The Duty of Loyalty - June 21 Flashcards
A corporation that operated hotels sought to acquire a new property to open a new location. The corporation’s president, whose girlfriend was a commercial real estate agent, identified an ideal property that his girlfriend had listed for sale. Because the property had already been renovated as a hotel, the president agreed to a purchase price significantly higher than what the corporation had typically paid for other properties. The president called a board meeting and explained that the price was objectively fair and reasonable to the corporation because of the renovations, but the president did not disclose to the board that his girlfriend was the listing agent. The board voted to approve the transaction.
Did the president breach his duty of loyalty to the corporation? (Q)
No, because the transaction was objectively fair and reasonable to the corporation. The president did not breach the duty of loyalty to the company because the interested transaction fell within a permissible exception. Interested transactions are dealings between a corporation and either: (1) a director, officer, or major shareholder, or (2) someone with whom the corporate insider has a close personal or financial relationship. See Model Bus. Corp. Act § 8.60(1)(i)-(ii) (2016). Interested transactions may violate the duty of loyalty, and the business judgment rule will not save an interested transaction. However, although the rules vary among states, interested insider transactions do not violate the duty of loyalty and are still allowed if the transaction is either: (1) objectively fair to the corporation at the time entered, or (2) ratified by a disinterested board or the corporation’s shareholders after a full disclosure of all material facts. See, e.g., N.Y. Bus. Corp. Law §§ 713(a), 714(b). Here, the corporation’s president is a corporate insider, and his girlfriend, a close personal relation, has a significant financial interest in this corporate transaction as the listing agent. Therefore, this is an interested insider transaction that potentially violates the president’s duty of loyalty to the corporation. However, the transaction was objectively fair and reasonable to the corporation because of the renovations. Because this transaction was objectively fair to the corporation at the time it was entered, the transaction fell within the first exception, and the president did not violate the duty of loyalty.
The board of directors and executive officers of a private corporation held a meeting to determine the compensation for the corporation’s executive officers. The board determined that doubling executive salaries, including the salaries of several high-level executives who participated in the vote, would benefit the corporation. The board also decided that a personal loan from the corporation to the chief executive officer would benefit the corporation.
Which actions, if any, complied with the duty of loyalty? (Q)
Both doubling the officers’ salaries and the personal loan. Generally speaking, the duty of loyalty prohibits a corporation’s board and its officers from engaging in self-dealing. However, there are at least two exceptions to this general rule: (1) setting director and executive compensation and (2) making loans to directors and executives that benefit the corporation.
First, unless prohibited by the articles of incorporation or bylaws, a corporation’s board of directors is empowered to set its own (the directors’) compensation. See Model Bus. Corp. Act § 8.11 (2016). Similarly, high-level executives may have significant influence with the board with respect to executive and officer pay without violating the duty of loyalty. In general, courts are extremely deferential to board determinations of executive and officer compensation; courts will invalidate a compensation decision generally only if it rises to the level of waste or the action otherwise violates the business judgment rule. See generally, Rogers v. Hill, 289 U.S. 582 (1933); Beard v. Elster, 160 A.2d 731 (Del. 1960).
Second, private corporations may make loans to directors and officers without violating the duty loyalty—as long as the board believes that doing so will benefit the corporation. See Del. Code Ann. tit. 8, § 143. However, although the duty of loyalty does not prohibit inside loans that benefit the corporation, note that the Sarbanes-Oxley Act generally prohibits public corporations from making loans to directors and officers, regardless of whether the loan benefits the corporation or not. See Pub.L. 107–204, 116 Stat. 745.
Here, the directors and executives were involved in decisions that gave more compensation to some officers personally. Usually, this would mean that the decisions violated the duty of loyalty. However, the board determined that both the raises and the loan would benefit the company. Even though the raises doubled the officers’ salaries, because the raises were justified, they do not qualify as corporate waste. Thus, the duty of loyalty’s usual prohibition against self-dealing does not prohibit the raises. Further, because the personal loan to the officer benefited the corporation, this personal loan is still allowed, regardless of whether it might otherwise qualify as self-dealing or not. Accordingly, both acts comply with the duty of loyalty. However, note that if the corporation had been a public corporation, the board’s decision to issue a personal loan to the corporation’s chief executive officer would have likely violated the Sarbanes Oxley Act.
A shareholder filed a lawsuit alleging that an executive officer of a corporation had engaged in a prohibited insider transaction. The claim ultimately went to trial.
Which of the following most accurately describes the parties’ burdens of proof at trial? (Q)
The shareholder has the initial burden of proving that the officer engaged in a prohibited insider transaction, but then the burden shifts to the officer to prove that the transaction fell within a permissible exception. In a lawsuit challenging an allegedly interested transaction, the shareholder must first demonstrate that the corporate insider (officer, director, majority shareholder, or a close affiliate or relative of the first three) held an insider interest in the transaction. Once that showing is made, the burden then shifts to the insider to prove the transaction was either: (1) fair and objectively reasonable to the corporation, or (2) approved by the requisite number of disinterested directors or shareholders after full disclosure of all material facts. See Lewis v. S. L. & E., Inc., 629 F.2d 764 (2d Cir. 1980). Here, that means that if the shareholder demonstrates that the executive officer held an insider interest in the transaction, then the burden will shift to the executive officer to prove that the transaction fell within either of the two permissible exceptions.
An officer in a small business planned to leave the company to start his own competing business. While still working at the company, the officer solicited the company’s customers to follow him to his new, competing business. The officer then left the company and started his own business. Many of the company’s customers followed the officer and became customers of his new business. The company sued the officer for violation of the duty of loyalty, seeking to place the officer’s business in a constructive trust.
How will a court likely rule? (Q)
The officer breached the duty of loyalty, but only damages, not a constructive trust, is available as a remedy. Corporate directors, officers, and high-level executives have a duty not to compete with the corporation if doing so could potentially harm the company. Robert N. Brown Associates, Inc. v. Fileppo, 38 A.D.2d 515 (N.Y. App. 1971). Insiders who violate the prohibition on competition with the corporation may be held liable for damages to the company, but a constructive trust on the competing business is not an available remedy. Lincoln Stores v. Grant, 34 N.E.2d 704 (Mass. 1941).
Here, the officer breached the duty of competition by soliciting current customers of the company to leave the company and become customers of his business instead.
A corporation sought to purchase a piece of property on which to build a new factory. A corporate director owned a parcel of land that had recently been appraised at $200,000. The corporation purchased the parcel of land at an open auction for $195,000. The second-highest bid on the parcel was $190,000.
If a shareholder later sues the director for violating the duty of loyalty, how is a court likely to rule? (Q)
For the director, because the deal was objectively fair to the corporation at the time it was entered into. Interested transactions are any transaction or dealing between a corporate insider (such as a director, officer, or high-level executive) and the corporation itself, such as the sale of a piece of property by a director to the corporation. MBCA § 8.60(1)(i). Historically, such transactions were absolutely forbidden. However, courts will now permit interested transactions in two situations. First, the transaction was objectively fair to the corporation at the time it was entered into, even without director or shareholder approval. N.Y. Bus. Corp. Law § 714(b). And second, the transaction was approved or ratified by a sufficient number of disinterested directors or the shareholders, provided that there has been a full disclosure of material facts. Id. at § 713(a).
Here, the facts indicate that the transaction was objectively fair to the corporation when entered into. The corporation purchased the property for slightly below its appraised value, at a public auction where the second-highest bid was only slightly lower than the eventual sale price. Therefore, the transaction was objectively fair to the corporation and does not constitute a violation of the interested director’s duty of loyalty.
A court found that a corporate insider had breached her duty of loyalty to the corporation.
Which of the following facts, if true, would most support the court’s finding? (Q)
The insider had consulted for a corporate competitor on a business matter. The duty of loyalty is a fiduciary obligation that requires that corporate insiders deal with the corporation fairly and without financial conflicts. See, e.g., Gantler v. Stephens, 965 A.2d 695 (Del. 2009). Generally, the duty of loyalty means that corporate insiders must avoid (1) engaging in interested transactions, unless certain conditions are satisfied; (2) usurping corporate opportunities; and (3) competing with the corporation. Therefore, a finding that the insider consulted with a corporate competitor on a business matter would most support a court’s finding that the insider breached her duty of loyalty.
A majority shareholder in a corporation was offered a management position with a corporate competitor.
Does the duty of loyalty preclude the shareholder from accepting the position with the corporate competitor? (Q)
Yes, because the duty of loyalty applies to corporate officers, directors, and majority shareholders. The duty of loyalty is a fiduciary obligation that requires corporate directors, officers, and majority shareholders to deal with the corporation fairly and without financial conflicts. See Gantler v. Stephens, 965 A.2d 695 (Del. 2009). Generally, the duty of loyalty means that those parties must avoid (1) engaging in interested transactions (unless certain conditions are satisfied), (2) usurping opportunities that rightfully belong to the corporation, and (3) competing with the corporation. Therefore, here, because the duty of loyalty applies to corporate officers, directors, and majority shareholders, it precludes the shareholder from accepting the position with the corporate competitor.
