Director conflicts of interest under the Florida Business Corporation Act: hidden shoals in a safe harbor.
The Florida Business Corporation Act, F.S. [sections] 607.0832, provides a safe harbor procedure to insulate transactions from shareholder challenges based on a director's conflict of interest. However, the statute, as presently drafted, may create a false sense of predictability and finality for interested director transactions insofar as technical compliance with the procedural provisions for disinterested director approval may not foreclose judicial inquiry into the substantive fairness of the transaction.
A growing number of courts have interpreted the Model Business Corporation Act provision, which forms the basis for Florida's present director's conflict of interest statute, as requiring the transaction both to pass the safe harbor procedures and be substantively fair to the corporation in order to obtain full immunity from judicial scrutiny. In light of this trend, the following discussion will review Florida's current statute, consider two recent model legislation proposals, and conclude with a recommendation regarding the direction that the Florida Legislature should take in order to provide interested director transactions with adequate protection from judicial scrutiny.
The Development of Present Statute
At common law, interested director transactions were voidable, regardless of whether the transaction was fair or approved by a majority of disinterested shareholders or directors. A director's participation in any interested transaction was treated as a breach of the director's duty of loyalty to the corporation. As corporate management became more complicated, this approach became impractical, and in 1969, the American Bar Association's Committee on Corporate Laws introduced [sections] 41 the Model Business Corporation Act. Section 41, and its successor, [sections] 8.31, adopted in 1984, created safe harbor procedures by which conflict of interest transactions between corporations and their directors could be salvaged, while at the same time corporations and their shareholders could be protected against unfair dealing by self-aggrandizing directors.
The procedure basically requires that the interested director disclose the conflict to either the shareholders or the board of directors (depending on which group functions as the decisionmaker of the corporation), and that they approve the transaction by a majority vote after gaining knowledge of the conflict. If approved, the transaction will be encompassed by the safe harbor, and the presumptions of the business judgment rule will shield the transaction.
Provisions for Interested Director Transactions
Florida's statutory provision regarding directors' conflict of interest transactions is F.S. [sections] 607.0832. The language of [sections] 607.0832 closely resembles that of the 1984 model act provision 8.31, providing a safe harbor for interested director transactions if the director discloses the conflict and if the transaction is approved by a majority of disinterested directors or shareholders, or if the transaction is fair to the corporation at the time it is made. Notably, the Florida statute does not require that the director disclose the material facts of the conflicting interest; the director must only disclose the fact that the relationship or interest exists.
The disjunctive language of both the model act provision 8.31 and the Florida statute suggests that the burden of establishing fairness is lifted from the director once he or she discloses the conflict, and the transaction meets the approval of a majority of disinterested directors or shareholders. The disjunctive language also suggests that a transaction is valid even if the director does not disclose his or her interest to the directors or shareholders, provided that the transaction is fair to the corporation. Since the Florida judiciary has not directly addressed the question of whether fairness is required on all interested transactions, confusion exists regarding whether the fairness standard in Florida is conjunctive or disjunctive.
According to older Florida case law, any transaction was required to meet a basic standard of fairness, regardless of whether the director disclosed his or her interest to the disinterested directors or shareholders.(1) In recent decisions, Florida courts have emphasized the importance of maintaining this standard of fairness by holding that the fairness of a transaction is a defense to the claim of self-dealing.(2) If one reads F.S. [sections] 607.0832 within the context of this historical importance of maintaining a standard of fairness in interested director transactions, it appears that [sections] 607.0832 should be interpreted to require that the transaction be fair to the corporation, regardless of whether the safe harbor procedures were met.
Professor Stuart Cohn and Stuart Ames, in their commentary to the Florida Business Laws Annotated, appear to agree with this interpretation.(3) They state that since the purpose of the statutory provision is to overcome the automatic voidability of transactions at common law, it would appear that the legislature did not intend to remove conflict of interest transactions from traditional standards of fairness. Cohn and Ames suggest that if the transaction is fair and reasonable to the corporation, the approval process is not relevant to its validity; however, they do not believe that the reverse is true--that if the transaction is approved, fairness is irrelevant. They note that the statute does not automatically validate transactions or contracts that come within its purview.
The 1996 case of Sunrise Island, Ltd. v. Goldman Sachs & Co., 203 B.R. 171, 175 (Bankr. N.D. Okla. 1996), somewhat clarifies the question of whether F.S. [sections] 607.0832 should be interpreted conjunctively or disjunctively. The U.S. Bankruptcy Court for the Northern District of Oklahoma, applying Florida law in a director's conflict of interest case, held that when an interested transaction is challenged, the interested director must obtain approval by a majority of the fully informed directors or shareholders and the director also must establish fairness, or the transaction is voidable. Although this case is not directly on point since neither the directors nor the shareholders initially approved the transaction, the decision does support the conjunctive interpretation which requires an interested transaction to be substantively fair to the corporation, even with director or shareholder approval.
Delaware's conflict of interest statute, Del. Code Ann. tit. 8, [sections] 144, is similar to those of Florida and the other states which have adopted [sections] 8.31 of the model act. Section 144 provides that an interested director transaction is not voidable solely because of a conflict of interest, provided that: a) there has been full disclosure of the conflict and the material facts relating to the transaction; and b) there has been good faith approval by a majority of disinterested directors or shareholders. Once this disclosure and approval occurs, the business judgment rule applies to protect the transaction from judicial scrutiny. Otherwise, the transaction will be held valid if the directors can demonstrate that the transaction is fair to the corporation.
The Delaware courts use a rather unique analogy when articulating the reasoning behind their safe harbor procedures. The purpose of [sections] 144 is to "remove the interested director cloud" from a transaction and bring it within the protection of the business judgment rule.(4) Since the key to upholding an interested transaction is the approval of some neutral decisionmaking body, a transaction may be sheltered from shareholder challenge if approved by either a committee of independent directors, the shareholders, or the courts.(5) This means that if the interested director does not disclose the conflict to the shareholders or to the board (or where shareholder control by interested directors precludes independent review), the director can "remove the taint of interestedness" by proving the entire fairness of the transaction. The Delaware Supreme Court has applied a two-tiered analysis when testing for fairness: application of [sections] 144 coupled with an intrinsic fairness test.(6)
By realizing the importance of maintaining some substantive fairness standard against which interested transactions may be measured, the Delaware courts adhere to the following subtle distinction: Although procedural fairness can equate to substantive fairness in some situations, there might be occasions when it does not.(7) Delaware's fairness standard is met if the court can view the deal as the result of an arm's length transaction. If a corporation employs a special committee consisting of outside directors to review the transaction, this standard has been met; anything less might not prove to be fair.
Substantive Fairness Test
The judicial history regarding interested director transactions reveals a trend of doubts about whether the process of disinterested director validation can be a reliable proxy for substantive fairness. Recent social research on group dynamics has raised the issue of a structural bias concerning whether disinterested directors are in fact truly disinterested--this suggests a need for substantive safeguards in the conflict of interest field.(8)
In Remillard Brick Co. v. Remillard-Dandini Co., 109 Cal. App. 2d 405, 241 P.2d (1952), the California court of appeals refused to uphold transactions that were "unfair and unreasonable to the corporation" even if there was technical compliance with the portions of the statute that required disclosure of the conflicting interest, as well as ratification by the directors. Similarly, in In re Whellabrator Technologies, 663 A.2d 1194 (Del. Ch. 1995), a Delaware court held that fully informed shareholder ratification does not automatically extinguish duty of care and duty of loyalty claims. In Globe Woolen Co. v. Utica Gas & Electric Co., 224 N.Y. 483, 491, 121 N.E. 378, 380 (1918), Judge Cardozo required fairness despite independent committee ratification because in reaching its decision, the ratifying committee depended entirely on the superior knowledge of an interested party. Although the transaction would not have passed scrutiny under the model act provisions since the interested director failed to disclose the conflict, Cardozo's primary concern was with the unfairness of the contract and its consequences--the procedure of director approval masked the lack of underlying substantive fairness. In response to the model act's disjunctive standard of either requiring disinterested validation or fairness, most courts have interpreted [sections] 8.31 as simply providing a method of avoiding the automatic voidability review, without changing the requirement that a transaction be fair.(9)
Model Business Corporation Act, Subchapter F
In 1988, the Committee on Corporate Laws emerged with a new approach to directors' conflicts of interest, embodied in the new Subchapter F. Subchapter F attempts to enhance certainty by exhaustively defining both the terms of the provisions governing interested director transactions and the scope of the provisions themselves. Subchapter F also delineates the safe harbor procedures for interested director transactions more specifically than its predecessors, and it specifies under what conditions judicial intervention is appropriate. In sum, Subchapter F is more regulatory in nature, and it is deliberately weighted toward bright-line specificity and predictability.
The primary argument against the model act amendments is that Subchapter F goes too far in loosening the standards that apply to a director's duty of loyalty and a transaction's substantive fairness. Under Subchapter F, any transaction that passes through the procedural requirements of disclosure and director/shareholder approval would automatically be presumed to be substantively fair by the judiciary, and could be reviewed only on the basis of the statutory procedural requirements. Even if one accepts the assumption that shareholder ratification means that the approved transaction is automatically fair to the corporation, the same assumption of fairness cannot necessarily be made regarding disinterested director approval. In my opinion, Subchapter F, with its reliance on technical definitions of what constitutes a conflict of interest, does not go far enough to ensure procedural fairness in the disinterested director approval process, much less substantive fairness.
American Law Institute Approach
In 1986, the American Law Institute's Corporate Governance Project (ALI) proposed a safe harbor statute, [sections] 5.02 of the Principles of Corporate Governance, which takes a conjunctive, as opposed to a disjunctive, approach to the fairness standard of interested director transactions.(10) The underlying perspective taken by the ALI drafters is that all interested transactions are per se suspect, and that due to structural bias, even disinterested directors are not always capable of protecting stockholders from overreaching fiduciaries. Under the ALI proposal, if a transaction is not approved by a majority of disinterested directors or shareholders, the interested director bears the burden of proving the fairness of the transaction. Conversely, if a transaction is approved by a majority of directors, it can still be challenged on fairness grounds, but the burden shifts to the plaintiff to prove that the transaction is unfair. If the transaction is approved or subsequently ratified by the disinterested shareholders, the burden shifts to the party challenging the transaction, and the level of proof required is that the transaction constituted a waste of corporate assets.
I believe Florida's conflict of interest statute is flawed because a literal reading suggests that procedural compliance affords absolute insulation from judicial scrutiny, but the emerging case law indicates that a court actually may reach the substantive fairness of the conflict transaction. Moreover, if a court becomes involved, the statute provides no guidance regarding the appropriate parameters for judicial review. In light of this interpretative discrepancy, the question becomes whether Florida should adopt a different statutory standard, retain the present statute and allow the fairness standard to be judicially determined, or wait to see whether the Committee on Corporate Laws proposes a better alternative under the next round of revisions to the model act.
If revision of Florida's statute is warranted at this time, I believe the legislature should adopt the ALI proposal, in which the fairness requirement is tempered by a burden-shifting provision. However, I recommend that any legislative action be postponed until the Committee on Corporate Laws completes its current efforts to revise substantially the model act provisions regarding the duty of loyalty, the duty of care, and interested transactions. In the interim, Florida counsel must be mindful that the present statutory safe harbor provides less safety than meets the eye.
(1) Chipola Valley Realty Co. v. Griffin, 115 So. 541 (Fla. 1927); Orlando Orange Groves Co. v. Hale, 114 So. 674, 677 (Fla. 1932).
(2) Cohen v. Hattaway, 595 So. 2d 105 (Fla. 5th D.C.A. 1992).
(3) Stuart R. Cohn and Stuart B. Ames, Annotation, Author's Note, Florida Business Laws Annotated 117 (1997).
(4) Marciano v. Nakash, 535 A.2d 400, 403-405 (Del. 1987).
(5) Williams v. Geier, 671A.2d 13689 1379 (Del. 1996).
(6) Fliegler v. Lawrence, 361 A.2d 218 (Del. Supr. 1976).
(7) Marciano, 535 A.2d at 404; Merritt v. Colonial Foods, Inc., 505 A.2d 757, 764 (Del. Ch. 1986); Weinberger v. UOP, Inc., 457 A.2d 701 (Del. Supr. 1983).
(8) Alan Palmiter, Reshaping the Corporate Fiduciary Model: A Director's Duty of Independence, 67 Tex. L. Rev. 1351 (1989).
(9) Palmiter at 1411, citing Cohen v. Ayers, 596 F.2d 733, 740-41 (7th Cir. 1979) (interpreting validation as merely shifting to plaintiff the burden of proving unfairness), Scott v. Multi-Amp Corp., 386 F. Supp. 44 67-68 (D.N.J. 1974) (requiring transactions to pass muster under each subdivision of the New Jersey statute, despite "or"); Aronoff v. Albanese, 85 A.D.2d 3, 6, 446 N.Y.S.2d 368, 371 (1982) (holding that compliance with corporation statutes does not automatically validate any transaction).
(10) Principles of Corporate Governance v. 1, ch. 2, [sections] 5.02 (American Law Institute 1992).
Gardner Davis is a partner with Foley and Lardner in Jacksonville and serves as vice chair of the Corporate and Securities Law Committee of the Business Section and as the chair of the committee's recent study regarding possible revision to the Florida director's conflict of interest statute. Mr. Davis graduated from Dartmouth College and Duke Law School. Mr. Davis gratefully acknowledges the assistance of Karen Crew in the preparation of this article.
This column is submitted on behalf of the Business Law Section, Roberta A. Colton, chair and Mark J. Wolfson, editor.
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|Publication:||Florida Bar Journal|
|Date:||Feb 1, 1998|
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