Directors, Conflicts of Interest and Fiduciary Duties
February 24, 2015
How safe are directors, under “safe harbor laws”–really?
What happens when minority shareholders bring a derivative action against some of a corporation’s directors for breach of fiduciary duty and conflict of interest, alleging that a Marketing Service Agreement approved by the corporation’s board of directors siphoned off a significant portion of the corporation’s revenues to another entity in which the defendant directors had an interest? That was the issue in McRedmond v. Marianelli, a case heard by the Court of Appeals of Tennessee in the year 2000. McRedmond v. Marianelli, 46 S.W.3d 730 (Tenn.Ct.App. 2000).
In McRedmond, the Court held that the evidence presented established ratification of the Marketing Service Agreement by disinterested directors, under the safe harbor provision of the conflict of interest statute, KY.Rev.Stat. § 271B.8-310, a Kentucky law, because Elk Brand is a corporation organized under the laws of the Commonwealth of Kentucky and its internal corporate affairs are governed by Kentucky law. The conflict of interest statute reads, in relevant part:
(1) A conflict of interest transaction shall be a transaction with the corporation in which a director of the corporation has a direct or indirect interest. A conflict of interest transaction shall not be voidable by the corporation solely because of the director’s interest in the transaction if any one of the following is true:
(a) The material facts of the transaction and the director’s interest were disclosed or known to the board of directors or a committee of the board of directors and the board of directors or committee authorized, approved, or ratified the transaction;
(b) The material facts of the transaction and the director’s interest were disclosed or known to the shareholders entitled to vote and they authorized, approved, or ratified the transaction; or
(c) The transaction was fair to the corporation.
(2) For purposes of this section, a director of the corporation shall have an indirect interest in a transaction if:
(a) Another entity in which he has a material financial interest or in which he is a general partner is a party to the transaction; or
(b) Another entity of which he is a director, officer, or trustee is a party to the transaction and the transaction or should be considered by the board of directors of the corporation.
(3) For purposes of subsection (1)(a) of this section, a conflict of interest transaction shall be considered authorized, approved, or ratified if it receives the affirmative vote of a majority of the directors on the board of directors (or *736 on the committee) who have no direct or indirect interest in the transaction, but a transaction shall not be authorized, approved, or ratified under this section by a single director. If a majority of the directors who have no direct or indirect interest in the transaction vote to authorize, approve, or ratify the transaction, a quorum shall be present for the purpose of taking action under this section. The presence of or a vote cast by, a director with a direct or indirect interest in the transaction shall not affect the validity of any action taken under subsection (1)(a) of this section if the transaction is otherwise authorized, approved, or ratified as provided in that subsection.
Under section (2) of that statute, the defendant’s, Walter Marianelli’s, interest in the transaction was held to have met the definition of an indirect conflict of interest under section (2) of the statute. However, the transaction was held to be not voidable if at least two directors did not have an interest in the transaction, and were fully informed of the material facts of the transaction and of Walter Marianelli’s interest in it, before voting for it. KY.Rev.Stat. § 271B.8–310 (3).
Tennessee’s courts have consistently followed non-interventionist policies in regard to internal corporate matters. McRedmond. See also Lewis v. Boyd, 838 S.W.2d 215, 220 (Tenn.Ct.App.1992). They have also held to “the general principle that the business and affairs of a corporation are to be managed by its directors.” Aronson v. Lewis, 473 A.2d 805, 812 (Del.Supr.1984). McRedmond. The Court, therefore, was unwilling to accept the Plaintiffs’ argument that the disinterested directors who voted to ratify the Marketing Service Agreement (“M.S.A.”) had such close personal relationships with Walter Marianelli that said relationships constituted a conflict of interest. The Court said, “We believe that if the ties of friendship or a long history of voting the same way were sufficient to constitute a conflict of interest , the actions of a great many corporate directors would likely fall under attack.” McRedmond.
Nevertheless, the Court held that, though “the trial judge disposed of the issue of the fiduciary duty by concluding that the M.S.A. was ‘fair.’ Her conclusion was based on a factual finding that Elk Brand survived and profited from the MSA.”
The Court disagreed, believing “the facts [fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][were] in dispute on that issue. Although Elk Brand faced an uncertain future in 1989,” the Court said, in its opinion, “we think a finder of fact could conclude that it could have survived even without the benefit of the M.S.A. with Milano, and that the profits transferred to Milano, with little investment on its part, could have accrued to Elk Brand.”
Under Tennessee law, directors and officers of a corporation are fiduciaries to the corporation and its shareholders, and must act in good faith and remain loyal to the corporation and its shareholders. May v. National Bank of Commerce, 2004, 387 F.Supp.2d 770. When directors of a corporation have the means of knowledge, ignorance will not excuse them for allowing the funds thereof to be diverted from the purposes of the trust, and they are individually responsible therefor. Shea v. Mabry, 1878, 69 Tenn. 319. In action for damages by or on behalf of corporation against its officers and directors who are found to be liable for their collective breach of fiduciary duty, negligence, or breach of contract, liability of officers and directors to corporation is joint and several, not proportional to fault. Resolution Trust Corp. v. Block, 1996, 924 S.W.2d 354.
So, what is the take-away message from this discussion? If you are the officer of a corporation, do not trust in the protections of “safe harbor provisions” of your state’s conflict of interest statutes, because they will not protect you from violations of your fiduciary duty, which may arise out of circumstances which constitute one or more conflicts of interest. Shareholders want to get paid their due dividends, and even Courts that prefer not to meddle in the internal governance of corporations cannot always refrain from doing so, if the directors of the corporation do not uphold their fiduciary duties to the corporation they are supposed to serve.
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