- Dual Directorship: The Perils of Serving Two Masters
- July 30, 2003 | Author: James E. Berchtold
- Law Firm: Lewis and Roca LLP - Las Vegas Office
Most attorneys would be overjoyed with a client who cultivates numerous and varied business interests and, indeed, would likely encourage the client's endeavors. What could be better, for example, than a client who serves as a director on the boards of directors of multiple corporations?
As the number and variety of a client's business interests increase, so too do the complexity of the legal duties and obligations the client owes to those with whom he does business -- along with the likelihood that the client may find himself in a situation where his business interests and duties collide. If you have a client that serves on multiple boards of directors, you should take steps to prepare your client for such potential conflict situations. A client who is forewarned and educated in identifying potential conflicts is also forearmed.
This article analyzes the issues that could arise because of an individual sitting on the boards of directors of multiple corporations. It describes the fiduciary obligations owed by the director, analyzes how those obligations might be impacted by the director's dual directorship, describes potential conflicts, and offers suggestions for avoiding claims of conflict of interest and breach of fiduciary duty.
No Inherent Conflict of Interest or Breach of Duty.
Dual directorship alone does not constitute a breach of fiduciary duty or present a conflict of interest. As stated by one court, "[i]t is only when a business opportunity arises which places the director in a position of servicing two masters, and when, dominated by one, he neglects his duty to the other, that a wrong has been done." 1
However, a director in two corporations -- especially two corporations whose interests could potentially conflict -- must be conscious of his fiduciary obligations to both corporations and to potential conflict situations.
The Duties of Care and Loyalty
Should a director accept directorships in two corporations, he will stand in a fiduciary relationship with both and owe them identical duties of care and loyalty.
The duty of care requires that a director "exercise the care that a reasonably prudent person in a similar position would use under similar circumstances."2 Compliance with the duty of care requires that a director will, for example, regularly attend board meetings, place important matters on the agenda, and obtain sufficient information to keep informed. The duty of care is qualified by the "business judgment rule," which protects the director from personal liability so long as the director acted in good faith, was reasonably informed, and reasonably believed his action was in the corporation's best interests.3
The duty of loyalty requires a director to act in the interests of the corporation and not in his own interest or those of another.4 In other words, a director cannot use his position to further his own or a third party's interests and must exert all reasonable efforts to ensure the corporation is not deprived of an opportunity. Generally, the business judgment rule will not insulate the director where there is a breach of the duty of loyalty.5
A Dual Director Must be Vigilant for Potential Conflict Situations
A dual director must be vigilant for and adept at identifying potential conflict situations. When such conflict situations arise, the director must be sensitive to the duties of care and loyalty he owes to both corporations and unwavering in his adherence to those obligations. The following are examples of frequently litigated conflict situations:
Competition with the Corporation
One conflict situation a dual director could face is the possibility that one corporation will find itself in direct competition with the other. Generally, a director is not precluded from engaging in a business similar to that carried on by his corporation.6 If a director chooses to compete with his corporation, he must act in good faith and breach no independent duty owing to the corporation.
To illustrate, in Tovrea Land & Cattle Co. v. Linsenmeyer7, a group of minority shareholders in a feed operation brought suit against the corporation and certain directors, claiming that the directors had breached their duty of loyalty by raising cattle in competition with the corporation. On appeal, the court noted, "the essential inquiry of the 'business competition' doctrine is good faith. Good faith will insulate the directors or officers from liability unless the rival business is actually and demonstrably detrimental to the corporation."8 The court concluded that the directors had acted in good faith by conducting their businesses openly and with full knowledge of the directors and stockholders.
In contrast, in Red Top Cab Co. v. Hanchett9, Red Top Cab sued its former president who, while associated with Red Top Cab, had organized and operated a competing cab company, Green Top Cabs. In doing so, the president had recruited drivers from Red Top Cab and used Red Top Cab's garage and shops to store and service the Green Top cabs. In addressing the president's actions, the district court reiterated that directors are not precluded from competing with the corporation. It noted, however, "directors or officers entering into such competing enterprises must act in good faith and may not cripple or injure the corporation which they serve."10 The court concluded that the president, in organizing Green Top Cabs, knowingly crippled and injured Red Top Cab, depriving it of selected personnel and using its facilities in the launching of his own project.
As demonstrated by these cases, a director who is competing against his corporation must act in good faith and refrain from injuring the corporation. The director should fully disclose his relationship with both corporations, the nature of their businesses, and any specific project in which both corporations may be interested.
The general rule is that a director may not appropriate an opportunity belonging to the corporation.11 A corporate opportunity exists when a proposed activity is reasonably incidental to the corporation's business and is one in which the corporation has the capacity to engage.12 The duty of loyalty may require that a director make a business opportunity available to the corporation before the director may pursue the opportunity for himself or another. 13
The seminal case involving the usurpation of a corporate opportunity is the Delaware case of Guth v. Loft, Inc. 14 In Guth, the Loft Corporation sued one of its officers, Guth, after learning that Guth had acquired a corporate opportunity for himself and another corporation in which he was involved. Guth allegedly positioned the other corporation to obtain a contract to supply syrup to Pepsi, although Loft was in the same business and should have been afforded the opportunity of securing the Pepsi contract. The Court found in favor of Loft and ordered Guth and the other corporation to transfer shares of Loft; pay Loft dividends, profits, and gains attributable to the Pepsi arrangement; and pay Loft all salary paid to Guth.
The corporate opportunity doctrine under Guth and its progeny holds that a director may not take an opportunity for himself if: (1) the corporation is financially able to exploit the opportunity; (2) the opportunity is within the corporation's line of business; (3) the corporation has an interest or expectancy in the opportunity; and (4) by taking the opportunity, the director is placed in a position inimical to his duties to the corporation.
Conversely, a director may take a corporate opportunity if: (1) the opportunity is presented to the director in his individual capacity; (2) the opportunity is not essential to the corporation; (3) the corporation holds no interest or expectancy in the opportunity; and (4) the director has not wrongfully employed the corporation's resources to pursue the opportunity.15
How a court might analyze the Guth factors can be seen in the Delaware case of Johnston v. Greene.16 In Johnston, the defendant director was president of Airfleets, Inc., a company in the business of financing aircraft, and also president of Atlas Corporation, an investment company that became Airfleets' largest stockholder. The director was presented with an opportunity to buy a business that manufactured self-locking nuts and the business' patents. After deciding the deal was not suitable for Atlas, the director thought the deal might fit Airfleets. Airfleets' board considered the deal and decided to buy the company's stock, but not the patents. The director then purchased the patents and Airfleets sued the director for usurpation of a corporate opportunity. Analyzing the Guth factors, the court first noted that the opportunity had been presented to the director in his individual capacity and not as a director of Airfleets. Second the nature of the opportunity -- the manufacture of self-locking nuts -- was not related to Airfleets' business. Third, Airfleets had no expectancy interest in the opportunity because there was no tie between Airfleets and the self-locking nut business. The court, therefore, concluded that the opportunity was not one properly belonging to Airfleets, stating that "[t]here is nothing inherently wrong in a man of large business and financial interests serving as a director of two or more investment companies, and both Airfleets and Atlas . . . must reasonably have expected that [the director] would be free either to offer to any of his companies any business opportunity that came to him personally, or to retain it for himself -- provided always that there was no tie between any of such companies and the new venture or any specific duty resting upon him with respect to it." 17
In sum, a dual director must tread lightly when presented with an opportunity that could belong to another and should use the Guth factors as a guide. If he believes a contemplated transaction might be a corporate opportunity, he should make full disclosure to the board and seek its authorization to pursue the opportunity on behalf of himself or another corporation.
Confidential or Inside Information
A dual director is obligated to keep all information learned in his capacity as a director in the strictest confidence. In determining whether information is confidential, the following factors are likely to be relevant: (1) whether the protected matter is generally known or readily ascertainable; (2) whether it provides demonstrable competitive advantage; (3) whether it was gained at expense to the corporation; and (4) whether it is such that the corporation intended to keep it confidential.18
If a director acquires and personally benefits from confidential information to the detriment of the corporation, he may be enjoined and may be required to account to the corporation for all profits derived from the information.19 The corporation may also obtain injunctive relief against the abuse or misuse of such information by a third person.20
Thus, a dual director must keep all information regarding both corporations confidential, regardless of whether he learns of the information in his capacity as director and regardless of whether the information is specifically deemed confidential.
Common Director Transactions
Another potential conflict situation could arise if the two corporations that the director serves enter into a contract or other business transaction. Such a situation is termed a "common director" transaction.
Common director transactions are specifically addressed in section 78.140 of the Nevada Revised Statutes. Section 78.140(1) provides that a contract or transaction is not void or voidable solely because an individual is a director on the boards of both corporations, because he was present at the board meeting at which the board authorized the contract, because he joined in a written consent to the contract, or because his vote was counted in authorizing the contract or transaction.
Section 78.140(2) lists four circumstances in which the exemptions contained in 78.140(1) apply. If any of the four circumstances are present, the contract or transaction in question will not be void or voidable. First, the transaction will not be void or voidable where the board knows the common directorship or financial interest of a director and the board approves or ratifies the contract in good faith, excluding the vote of the common or interested director.
Second, the transaction will not be void or voidable where the stockholders know the common directorship or financial interest of the director and they approve or ratify the contract in good faith by a majority vote, including the votes of the common or interested director. Third, the transaction will not be void or voidable where the director, himself, is unaware of the common directorship or financial interest at the time the contract is brought before the board. And fourth, a contract or transaction will not be void or voidable if it is fair to the corporation at the time it is authorized or approved.
The Nevada Supreme Court has indicated that the hallmark of a valid common director transaction is fairness. In Schoff v. Clough,21 the Supreme Court affirmed a lower court's ruling that a director's sale of a mining claim to the corporation for $18,000 was fair. The plaintiff alleged that the claim was worth little or nothing and the action of the corporation's board of directors in authorizing the purchase was not in the best interests of the corporation. The court reasoned, however, that the seller, who was also a director, and the corporation, had determined that the purchase price was fair and reasonable, and the fact that the director would make a profit on the deal was immaterial to the analysis.
Similarly, in Drobbin v. Nicolet Instrument Corp.,22 the Federal District Court for the District of Nevada noted that, under the various circumstances listed in section 78.140, the presence of interested directors on the board does not render a transaction void or voidable. The court stated that once a prima facie showing is made that directors have a self-interest, the burden shifts to them to demonstrate that the transaction is fair to the corporation and its shareholders. The court noted that an inquiry into "fairness" has two basic aspects: fair dealing (which relates to how the transaction was timed, initiated, structured, negotiated, disclosed, and approved) and fair price (which relates to economic and financial considerations). "However, all aspects of the issue must be examined as a whole since the question is one of entire fairness."23
In sum, should a situation arise in which two corporations are contemplated entering into a contract or transaction, an interested director's conduct should be structured according to the requirements of section 78.140. He should ensure that both corporations are aware of his interest in the transaction, that the transaction is fair, and that the corporations are provided with all material information relating to the transaction. The interested director should also obtain either board or stockholder ratification to insulate himself from liability.
As stated above, there is no general prohibition against a director serving on the boards of two different corporations. Dual directorship, in and of itself, is not improper. It is improper, however, for a director to fail in his fiduciary duties to a corporation or to act in his own self-interest or for the interests of another so as to harm the corporation. Thus, the director will need to be vigilant for situations in which his, or one corporation's interests, could potentially come into conflict with the interests of the other corporation.
If the director suspects a potential conflict, he should take the steps outlined above and consult his counsel. Further, until the potential conflict situation is thoroughly examined and analyzed, he should fully disclose to both corporations his suspicions regarding the potential conflict, excuse himself from any board meeting at which that particular topic is addressed, and refrain from voting in regard to that topic. He should also ensure that these steps are recorded in the meeting minutes.
1Singer v. Carlisle,26 N.Y.S.2d 172, 182 (N.Y. 1940).
2 Horwitz v. Southwest Forest Indus., Inc., 604 F. Supp. 1130, 1134; see generally 3A William A. Fletcher, Fletcher Cyclopedia of the Laws of Private Corporations §§ 1029-1035.80 (1994).
3Horwitz, 604 F. Supp. at 1134, Committee on Corporate Laws, American Bar Association, Corporate Director's Guidebook 11-12 (2d ed. 1994) [hereinafter Corporate Director's Guidebook]; 3A Fletcher, supra note 2, § 1036, see also Nev. Rev. Stat. § 78.138.
4Nev. Rev. Stat. § 78.138(1); Horwitz, 604 F. Supp. at 1134; In re Sea-Land Corp. Shareholders Lit., 642 A.2d 792 (Del. Ch. 1993).
5Revlon, Inc. v. Mac Andrews & Forbes Holdings, Inc., 506 A.2d 173, 180 (Del. 1986).
6Craig v. Graphic Arts Studio, Inc., 166 A.2d 444, 445 (Del. Ch. 1960).
7412 P.2d 47, 57 (Ariz. 1966).
8Id. at 57.
948 F.2d 236 (N.D. Cal. 1931).
10Id. at 238.
111 R. Franklin Balotti & Jesse A. Finkelstein, The Delaware Law of Corporations & Business Organizations § 4.10, 4-263 to ¿246.1 (1997).
123 Fletcher, supra note 2, § 861.10, at 284.
13Corporate Director's Guidebook, supra note 3, at 13.
145 A.2d 503 (Del. 1939).
15Id. at 155; Equity Corp. v. Milton, 221 A.2d 494, 497 (Del. 1966).
16121 A.2d 919 (Del. Ch. 1956).
17Id. at 924.
18Davis v. Eagle Products, Inc., 501 N.E.2d 1099, 1103 (Ind. Ct. App. 1986). Confidential information may also be considered a "trade secret" and protected under Chapter 600A of the Nevada Revised Statutes.
19Videotronics, Inc. v. Bend Electronics, 564 F.Supp. 1471, 1475-76 (D. Nev. 1983); Diamond v. Oreamuno, 248 N.E.2d 910, 912 (N.Y. Ct. App. 1969).
20Bancroft-Witney Co. v. Glen,411 P.2d 921 (Cal. 1966).
21380 P.2d 464 (Nev. 1963).
22631 F. Supp. 860 (D. Nev. 1986).
23Id. (quoting Weinberger, 457 A.2d at 711).