The classic duty of loyalty defendant is a fiduciary (a director or officer or in some cases controlling shareholders) who contracts or transacts unfairly with her own corporation, receiving a benefit that is not equally shared with the other shareholders and thereby creating a conflict of interest.
In an early common law case, Judge Cardozo established a high standard for interested director transactions. For instance, in Globe Woolen Col. v. Utica Gas & Electric Co. , the court voided the contract
- Maynard's absention from the vote gave the contract a presumption of propreity but did not excuse Maynard of his responsibility. Maynard had a dominating influience, which means that he had a duty to warn - provide full disclosure of both his interested and the details of the contract itself.
- The court went further, however, holdling that disclosure along was insufficient because the contract must also be fair. Here, the idea of fairness was that the contract have "some reasonable proportion between the benefits and burdens," that is, equivalent to an arm's-length bargain.
Cases generally follow the view that the process of approval and the terms of the transaction itself must be fair, with the burden of proof on the fiduciary. This rule protect shareholders from exploitation and permits flexibility in corporate dealings. In determining substantive fairness, court look to factors such as the
- value of what is recevied
- the varket value
- the value of the bargain compared to what is could have obtained from others
- the need for the property
- the ability to finance the transaction
- the exsitence of a detriment
- the quality of the disclosure - the possibility of corporate gains being siphoned off by the directors. Some cases suggest that lack fo disclosure itself is a grounds for voiding a contract without regard to its fairness. But even a fair contract in tterms of disclosure and its terms the contract must be in teh best interests of the corporation.
Many states have enacted statutory provisions that deal with interested director transactions ("interested director statutes"). Many of these statutes do not codify the duty of loyalty, but provide mechanisms that may create presumptions, or deal with the burden of proof, or act as safe harbors that limit or preclude any judicial review.
The California statute became a model for other states ("the California model") and provided, if certain requirements were met, that such a transaction would not be void solely because of a conflict of interest, or the voting and presence of an interested director. The disjunctive "or," between three different requirements, suggests one needs only one of these requirements to validate the contract.
- 1) The transaction was approved by the disinterested directors with disclosure of the conflicting interest; or
- 2) Disclosure was followed by shareholder approval; or
- 3) The contract was just and reasonable at the time of approval (i.e., fair)
The statue also dealt with procedural issues by allowing the interested director to be part of the quorum and indicating that a vote of the disitnerested directors was needed for board approval.
This interpretation of the California statute and similar interested director statutes would look at process or substance. This view presents a dramatic change from the common law that looked at both process and substance for fairness.
The primary issue for compliance with the interested director statutes is the effects on judicial scrutiny on the transaction when approved by disinterested directors.
There are three primary approaches for reconciling the implications of compliance with interested director statue with the common law doctrine. They can be described as:
- Weak form
- Semi-strong form
- Strong form statutes.
A weak form view of the statute is that compliance with the interested director statute was not intended to change common law. That is,
- Burden of proof - the burden of proof is still on the fiduciary (defendant), and
- Fairness - still requires fairness in process and substance.
Thus, the statutes only removed the taint of the conflict of interest or dealt with procedural issues. Also, like common law, transactions were still voidable, not void. Close judicial scruitny should still be required. If the common law is retained, a fairness inquiry allows a court...
Compliance with the interested director statute
- Burden of proof - shift the burden of proof to the plaintiff. A semi-strong view of the interested director statute is that compliance with distinterested board approval shifts the burden of proof to the plaintiff.
- Fairness - retains a fairness inquiry. Under this view, fairness would always remain an issue when the disinterested directors approve the transaction (that is, no business judgment rule protection). With a fairness inquiry the court could look at process and substance.
- The rationale for retaining a fairness inquiry rather than the business judgment rule rests on the possible influence the interested director could have on the other disinterested directors and the difficulty of detecting the effects that influence on the judgments of the disinterested directors. The collegial atmosphere of the board could preclude close scrutiny by the disinterested directors. In addition, disinterested directors who do not have a pecuniary interested in the transaction could have other relationships or connections that would not automaitically disqualify the director but could raise an issue of imparitality. The continued use of a fairness test allows the court the flexibility to ensure that the process of approval and substance was fair.
- Burden of proof - the burden of proof is on the plaintiff to prove that the rule should not apply and with courts generally looking at the process. Shifts the burden of proof to the plaintiff.
- Fairness - disinterested board approval removes a fairness inquiry.
A strong form view of the interested director statute is that approval of the disinterested board would generally limit judicial scrutiny. There still must be full disclosure, but the decision of the disinterested directors are now protected by the busines judgment rule (i.e., no substantive review), which must be rebutted. The rational for the use of the business judgment rule is that the disinterested director act for the corporation's best interests and therefore, a lessened scrutiny is in order.