The Duty of Loyalty

• Pages: 179-253
• Author: Stephen M. Bainbridge

179

Chapter 7

THE DUTY OF LOYALTY

§ 7.1 Distinguishing Care and Loyalty

It is well-settled that directors have a duty to maximize

shareholder wealth. As the Michigan supreme court famously

observed in Dodge v. Ford Motor Co.: “A business corporation is

organized and carried on primarily for the profit of the

stockholders.”

1

To be sure, in many settings, the business judgment

rule will preclude judges from evaluating the shareholder wealth

effects of board decisions. It is also well-settled, however, that the

business judgment rule does not preclude judicial review of self-

dealing transactions.

At first blush, the differing legal treatment of care and loyalty

seems puzzling. Because both reduce shareholder wealth, negligence

and self-dealing arguably differ more in degree than in kind.

On closer examination, however, loyalty does differ in kind, not

just in degree, from care. Few of the arguments for insulating

negligent board of director carry over to self-dealing. For example,

decisions implicating the duty of care typi cally are collective actions

of the board as a whole. In making such decisions, the board is

constrained to exercise reasonable care in decision making by a

combination of external market forces and internal team governance

structures. Judicial review thus is at best redundant and may, in fact,

have deleterious consequences for the efficiency of decision making.

In contrast, self-dealing typically is more difficult to detect than

is negligence. Self-dealing transactions rarely implicate the entire

board. To the contrary, they often involve misconduct by a single

director. Those who intentionally self-deal, moreover, likely will also

actively seek to conceal their defalcations. Given the potential gains

of self-dealing in an organization characterized by a separation of

ownership and control, legal liability thus may be a necessary

deterrent against such misconduct. When an individual director

engages in self-dealing, moreover, he has already betrayed the

internal team relationships that characterize boards. Courts

appropriately are less concerned about destroying internal team

relationships in such cases.

Yet, the intensity of judicial rhetoric in loyalty cases suggests

something else is going on as well. Judge Cardozo’s famous dictum

on the duties of a partner, holding them to “something stricter than

1

170 N.W. 668, 684 (Mich.1919). See generally Chapter 9.

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THE DUTY OF LOYALTY

Ch. 7

the morals of the market place,”

2

has provided a model for countless

decisions excoriating those who self-deal. In part, this rhetoric likely

rests on an assessment of self-dealing as reflecting greater moral

culpability than does mere negligence. In part, however, judicial

rhetoric in this area also likely reflects an attempt by judges to

inculcate desirable social norms of honesty and trustworthiness.

As we review the material that follows, pay especially close

attention to one question that frequently recurs; namely, to what

extent does approval of a conflicted interest transaction by the board

of directors or shareholders insulate that transaction from the

exacting scrutiny usually applied to self-dealing?

§ 7.2 Conflicted Interest Transactions

Directors and officers frequently contract with or otherwise

transact business with their corporations. Such transactions range

from routine and pervasive, such as employment and compensation

agreements, to unusual one-time events, such as a sale of real

property. In either case, the director has an obvious conflict of

interest.

3

On the one hand, the director is acting in his own self-

interest, with an incentive to get the best possible deal. On the other

hand, the director is a fiduciary with an obligation to maximize

shareholder wealth.

Conflicted interest transactions take two forms. In a direct

transaction, the director is dealing directly with the firm, such as

where a director sells property to the firm. In an indirect transaction,

a person or entity in which the director has an interest is dealing with

the firm. Both types potentially create a conflict of interest. Indirect

conflicted interest transactions, however, present greater problems

in several respects. On the one hand, they are more likely to escape

ex ante notice, whether because of deliberate concealment or m ere

inadvertence. On the other hand, as the director’s interest becomes

more attenuated, an indirect transaction may not rise to the level of

a legitimate conflict of interest.

4

At early common law, conflicted interest transactions were

voidable by the corporation without regard to whether they were fair

to the corporation or had been approved by the board or

shareholders.

5

At an abstract level, prohibiting conflicted interest

2

Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y.1928).

3

For semantic convenience, we shall refer solely to directors in this section.

Unless otherwise indicated, however, the same legal principles also apply to conflicted

interest transactions between an officer and the corporation.

4

Absent classic self-dealing, in which the director stands on both sides of the

transaction, the requisite be nefit must be material or even “substantial.” See

Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1169 (Del.1995).

5

See, e.g., Cuthbert v. McNeill, 142 A. 819, 820 (N.J.Ch.1928) (“a director of

a corporation cannot deal with the corporation which he represents. It does not matter

§ 7.2

CONFLICTED INTEREST TRANSACTIONS

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transactions fails to give due deference to the principles of party

autonomy and freedom of contract, which are important values both

in themselves and because they promote efficient transactions. At a

practical level, many transactions between the corporation and a

director prove beneficial to both sides. If a director owns a valuable

piece of property, which would be useful to the corporation, should

not the director be allowed to sell it to the firm? Yet, what rational

director would do so under the early common law rule? A rule that

makes conflicted interest contracts voidable at the corporation’s

option in effect gives the firm a put option in the underlying

transaction. If the deal goes sour, the corporation can walk away from

it, which will deter directors from making such contracts in the first

place. Accordingly, consistent with the general modern corporate law

trend of policing conflicts of interest rather than prohibiting them,

the law gradually moved towards permitting interested director

transactions subject to judicial review. Modern statutes have even

further liberalized this area.

6

A. Common Law Evolution

In 1918, the New York court of appeals decided the oft-cited case

of Globe Woolen Co. v. Utica Gas & Electric Co.

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John F. Maynard

was the major shareholder, president, and a board member of Globe,

a textile manufacturer. Maynard also was a director of Utica, a

utility. Globe had long considered converting its mills to electrical

power; but Maynard had insisted on a guaranty that electricity would

be cheaper than the plants’ existing steam-generated power. A Utica

employee, Greenidge, presented to Maynard the results of a study

claiming such a conversion would generate considerable savings for

Globe. Based on that study, Maynard and Greenidge prepared a

contract for Utica to supply power to Globe, which included a

guarantee that Globe would realize savings of $300 per month. The

contract was brought before the Utica board of directors’ executive

committee for approval. At the meeting, one director asked whether

how much good faith may have been exercised on his part, his contracts with his

corporation are voidable at the instance of the corporation—they will not stand if

repudiated as contracts” by the corporation).

6

Sarbanes-Oxley Act § 402 bars publicly held corporations registered with the

SEC from directly or indirectly lending or arranging for the extension of credit to their

own officers or directors. Prior to § 402, such loans were permitted by state corporate

law so long as the firm complied with the rules discussed in this section. The state law

rules, of course, still apply to related party transactions in close corporations.

In addition, Sarbanes-Oxley § 406 requires a corporation to adopt a code of ethics

applicable to its CEO, CFO, controller, and chief accountant. If the company fails to do

so, it must disclose that failure and explain its reas ons for not adopting the required

code. In order to pass muster, the ethics code must provide for “the ethical handling of

actual or apparent conflicts of interest between personal and professio nal

relationships.”

7

121 N.E. 378 (N.Y.1918).