The Duty of Loyalty

This chapter begins our exploration of fiduciary duties. As previously mentioned, fiduciary duties originate in equity and comprise the duty of loyalty and the duty of care. This chapter focuses on the duty of loyalty; Chapter 5 considers the duty of care.

Both duties apply equally to directors and officers (Gantler v. Stephens, Del. 2009). Controlling stockholders are subject to fiduciary duties as well and generate some of the most important duty-of-loyalty cases (cf. Sinclair in this section and Weinberger and MFW in the M&A part of the course).

As a first approximation, the duties of care and loyalty target what their names imply: the duty of care demands that the fiduciary act with appropriate care, while the duty of loyalty demands that the fiduciary act loyally, i.e., guided by the interests of the principal. In other words, the former addresses simple mistakes, while the latter addresses conflicts of interest, i.e., self-dealing. Delaware courts vigilantly police self-dealing but are unreceptive to claims of honest mistakes.

(Minority) Shareholders' interests are most at risk in transactions between the corporation and its controllers, be it management or large shareholders. The risk is obvious: the controllers may attempt to extract more than their agreed share* of the corporation’s value for themselves, at the expense of (minority) shareholders.**

Some (not so) fictitious examples

Here are three typical ways controlling shareholders do it. We will illustrate using a fictitious oil company, OilCo, with a controlling stockholder, Mikhail. Mikhail owns 50% of OilCo, and 100% of another fictitious company, Honeypot.

1. The first thing Mikhail can do is to have OilCo sell its oil to Honeypot at below-market prices. For example, if the market price of oil is $16 per barrel, Mikhail might arrange for OilCo to sell its oil to Honeypot for $10. For every barrel of oil, this redistributes $3 from minority shareholders to Mikhail. Why? Because if OilCo had sold its oil on the market instead, it would have received $16 per barrel. These $16 would have been shared equally between Mikhail and the minority shareholders. Each would have received $8. But when OilCo instead sells to Honeypot for $10 per barrel, minority shareholders get only $5 (half of $10). The difference of $3 is captured by Mikhail: per barrel of oil, he gets $5 as a shareholder of OilCo and $6 as the sole shareholder of Honeypot (because Honeypot buys for $10 and sells for $16, generating a $6 profit), or a total of $11. The use of artificially inflated or deflated prices to shift value from one company to another is called a transfer pricing scheme. It is also used for tax avoidance purposes.

2. Mikhail can also have OilCo issue new shares to himself or to Honeypot at low prices. For example, imagine that OilCo owns oil fields worth $100 m(illion), and that OilCo has one million shares outstanding. That means each share is worth $100 (assuming no transfer pricing scheme), and Mikhail’s 50% stake and the 50% minority shares as a group each comprise 500,000 shares worth $50 million in total. Mikhail now has OilCo issue 100 million shares to himself at $0.01 per share for an overall price of $1 million. This means three things. First, OilCo is now worth $101 million: In addition to the $100 million oil field, it now has the $1 million cash that Mikhail put in for the new shares. Second, Mikhail now owns almost the entire company, owning 100.5 million out of 101 million shares (99.5%). Third, the transaction earned him $49.5 million: Before the transaction, Mikhail owned OilCo shares worth $50m (50% × $100m). After buying the new shares, Mikhail now owns shares worth $100.5m (99.5% × $101m). Thus, Mikhail spent $1m to increase his OilCo holding by $50.5m ($100.5m – $50m), generating a pure profit of $49.5m ($50.5m – $1m). Mikhail’s gain is the minority shareholders’ loss: they lost $49.5 million in this dilution of their share.

3. Finally, Mikhail can also dispense with the minority altogether by selling OilCo’s assets to Honeypot for a low price. To wit, he could have OilCo sell its oil fields to Honeypot for less than their $100 million value. This is another transfer pricing scheme, but executed on OilCo’s productive assets rather than its products, and hence also known as asset stripping. As with other transfer pricing schemes, it can also be done in reverse: Mikhail could have OilCo buy an asset from Honeypot at an inflated price.

None of these schemes is fictitious at all. For example, they are stylized versions of what Mikhail Khodorkovsky and all the other Russian oligarchs are said to have done to the oil companies they came to control in Russia in the 1990s. Russian corporate law erected barriers to such self-dealing. But corrupt, scared, or just plain incompetent courts breached those barriers. It is a vivid illustration of the importance of the general “legal infrastructure” for the enforcement of corporate law. See generally Bernard Black, Reinier Kraakman, & Anna Tarassova, Russian Privatization and Corporate Governance: What Went Wrong?, 52 STAN. L. REV. 1731 (2000).

The U.S. approach

Now back to the U.S., where we nowadays take a functioning “legal infrastructure” for granted. What protections does it offer against minority expropriation?

First, public corporations are prohibited from making loans to its directors or officers (section 13(k) of the Exchange Act, as amended by section 402 of the Sarbanes-Oxley Act of 2002). More importantly (because loans are only one form of self-dealing among many), public corporations must disclose all self-dealing transactions in an amount above $120,000 in their annual report (item 404 of the SEC’s Regulation S-K). Managers or a controlling shareholder may choose to not comply with this rule, but only at the risk of becoming the target of an SEC enforcement action.

The only provision of the DGCL that explicitly addresses self-dealing is DGCL 144. On its face, DGCL 144 merely declares that transactions between the corporation and its officers and directors are not void or voidable solely because of the conflict of interest, provided the transaction fulfills one of the three conditions in subparagraphs (a)(1)-(3). This statutory text implies that transactions not fulfilling either of these conditions are automatically void or voidable. But the text leaves open the possibility that some conflicted transactions might be void or voidable even though they do fulfill one of the three conditions of DGCL144(a)(1)-(3).

Notwithstanding, Delaware courts do treat the three conditions as individually sufficient and jointly necessary for the permissibility of self-dealing by directors and officers. That is, self-dealing by officers and directors is beyond judicial reproach if and only if it has been approved in good faith by a majority of fully informed, disinterested directors or shareholders, or it is otherwise shown to be “entirely fair.” The courts do not derive this formulation from DGCL 144, however, but from “equitable principles.” Moreover, controlling shareholders are subject to more stringent review: their self-dealing is always reviewed for “entire fairness;” approval by a “well-functioning committee of independent directors” or by fully informed disinterested shareholders merely shifts the burden of proof (subject to the recent doctrinal-transactional innovation of Kahn v. MFW, covered in the M&A part of the course).

What is “entire fairness”? It is not clear anybody knows. The Delaware Supreme Court essentially refuses to define it. In the authoritative words of Weinberger (covered in the M&A part below):

“The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of 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. The latter aspect of fairness relates to the economic and financial considerations of the [transaction], including all … elements that affect the intrinsic or inherent value of [the object of the transaction]. … However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.”

-Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983).

Presumably the message to fiduciaries is: if you are self-interested, then you better pay top dollar and generally go out of your way to show you treated the corporation fairly (or, if you are a mere director or officer, you get absolution from the independent directors or shareholders).

Before diving into the details of this self-dealing jurisprudence, consider a preliminary question: why permit any self-dealing? Delaware law can be characterized as an attempt to differentiate self-dealing that expropriates shareholders, from self-dealing that does not. It is likely that courts will make mistakes, however, and that some expropriation will slip through the judicial cracks.***

Question:

Why not seal those cracks by prohibiting all self-dealing? The potential harm from self-dealing is great. What is the redeeming benefit, if any?