PARTNERSHIPS, CORPORATIONS AND THE VARIANTS PROF. BRUCE MCCANN SPRING SEMESTER LECTURE 1 DUTY OF LOYALTY PP Business Organizations Lectures

The Duty of Loyalty and the BJR Lec. 1 Sem 2, pp Corps Prof. McCann The Business Judgment Rule only shields directors where there is no conflict of interest. Where a potential conflict of interest exists, burden is on directors to demonstrate decision is fair and reasonable to the corporation.

The Business Judgment Rule Lec. 13, pp Corps Prof. McCann Applies when what is at issue is a business decision made by the directors Does not come into play where directors are accused of failing to monitor or similar derelictions of the duty of care, only when making a business decision

Calif. Corp Code Sec. 309 Lec. 13, pp Corps Prof. McCann (a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. (b) In performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by [officers, consultants, etc]. (c) A person who performs the duties of a director in accordance with subdivisions (a) and (b) shall have no liability based upon any alleged failure to discharge the person's obligations as a director. In addition, the liability of a director for monetary damages may be eliminated or limited in a corporation's articles to the extent provided in paragraph (10) of subdivision (a) of Section 204.

Model Act Lec. 13, pp Corps Prof. McCann SECTION GENERAL STANDARDS FOR DIRECTORS (a) A director shall discharge his (sic) duties as a director, including his (sic) duties as a member of a committee: (1) in good faith; (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner he (sic) reasonably believes to be in the best interests of the corporation. (b) In discharging his (sic) duties a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by: (1) one or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented; (2) legal counsel, public accountants, or other persons as to matters the director reasonably believes are within the person's professional or expert competence; or (3) a committee of the board of directors of which he (sic) is not a member if the director reasonably believes the committee merits confidence. (c) A director is not acting in good faith if he (sic) has knowledge concerning the matter in question that makes reliance otherwise permitted by subsection (b) unwarranted. (d) A director is not liable for any action taken as a director, or any failure to take any action, if he (sic) performed the duties of his (sic) office in compliance with this section.

Shareholder Ratification Lec. 13, pp Corps Prof. McCann Shareholders may ratify acts of even interested directors PROVIDED shareholders are “fully informed”  Burden is on directors to establish shareholders were fully informed

Delaware Gen Corp Law Sec. 141 Lec. 13, pp Corps Prof. McCann (e) A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.

SMITH V VAN GORKOM Lec. 13, pp Corps Prof. McCann "Informed" within meaning of "due care" means board reviewed all material information reasonably available Liability under Business Judgment Rule arises only where there is a showing of gross negligence, meaning something more careless than ordinary negligence.  E.g., failure to even read a report which was itself deficient

ALI Version Lec. 13, pp Corps Prof. McCann No liability for a business judgment reached in good faith provided: 1. Director or officer was disinterested 2. Director or officer was informed as to the subject of the decision to a degree the director or officer reasonably believes appropriate; and 3. Rationally believes decision is in the best interests of the corporation

The Rule Lec. 13, pp Corps Prof. McCann Absent fraud, illegality or conflict of interest, a director who acts in good faith is not personally liable for mere errors of judgment short of CLEAR AND GROSS NEGLIGENCE Shlensky v Wrigley 237 N.E. 2d 776 (Ill. 1968) Unless director(s) had an interest in the subject of the decision or Unless decision constitutes illegal conduct (e.g., decision to pay a bribe)

The Business Judgment Rule Lec. 13, pp Corps Prof. McCann Applies when what is at issue is a business decision made by the directors Does not come into play where directors are accused of failing to monitor or similar derelictions of the duty of care, only when making a business decision

What is “Fair and Reasonable”? Lec. 1 Sem 2, pp Corps Prof. McCann An objective test. There must be procedural fairness There must be substantive fairness The transaction must be reasonable in the overall context of the objectives of the corporation  As measured against transactions with unrelated parties  As measured against strategic goals – i.e., not only must the terms be fair, but the transaction itself has to be one the corporation would have pursued even were the other party not affiliated  As measured at the time of the decision

Safe Harbor for the Interested Director/Officer Lec. 1 Sem 2, pp Corps Prof. McCann Delaware provides: No transaction void or voidable just because interested director or officer participated if: a. All material facts regarding the conflict of interest were disclosed to the board or shareholders who nonetheless approved the transaction in good faith; or b. The transaction was intrinsically fair to the corporation at the time it was approved. NOTE: Regardless of board or shareholder approval, many states require fairness test be satisfied

Split As to Application of Safe Harbor Rules Lec. 1 Sem 2, pp Corps Prof. McCann Majority: Burden is on shareholders to prove board action unfair so long as BJR criteria met Shifting burden to shareholders to show unfair provided one of the safe harbor tests is met (i.e., board need not also show intrinsic fairness) Burden of proof on board to demonstrate intrinsic fairness (Minority)

Interplay with BJR Lec. 1 Sem 2, pp Corps Prof. McCann Benihana: If fully informed disinterested directors approve the transaction, the burden shifts to the shareholders to show decision does not satisfy the Business Judgment Rule (i.e., that the process followed in reaching the decision was flawed, regardless of the merits of the decision) Effect is to insulate the decision from judicial review for fairness

Alternative Attacks on the Transaction Lec. 1 Sem 2, pp Corps Prof. McCann Waste Fraud Exceeding Authority Breach of Loyalty action against the interested director