When Conflicts of Interest Can Work: If the board employs appropriate procedures and protections, it can confidently approve related-party and other conflicted transactions.

• Author: Raymond, Doug
• Position: LEGAL BRIEF

In recent years, a persistent theme in corporate governance has been the board's role in protecting the corporation from the predations of management or significant shareholders. Ever since the creation of the corporate form, which facilitated the separation of management from investment capital, there have been concerns that unscrupulous management or controlling shareholders may seek unfair advantage at the expense of other shareholders. Indeed, the fiduciary duties imposed on directors are based, in significant part, on the need to establish protections for shareholders who do not have an effective voice in managing the business or protecting their investment. These duties --the duty of care and the duty of loyalty--require directors to act in good faith and with reasonable care and prudence. They further require directors to act always in the best interest of the corporation and the shareholders, not for their own personal benefit.

Because of these fiduciary duties, it is often said that boards should avoid every conflict of interest, and that the corporation should avoid any transaction where a director or significant shareholder has an interest that is not common to all other shareholders. However, directors and shareholders can add significant value to the corporation by leveraging their other relationships and connections. It can be short-sighted, in the name of "best practices," to lose these opportunities. If the board employs appropriate procedures and protections, it can confidently approve related-party and other conflicted transactions that benefit both the corporation and the conflicted party.

In general, courts will not substitute their judgment for that of corporate directors. When board decisions are challenged, a court typically will presume that the directors acted on an informed basis and with the honest, good-faith belief that the decision was in the best interest of the corporation. This presumption, known as the business judgment rule, protects most board action from being successfully challenged.

However, if the board approves an action in which some of the directors or a significant shareholder has an interest, a court will not presume the independence and good faith of the directors. It will instead take a more careful look through a process called "entire fairness review." When entire fairness review applies, directors must demonstrate both "fair price and fair dealing." First, they must establish that the deal...