The Duty of Loyalty

Question 1

What is the duty of loyalty?

Answer 1

In situations where there are conflicts of interest, it requires the fiduciaries (officers and directors) of a corporation to act in a good faith effort to advance the interests of the company rather than their own.

There is a similar duty in agency. (Seen Meinhard)

Question 2

Who is the duty of loyalty owed to?

Answer 2

In short, to the shareholders (the shareholder primacy norm)

Question 3

If a company eliminates a dividend and reduces prices claiming that they want to share the company’s success with public, does this violate the duty of loyalty?

Answer 3

Yes, according to Dodge v. Ford. Ford had an obligations to look out for the shareholder interests first. (Example of the shareholder primacy norm)

Question 4

If a company is formed as a for-profit firm, are the directors bound by the fiduciary duties and standards that accompany that form?

Answer 4

Yes!

Question 5

Milton Friedman argues that if corporations focus exclusively on maximizing profit, they will engage in Kaldor-Hicks efficient transactions and thus…

Answer 5

Increase overall welfare

Question 6

What is the competing norm to the shareholder primacy norm?

Answer 6

Directors should at to advance the interest of all constituencies in the corporation.

Question 7

What is a constituency statute

Answer 7

These are in some states and expressly permit a director to consider the interests of other stakeholders other than shareholders when making decisions. These are almost never invoked.

Question 8

What is a public benefit corporation?

Answer 8

States allow the formation of Public Benefit corporations , in which the charter includes one or more specific social purposes along with profit-making purposes. In this case, the directors have a fiduciary duty to pursue that goal as well.

Question 9

What must for-profit company’s directors do under Delaware law when it comes to managing a company?

Answer 9

Delaware case law has show that a director of a for profit company must, within the legal limits of discretion, treat stockholder welfare as the only end, considering other interests only to the extent that doing so is rationally related to stockholder welfare.

Question 10

What is a self-dealing transaction?

Answer 10

Corporate transactions in which directors, officers, or controlling shareholder have a personal interest.

Question 11

How does the law regulate self-dealing transactions in agency? (Review)

Answer 11

An agent can engage in a transaction in which he has an interest so long as:

1) The transaction was fair
2) Disclosure of all material facts
3) The principal approved.

Question 12

How does corporate law regulate self-dealing?

Answer 12

In a fairly similar way to agency:

1) Fairness review.
2) Disclosure requirement
3) Approval by the majority of the disinterested parties (directors or shareholders)

Question 13

Why not just simply prohibit self-dealing transactions?

Answer 13

They can be Kaldor-Hicks efficient.

Question 14

A conflicted transaction is not void if its….

Answer 14

Fair - which implies full disclosure.

Question 15

Which judicial standard of review is used when there is a conflicted transaction?

Answer 15

It depends. Either Entire Fairness Review of BJR.

It depends on the type of interested party, which we will get to in a moment.

Question 16

If the director is involved in a conflicted transaction and there is no approval by any parties, which standard of review will we use? Who bears the burden of proof?

Answer 16

Entire Fairness; and the defendant (director)

Question 17

If the director is involved in a conflicted transaction and there is approval by disinterested directors, which standard of review will we use? Who bears the burden of proof?

Answer 17

We will use the BJR; and the plaintiff.

Question 18

If the director is involved in a conflicted transaction and there is approval by the the the shareholders, which standard of judicial review will we use?

Who bears the burden of proof?

Answer 18

BJR; and the plaintiff

Question 19

If the director is involved in a conflicted transaction and there is approval by the disinterested director and the shareholders, which standard of judicial review will we use?

Who bears the burden of proof?

Answer 19

We will use the BJR; and the plaintiff.

Question 20

If a controlling shareholder is involved in a conflicted transaction and there is no approval by any parties, which standard of judicial review do we use?

Who bears the burden of proof?

Answer 20

Entire fairness; the burden is on the defendant.

Question 21

If a controlling shareholder is involved in a conflicted transaction and there is approval by the disinterested directors, which standard of judicial review do we use?

Who bears the burden of proof?

Answer 21

We will use entire fairness; and the burden will be on the plaintiff

Question 22

If a controlling shareholder is involved in a conflicted transaction and there is approval by the majority of the minority shareholders, which standard of judicial review do we use?

Who bears the burden of proof?

Answer 22

We will use entire fairness; the burden is on the plaintiff

Question 23

If a controlling shareholder is involved in a conflicted transaction and there is approval by the majority of the minority shareholders and the disinterested directors, which standard of judicial review do we use?

Who bears the burden of proof?

Answer 23

The business judgment rule; and the burden is on the plaintiff.

Question 24

What is entire fairness review?

Answer 24

As codified under the DGCL (it was a common law traditions before):

No transaction between and corporation and any of its directors or officers is void or voidable solely because it is conflicted, so long as:

1) The transaction is approved in good faith, after a full disclosure, by the majority of the (1) disinterested directors or (2) the majority of the shareholders OR;
2) The transaction is fair. (In practice though, it must always be fair, so we analyze the fairness prong always unless there is approval).

Question 25

What happens to a conflicted transaction if it is either the disinterested directors of the (majority of the minority) shareholders approve the transaction?

Answer 25

Then it is shifted from entire fairness to BJR (Cooke)

Question 26

How is a transaction “fair” under entire fairness review? (2)

Answer 26

A transaction is entirely fair if there are two basic steps:

1) Fair dealing; and
2) Fair price

Question 27

What is fair dealing in entire fairness review?

Answer 27

Fair dealing refers to the process, such as whether the fiduciary revealed all material facts, negotiated with candor, and did not pressure the corporation.

Question 28

What is fair price in entire fairness review?

Answer 28

Fair price refers to the economic substance of the transaction - whether the economic conditions resemble the terms of a transaction with an unrelated party.

Question 29

In entire fairness, who has the initial burden of proof to show that it was entirely fair?

Answer 29

The defendant.

Question 30

Does fair dealing involve disclosure of all material information (entire fairness review)

Answer 30

Yes. The first part of entire fairness is fair dealing and it related to the process of the deal, including disclosure of all material information.

Question 31

What happens if a conflicted deal is found to be unfair?

Answer 31

Then it is a breach of the duty of loyalty.

Question 32

What are the two ways the courts like to avoid entire fairness review?

Answer 32

1) If there is approval by the majority of the informed disinterested directors

and

2) If there is approval by a majority of the informed shareholders

In both cases, full disclosure is required and then the standard of review becomes BJR (Cooke)

Question 33

What does majority of the minority shareholders mean?

Answer 33

It means the majority of the shareholders not affiliated with the controlling shareholder.

Question 34

If disinterested directors approve the transaction, then the standard is BJR instead of entire fairness. But what are the two limitations?

Answer 34

1) The majority of the shareholders have a conflict of interest with the decision; or
2) The transaction ratified constituted waste - Unless there was unanimous consent.

In both these situations the BJR will apply

Question 35

Review: what is “waste?”

Answer 35

an exchange of corporate assets for consideration that is so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade (essentially it serves no corporate purpose and little to no consideration is received.)

Question 36

Note that there are other approaches to entire fairness besides Delawares.

Answer 36

Just look in the outline, too much for these cards. No that important.

Just know that under the Delaware approach we can use the BJR in some circumstances. the ALI proposal would not do that.

Question 37

Why can we still apply the entire fairness review if the disinterested directors approve but the shareholders are conflicted?

Answer 37

The directors are collegial, so there is a risk of bias.

Question 38

Is is true that less deference is given to conflicted deals that are ratified by the company ex post (after the fact)?

If so, why?

Answer 38

Yes!

1) The board might not reject deals that it would reject ex ante (before the fact)
2) it could be costly to void the deal;

and

3) there are transaction costs already sunk.

Question 39

Who is a controlling shareholder?

Answer 39

Generally a shareholder who has > 50% of the voting shares.

Question 40

What is the problem with imposing the duty of loyalty (and EF) on a controlling shareholder?

Answer 40

The shareholder has a legitimate interest to pursue their own investments.

Question 41

Why might the duty of loyalty (and EF) be potentially more important in the controlling shareholder context?

Answer 41

It may give them more power over the corporation in the long run.

Question 42

Does Entire Fairness review apply to controlling shareholder’s actions?

Answer 42

Yes, it does and it is similar to the standard that applies to directors.

However, it is generally true that a court will apply entire fairness if there is a conflict of interest and if there is no conflict of interests, the business judgment rule will apply. (However, if there is approval by the majority of the minority shareholders, and the disinterested directors, we can use BJR instead. More on this on other cards)

Question 43

What is a conflict of interest in the context of entire fairness when there is a controlling shareholder transaction

Answer 43

There is a benefit for the controlling shareholder at the expense of the minority shareholders.

Question 44

What can a controlling shareholder (or maybe director) do to increase chances that it will succeed in entire fairness review.

Answer 44

Form a special committee of independent directors. There will be more deference given.

Question 45

What happens if a controlling shareholder does not disclose all material information about the transaction?

Answer 45

That means it was not fair.

Question 46

Even if there is a conflict of interest, how can a controlling shareholder avoid entire fairness review.

Answer 46

Well, even if there is a conflict of interest with some shareholders, if the majority of the minority shareholder approve the transaction and the disinterested directors also approve, then we can apply BJR.

(This is from MFW in the context of parent/subsidiary mergers, but now it is used more broadly in third-party mergers (Hammons) and in non-merger transactions IRA trust)

Question 47

Courts will give the most deference to the controlling shareholder if there is approval by a special committed of independent directors (the most disinterested directors lol) and majority of the minority shareholders?

Answer 47

1) With the special committee, they are a bargaining agent for minority shareholders; it eliminates collective action problems.
2) The MOM can check on the actions of the special committed; ensuring that it is not “captured” or incompetent.

Question 48

Corporate opportunities pose a potential conflict of interest, what are the main questions we ask?

Answer 48

With the corporate opportunities doctrine we will ask:

(1) Whether the opportunity belongs to the corporation, and therefore, whether there is a conflict of interest.
(2) Whether the appropriation of the opportunity is a breach of the duty of loyalty.

Question 49

What are the four factors used in Delaware to determine which opportunities belong to the corporation? (line of business test)

Answer 49

1) The corporation is financially able to exploit the opportunity
2) The opportunity is within the corporations line of business
3) The corporation has an interests of expectancy in the opportunity
4) By taking the opportunity, the fiduciary will be placed in a conflict with the corporation.

Question 50

What happens if a fiduciary takes advantage of a corporate opportunity?

Answer 50

Breach of the duty of loyalty.

Question 51

What is the expanded line of business factor? (Aka, the “opportunity is within the corporation’s line of business” factor from the line of business test.)

Answer 51

An opportunity outside the corporations line of business could be a corporate opportunity if:

1) It contributes to the exercise of the corporations line of business. (This includes expansion into new lines of business).

The second factor of the line of business test should be applied broadly and loosely. (Personal Touch Holding).

Question 52

What are some elements used to analyze the “corporation is financially able to exploit the opportunity” factor?

Answer 52

1) Did the matter come to the attention of the fiduciary by reason of his corporate capacity?
2) Does the activity fall within (or close to) the core economic activities of the corporation?
3) Was corporate information used in identifying exploiting the opportunity.

Question 53

Do fiduciaries have to present all opportunities to the board?

Answer 53

No.

Question 54

When will a board’s decision that a fiduciary can take a corporate opportunity be upheld?

What does the director taking the opportunity need to show?

Answer 54

A board’s decision that a fiduciary can take a corporate opportunity will be upheld if it was done in good faith.

The director taking the opportunity needs to show:

1) The decision to reject the opportunity for the corporation was a good faith business decision.
2) The directors making the determination if the party could take the opportunity from the corporation made that determination in good faith.

Question 55

Can a corporation’s charter waive corporate opportunity constraints for fiduciaries?

If so, what is a benefit and what is a problem?

Answer 55

Yes! (DGCL 122(17)

A benefit is that these waivers induce individuals to serve as directors.

But, a. problem is that these directors may selectively appropriate opportunities for themselves.

Question 56

Is there a heightened duty if loyalty for directors in closely held corporations?

If so, what is the standard?

Answer 56

Yes!

The standard is the same as the duty of loyalty that partners owe to each other, “utmost good faith and loyalty.”

Question 57

Do we apply the BJR in closely held corporations when it is a question of the breach of duty of loyalty?

Answer 57

No! We need to see if the director behaved in “utmost good faith and loyalty.” (Donahue)

Question 58

What remedies do plaintiff’s have in cases where a breach of loyalty occurs in a closely held corporation? (2)

According to Donahue and not Delaware law?

Answer 58

1) Rescind the transaction
2) Force the corporation to give the same benefit to the plaintiffs that the fiduciary took advantage of, this is called equal treatment (i.e., purchase plaintiff’s shares a the price which the controlling shareholder’s shares were bought.)

Question 59

In closely held corporations, will courts even sometimes ignore express agreements that a directors can take advantage of corporate opportunities?

Answer 59

Yes! In closely held corporations courts really need directors to adhere to the “upmost good faith and loyalty” standard.