6.4 The Duty of Loyalty

• Library: Corporations and Partnerships in Virginia (Virginia CLE) (2016 Ed.)

6.4 THE DUTY OF LOYALTY

6.401 In General. Unlike the duty of care, the duty of loyalty owed by directors and officers to the corporation and its shareholders has been considered on numerous occasions by the Supreme Court of Virginia and has been the subject of provisions in both the Act and its predecessor.

6.402 Case Law. The duty of loyalty prohibits directors and officers from gaining personal advantage through a corporate transaction unless the transaction is open, fair, and honest and the corporation acts through competent and authorized agents. ⁵⁶ Violation of the duty in a conflict of interest situation may expose interested directors or officers to individual

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liability. Breaches of the duty of loyalty may also constitute a basis for invalidating the underlying corporate transaction to which the conflict of interest relates.

Interested directors or officers have the burden of proving that they fulfilled their duty of loyalty when a plaintiff seeks to hold them personally liable. ⁵⁷ The board of directors as a whole has this burden when a plaintiff seeks to invalidate the action to which the conflict of interest relates. ⁵⁸ Courts scrutinize the underlying transaction to ensure it is fair. ⁵⁹

Case law has developed three requirements that allow interested directors to cleanse a conflict of interest.

1.	Full disclosure of the conflict of interest to the board of directors or the shareholders;
2.	Approval or ratification of the transaction by a disinterested majority of the board of directors or, if the conflict of interest made such approval or ratification impossible, approval or ratification by the shareholders; and
3.	A showing that the transaction is fair to the corporation and its shareholders. 60

In the last 25 years, many states have moved away from insisting upon all three of these requirements. These jurisdictions instead have adopted a more liberal test based on an evaluation of the fairness of the transaction to the corporation and its shareholders. Virginia has been part of this movement, as indicated by the conflict of interest provisions in the Act. ⁶¹

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6.403 The Virginia Statutes. The Virginia General Assembly has dealt with conflicts of interest by enacting standards for validating transactions that might otherwise be open to question. If the requirements of the relevant statute are met, the transaction becomes a valid, binding obligation of the corporation. While the statutes provide a means for validating questionable transactions, they do not address the personal liability of those involved in a possible conflict of interest. For example, a board might have reason to use the statutory procedure to ratify a contract as a valid corporate obligation. However, on common law principles of fiduciary duty, the board could still seek recovery from an interested director who obtained an improper personal advantage under the contract.

The conflict of interest statutes change the common law duty of loyalty requirements. On one hand, section 13.1-691 of the Virginia Code provides that fair conflict of interest transactions may be validated, without regard to the additional common law requirements of full disclosure of the conflict of interest and disinterested board or shareholder approval. On the other hand, the statute also provides that conflict of interest transactions may be validated without regard to fairness if full disclosure occurred and either disinterested directors or shareholders approved the transaction.

Section 13.1-691 of the Virginia Code deals with director conflicts of interest; no similar provision exists for officers. Section 13.1-691(A) defines "conflict of interests transaction" as "a transaction with the corporation in which a director of the corporation has an interest that precludes the director from being a disinterested director."

The Virginia Code defines "disinterested director" as one who "does not have (i) a financial interest in a matter that is the subject of such action or (ii) a familial, financial, professional, employment or other relationship with a person who has a financial interest in the matter, either of which would reasonably be expected to affect adversely the objectivity of the director when participating in the action." ⁶² The mere fact that a director was nominated by an interested party or serves on another board in which an interested party also is a director does not "by itself prevent a person from being a disinterested director." ⁶³

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The corporation may not void a conflict of interests transaction on the sole grounds of the conflict if any one of the three following conditions is met:

1.	The board of directors or a committee authorizes, approves, or ratifies the transaction after the material facts of the transaction and the director's interest are disclosed or known to the board of directors or the committee. In order to approve, a majority of the disinterested directors on the board or on the committee must vote to authorize, approve, or ratify. If a majority of the disinterested directors votes to authorize, approve, or ratify, a quorum is present for purposes of acting under section 13.1-691. A transaction may never be approved by a single director, whether interested or disinterested; 64
2.	Those shareholders entitled to vote authorize, approve, or ratify the transaction after the material facts of the transaction and the director's interest have been disclosed to them. Approval must be given by "a majority of the shares entitled to be counted" for that purpose. A majority of such shares constitutes a quorum for approving the conflict of interest transaction. Shares owned or controlled by a director who is not disinterested may not be counted for this pur-pose; 65 or
3.	The "transaction was fair to the corporation." 66

Section 13.1-691 does not allocate the burden of proof in conflict of interest disputes. Case law has developed the rule that a party challenging the actions of a board of directors has the burden of proving that the challenged action did not meet the directors' good faith business judgment test. In a conflict of interest situation, however, the burden shifts to the directors, who must show that their actions met the statutory standards of this section. ⁶⁷

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6.404 Interested Director and Officer Contracts. Contracts with the corporation that involve interested directors or officers provide the most frequently encountered setting for duty of loyalty cases. In Deford v. Ballentine Realty Corp., ⁶⁸ the Supreme Court of Virginia, after making a searching inquiry into the fairness of a director's sale of property to his corporation, found the transaction to be fair to the corporation and its shareholders. ⁶⁹ A special type of interested director contract arises when a board fixes the salaries of those officers who are also directors of the corporation. The Virginia Supreme Court confronted this issue in Giannotti v. Hamway. ⁷⁰ In that case, the court held that the business judgment rule is inapplicable when directors elect themselves officers and set their own salaries:

Courts are hesitant to question the reasonableness of a corporate officer's compensation when it is set by a disinterested board. However, as in this case, where the directors of a close corporation elect themselves as officers and set their own salaries, and they are all accused of combining to fix excessive salaries for each other, it is impossible to have a "disinterested board." ⁷¹

The Giannotti court identified several factors for judging the reasonableness of a director-officer's salary:

They include qualifications of the employee; the nature, extent, and scope of the employee's work; the type of services rendered; the difficulties involved in discharging responsibilities; success of the business; comparison between salary paid to the corporation's net income; comparison of compensation paid to comparable officers in other companies; and similar factors. ⁷²

Finally, in Giannotti, the court placed the burden of proof on the interested directors to establish that their compensation was reasonable.

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In Cascades West Associates L.P. v. PRC, Inc., ⁷³ the court held that interested directors must prove the fairness of their transaction by clear and convincing evidence. This "fairness" test requires only that the transaction carry the earmarks of an arm's length bargain under the circumstances at the time of the deal—not that it be the best deal possible for the corporation...