The duty of loyalty requires a fiduciary to act for the best interests of their corporation and in good faith. Thus, there are in a sense, two different means of violating one's duty of loyalty.
In a duty of loyalty analysis involving a conflict of interest and not good faith, the directors usually have the burden of proof as to the fairness of their decision and, thus, the courts scrutinize the process and the substance of the decisions with a greater possibility of liability.
The classic duty of loyalty scenario is the interested director transaction; that is, defendant is a fiduciary who contracts or transacts unfairly with her own corporation, receiving a benefit that is not equally shared with the shareholders and thereby creating a conflict of interest. There are a variety of cirucmstances in which such self-dealing can occur.
- For example, an officer or director may sell personal property to the corporation or buy corporate property.
- A conflict of interest would also arise where a fiduciary's corporation contracts with another corporation or busines entity in which the fiducariy has a significant financial itnerest. For exmplae, Corporation A sells property to Corproation B and a director of A is the controlling sharehodler of B.
- Another example is when a parent corporation contracts with its subsidiaries (that it controls) and the subsidiary has other shareholders.
- There may also be conflicts of intereste when two corporations have common directors (also called "interlocking directros") but they have no signficant interest in either. Thse transactions (which will be called "disinterested director transactions") can involve a variety of exchanges such as loans to or form the corporation or purchases and sales of property or services.
Early courts - void
Modern times - voidable standard; under this standard, the courts focused on the fairness of the process of approval and the substance of the transaction. The process often would require full disclosure and approval by either disinterested directors or shareholders. The contract itself would need to be fair and the burden of proof would generally be placed on the fiduciary.
It self dealing is found the usualy remedy are restitutionary in nature with recission of the unfair contract or seeking the gains made by the fiduciary. But loyalty claims also allows the coruts to fashion "broad, discretionary and equitable remedies." This general approach to interested director transactions (as well as other conflicts of interest) varies depending upon the cirucmstances and the availability of a relevant statutory provision. Thus a variety of rules exist. In approaching the cases and the statutory provisions dealing with interested director transactions, these issues should be kept in mind.
- First, what are the legal procedural requirements in terms of voting, quorum and disclosure?
- Second, how does compliance with those requirements affect the level of judicial scrutiny applied to the transaction (business judgment rule, fairness, waste or some other test) or the burden of proof?
- Third, if there is a failure in the procedure, does that void the contrat or have some other effect, such as increasing the level of judicial scrutiny or shifting the burden of proof?
Duty of loyalty cases raise issues of self-dealing in a variety of transactions and corporations, fiduciary duty rules tend to differ. In many cases, process issues may be significant in setting those rules. The procedural issues will look at disclosure and the approval process by either disinterested directors or shareholders. Court will need to decide the extent to which process will be substitute for substantive issues of fairness.
Difference between Duty of Loyalty and Duty of CareEdit
The duty of loyalty is different from the duty of care because it seeks to prevent directors from acting against the best interests of the corporation or self dealing in such as way as to reap a personal benefit unavailable to other shareholders. The duty of care involves poor decision making or lack of attention, but no personal benefit.
Self-dealing raises the specter of corruption and personal profit at the expense of shareholders. When personal benefits are at stake, a director's incentives and motivation for a transaction change. For example, the person who is self-dealing seeks to avoid disclosure and detection. While self-dealing trasactions are sometimes beneficial to the cororpation, it may blaos have no real buisness purpose other than to provide personal beenfits at the expense of the shareholders.
Conflicts of interest usually involve some form of self-dealing where the fiduciary is on both sides of a transaction and in a position to receive a benefit unavailable to other shareholders or the corpration generally.
Generally, when the duty of loyalty in a conflict of interest applies. There is a duty of complete candor.
- Burden of proof - the burden of proof shifts to the directors - to prove fairness.
- Greater judicial scrutiny - there is greater judicial scrutiny of both the fairness of the process and the substance of the transaction (sometiems describes as entire fairness).
- Defendants are not afforded the protection of the business judgment rule with its presumption of a proper decision.
Thus, a plaintiff will often try to characterize the actiivyt of a defendant as a breach of the duty of loyalty in order to take advantage of greater judicial scrutiny.
Typical scenarios in which Duty of Loyalty issues ariseEdit
The context in which the conflict of interest arises can affect the level of judicial scrutiny.
- Self-dealing that may involve controlling shareholders
- Conflicts of interest in tender offers
- Insider trading also raises an issue of conflict of interest.