[1] In corporate law, self-dealing by fiduciaries is a fundamental concern, and there is significant debate over how to regulate it [2] Self-dealing—the expropriation of corporate wealth from fiduciaries presents a conflict-of-interest question, and scholars have disagreed on which of two rules is more effective at addressing the issue.[3] Some advocate for a “strict” no conflict rule which outright bans self-dealing, while others prefer a more flexible “fairness” rule which allows self-dealing if it is fair to beneficiaries .[4] This article surveys the differences in self-dealing law between the U.S. and the E.U.
Delaware Self-Dealing Law
In the U.S., directors owe two core fiduciary duties.[5] First, is the duty of care, which requires a director or officer to the corporation to make decisions that pursue the corporation’s interests with reasonable diligence and prudence.[6] The business judgment rule is the legal standard a court uses to analyze whether the board has fulfilled the duty of care.[7] First, a director or officer must make a business decision in good faith.[8] As long as the board is reasonably informed, it can make a decision in good faith and get protection of the business judgment rule.[9] Second, the board must not be financially interested in the transaction.[10] Third, it is duly informed about the transaction to the extent the director or officer believes to be appropriate under the circumstances.[11] Lastly, the board rationally believes the transaction is in the best interests of the corporation.[12]
The other core fiduciary duty the board owes to shareholders is the duty of loyalty,[13] which requires directors to act in the best interests of the corporation and not in their own personal interests.[14] Conflicts arise when a director has a financial interest in both companies in the transaction.[15] If a corporation does not have a controlling shareholder, the board has three options to cleanse the transaction of a duty of loyalty conflict under Delaware corporate law.[16] Corporations can address conflicts in three ways to receive protection under the business judgment rule for the transaction: (1) obtaining the approval of disinterested directors,[17] (2) securing the support of shareholders,[18] or (3) demonstrating the “entire fairness” of the transaction.[19]
The Delaware Supreme Court established the latest iteration of the entire fairness standard in Weinberger v. UOP Inc..[20] There are two components to the entire fairness standard: (1) fair dealing and (2) fair price.[21] The court in Weinberger offered 3 factors to consider when determining whether the board engaged in fair dealing with respect to the conflicted transaction.[22] First, the board must demonstrate that the timing of the transaction was fair.[23] Second, the court will consider how the conflicted director initiated, negotiated and disclosed the conflict to the other directors.[24] Lastly, the court will examine the manner in which the board obtained approval of the conflicted directors and the shareholders.[25] The court reviewing the transaction will also evaluate whether the board got a fair price for the deal.[26] Financial metrics the court can evaluate for whether the price was fair include: assets, earnings, future prospects, and market value of the company.[27] The court in Weinberger noted that courts should more heavily weigh the fair price element than the fair dealing element of the entire fairness standard.[28]
- Identifying Controlling Shareholders
In In re Tesla Motors, Inc. S’holder Litigation, the Delaware Chancery Court outlines the test for determining whether a corporation has a controlling shareholder.[29] A controlling shareholder is present where (1) when one person or entity owns over 50% of the shares in the corporation, or (2) when one person or entity owns less than 50% of the shares in the corporation but still exercises significant control over the corporation.[30] The court outlined a two part test to identify whether a party that owns less than 50% of the shares in a corporation is nevertheless a controlling shareholder.[31] First, there has to be a significant but less than majority shareholder.[32] The court in In re Tesla Motors Inc found that Elon Musk, who owned 22.1% of the shares of Tesla at the time of case, was a controlling shareholder.[33] Second, the court must analyze whether this shareholder has outsized influence in the company.[34]
The court in In re Tesla Motors Inc. laid out two factors to consider for determining whether a shareholder has outsized influence at the company.[35] The first factor is whether this shareholder has managerial supremacy.[36] Can the shareholder determine what is going on at the company despite owning less than 50% of the shares?[37] The second factor the court looks to for finding outsized influence is to look at the corporation’s representations of the shareholder’s role.[38]
If a court under the In re Tesla Motors Inc. analysis finds that there is a controlling shareholder at the company, the court must then determine if the board engaged in a conflicted transaction.[39] In Sinclair Oil Corp, the Delaware Supreme Court introduced the “benefit to the detriment” test for determining whether a corporation engaged in a conflicted transaction.[40] A court under this test determines whether a transaction at issue brings a benefit to the controlling shareholder and is detrimental to other shareholders at the company.[41] If the court determines that there is not a conflict in the transaction, the transaction is reviewed under the business judgment rule.[42] If there is a conflict, then the court will proceed to analyze the conflict under the entire fairness standard outlined in Weinberger.[43]
E.U. Directive on Self-Dealing Law
The E.U. sets out its self-dealing laws in Article 9C of its shareholders’ rights directive,[44] which relies on a statutory approach for cleansing rather than the common law approach in the U.S. The directive requires that member state companies publicly announce material[45] related party transactions at the time of the conclusion of the transaction.[46] The announcement must contain information on the nature of the relationship to the related party, the name of the related party, the date and the value of the transaction, and other information necessary to assess whether or not the transaction is fair and reasonable from the perspective of the company and unrelated parties such as the shareholders.[47]
E.U. member states must ensure that material transactions between related parties are approved by the general meeting or by administrative or supervisory body of the company according to procedures which prevent the related party from taking advantage of its position.[48] Member states may provide for shareholders in the general meeting to have the right to vote on material transactions with related parties which have been approved by the administrative or supervisory body of the company.[49] Where the related party transaction involves a director or a shareholder, the director or shareholder shall not take part in the approval or the vote.[50] Member states may nevertheless allow the shareholder who is a related party to take part in the vote provided that national law ensures appropriate safeguards which apply before or during the voting process to protect the interests of the company and of the shareholders who are not a related party, including minority shareholders, by preventing the related party from approving the transaction despite the opposing opinion of the majority of the shareholders who are not a related party or despite the opposing opinion of the majority of the independent directors.[51]
Conclusion
In conclusion, the ongoing debate around the regulation of self-dealing by fiduciaries is reflected in the contrasting approaches between the U.S. and the E.U. In the U.S., conflicts are managed through the business judgment rule and common law standards such as fair dealing and fair price. The E.U., on the other hand, follows a statutory approach to mandate transparency by requiring disclosures of related party transactions. Despite the contrasts, these regulatory frameworks each exist for the same purpose: protecting corporate and shareholder interests.
[1] Excerpt of a Paper for Comparative Corporate Law, Professor Martin Gelter. Consent was obtained to publish.
[2] See Andrew F. Tuch, Reassessing Self-Dealing: Between No Conflict and Fairness, 88 Fordham L. Rev, 939, 939 (2019), https://ir.lawnet.fordham.edu/flr/vol88/iss3/3/.
[3] See Id. at 940.
[4] See Id.
[5] See Practical Law of Corporate and Securities, Fiduciary Duty of the Board of Directors, p. 2 https://law.stanford.edu/wp-content/uploads/2023/01/Fiduciary-Duties-of-the-Board-of-Directors.pdf (last visited Nov. 4, 2024) (describing the fiduciary duties of the board of directors, including the core duties of care and loyalty).
[6] See Legal Information Institute, duty of care, https://www.law.cornell.edu/wex/duty_of_care (last visited Nov. 4, 2024) (outlining the elements of the common law duty of care directors and officers owe to the shareholders of the corporation).
[7] See Barbara J. Arsdale, et. al., Duty to be informed, under the business judgment standard, 18B Am. Jur. 2d Corporations § 1457, https://1.next.westlaw.com/Document/I47c40311b27b11d9815db1c9d88f7df2/View/FullText.html?navigationPath=Search%2Fv1%2Fresults%2Fnavigation%2Fi0a89db0a00000192f8ac055601c403ed%3Fppcid%3D3315f910646d4cc98f96aedaa5b38fbb%26Nav%3DANALYTICAL%26fragmentIdentifier%3DI47c40311b27b11d9815db1c9d88f7df2%26parentRank%3D0%26startIndex%3D1%26contextData%3D%2528sc.Search%2529%26transitionType%3DSearchItem&listSource=Search&listPageSource=f3c8df71e981a7fe65a57fb247348575&list=ANALYTICAL&rank=20&sessionScopeId=0d2d55c15b7393b54ca09ca7606cb9c244ddd9b2fec1e9779e5a3755b3eaca17&ppcid=3315f910646d4cc98f96aedaa5b38fbb&originationContext=Search%20Result&transitionType=SearchItem&contextData=%28sc.Search%29 (stating the elements of the business judgment rule standard for the board of directors fulfilling the duty of care owed to shareholders).
[8] See Id.
[9] See Id.
[10] See Id.
[11] See Id.
[12] See Id.
[13] See Practical Law of Corporate and Securities, supra at 7.
[14] See Id.
[15] See Practical Law of Corporate and Securities, supra at 10.
[16] See D.G.C.L. §144(a), https://delcode.delaware.gov/title8/c001/sc04/ (outlining methods for cleansing a conflicted transaction to avoid a beach of the fiduciary duty of loyalty that directors owe to the corporation’s shareholders).
[17] See Id.
[18] See In Re Wheelabrator Tech. S’holder Litigation, 663 A.2d 1194, 1201 (Del. Ch. 1995) (stating the rule that in a breach of duty of loyalty claim, if the board gets the shareholders to vote on the deal or get the shareholders to approve the deal, the board gets protection of the business judgment rule).
[19] See Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) (outlining the entire fairness standard of review for when a corporation engages in a conflicted transaction with a controlling shareholder.)
[20] See Id.
[21] See Id.
[22] See Id.
[23] See Id.
[24] See Id.
[25] See Id.
[26] See Id.
[27] See Id.
[28] See Id.
[29] See In re Tesla Motors, Inc. S’holder Litigation., 2018 WL 1560293 at *12 (Del. Ch. Mar, 28, 2018) (quoting Kahn v. Lynch Communications Systems, Inc. 638 A.2d 1110, 1113-14 (Del. 1994)) (outlining the Delaware Chancery Court’s test for whether a corporation has a controlling shareholder).
[30] See In re Tesla Motors, Inc., supra at *12.
[31] See Id. at *13 (citing In re Rouse Props, Inc. Fiduciary Litig., 2018 WL 1226015, at *12 (Del. Ch. Mar. 9, 2018)).
[32] See Id. at *14.
[33] See Id.
[34] See Id.
[35] See Id. at *14.
[36] See Id.
[37] See Id. The Court noted that plaintiffs alleged that Musk demonstrated a willingness to facilitate the ouster of senior management when displeased, as evidenced by the fact that he forced founder and then-CEO Eberhard out of the Company and appointed himself CEO. See Id. at *15. This development had to be on the minds of the Tesla board when they were considering Musk’s proposal that Tesla acquire SolarCity. Id.
[38] See Id. at *18. Plaintiffs argued that Tesla and Musk himself conceded in Tesla’s public filings that he has outsized influence at the company. See Id. Tesla’s public filings disclose that in addition to serving as CEO since October 2008, Musk contributed significantly and actively to Tesla since April 2004 by recruiting executives and engineers, contributing to the Tesla Roadster’s engineering and design, and raising public awareness of the company. See Id. The public filing also disclosed that Musk spent significant time with Tesla and was highly active in Tesla’s management. See Id.
[39] See Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) (Defining what it means for a company to engage in a conflicted transaction when there is a controlling shareholder).
[40] See Id.
[41] See Id.
[42] See Id.
[43] See Weinberger 457 A.2d 701 at 711.
[44] See Directive (EU) 2017/828 of the European Parliament and of the Council of 17 May 2017 amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement, Article 9C,https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32017L0828#d1e1525-1-1. Related party transactions are the E.U. equivalent of self-dealing transactions in the U.S.
[45] Member states may adopt different definitions for material and may differentiate the definitions according to company size. See Id. at Article 9C §(1).
[46] See Id. at Article 9C §(2).
[47] See Id.
[48] See Id. at §(4).
[49] See Id.
[50] See Id.
[51] See Id.
