Corporations Feb 2002 Flashcards
(9 cards)
Summary
The Class B Shareholder is unlikely to prevail in this derivative action. Ordinarily, the Business Judgment Rule (BJR) would preclude the court from second-guessing the board of directors on an issue of this sort (i.e., how best to finance a business expansion). In this case, however, even though the directors did not breach their duty of care to the corporation, Dart clearly did breach the duty of loyalty by voting to cause the corporation to enter into a transaction that provided her with a financial benefit. Because of the breach of the duty of loyalty, the BJR does not immunize the transaction from scrutiny. Nevertheless, the court would not enjoin the transaction because it was carried out in a manner that removes the taint of the breach of loyalty.
In a shareholder derivative action, decisions of the board on business issues are presumptively correct under the Business Judgment Rule (BJR).
In order to prevail in this derivative action to enjoin the issuance of Class C Preferred, the Class B shareholder must overcome the BJR. The BJR is a legal presumption. Absent a showing that the directors have violated a fiduciary duty to the corporation or committed fraudulent or illegal acts, the court will not second-guess their judgments. See Davis v. Louisville Gas & Electric Co., 142 A. 654, 659 (Del. Ch. 1928) (court refused to enjoin the directors from amending the certificate of incorporation, stating “it is not [the court’s] function to resolve . . . questions of policy and business management. The directors are chosen to pass upon such questions and their judgment unless shown to be tainted with fraud is accepted as final.”)
If the Class B shareholder puts forth sufficient evidence to demonstrate that the directors breached a fiduciary duty to Ergo, the BJR will no longer apply.
Although the directors discussed the matter for only one hour, they did not violate their duty of care to Ergo when they voted to recommend to shareholders the amendment to the Articles.
Directors owe a duty of care to Ergo; they must act on an informed basis, in good faith in the honest belief that the action taken is in the best interest of the corporation. See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). Under the Revised Model Business Corporation Act (RMBCA), directors are required to discharge their duty “in good faith and in a manner the director reasonably believes to be in the best interests of the corporation.” RMBCA § 8.30(a). When becoming informed to make a decision, directors must discharge their duty “with the care that a person in alike position would reasonably believe appropriate under similar circumstances.” RMBCA § 8.30(b). The duty of care is procedural (process oriented), not substantive.
Application
The facts do not support an argument for lack of good faith or failure to act “with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” RMBCA § 8.30(b). Even if the other funding alternatives might have been better for Ergo, directors are not liable for bad decisions so long as they follow the appropriate procedures, which they did here.
The directors spent only one hour considering and deciding the issue. In Smith v. Van Gorkom, two hours was held insufficient for a major corporate decision. See Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (Duty of care violated when directors approved a merger after a 20-minute oral presentation without reviewing the documents or assessing the valuation at a meeting that was called without much notice.) However, courts are generally concerned with major corporate decisions, like the sale of control in Van Gorkom. See Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 370 (Del. 1993). In Ergo’s case, the issue was only the source of funding, as the directors had already properly approved the expansion plan.
Dart violated her duty of loyalty to Ergo when she voted to issue the Class C Preferred to herself.
The duty of loyalty requires a director to put the interests of the corporation before the director’s own interests. If a director enters into a transaction with the corporation that provides the director with financial benefit, it is a violation of the duty of loyalty. The purchase of the Class C Preferred by Dart is a transaction with Ergo that provides Dart with a financial benefit. Therefore, Dart violated her duty of loyalty to Ergo when she voted to issue the Class C Preferred to herself. This was also a conflicting interest transaction under the RMBCA because Dart knew she could benefit. RMBCA § 8.60.
Dart has a conflicting interest transaction because, at the time she voted to issue the Class C Preferred to herself, she knew she had a significant financial interest.
Although the directors did not violate their duty of care to Ergo, Dart violated her duty of loyalty. Regardless, the court would not enjoin the issuance of the Class C Preferred because Dart could show the transaction was (1) approved by a majority of disinterested directors after full disclosure, (2) approved by a majority of shareholders after full disclosure, or (3) fair to Ergo.
Even though the directors did not violate their duty of care, Dart violated her duty of loyalty to Ergo, and that fact prevents the application of the BJR. Nonetheless, the court would NOT enjoin the issuance of the Class C Preferred if Dart could demonstrate that the sale of Class C Preferred to her was (1) approved by a majority of disinterested directors after full disclosure, (2) approved by a majority of shareholders after full disclosure, or (3) fair to Ergo. See Robert C. Clark, CORPORATE LAW § 5.2 (1986); Revised Model Bus. Corp. Act (RMBCA) §§ 8.61-.63. In this case, Dart can demonstrate all three.
Disinterested Director Approval
All seven directors voted to offer the Class C Preferred to Dart after full disclosure of all material facts relating to the transaction. Disclosure of all material facts constitutes full disclosure. Approval must also be by a majority of disinterested directors. Dart is interested because she is a party to the transaction. The three remaining Class A directors are arguably interested because their positions as Ergo directors are dependent upon election by Dart, the sole Class A shareholder. If they failed to support Dart, Dart could remove them from their positions as directors. The three Class B directors, however, are disinterested directors. They all voted in favor of issuing the shares to Dart. Therefore, a majority (indeed all three) of the disinterested directors approved the offering of the Class C Preferred to Dart. Under the RMBCA (and most state statutes), the three disinterested directors who voted are sufficient to constitute a quorum when voting on a conflicting interest transaction.
Shareholder Approval
According to the facts, the proxy solicitation provided full disclosure of all relevant information regarding the plan to issue the Class C Preferred to Dart for $5 million. The fact that the directors did not disclose that they had considered and discarded other financing options is unimportant because information on other options was properly considered and discarded. All Class A shares voted in favor of the transaction, as did a majority of Class B shares (720,000 of 820,000 shares). Therefore, a majority of shareholders approved the transaction after full disclosure. Note that there is no requirement that the shareholders be disinterested.
Fair
Alternatively, Dart can show that the transaction was fair to Ergo at the time the Class C Preferred shares were issued. In assessing fairness, directors may rely on expert opinions. See RMBCA §8.30(e). To demonstrate that the price was fair to Ergo, Dart would offer the opinion of the independent investment bank stating that (1) $5 million would be fair value for the Class C Preferred, and (2) in the long run, payment of the Class C Preferred dividend would be less costly to Ergo than interest payments on a loan.
