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Module VII – Fiduciary Duties. Chapter 20 Director Conflicts. Bar exam. Corporate practice. Law profession. Self-dealing transactions Definition: director on both sides History: void  process + substance  substance only  process enough (DGCL 144)

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Chapter 20 director conflicts

Module VII – Fiduciary Duties

Chapter 20Director Conflicts

Bar

exam

Corporate practice

Law profession

Self-dealing transactions

Definition: director on both sides

History: void  process + substance  substance only  process enough (DGCL 144)

Subchapter F: statutory safe harbor

Process

Disinterested/independent directors

Shareholder ratification

Collective action problems

Effect: validates or shifts burden?

Corporate opportunities

Compare to self-dealing

Definition: expectancy / line of business

ALI Principles

Disclosure + process

Distinguish: officers / directors

Citizen of world

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Director Conflicts


Director self dealing

Director self-dealing

Shareholder

X

Corporation A owns and leases a number of commercial buildings. Corporation A leases one of its buildings to Store X. Any problems?

When Store X faces financial difficulties, Corporation A agrees to waive “bonus rents” and past arrearages – to help Store X get back on its feet. Any problems?

X is a significant shareholder and member of the board of directors of Corporation A. X is also the owner of Store X. Any problems?

Board

Lease

Rent

Corp

A

Store

X

Waive

How should corporate law respond to director self-dealing?

Chapter 20

Director Conflicts


Chapter 20 director conflicts

Possible Approaches

  • Flat prohibition: The corporation cannot enter into any transaction with any person or entity in which a director has a conflicting interest.

  • Shareholder ratification. The corporation can enter into conflicting-interest transactions if the shareholders validate -- ratification or approval.

  • Director ratification. The corporation can enter into conflicting-interest transactions if the disinterested directors approve.

  • Fair. The corporation can enter into conflicting-interest transactions if a judge finds the transaction was fair.

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Judicial review

Common law

Procedure AND Substance

Evolving common law

Substance only

Judicial review

Modern common law

Procedure OR Substance

1900

1950

2000

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Director Conflicts


Common law in age of statutes

Common law in age of statutes …

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Director Conflicts


Remillard brick co v remillard dandini co calif app 1952

Stanley and Sturgis were in the brick business. They owned a majority of Brick Corp, a brick manufacturing firm. 

Stanley and Sturgis also owned all of Sales Corp, which contracted with Brick Corp to sell the bricks. 

What's the problem? 

Who sued? 

Wasn't the deal approved by Brick Corp board? 

Didn't the Brick Corp stockholders approve, as well?

Remillard Brick Co v. Remillard Dandini Co (Calif App 1952)

Shareholders

Stanley / Sturgis

Minority

100%

Majority

Brick Corp

Dealings

Sales Corp

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Director Conflicts


Chapter 20 director conflicts

Del. G. Corp. L. § 144 [edited a little]

(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:

(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors OR

(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders OR

(3) The transaction is fair as to the corporation as of the time it is approved.

Is the statute

a safe harbor?

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Chapter 20 director conflicts

"But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply because there has been a disclosure and approval by the majority of the stockholders"

Even though the requirements of section 820 are technically met, transaction that are unfair and unreasonable to the corporation may be avoided. ... It would be a shocking concept of corporate morality to hold [otherwise]

Remillard Brick Co v. Remillard Dandini Co (Calif App 1952)

California Appeals Court

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Director Conflicts


Common law in age of statutes in delaware

Common law in age of statutes in Delaware …

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Director Conflicts


Delaware cases

Delaware cases

Fliegler v. Lawrence (Del 1976)

DGCL 144 “merely removes an “interested director” cloud when its terms are met … nothing in the statute removes the transaction from judicial review”

Marciano v. Nakash (Del 1987) - dicta

"... approval by fully-informed disinterested directors under Section 144(a)(1) or disinterested stockholders under section 144(b)(2) permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof on the party attacking the transaction.”

Benihana of Tokyo v. Benihana, Inc (Del 2006)

DGCL Section 144 provides a safe harbor for interested transactions, like this one, if "[t]he material facts as to the director's . . . relationship or interest and as to the transaction are disclosed or are known to the board of directors ... and the board ... in good faith authorizes the transaction by the affirmative votes of a majority of the disinterested directors...."

After approval by disinterested directors, courts review the interested transaction under the business judgment rule.

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Director Conflicts


Benihana del 2006

Benihana (Del 2006)

Benihana in middle of family imbroglio and needs capital. Bank loan not attractive.

Board approves issuance of $20 mm preferred stock to finance company, in which Abdo (Benihana director) is 30% shareholder and director/vice chair.

Board knew that Abdo was negotiating for finance company. “Abdo did not use confidential information, set the terms deceive the board, dominate any directors.”

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Director Conflicts


Mbca subchapter f hypothetical

MBCA Subchapter F - Hypothetical

Fred, the favorite cousin of Director A and principal legatee of A’s estate, sells Blackacre to Corporation XYZ. The board approves and shareholders ratify.

How does Subchapter F handle this transaction?

What if Fred is Director A’s son? How does that change things?

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Director Conflicts


Subchapter f

Subchapter F

  • § 8.60 Definition

  • “DCIT”?

  • direct interest

  • indirect interest

  • § 8.61(b)

  • Safe Harbor

  • not challenge DCIT

  • if (1) or (2) or (3)

  • § 8.62

  • Board approval

  • maj “qualified Ds”

  • required disclosure

  • review: manif unfav ?

Yes

  • (2) § 8.63

  • SH action

  • maj “qualified shs”

  • notice / req’d discl

  • review: no substance

No

  • § 8.61(a)

  • Exclusive

  • can’t challenge tx

  • if not DCIT

  • (3) “fair” (Note)

  • review: tx terms +

  • corp benefit

  • BOP on defendant

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Pop quiz

Pop quiz

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Director Conflicts


Chapter 20 director conflicts

B owns Blackacre and also sits on the board of Corp X. If B sells Blackacre to X, the transaction is:

Insider trading

Director self-dealing

Usurpation of corporate opportunity

B’s sale to Corp X is:

Void (or voidable)

OK, if approved by independent directors

OK, if approved by majority of shareholders

OK, if judge determines to be “fair”

  • 3. “Fairness” means:

    • Transaction is within corporation’s line of business

    • Transaction reflects market price / terms

    • Transaction reflects director’s “reservation price”

  • 4.In shareholder suit challenging Corp X’s purchase of Blackacre:

    • Burden in on shareholder to show unfairness

    • Burden is on shareholder to show inadequate approval

    • Burden is on Corp X (and B) to show fairness – process or substance

1–b / 2-d / 3-b / 4-c

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Chapter 20 director conflicts

5. DGCL 144:

Simply prevents automatic voidability of DCIT

Requires fairness showing even if board/Shs approve

Applies BJR if defendant shows proper board approval

6. When Benihana Inc raised capital from director, Del Sup Ct said DGCL 144:

Did not apply because director did not explain his role

Did not apply because court must determine fairness

Provided safe harbor since “qualified” directors OK’d deal

  • 7. Under DGCL 144:

    • BJR applies if DCIT approved by informed directors

    • BJR applies if DCIT approved by disinterested directors

    • BJR applies if DCIT approved by independent directors

  • 8 . MBCA Subchapter F:

    • Covers all situations of DCIT

    • Ensures judicial review of DCIT under fairness standard

    • Creates BJR safe harbor, beyond judicial scrutiny

1–c / 2-c / 3-abc / 4-a

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Director Conflicts


Board cleansing

Board “cleansing”

When are directors –

disinterested?

independent?

Effect of such approval

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Director Conflicts


Contexts disinterested and independent director

Contexts“Disinterested” and “independent” director

Board reviews

DCIT

(Cullman v. Orman)

SLC reviews

Sh lawsuit

(Oracle Corp)

Board reviews

Sh demand(Disney I)

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Director Conflicts


What is disinterested and independent

What is “disinterested”and “independent”?

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Director Conflicts


Cleansing dcit

“Cleansing” DCIT

If a plaintiff alleging a duty of loyalty breach is unable to plead facts demonstrating that a majority of a board that approved the transaction in dispute was interested and/or lacked independence, the entire fairness standard of review is not applied and the Court respects the business judgment of the board.

Chancellor William Chandler(Delaware Chancery Court)

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Director Conflicts


Cleansing dcit1

“Cleansing” DCIT

Disinterested:

“… directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self- dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally."

Independent:

… a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.“ Plaintiff must show particularized facts manifesting 'a direction of corporate conduct in such a way as to comport with the wishes or interests of … persons doing the controlling.'

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Director Conflicts


Chapter 20 director conflicts

Apply to law professor …

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Director Conflicts


Is independence same in slc as demand cases

Is “independence” same in SLC as “demand” cases …

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Director Conflicts


Director independence in board demand case

“Allegations that Martha Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends” even when couple with Stewart’s 94% voting power, are insufficient without more, to rebut the presumption of independence.”

Martha Stewart

MS Living Omnimedia

Director independence in board-demand case:

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Director Conflicts


Supreme court distinguishes oracle

“Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife” -- above reproach.”

Delaware Supreme Court

Supreme Court distinguishes Oracle:

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Director Conflicts


Can directors be truly independent

Can directors be truly “independent”?

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Director Conflicts


Charles elson director delaware center corporate governance

Charles Elson Director – Delaware Center Corporate Governance

A solution …

Chapter 20

Director Conflicts


Shareholder ratification

Shareholder ratification

Shareholders ratification?

Effect of ratification?

“Waste” standard as safety valve?

Chapter 20

Director Conflicts


Lewis v vogelstein del ch 1997

Lewis v. Vogelstein (Del Ch 1997)

  • What are stock options?

    • Why grant to directors?

    • Why need shareholder ratification?

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Director Conflicts


Stock options

Stock options

“in money”

Expire

Grant

Exercise price

Vest

“out of money”

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Director Conflicts


Stock options1

Stock options

“in money”

Expire

Grant

Exercise price

Vest

Back-date

“out of money”

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Director Conflicts


Lewis v vogelstein del ch 19971

Lewis v. Vogelstein (Del Ch 1997)

Effect of informed ratification?

  • Complete defense

  • Shift burden to Pl to show waste

  • Shift burden to Pl to show unfairness

  • No effect

    Problems w/ ratification

  • Inability to negotiate – “take or leave”

  • Collective action problems

Chapter 20

Director Conflicts


Lewis v vogelstein del ch 19972

Lewis v. Vogelstein (Del Ch 1997)

What is “waste”?

  • “consideration so disproportionately small as to lie beyond range at which any reasonable person might be willing to trade”

  • “such a transfer is in effect a gift”

    Why not dismiss complaint?

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Director Conflicts


Safety valve review who wins argument allen or strine

“Safety valve” review …(who wins argument – Allen or Strine?)

Chapter 20

Director Conflicts


Harbor finance partners v huizenga del ch 1999

Harbor Finance Partners v. Huizenga (Del Ch 1999)

Shareholders

  • What was transaction?

    • Why interested?

    • Effect of ratification?

merger

Chapter 20

Director Conflicts


Harbor finance partners v huizenga del ch 19991

Harbor Finance Partners v. Huizenga (Del Ch 1999)

Waste

  • “I question utility of this equitable safety valve”

  • “presumes stockholders are, as a class, irrational and that they will rubber stamp outrageous transactions”

  • “the corporation is not personal property of the stockholders”

  • “If fully informed, uncoerced, independent stockholders approve, they have decided the tx is “fair exchange”

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Director Conflicts


Corporate opportunities

Corporate Opportunities

“Corporate opportunity”? The rule?

“Corporate expectancy” vs “line of business”?

“Rejection” vs “acquiescence”?

Disclosure necessary?

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Director Conflicts


Competing spheres

Entrepreneurship

Corporate expansion potential

Competing spheres

"Every corporation has the power to .... renounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in ... specified business opportunities ... that are presented to the corporation ... 

Fairness

Line of Business

Acquiescence

Expectations

(actual / inferred)

Rejection /

Renunciation

Contract

Contract /

Property

Inability to finance

Del GCL § 122(17)

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Director Conflicts


Approaches corporate opportunity

Traditional - Focus on corporation

“expectancy”

“line of business”

“ability to finance”

Balance - Focus on fiduciary

Rejection (implied)

Acquiescence

Procedure - ALI Principles

Different levels: directors vs. executive officers

Require presentation and disclosure

Formal rejection by disinterested directors, shareholders, court

Approaches – corporate opportunity

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Chapter 20 director conflicts

Farber v. Servan Land Co. (5th Cir 1981)

Servan Land owns a 180-acre golf course and country club. Third-party Farquhar offers to sell the corporation an abutting 160-acre tract. 

This idea is presented at the 1968 annual shareholders' meeting, but nothing happens. Then, within a year, Servan's principals (Serriani and Savin - majority shareholders and principal officers) buy the tract for themselves.

Four years later the country club and S&S sell the golf course and 160 acres as a $8.3 MM package: $5 MM to the club, $3.3 to S&S.

Scoundrels or entrepreneurs?

Issues?

Chapter 20

Director Conflicts


Farber v servan land co

Farber v. Servan Land Co.

What is the definition of "corporate opportunity"? 

  • what is the expectancy test? 

  • what is the line of business test? 

    Internal decision-making / notice and rejection? 

  • must the fiduciary have offered the opportunity to the corporation? 

  • what constitutes corporate rejection / ratification? 

  • is the corporation's financial ability to take the opportunity relevant? 

    Remedy:  what is "constructive trust"? 

  • how are profits computed? less net purchase price? 

  • causation defense: would corporation have realized same profits? 

By the way, “majoritarian” or “tailored”?

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Director Conflicts


Acquiescence hypothetical

Acquiescence - hypothetical

The Horns and Burgs are friends in Brooklyn. The Horns had invested in low-price real estate, and they urged the Burgs to "get their feet wet" too. A slumlord venture!

Lillian Burg became a one-third shareholder with Max and George Horn in Darand Realty, an incorporated landlord operating tenements in Brooklyn. Max and George run the business. When Lillian learns that Max and George bought 9 other tenements for themselves, she is upset. 

What are the arguments?

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Chapter 20 director conflicts

Second Circuit

... a person's involvement in more than one venture of the same kind may negate the obligation which might otherwise be implied to offer similar opportunities to any one of them, absent some contrary understanding.

Judge Hays (dissent):

... the Horns were under a fiduciary duty imposed by law not to take advantage for themselves of corporate opportunities, it is irrelevant that ... there was no agreement under which the Horns would ... offer every property they located to Darand.

Burg v. Horn (2d Cir 1967)

Aren’t fiduciary

duties mandatory?

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Director Conflicts


Ali principles

ALI Principles …

Chapter 20

Director Conflicts


Ali principles of corporate governance

ALI Principles of Corporate Governance 

“Corporate

Opportunity”?

§ 5.05 Taking of Corporate Opportunities by Directors SeniorExecutives

(a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless:

  • the director or senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity;

  • the corporate opportunity is rejected by the corporation; and

  • (A) the rejection of the opportunity is fair to the corporation; or (B) the rejection is authorized in advance following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, authorized in advance by a disinterested superior, in a manner that satisfies the standards of the business judgment rule; or (C) the rejection is authorized in advance or ratified following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets.

Fiduciary offers

to corporation

  • Corporation rejects

  • Judge: “fair”

  • Disinterested Ds

  • (subject BJR)

  • Disinterested Shs

  • (not waste)

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Ali principles of corporate governance1

ALI Principles of Corporate Governance 

Director or

Senior executive

(b) Definition of a Corporate Opportunity. For purposes of this Section, a corporate opportunity means:

(1) any opportunity to engage in a business activity of which a director or senior executive becomes aware, either:

(A) in connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or (B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or

(2) any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage.

  • Offeror expects

  • to corporation OR

  • Fiduciary expects

  • corporate interest

Senior executive

Fiduciary aware

closely related

to actual/expec business

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Chapter 20 director conflicts

  • 4.If fiduciary usurps corporate opportunity, the remedy is …

    • Damages for opportunity costs

    • Damages for revenues realized by fiduciary

    • Constructive trust as though corporation had taken opportunity

  • 5. If the parties in a CHC understand that the corporate managers have other outside interests …

    • COD is waived completely

    • COD is waived as to those interests

    • Cannot be waived because COD is mandatory

  • Under ALI Principles…

    • Corporate directors and officers have same COD duties

    • Any “corporate opportunity” must be disclosed to corporation

    • COD is defined as “expectation”

  • A corporate opportunity is one in which …

    • Corporate fiduciary deals with corporation unfairly

    • Corporate fiduciary deals with outside party on market terms

    • Corporate fiduciary deals with outside party unfairly

  • A business opportunity is a “corporate opportunity” when …

    • Corporation has resources to take opportunity

    • Corporation has made plans to take opportunity

    • Corporate insider learns of it through corporation

  • Corporate opportunities …

    • Must be offered to corporation

    • Can be taken by fiduciary if disclosed to corporation

    • Can be taken by fiduciary if corporation rejects

Answers: 1-b / 2-b / 3-c / 4-c / 5-b / 6-b

Chapter 29

Planning in CHC


The end

The end

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Director Conflicts


Disney i

Disney I

Shareholders of The Walt Disney Company claim that executive compensation package to Michael Ovitz was “waste.”

Ovitz received stock options and severance payments totaling $140 million – after 14 months of inept service.

What must a shareholder do to bring a derivative suit in Delaware?

The Michaels

(in better days)

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Director Conflicts


Demand requirement

Demand Requirement

Shareholders

Shareholder

Plaintiff

  • Demand requirement. “To proceed with their derivative claims, Plaintiffs must set forth in their complaint particularized facts that create a reasonable doubt that

  • a majority of the members of Disney's board of directors are disinterested and independent or

  • the challenged transaction was otherwise the product of a valid exercise of business judgment.”

Pre-suit

demand

Board of

directors

Corporation

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Chapter 20 director conflicts

Chapter 20

Director Conflicts


Entire fairness

Entire Fairness

The concept of fairness has two basic aspects: fair dealing and fair price. Weinberger v. UOP (Del 1983)

Fair Dealing:

  • when the transaction was timed

  • how it was initiated, structured, negotiated, disclosed to the directors

  • how the approvals of the directors and the stockholders were obtained

    Fair Price:

  • relates to the economic and financial considerations of the proposed merger

  • 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....

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Director Conflicts


Oracle derivative litigation

Oracle Derivative Litigation

Oracle shareholders brought a derivative suit claiming company insiders knew December 2001 earnings would fall short of expectations, so they sold their stock – insider trading.

The Oracle board constituted a “special litigation committee” composed of two eminent Stanford professors. The SLC said the suit should be dismissed.

Corporations:

A Contemporary Approach

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Slide 53

of 67


Legal standard

Legal standard

“The SLC must convince me that

Its members were independent

They acted in good faith

They had reasonable bases for their recommendations

“If the SLC meets this burden, I can grant its motion or in my judicial “business judgment” allow the suit to proceed.”

Vice Chancellor

Leo Strine

Corporations:

A Contemporary Approach

Chapter 20

Director Conflicts

Slide 54

of 67


The slc

The SLC

Investigation

SLC counsel interviewed 70 witnesses

Interviews included defendants and Oracle senior management

Reviewed email messages

Interviewed witnesses identified by plaintiffs

Deliberations

SLC members met with counsel 35 times for 80 hours

Report

1,110 pages – concluded should not sue Oracle officials accused of insider trading

Special Litigation Committee

All outside directors

None on board at time of insider trading

All waived their SLC fees

None does any business with Oracle

Hired SLC advisors – none does business with Oracle

Corporations:

A Contemporary Approach

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Director Conflicts

Slide 55

of 67


Independent

Independent?

Joe Grundfest

Tenured, chaired law professor at Stanford

Senior fellow Stanford Institute for Economic Policy Research

Not fundraiser

Corporations:

A Contemporary Approach

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Slide 56

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Structure

“Structure”

Insider

traders

Ellison

Grundfest

Special

litigation

committee

Lucas

Garcia-Molina

Boskin

Stanford University

Stanford Institute

for Economic

Policy Research

Corporations:

A Contemporary Approach

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Director Conflicts

Slide 57

of 67


Structural bias

“Structural bias”

“Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement. Homo sapiens are not merely homo economicus.”

Vice Chancellor Leo Strine

Corporations:

A Contemporary Approach

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Chapter 20 director conflicts

Vice Chancellor Strine:

“… a person in Grundfest’s position [with respect to colleague and former professor] would find it difficult to assess Boskin’s conduct without pondering his own association with Boskin and their mutual affiliations.”

Corporations:

A Contemporary Approach

Chapter 20

Director Conflicts

Slide 59

of 67


Effect of ratification

Effect of ratification

Shareholder ratification

Yes

No effect – Defendant

must prove fairness

Coerced?

No

No

Informed?

Plaintiff must

prove unfairness

(squeeze-outs)

Yes

Yes

Yes

Majority interested?

Plaintiff must

prove “waste”

(executive pay)

OR

Majority of minority?

Yes

OR

No review –

complete validity

Yes

Unanimous?

Corporations:

A Contemporary Approach

Chapter 20

Director Conflicts

Slide 60

of 67


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