In 2017, shareholders of Tesla Motors sued Tesla’s CEO, Elon Musk, and its directors, claiming that the company, at Musk’s urging and under his influence, engaged in a conflict of interest transaction when it purchased SolarCity, a corporation owned by Musk and his family. That litigation reflected the substantial concerns that shareholders have when their corporations undertake business transactions directly with their directors, officers, or principal shareholders or with companies that management personnel own or control.

Conflict of interest transactions occur frequently in both small and large corporations. They can range from somewhat innocent transactions such as loans to corporations that need capital to more questionable transactions involving compensation, retirement payments, stock issuances, or, as in the Tesla case, companies in which management has material financial interests. All conflict of interest transactions, large or small, are subject to fiduciary duty evaluation, in particular the duty of undivided loyalty owed to the corporation by all directors and officers. Because of the sensitivity of conflict transactions, and their potential for abuse, there is a long history of litigation by shareholders challenging either the fairness of transactions or the process by which they were approved.

Evolution of Conflict of Interest Standards

In the early days of corporate law, courts upheld all shareholder challenges to conflict of interest transactions, regardless of purpose or result. The theory was that corporate managers were equivalent to trustees charged with the preservation of corporate assets and could not use those trust assets for their own benefit. The strict judicial attitude relaxed as courts recognized that in some circumstances companies could benefit from help from those who are closest to it. The judicial standard for validating conflict of interest transactions moved from void ab initio to voidable if the transaction was not fair and reasonable to the corporation. At the same time, states began adopting corporate statutes intended to negate the strict judicial attitude and allow for conflict of interest transactions under limited, specified conditions.

Statutory Variations

There are two principal statutory variations among states with regard to conflict of interest transactions. Approximately half the states have statutes similar to Delaware’s, which provides that a transaction is not void or voidable because of a conflict if:

(1) there is full disclosure to and approval by a majority of disinterested members of the board of directors,

(2) there is full disclosure to and approval by a majority of disinterested shareholders, or

(3)  the transaction is fair to the corporation.

The enigmatic use of the word “or” before the third condition raises an interpretive question whether board or shareholder approval ipso facto validates a conflict transaction and precludes the historical ability of shareholders to challenge the transaction based on fairness. Delaware courts have held that the conflict provisions do not preclude the right of a shareholder to bring a fairness challenge, but such shareholders have the burden of proof regarding fairness if there had been board or shareholder approval. Case law in other states with similar statutes has substantially followed the Delaware approach.

The second principal statutory model is found in the Model Business Corporation Act (“MBCA”) created by the Corporate Law Committee of the American Bar Association. Approximately 23 states have adopted the MBCA conflict of interest provisions or a close variation thereof. The MBCA provisions retain validating conditions similar to the three in Delaware’s statute, including the enigmatic “or” prior to the third condition regarding fairness to the corporation. However, the lead-in language to those conditions (“may not be enjoined, set aside, or give rise to an award of damages or other sanctions, in a proceeding by a shareholder…”) is an effort to chill judicial challenge. Unlike the interpretation given to the Delaware statute, the MBCA drafters wanted to foreclose the possibility of a shareholder challenge based solely on the fairness of the transaction if the transaction had received the requisite board or shareholder approval. The MBCA drafters were motivated by a desire to bring certainty and finality to board decisions, noting in their official commentary that “while conflicting interests surely carry potential danger, other important social values, such as economic efficiency, predictability, and business finality, are also at stake and should be accorded heavy countering weight in the law.”  Although the drafters intended a bright-line test that would preclude shareholder fairness challenges, the commentary acknowledged that a conflict transaction might be “vulnerable to attack on some other ground,” giving as an example a transaction that lacked any benefit to the corporation and was therefore a dereliction of the board’s duty of care. The MBCA’s “on the one hand, on the other hand” commentary raises significant interpretive questions as to whether in fact the MBCA provisions should be interpreted to exclude shareholder fairness challenges.

Principal Interpretive Issues

Despite statutes and numerous lawsuits challenging conflict transactions, there remains much uncertainty as to basic principles. The rise of limited liability companies has only exacerbated those issues, as LLC statutes and the substantial leeway given to the content of operating agreements leave open many questions as to requirements and standards. For both corporations and LLCs, two fundamental questions exist:

(1) As a prerequisite to a valid conflict transaction, is the conflicted director or officer required to disclose to and obtain advance approval from the board or other governing authority? In other words, can directors, officers, or LLC managers choose to undertake conflict transactions without prior disclosure and approval, subject only to a concern that, if challenged, they must prove the transaction’s fairness?

(2) If advance board, shareholder, or member approval is in fact obtained, does that preclude a shareholder or member challenge to the transaction based on an alleged lack of fairness to the company?

The manner in which most statutes are written, with the three validating conditions set forth as alternatives, has led to a common assumption that a conflict transaction need not be brought to the attention of the board in advance, allowing the conflicted party to avoid advance disclosure and defend a challenged transaction (if one is in fact brought, which may not occur given the substantial litigation hurdles of derivative actions) on the grounds that although there was no approval the transaction is nevertheless fair to the company. This assumption is contrary to principles of good governance and fundamental fiduciary obligations. Every corporate statute centers the principal governing authority in the board. It is contrary to both statutory norms and fiduciary duties of care and loyalty to suppose that a director or officer can unilaterally choose to undertake a conflict transaction without notice to and approval by the board. There may be compelling circumstances in which transactions must be undertaken immediately without board or shareholder approval, but in the absence of such circumstances conflicted parties should not be allowed to obtain benefits from transactions that were not disclosed to and approved by the appropriate governing bodies. The enigmatic “or” in the statutory provisions should be interpreted to allow for avoidance of board or shareholder approval only in circumstances where immediate action was necessary and approval could not be obtained in a timely manner.

The second principal issue regards whether shareholders can challenge conflict transactions on fairness grounds regardless of prior board or shareholder approval. That right appears to be firmly accepted in most states that follow the Delaware model. The drafters of the MBCA, however, sought finality to board or shareholder actions, and therefore shareholder fairness challenges appear to be in jeopardy in states that have adopted the MBCA version. However, despite the stated intent of the drafters, the combination of (i) a close analysis of the MBCA statutory provisions, (ii) the somewhat open-ended MBCA commentary acknowledging the possibility of challenge, and (iii) well-established traditional corporate principles argue in favor of retaining shareholder rights to challenge conflict transactions on fairness grounds, even where board or shareholder approval was obtained.

Ultimately, courts will interpret the statutory conflict of interest provisions and apply them in the context of challenged transactions. As in other areas of fiduciary duties, courts have enormous leeway in fashioning standards and remedies. It is hoped that courts will preserve the high standards of fiduciary duties of disclosure and fairness and will interpret statutory provisions in accordance with long-standing good corporate governance principles. Those standards and principles argue in favor of mandating advance disclosure to and approval by the company’s governing authority and the preservation of fairness challenges to conflict transaction by shareholders and members, regardless of formal approvals.

This post comes to us from Stuart R. Cohn, emeritus professor at the University of Florida’s Levin College of Law. It is based on his recent article, “The Shifting Sands of Conflict of Interest Standards: The Duty of Loyalty Meets the Real World with Questions of Process and Fairness,” available here.