The Price of Prosperity

Are Directors and Officers Taking the Corporate Spoils?

Doing the right thing, Mark Twain once said, will gratify some people and astonish the rest. Those sentiments are particularly prescient in today’s robust corporate environment, because among the principle shareholder concerns in a rising economy is the risk that corporate officers and directors are not doing the right thing and are instead taking corporate spoils themselves through improper self-dealing. This self-dealing strictly conflicts with directors’ and officers’ fiduciary duties and thus shareholders should be aware both of the manner in which self-dealing arises and how to navigate it.

Corporate fiduciary duty embodies two fundamental obligations – the duty of care (directors/officers must perform their work diligently and competently) and the duty of loyalty (directors/officers may not use their positions of trust to further their own individual interests). These complimentary duties demand that the interests of the corporation and the shareholders take primacy over those of the officer or director.

Accordingly, directors and officers must conduct themselves with “inherent fairness” to the corporation, and that includes the duty to disclose any personal interest they have in contracts to which the corporation becomes a party and as to which the Board of Directors is called upon to approve. And this issue is perhaps the most common form of self-dealing, one of which the shareholders must be aware if director/officer misconduct is to be deterred.

To start, California does not ipso facto prohibit contracts in which directors and officers are personally interested. The law instead provides that if the personal interest is disclosed and the Board concludes that the contract is nonetheless fair to the corporation, the transaction is presumptively enforceable. But that, in turn, begs the question of what constitutes an interested transaction and, by corollary, when is such a transaction appropriate under the fairness standard. These are critical issues for shareholder consideration.

Specifically, a director or officer is considered “interested” in a transaction if: (1) The transaction is directly between the director/officer and the corporation; or (2) the transaction is with another company in which the director/officer has a “material financial interest.” Thus, in the latter instance, if the corporation entered into a loan agreement with a lender, and one of the corporation’s director was simultaneously an executive with the lender, the director would be interested in the transaction.

An “interested” transaction may be validated in three ways: First, the shareholders may approve it after receiving full disclosure from the interested director/officer before the interested director/officer acts on the agreement. Second, the Board of Directors may approve the transaction where: (1) There is full disclosure, as defined above; (2) a disinterested majority of the Board – that is, a majority of the members not themselves interested in the contract – approves the transaction; and (3) the transaction is demonstrated to be “just and reasonable” to the corporation. The law presumes that if a disinterested Board majority approves the transaction, it concluded the agreement was fair.

All of which speaks to the overriding principle that shareholders should insist on full and complete advance disclosure by officers and directors of all “interested” transactions with the corporation. Short of that, the only remaining tool for challenging a director/officer interested transaction is litigation with all the attendant risks and costs associated with that process. Prevention, as ever, is worth a pound of cure.