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II: Management's Powers and Duties
A. The Business Judgment Rule
Basic Power Structure:
- director runs co.,
- directors owes duties to shareholders in the manner they run the co.
- shareholders elects directors and approve major changes of co.
• Agency Costs (of Equity) Paradigm
• Conflicts of Interests: how divergent and how important
- Job Retention
- Profitability versus other goals (growth?)
• Potential Constraints on Conflict
- Voting (shareholders or elected board)
- Fiduciary Duties (court)
• Are constraints effective? For which conflicts? Do they have downsides?
Agency Costs of Equity
- Shareholders and directors/managers creates agency costs of equity: managers may pursue their own personal interests, and which may be bad for the shareholders
- Constrains effective?
- E.g. Andrea, a CEO/ chairperson of a company would rather
Rest than to work long
Raise her own salary
Sell real-estate to co. owned by his brother
Promote people she prefers
oppose a group of shareholders who run against Andrea for election to XYZ's board of directors
approve of a charter amendment making directors removable only for cause
have XYZ sell stock of Alpha Inc. which have a (historic) book value of $5 million, but a market value of $7.5 million
not to have XYZ sell stock of Beta Inc. which have a (historic) book value of $5 million, but a market value of only $2.5 million
- How would any of the following factors affect the degree of conflict and/or Andrea's inclination to pursue her own, rather than XYZ's shareholders', interests?
o Andrea owns no stock of XYZ
o Andrea owns 50% of the stock of XYZ
o XYZ has no large shareholder
Bill (who is unrelated to Andrea) owns 51% of XYZ's stock.
o The other two directors of XYZ are personal friends of Andrea.
o The other two directors of XYZ are CEO's of large companies.
o The other two directors of XYZ are personal friends of Bill (from 4 above).
o The other two directors of XYZ are XYZ's outside legal counsel and the dean of a law school to which
XYZ makes major contributions.
o XYZ is in sound financial shape.
o XYZ is close to insolvency.
o XYZ has two classes of common stock. Voting class A stock, all of which are held by Andrea and nonvoting class B stock held by all other shareholders. (In all other aspects, the two classes are identical.)
1 II: Management's Powers and Duties
The Business Judgement Rule, Fiduciary Duties, and Shareholder Suits
Elements: If the decision by board is
No conflict of interest
Court categories conflict of interest into categories, some are categorized as no conflict of interest
Directors were not dependent on somebody else who have a conflict of interest, linked to disinterested (no other person who you are dependent on, who had a conflict of interest)
3. Informed, and
4. [Good faith]
Did not used to be an independent element, now starting to develop and still revolving
Court would not intervene such decision
Not required: intelligent
Going to court and arguing that board made a "stupid" decision that resulted in big losses does not get you anywhere.
Court uses business judgment rule in 3 different meanings, depending on the context
1. Evidentiary presumption (burden of proof on P) Cinerama
'Independent' not mentioned, but doesn't matter
Cinerama: The rule is a rebuttable presumption that directors … acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith. A party challenging a board of directors' decision bears the burden of rebutting the presumption that the decision was a proper exercise of the business judgment of the board.
2. Substantive decision rule to certain claims for breach of fiduciary duty courts will not pay much attention to [core meaning] if not rebutted court should not interfere
Gries: If the directors are entitled to the protection of the rule, then the courts should not interfere with or second-guess their decisions.
Cinemara: If a shareholder plaintiff fails to [rebut the BJR presumptions], the businessjudgment rule attaches to protect corporate officers and directors and the decisions they make,
and our courts will not second-guess these business judgments.
Caveat: For claims other than claims for breach of fiduciary, one does not need to rebut BJR
Company declared dividend and paid everyone but me.
Company did not hold annual meeting when required.
3. Characterization of the legal conclusion that P loses (without the court substantively reviewing the fairness of the board decision) even though P did rebut the presumptions of the Business Judgment
No substantive review = no assessment of the fairness of the transaction
What happen if the Business Judgment Rule is rebutted?
o Complicated, Topic of Many More Classes
Generally: Court will make further inquiries as to whether there was a breach of fiduciary duty.
o Gries: If a director fails to pass muster as to any one of these three, he is not entitled to the business judgment presumption. This does not mean that the director's decision is necessarily wrong; it only removes the protection provided by the business judgment presumption.
o If (merely) "uninformed", generally inquiry as to whether there was a breach of duty of care.
o If interested/ independent is rebutted, inquiry as to whether there was breach of duty of loyalty.
o Complications: "informed" considerations are often also relevant when some directors were interested and others are disinterested.
2 II: Management's Powers and Duties
Complications: what about breach "good faith" complicated
This doctrine is guidance of judges' preferred outcome, reflection of what the court think is right
1. Unlike normal doctrine, which imposes constrain on the judges' judgment judges had to follow what doctrine tells them to
Substantively - issue of whether board is informed
Fiduciary duty owed by directors and officers
Shareholders are the parties who benefit from and seek to enforce fiduciary duty
Court should take care to define and enforce fiduciary duties, so directors retains discretion in managing the company
Business judgment rule: insulate the board from shareholders suits
Defines broad set of circumstances which court will refuse to doubt the board's decisions, so is to protect directors' decisions from shareholder's attack
If decision falls outside the business judgment rule, court will examine the actions of directors more closely to determine whether there has been a breach of fiduciary duties
Shareholder derivative action or shareholder class action
Public corp. often have thousands/ ten thousands of shareholders
Will have no incentive to bear the costs of brining suit to enforce the fiduciary duties of officers and directors - since single shareholder gain only a tiny fraction of the benefit from a meritorious suit
Most non-US jurisdictions doesn't allow class actions
Shareholders in the US can recover generous compensation for legal costs (if their suits succeed) by framing their suits as
shareholder derivative actions: suits brought on behalf of the corp., or
shareholder class actions
Hence, small shareholders in the US has powerful incentives to bring suit, despite the business judgment rule.
Typical definition of the common law Business Judgment Rule
Gries Sports Enterprises, Inc. v. Cleveland Browns Football Co.
A shield to protect directors from liability for their decisions
court should not interfere their decisions if directors are entitled to its protection.
But if director is not entitled to such protection, court would scrutinize the decisions as to its intrinsic fairness to the co. and co.'s minority shareholders
The rule is a rebuttable presumption: directors are better equipped than the courts to make business judgments + directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith.
burden of rebutting lies on the party challenging the board's decision, to prove that the board's decision was not a proper exercise of business judgment
Shareholders, in a derivative action, challenging the fairness of a transaction approved by a majority of directors of a corporation, a director must be
(2) independent and
(3) informed in order to claim the benefit of the business judgment rule.
If any of these 3 is not satisfied, the director is not entitled to the business judgment presumption
protection of the business judgment decision presumption would be removed
(but doesn't mean its decision is wrong/ director becoming personally liable)
court must then inquire into the fairness of the director's decision o
Cinerama, Inc. v. Technicolor, Inc. The business judgment rule operates as
1. a procedural guide for litigants
a rule of evidence that places the initial burden of proof on P
3 II: Management's Powers and Duties
In Cede II¸ Court described the rule's evidentiary, or procedural, operation as follows
If a shareholder P fails to meet this evidentiary burden, the rule protects the corporate officers/ directors and their decisions - court would not second guess their business judgments
If rule is rebutted, burden shift to D directors to prove the entire fairness of the transaction to the shareholder P yet it doesn't create per se liability on directors but a "procedure which the Delaware courts of equity determine under what standards of review director liability is to be judged"
o Weinberger v. UOP: the entire fairness standard requires the board of directors to establish "to the court's satisfaction that the transaction was the product of:
1. fair dealing: when the transaction was timed, how it was initiated,
structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained; and
2. fair price: economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects,
and any other elements that affect the intrinsic or inherent value of a company's stock
All aspects of the issue must be examined as a whole since the question is one of entire fairness a substantive rule of law
Even if the procedural presumption has been rebutted, it does not necessary mean that substantive liability would be established
Burden of proof on the Board to demonstrate entire fairness by presenting evidence of the cumulative manner, by which it otherwise discharged all of its fiduciary duties
Weinberger stresses on whether the director disclosed to shareholders all material facts bearing upon a vote.
In Delaware, the law/ policy have evolved into a virtual per se rule of awarding damages for breach of the fiduciary of disclosure
2. B. The Duty of Care
Graham v Allis-Chalmers Manufacturing Co. (1963)
P argued that the Board violated its duty of care in permitting the co. to engage in anti-trust violations P
losses Board not involved in the violation: D not liable as a matter of law merely because, unknown to them,
some employees of Allis-Chalmers violated the anti-trust laws thus subjecting the corporation to loss
Board has 11 meetings a year, each for several hours - but AC is a big corp.: 31k employees, 24 plants,
Large publically traded co. are ran by the Board - the hours they meet do not permit directors to have deep knowledge of the company [normal: low standard of being informed]
5 board members are part of management [nowadays usually only 2/10 directors] "inside directors" - work every day; "outside directors" - only once a month to attend Board meeting
P alleged that Not sufficiently informed about what is going on in the company violation of duty of care
(should have paid more attention)
Duty imposed on directors personally Director may protect themselves by:
o Put in more process to reduce liability
e.g. by hiring antitrust monitors costs co. the money
Don't do enough directors pay
Do enough [hiring monitors] co. pays increase cost
Hold more meetings
e.g. enough to know what is going on in the co.
4 II: Management's Powers and Duties
But vague + more time = more compensation for directors = co. spend more $
[for outside directors, as inside directors are already working everyday]
Outside directors would then become inside directors.
But if we want outside directors, who are more detached, maintain on Board usually bring outsider perspective to the situation and monitor the inside directors
More meetings imposing more burden/time/compensation on outside directors
eliminating the role of outside directors, who would become CEOs/ inside directors
[Provide insurance - but absurd since director hurts the co. insurance pay the company but co.
Shareholders would want the co. to make profit, and would not care about antitrust
Penalized the company to compensate gov and victim
Penalized the specific individuals who violate the antitrust law: $ to gov or victim/ prison
Supplementary mechanism: Penalize the board by failing to monitor antitrust make them to give money to shareholders
But shareholders are the ones paying money to victim/ gov
If the shareholders would receive money because co. is violating antitrust law would defeat the purpose of the antitrust law
Co. violates antitrust law to make money for shareholders shareholders were the one who would benefit from antitrust breach [they are not victims of the violation] should not be rewarded
Would not work for private companies
Co. doesn't violate the antitrust law (since it is not a human being), it is the management/ employees who violate the law
Management violate the law for the company (which benefit shareholders)
But management can also get additional compensation form company through right incentives
[Management should not get this additional $]
It would benefits shareholders and hurt other people in the market place
Management can steal money from company, if unsanctioned
it would benefit the managers and hurt the shareholders
violating antitrust law is doesn't harm the shareholder should not allow shareholders to benefit from that
Directors are not in breach of their fiduciary duty violating antitrust law
Company $ to gov/ victim
Individual $ to victim/ gov/ imprisonment
Derivative action on behalf of Allis-Chalmers against its directors and 4 non-director employees
Complaint based on 8 indictments charged violation (including the co. and its directors) of the Federal anti-trust laws
Suit seeks to recover damages which AC claimed to have suffered by reason of these violations
P alleges D directors had actual knowledge (or knowledge of facts which should have put them on notice) of the anti-trust conduct
But no evidence that any director had any actual knowledge of the anti-trust activity, nor should have notice that anti-trust activity was being carried on by some of their co.'s employees
Ps then shifted into arguing that D are liable as a matter of law, by reason of their failure to take action to learn and prevent anti-trust activity on the part of any employees of AC
AC is a large manufacturer of variety of electric equipment.
o Operating policy is to decentralize by delegating authority to lowest possible management level capable.
5 II: Management's Powers and Duties
Price set by particular department manager, but general manager of the division set prices for product that is large and special.
o Products of repetitive manufacturing process are sold out of a price list, established by a price leader for the electrical equipment industry as a whole
The board conduct annual review on profit goals budget, and sometimes consider general questions on price levels (but doesn't participate in decisions fixing the prices of specific products
Indictment which AC and 4 non-director Ds pled guilty charge that the co. and individual non-director Ds,
conspired with other manufacturers and their employees to fix prices and to rig bids to private electric utilities and governmental agencies, in violation of the US anti-trust law
None of the directors were named as D in the indictment - Federal Gov acknowledged there is no probative evidence that could lead to the conviction of the directors
First actual knowledge of the directors had of anti-trust violation by co.'s employees was from newspaper in 1959 in 1960, the boar issued a policy statement to eliminate possibility of further/future violations of the antitrust laws
P argue that 1937 FTC decrees should have put directors on notice of their duty to prevent antitrust problems
But none of the director Ds were director in 1937. Though 3 of the Ds later learned of the decree, all 3 satisfied themselves that AC had not engaged in antitrust violation + consented to the decree merely to avoid expense and necessity of defending co.'s position
knowledge by 3 of the directors that in 1937, the co. had consented to the entry of decree enjoining it from doing something they had satisfied themselves it had never done, did not put the Board on notice of the possibility of future illegal price fixing
P failed to establish that the Board had actual/ imputed notice
P then argue directors are liable for losses suffered by their co. by reason of their gross inattention to their common law duty of actively supervising and managing the corporate affairs Briggs v Spaulding:
o Directors are bound to use that amount of care which ordinarily careful and prudent men would use
Duties are those of control, whether by neglect they have made themselves liable for failure to exercise proper control depends on the circumstances and facts of the particular case
But Briggs expressly rejected: Even though they had no knowledge of any suspicion of wrongdoing on co.'s employees, they still should have put into effect a system of watchfulness, so misconduct would be detected and put to an end.
o Briggs: directors are entitled to rely on the honesty/ integrity of their subordinates until something occurs to put them on suspicion that something is wrong. Without suspicion, there is no duty upon the directors to install and operate a corporate system to find out wrongdoings which they have no reason to suspect exists
Duties of the AC directors were fixed by the size of the company - since its so big, directors could not know personally all the company's employees - they are confined to their broad policy decisions
(which Ds did)
Whether a corporate director has become liable for losses to the corporation through neglect of duty is determined by the circumstances
If he has recklessly reposed confidence in an obvious untrustworthy employee, has refused or neglected cavalierly to perform his duty as a director, or has ignored either willfully or through inattention obvious danger signs of employee wrongdoing the law will cast the burden of liability upon him
But not the case at bar, for as soon as it became evident that there were grounds for suspicion, the
Board acted promptly to end it and prevent its recurrence
No rule that requires a corporate director to assume, with no justification that all corporate employees are incipient law violators who, but for a tight checkrein, will give free vent to their unlawful propensities.
Held: D not liable as a matter of law merely because, unknown to them, some employees of Allis-Chalmers violated the anti-trust laws thus subjecting the corporation to loss o
6 II: Management's Powers and Duties
1. What function would imposing liability for breach of the duty of care serve in
Allis-Chalmers? When might it be in the narrow economic interest of shareholders and when not?
2. To the extent that one is tempted to impose liability on the board for purposes of enforcing the antitrust laws, what alternative enforcement strategies are available? What about increased penalties against the company?
3. Assume the directors authorized the actions which were later found to have violated the antitrust laws. At the board meeting, legal counsel had informed them that such actions may (but are not certain to) be illegal but the directors concluded that the potential profits are high enough to justify the risk of violating the law. Should the directors be personally liable for violating the duty of care? What if the directors were told that the actions are clearly illegal, but that the probability of detection is low? What if the directors were told that the actions are clearly illegal, but that the government generally does not prosecute such kind of offenses?
Smith v Van Gorkom (1985)
Trans-Union, a Chicago public car leasing co., doesn't have enough income to use the Investment tax credits
(ITCs) to reduce tax
July 1980, its management proposed 4 alternative use of the projected 1982-1985 equity surplus, but the sale of
Trans Union was not considered
In August 1980 Van Gorkom suggested to Senior Management, to sell the Trans Union to a co. with a large amount of taxable income
Senior meeting on 5 September 1980, Romans, Chelberg and VG met Donald Romans (CFO of Trans
Union) announced his preliminary study on the possibility of a leverage buy-out (LBO) + possible being bought by the Management
Romans brought up leveraged buy-out and ran the numbers at $50 and $60 a share.
o $50 would be very easy to do, but $60 would be very difficult, very rough calculations.
o VG stated that he would be willing to take $55/share for his own 75,000 shares
VG banned the suggestion of a LBO by Management due to conflict of interest
Conflict of interest 1: management would be the buyers and sellers are shareholders
management wants to buy a low price; shareholders would want to sell the high price.
Managers has fiduciary duties to the shareholders they have the best info of the company
(knowing the lowest price $55) Managers buying the company are the one who supposed to help shareholders to get the best price [people who know best are the buyers]
Conflict of interest 2: VG was then approaching 65 years of age and mandatory retirement
he won't be a buyer in the Management buyout, but a seller as he is the CEO. [VG could negotiate the deal to the best interest of the shareholders as sellers reduce the conflict]
$55 seems to a good price to sell his shares
VG contacted Trans Union's Controller Peterson - secretly ask Peterson to calculate the feasibility of a LBO at
VG didn't want a LBO by management
Roman ran the numbers 5 days ago, but VG asked Peterson to calculate the feasibility of a leverage buy-out for $55/share [as CFO told VG the range is $50-60] and told him not to tell anyone nor reason why
VG should've asked Roman CFO (no.3 in the hierarchy), and not Peterson (lower in the hierarchy) to do the calculations VG wants to keep it confidential from Roman
Few days later, VG met Prizker (corporate takeover specialist)
o Prizker is a potential buyer (rich, well-known corporate takeover specialist) and VG's social acquaintance
VG told Prizker $55 (middle of $50-60)
13 September 1980, Prizker suggested $50 VG: $55 is better
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