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.”

Liability imposed under (hypothetical) negligence standard

Liability imposed under business judgment rule

More risky project

Less risky project

PayoffLow High

Probof Payoff

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 self-dealing 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 careof an ordinarily

prudent person!”

Business JudgmentRuleDuty of Care

BehavioralSide Effects

“Act with the careof an ordinarily

prudent person!”

“Defer to actionsby directors

taken in good faith!”

Example: Sarbanes-Oxley (2003)?

Critics Say Sarbanes-Oxley Law Hobbles Stocks, Chills Risk Taking, But Upshot Is Far Less DramaticWall 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.“. . .

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.

Independent Directors & Risk Aversion

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 self-interest 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.”