The Duty of Loyalty and its application for self-interested business decisions.

John is a 40% owner of XYZ Company with six of his good friends.  John is an entrepreneur and has many companies that do business with each other.  His ABC Company has the opportunity for a great business deal that will benefit both ABC and XYZ companies.  John is considered to be the controlling shareholder of XYZ company and he doesn’t want the opportunity to go bad or fall through because one shareholder thinks that John is making too much money on the deal or that it favors ABC more than XYZ.  What should John do?

 

This type of opportunity would be considered an “interested” transaction because it between the company and another company in which the company’s directors or managers have a financial interest.  Transactions of this kind will not be voidable if the opportunity is approved in good faith by a majority of the “disinterested” shareholders.  Those “disinterested” shareholders should approve or disapprove of the transaction without the “interested” shareholder taking part in the vote.

 

So lets say the transaction is approved by a large majority of the disinterested shareholders of XYZ, and it goes well for a while, but later on down the road, Jane, one of the other shareholders, thinks that the transaction favors ABC company too much, to the detriment of XYZ. The transaction would be protected by the business judgment rule which says that with the approval by fully informed, disinterested shareholders, the court would only be able to rescind the transaction if it was proven to be a gift or waste.  At that point, Jane, if she brought an action to terminate the transaction, would be the one with the burden to prove that the transaction was a gift or a waste.   This offers John, as well as the other members of the company, protection from a possible action from Jane.

 

“Where there has been independent shareholder ratification of interested director actions, the objecting stockholder has the burden of showing that no person of ordinary sound business judgment would say that the consideration received for [the offer or terms] was a fair exchange for the [offer or terms] granted.” Michelson v. Duncan, 407 A.2d 211, 224 (Del. 1979).

 

Contact your local counsel for more situation specific advice on how to go about protecting yourself in similar situations.

 

Photo By: Moyan Brenn