Corporations – Fiduciary
Obligations
Duty of Care (ALI § 4.01(a))
A director or officer has a duty to the
corporation to perform the director’s or officer’s
functions:
(1) in good faith,
(2) in a manner that he or she reasonably
believes to be in the best interests of the
corporation, and
(3) with the care that an ordinarily prudent
person would reasonably be expected to
exercise in a like position and under similar
circumstances.
Business Judgment Rule
(ALI § 4.01(c))
A director or officer who makes a business
judgment in good faith fulfills the duty under this
section if the director or officer:
(1) is not interested in the subject of the business
judgment;
(2) is informed with respect to the subject of the
business judgment to the extent that the director or
officer reasonably believes is appropriate under the
circumstances; and
(3) rationally believes that the business judgment is
in the best interests of the corporation.
The Business Judgment Rule
• Aronson v. Lewis (1984)
–“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.”
Business Judgment Rule
“[The business judgment rule] in effect provides
that where a director is independent and
disinterested, there can be no liability for
corporate loss, unless the facts are such that no
person could possibly authorize such a
transaction if he or she were attempting in good
faith to meet their duty.” (Gagliardi)
---BJR shifts to plaintiff the burden to explain why
the BJR shouldn’t protect the actions in question
Gagliardi Excerpt (p.241)
Chancellor Allen: “The [business judgment] ‘rule’ in effect provides that
where a director is independent and disinterested, there can be no liability
for corporate loss, unless the facts are such that no person could possibly
authorize such a transaction if he or she were attempting in good faith to
meet their duty.”
Prob
of
Payoff
Less risky project
Liability
imposed
under
(hypothetical)
negligence
standard
Low
Liability imposed under
business judgment rule
More risky project
Payoff
High
Ex ante
• Look at the graph without the vertical
dotted lines. It shows two possible
decisions.
• The less risky one has middling returns
but with a large degree of probability.
• The riskier one has both greater and
lesser returns than the other.
• Note: neither have negative returns
Ex post – fiduciary review is after
the fact
• Ignore the vertical axis. The corporation has
acted and the bottom shows the possible
outcomes.
• Under the BJR, there is liability (in practice) only
where no decision has been made (to the left of
dotted line)
• Under a negligence standard, there might also
would be liability if the decision turns out worse
than the other decision (which, it will be argued,
is the one that a prudent person would take).
Duty of Care
“[I]n the absence of facts showing selfdealing or improper motive, a corporate
officer or director is not legally responsible
to the corporation for losses that may be
suffered as a result of a decision that an
officer made or that directors authorized in
good faith.”
Gagliardi: The Rationale for the
Business Judgment Rule
• Shareholders want their portfolio companies to take risks
– They are protected through diversification
• Directors have little upside from risky decisions
– Liability would create significant downside
• Chancellor Allen:
– “Obviously, it is in the shareholders' economic interest to
offer sufficient protection to directors from liability for
negligence, etc., to allow directors to conclude that, as a
practical matter, there is no risk that, if they act in good
faith and meet minimal proceduralist standards of
attention, they can face liability as a result of a business
loss.”
Duty of Care
“Act with the care
of an ordinarily
prudent person!”
Duty of Care
Business Judgment
Rule
“Act with the care
of an ordinarily
prudent person!”
“Defer to actions
by directors
taken in good faith!”
Behavioral
Side Effects
Example: Sarbanes-Oxley (2003)?
Critics Say Sarbanes-Oxley Law Hobbles Stocks, Chills
Risk Taking, But Upshot Is Far Less Dramatic
Wall Street Journal (July 22, 2003)
Critics blame the Sarbanes-Oxley Act for everything from
slowing the stock-market recovery to draining the pool of
corporate-board directors to undermining capitalism itself. . . .
William Niskanen, chairman of the libertarian Cato Institute,
argued at a recent forum that the accounting changes have
caused so much uncertainty that investors have shunned the
stock market. . . . Robert Elliott, former partner of KPMG LLP
and former head of the American Institute of Certified Public
Accountants, says Sarbanes-Oxley has resulted in "the
criminalization of [corporate] risk taking, which is the same as
criminalizing capitalism.“. . .
Independent Directors & Risk Aversion
Blame Sarbanes-Oxley
Peter J. Wallison
Wall Street Journal op-ed (September 3, 2003)
[The Sarbanes-Oxley Act was] a wholesale change in the governance of
American corporations, putting significantly more authority into the hands of
independent directors and correspondingly reducing the power of corporate
managements. Although many who supported the act viewed this as a healthy
reform, it may have had unintended consequences -- a reluctance of
managements to take the risks and make the investments that had previously
brought the economy roaring back from periods of stagnation or recession.
The independent directors of a company are part-timers. No matter how astute
in the ways of business and finance, they know much less about the business
of the companies they are charged with overseeing than the CEOs and other
professional managers who run these enterprises day to day. Unfamiliarity in
turn breeds caution and conservatism. When asked to choose between a risky
course that could result in substantial increases in company profits, or a more
cautious approach that has a greater chance to produce the steady gains of
the past, independent directors are very likely to choose the safe and sure.
They have little incentive to take risk and multiple reasons to avoid it.
Waltuch v. Conticommodity Services
Waltuch is Vice President and Chief Metals Trader for
Conticommodity Services (“Conti”).
When silver prices crash, he becomes the target of lawsuits by
angry silver speculators and an enforcement proceeding brought by
the Commodity Futures Trading Commission (CFTC), for fraud and
market manipulation.
In the private actions, Conti settles for >$35 million; Waltuch is
dismissed with no settlement contribution, but incurs $1.2 million in
unreimbursed legal fees.
In the CFTC action, Waltuch agrees to a penalty that includes a
$100,000 fine and a six-month ban on buying or selling futures
contracts from any exchange floor, and spends another $1 million in
unreimbursed legal fees.
Waltuch brings suits against Conti for indemnification of his $2.2
million, under Conti’s charter and under §145 (c).
Framework for D&O Liability
Business Judgment Rule (RMBCA §8.31(a)(2)): presumes that
the duty of care standard has been met
Waiver of Liability (DGCL §102(b)(7)): 90% of Delaware
companies eliminate D&O liability for duty of care violations (“self
insurance” for gross negligence)
Indemnification: may indemnify for D&O actions in good faith
(DGCL §145(a)) and for those beyond those provided by statute
but still in good faith (§145(f)).
D&O Insurance: corporation may buy D&O insurance “whether
or not the corporation would have the power to indemnify such
person against such liability.” (DGCL §145(g)).
Reimbursement of legal expenses: even if not in good faith,
success in a legal action requires indemnification for legal
expenses (DGCL §145(c)).
Kamin v. American Express
In 1972 Amex acquired 2.0 million shares of DLJ common
stock for $29.9 million; by 1976 the stake was worth
approximately $4.0 million.
Amex declares a special dividend to all shareholders
distributing the DLJ shares in kind.
Two shareholders file suit to enjoin the distribution, or for
monetary damages, claiming waste of corporate assets
because Amex could sell the DLJ shares and use the
capital loss to offset capital gains, which allegedly would
have resulted in a net tax savings of $8 million.
Defendant directors claim that this possibility was
considered but rejected due to negative impact on
accounting profits; move for summary judgment.
Smith v. Van Gorkom
Trans Union Corp. is a publicly held company with unused NOL’s
(net operating losses) and a CEO (Jerome Van Gorkom) looking to
retire. Stock is selling for $35 per share.
Acting mainly on his own, Van Gorkom arranges a sale to Jay
Pritzker’s company for $55 per share cash.
Van Gorkom calls a special meeting of the board but does not give
them an agenda beforehand; board approves the merger, and deal
protection features, after two hour meeting.
Trans Union shareholder sues, claiming breach of the duty of care.
No allegation of conflict of interest, but claim that the board did not
act in an informed manner in agreeing to the deal.
Chancery Court approves the transaction, finding that board
approval fell within protection of the BJR. Delaware Supreme
Court reverses, 3-2, finding that the directors had been “grossly
negligent.”
Smith v. Van Gorkom
• Standard of Liability: “gross negligence”
• Information gathering deficiencies:
– Van Gorkom’s role
– Company’s “intrinsic value”
• Counter arguments
– Substantial premium over stock price
– “Market test”
– Director experience and expertise
– Reliance on Brennan
Cede v. Technicolor
Technicolor CEO Kamerman negotiates with takeover
artist Perelman to sell Technicolor to Perelman for $23
per share, representing a 100% premium over pre-bid
share price.
Disinterested board is incredibly casual (a la Van
Gorkom) in approving the transaction: gets no credible
valuation, company is not “shopped” to other potential
buyers, etc.
In appraisal proceeding Chancellor Allen finds that the
value of the Technicolor stock at the date of the merger
was $21.60 per share.
Dissenting shareholders nevertheless bring suit
against the Technicolor directors claiming breach of
the duty of care.
The Technicolor “Conversation”
Chancellor Allen (1991 WL 111134, June 1991): “Absent proof of selfinterest that casts upon the director the burden to prove the entire fairness of
an interested transaction, a shareholder-plaintiff must prove by a
preponderance of the evidence that director negligence did cause some
injury and must introduce sufficient evidence from which a responsible
estimation of resulting damage can be made.”
Justice Horsey (“Cede II”, 634 A.2d 345, Oct. 1993): “[B]reach of the duty
of care, without any requirement of proof of injury, is sufficient to rebut the
business judgment rule. . . . A breach of either the duty of loyalty or the duty
of care rebuts the presumption that directors have acted in the best interests
of the shareholders, and requires the directors to prove that the transaction
was entirely fair.”
Chancellor Allen (663 A.2d 1134, Oct. 1994): “I, of course, desire to accord
complete respect to the Supreme Court’s conclusion that the director
defendants were negligent and insufficiently informed. . . . And I recognize
the force of the claim that a process that is uninformed can never be fair to
shareholders. Yet . . . I find myself unable to conclude that [this was not] a
completely fair transaction.”
Justice Holland (“Cede III”, 663 A.2d 1156, July 1995): Affirmed
Technicolor Take-Aways
1. Duty of care does not require P to show
injury (Cede II).
2. Gross negligence with respect to process
is sufficient to put burden on directors to
show entire fairness (Cede II).
3. BUT: gross negligence doesn’t
necessarily mean that the substance was
unfair – you can have gross negligence
and still the transaction can be entirely fair
(Cede III) (acc. Allen).
Emerald Partners v. Berlin
Craig Hall is Chairman, CEO, and 52% owner of May’s common
stock. Hall proposes a “roll-up” transaction in which May would
acquire thirteen corporations controlled by Hall.
Transaction is negotiated and approved by May’s independent
directors. Emerald Partners, a minority shareholder in May, brings
suit alleging that the transactions were unfair to May.
Hall declares bankruptcy and is out of the picture; Chancery Court
dismisses the complaint against the remaining directors without
conducting an “entire fairness” analysis because all that is left are
duty of care claims, which May had waived under §102(b)(7).
Supreme Court reverses: “[W]hen entire fairness is the applicable
standard of judicial review, . . . injury or damages becomes a proper
focus only after a transaction is determined not to be entirely fair
[citing Cede II]. . . . §102(b)(7) only becomes a proper focus of
judicial scrutiny after the directors’ potential personal liability for the
payment of monetary damages has been established.”