plantiff has to prove that the transaction was unfair to the corporation. This means that not many will bother to do this as there is the business judgment rule.

Question 23

Good Faith – Why? (Directors – Duty of Loyalty)

Answer 23

“fiduciary conduct … which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed” → duty to act in good faith.
(Delaware Supreme Court, Disney litigation)

Question 24

Good Faith – What? (Directors – Duty of Loyalty)

Answer 24

“a failure to act in good faith may be shown, for instance, [1] where the fiduciary intentionally acts with a purpose other than that of advancing the best interest of the corporation, [2] where the fiduciary acts with the intent to violate applicable positive law, or [3] where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”

(Delaware Supreme Court, Disney litigation)

Question 25

Duty to Monitor - What? (Directors – Duty of Loyalty)

Answer 25

A “duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”
(In re Caremark)

Question 26

Duty to Monitor - How violated (old formulation) (Directors – Duty of Loyalty)

Answer 26

“…only a sustained or systemic failure of the board to exercise oversight… will establish the lack of good faith that is a necessary condition to liability.”

(In re Caremark)

Question 27

Stone v. Ritter (Directors – Duty of Loyalty → Duty to Monitor)

Answer 27

Court affirms Caremark liability standard but places duty to monitor/good faith under banner of duty of loyalty with important consequences

Question 28

Duty to Monitor - How violated (new formulation) (Directors – Duty of Loyalty) - weakening

Answer 28

“(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”

(Stone v. Ritter)

Question 29

Stone v. Ritter - Challenges for plaintiffs to prove violation

Answer 29

o Requires proof of scienter
o Board is responsible to prevent only wrongful
or illegal acts
o Board not responsible for bad outcomes of prior board decisions

Question 30

Scienter

Answer 30

an offending party has knowledge of the “wrongness” of an act or event prior to committing it.

Question 31

Duty of Care vs. Duty of Loyalty

Answer 31

o Conduct that involves an exculpable or indemnifiable breach of duty (Care)
o Conduct that involves a breach of duty and that should be remediable by an award of monetary damages (Loyalty)

Question 32

Reconciling Duties w/BJR

Answer 32

“the directors’ business judgment cannot be attacked unless their judgment was arrived at in a [grossly] negligent manner, or was tainted by fraud, conflict of interest, or illegality.”

Question 33

“demand” requirement

Answer 33

Plaintiff SH must tell the BoD that they want to bring a lawsuit against them – so that innocent board members are spared

Question 34

DUTY OF CONFIDENTIALITY

Answer 34

duty of loyalty also implies that directors have a duty to keep corporate information confidential

Question 35

Graham v. Allis-Chalmers Manufacturing Co. (Prior to Caremark)

Answer 35

established that unless directors had reason to believe there was wrongdoing within the corporation, the duty of care did not require that they “install and operate a corporate system of espionage” by implementing a corporate compliance program.

Question 36

In re Caremark International, Inc. Derivative Litigation

Answer 36

the Board could not escape liability unless it took some actions to implement a program to detect potential violations of law or corporate policy and exercised a duty of oversight. This is understood to require that the compliance program incorporate procedures by which the Board can track and analyze compliance problems that surface and take steps to assure that they do not persist.

Question 37

Stone v. Ritter

Answer 37

reinforces the proposition that directors are not responsible for ensuring the legality of every act by the corporation’s personnel, even if the illegal conduct disclosed a failure of the corporate compliance program.

Question 38

Entire Fairness Test

Answer 38

♣ Whether the timing of the transaction benefited the proponents of the transaction to the detriment of the company or its minority shareholders – who initiated negotiations and why;
♣ Whether the structure of the transaction favored insiders to the detriment of the company or its minority shareholders;
♣ Whether the negotiation of the transaction was conducted, controlled or overseen by competent and independent individuals free of conflict of interest;
♣ Whether a competitive bidding process was implemented so as to maximize shareholder value;
♣ Whether the directors were fully informed and provided with all relevant information; and
♣ Where shareholder approval is required, whether the shareholders were fully informed and provided with all relevant information.