The Complaint against the Board of Directors - Essay Example

Corporations Exam, Question Part I: Substantive and Procedural Merits of Lawsuit The Complaint against the Board of Directors The class action against the board of directors is founded on the assumption that directors are fiduciaries. As fiduciaries, directors owe the shareholders of the corporation and the corporation as a whole a duty of loyalty and duty of care (Aronson v Lewis). The duty of loyalty is a firmly established principle of corporate law. The duty of loyalty imposes upon directors and other relevant corporate officers, a duty of care. In this regard, a duty of care involves the duty to ensure that the corporation’s interests are protected and in doing so, directors must ensure that their conduct does not bring about harm to the corporation (Guth v Loft, Inc.). In the class action lawsuit against the board, the claim is that the board of directors is jointly liable for the illegal conduct of Operator and Accountant. The claim is therefore substantiated by findings that board directors Operator and Account breached their duty of loyalty and the board as a whole was negligent in not preventing or acquiescing in that breach of the duty of loyalty. Liability in this regard will be founded on the statutory duty of care articulated by the Model Business Corporation Act 1984. Pursuant to Section 8.30 of the Model Business Corporation Act 1984, directors have a responsibility to act with the care of an ordinary reasonable person in the director’s position and how such a person would be expected to act in “similar circumstances” (Model Business Corporation Act, Section 8.30). Therefore the substantive issue is whether or not the board as whole indirectly and through agency, breached the duty of loyalty and in doing so, directly breached the duty of care. From a purely procedural perspective, the business judgment rule engages judicial review of the substantive issues and argument. Under the business judgment rule, the board of directors will escape liability if the court is satisfied that the directors in making a judgment of decision, did so with no conflict of interest, uses some degree of care in apprising themselves of the relevant facts and circumstances in making the decision or judgment and there was a rational justification for making the decision or judgment (Aronson v Lewis,1984). On the facts of the case, it appears that the board relied on Accountant and his teams to appropriately carry out the corporation’s financial affairs. Moreover, the audited financial statements sent to the directors would not have revealed an obvious issue although a closer examination of the books would have revealed the unlawful activities. The main question in assessing the business judgment rule is therefore whether or not it was prudent for the board to trust Accountant and to accept the audited financial statements at face value. Since audited financial statements are usually prepared by a certified public accountant and its authentic is confirmed by the certified public accountant, it does not appear to be unreasonable for the board to rely on the audited financial statements (Merrill Lynch). If the certified public accountant was Accountant and his team, it is only with hindsight that the board might have a reason to second guess his preparation of the audited financial statements. Therefore this part of the class action lawsuit will not likely succeed. The board appears to have acted prudently or reasonably and had a rational basis for their decision and cannot be said to have acted in breach of a duty of care and therefore did not breach the duty of loyalty. With respect to the payment of a US$50 fine to avoid an indictment against the company, it can be argued that this particular act is negligent since the case against Operator appears to be falling apart. Procedurally, if the case against Operator, the main actor in the scandal is weakening, the case against Mousetrap is decidedly weaker. However, the prospect of facing an investigation and an indictment and the negative publicity it would involve most likely persuaded the board to act quickly to save the company from ruin. Given the facts and the circumstances it is highly likely that the court will find that the business judgment rule was satisfied and the board acted reasonably and prudently. Likewise, the decision to pay Accountant US$ 1 million was reasonable since Accountant’s contract stipulated that he could not be fired unless he was indicted. Moreover, Accountant was not going to be indicted since he was cooperating with the prosecutor and he had been complicit in facilitating the payment of briberies and the subsequent cover-up. The board was therefore bound by the duty of loyalty to protect the company from further harm and did so by negotiating a severance that was proportionate to the harm Accountant’s continued employment would have caused Mousetrap. In the final analysis, the business judgment rule permits directors significant latitude providing they believe that they are making decisions and judgments in the company’s best interest (Aronson v Lewis). Even so, it may be a conflict of interest for the board to determine compensation for another director since it can establish a threshold for all directors (Beard v Elste). The Complaint Against Operator The duty of loyalty can be breached in circumstances where there is a potential for a conflict of interest. A conflict of interest can arise when a director’s personal interest is either directly or indirectly tied to financial matters associated with the corporation or the corporation’s assets (Model Business Corporation Act, Section 8.60(1)). In this regard, a director is in breach of the duty of loyalty on the grounds of a conflict of interest when he or she knowingly decides on a course of conduct for self-gain as opposed to profitability for the corporation or if he is negligent in performing his fiduciary duties or if he consciously agrees to unlawful conduct (Aronson v Lewis). Moreover, in order to avoid liability for a breach of the duty of loyalty on the grounds of a conflict of interest, the interested director (Operator) must disclose all material facts relative to the undertaking in question to either the board or shareholders (Delaware General Corporation Law, Sec. 144(a)). While it is clear that Operator consciously agreed to unlawful conduct in using donations to bribe officials, it not altogether clear how he gained a personal benefit and whether or not this was more important to him than the corporation’s profitability. It is clear however, that the details of Operator’s personal interest were revealed to the board in that his own properties were submitted to the board and subsequently approved. At the very least, the board should have been aware that Operator was competing with the corporation and that there was a potential for a conflict of interest. However, had the board been informed that Operator was using the corporation’s donation funds to bribe officials for the speedy approval of work permits, it is unlikely that they would have approved his properties. The main question is whether or not Operator took advantage of a corporate opportunity in the acquisition and subsequent approvals of his own properties. What Operator should have done in these kinds of circumstances was to inform the board of the opportunity and allow the corporation to take advantage of that opportunity or if it chooses to, approve Operator’s acquisition of that opportunity (Guth v Loft, Inc.). In other words, a director should never take advantage of an opportunity unless and until, he brings the opportunity to the attention of the board and allows them to exercise a first option on the opportunity. Essentially, in determining whether or not there was a conflict of interest in that Operator took advantage of a corporate opportunity, the court must be satisfied that the opportunity in question was one similar to the corporation’s current or prospective business (Science Accessories Corp. v Summagraphics Corp.). The similarities are established in that Operator was seeking building permits for his own properties while seeking to achieve the same for Mousetrap. The court would also take into account whether or not the opportunity was one that the company would be interested in (Science Accessories Corp. v Summagraphics Corp.). On the facts, it would appear that the board approved Operator’s property transactions and therefore evidencing that the company was not interested in those properties. Therefore a stronger case will be made against Operator on the basis of a conflict of interest substantiated by Operator’s unlawful activities. The Complaint Against Accountant The Supreme Court of Delaware ruled that in addition to the fiduciary duties of loyalty and the duty of care, directors owe a duty of good faith (Cede & Co. v Technicolor Inc.). The duty of good faith is expressly provided for in the Model Business Corporation Act which requires that all directors and officers act in good faith when acting in the capacity of director (Sections 8.30 and 8.42). Moreover, under Delaware General Corporation Law, a director may be indemnified for any litigation against the director and/or the company if the director acted in good faith (Sections 145(a) and (b)). In general the duty of good faith requires that corporate directors act when acting the best interest of the corporation, do so honestly (Cede & Co. v Technicolor Inc.). In determining whether the director acted in good faith, an objective standard is applied to ascertain whether or not it can be said, by reference to the facts and circumstances that the director honestly believed that he was acting in the best interest of the corporation (Smith v Van Gorkom). The court must be satisfied that the director acted on an informed basis and with due care in order to conclude that the director acted in good faith (Smith v Van Gorkom). On the facts of the case, it would appear that Accountant not only knew of Operator’s malfeasance, but he also manipulated the company’s financial statements to cover up the malfeasance. Therefore Accountant was complicit in Operator’s misconduct and since he was responsible for the financial statements and the financial affairs of the company, he could have discovered the misconduct by an inspection of the books. Therefore whether or not it can be proven that Accountant was a participant in the misconduct, he was in a position where with the minimum amount of care, he could have discovered the misconduct. As a result a strong case can be made against Accountant that he breached the duty of good faith. Redeeming the Pill Worker’s acquisition of a majority shares (50.01%) appears to be takeover bid since he promises to oust “the rascals” and to return the company to its “roots as a pest extermination firm”. In this regard, pursuant to the business judgment rule, if after conducting a reasonable investigation, the board is satisfied that the takeover is not in the corporation’s best interest, it may resist the takeover bid (Unocal Corp v Mesa Petroleum Co.). On the facts of the case, the board has determined that it wants to rehabilitate the company’s image and Worker’s previous affair is incompatible with this objective. Thus the business judgment rule will arise to protect the board having to undergo judicial review of what appears to be a reasonable decision. It was also held in Moran v Household International, Inc. that a poison pill was a reasonable and fair reaction to a threat involving what amounts to or is tantamount to a coercive merger or acquisition at prices that are unfair to the targeted shareholders. It has already been established that Worker’s takeover bid was decidedly hostile. Worker is taking advantage of a drop in share prices and is offering to increase the price. He is also taking advantage of the situation that the corporation now finds itself in via the scandals created by Accountant and Operator. In doing so, Worker is using proxies to replace Accountant and Operator. In carrying out his plan to replace the management of Mousetrap, it would appear that Worker is planning to replace outgoing directors with scandals harming the company with a director who was previously involved in a scandal. It would therefore appear that the pill that Worker wants the board to redeem is both coercive and unfair. In Grand Metro, Public, Ltd. v Pillbury Co. it was held that the board may not refuse to redeem a pill if the pill is on its face, not coercive and not unfair. Therefore two conditions must be met by Worker if he wants to prove that his takeover bid is indefensible. He must prove to the satisfaction of the court that the takeover bill is not coercive and that it is fair. Since Worker took advantage of the scandal and in doing so purchased shares at a time when the stocks fell exponentially and is making statements calculated to remove management and change the company’s business objectives in a way that takes the company backwards, it can be argued that Worker’s takeover bid is not only unfair, but also coercive. Therefore the board of directors are at liberty to refuse to redeem the pill. In addition, it has been held that the courts will be entirely supportive of any board’s decision against the redemption of a pill if the board makes a decision or executes a plan that will be more beneficial to the shareholders (Dynamics Corp. of America v WHX Corp.). Obviously, the board’s decision to rehabilitate the corporation’s reputation and increase its stock prices is more beneficial to the shareholders who will part with their shares at a reduced price at worse and for par value at best under Worker’s plan. For those shareholders who would remain with the corporation, they confront the risk of the corporation’s image worsening if it places a previously scandalized director at the helm, considering the difficulties it is not undergoing with respect to a new scandal. Stock prices may very well decline again. Moreover, taking the company back to its original roots will also reduce the company’s profitability to the detriment of existing shareholders. Essentially, the board of directors is entitled to devise a plan and/or to refuse to redeem a pill if the pill is activated in a manner that is not adequate. In such a case, the appropriate response is to make a counter plan that provides for greater returns for the corporation and its shareholders. One appropriate response is to make another offer or tender offer for some percentage of the corporation’s shares. The court is likely to view the tender offer as a feasible means by which the value of the corporation can be maximized for the shareholder’s benefit (British Printing & Communication Corp. v Harcourt Brace Jovanovich). The tender offer is perceived as an additional or alternative plan in which the shares will be offered at US$45 as opposed to the US$40 offered by Worker and perceived as insufficient and disproportionate to a takeover bid or for ultimate control of the corporation. Based on the authorities and the facts and circumstances, it would appear that the board’s decision to refuse to redeem the pill and to offer a more fair and reasonable solution via a poison pill will be upheld by the courts. 2531 Words Part II: Family Business Corporate Charter: ARTICLES OF INCORPORATION OF Family Business The undersigned Incorporator of Family Business, a Close corporation, adopts the following Articles of Incorporation: ARTICLE I Name The name of the corporation is Family Business. ARTICLE II Duration The period of the corporation’s duration is __________________. ARTICLE III Purpose The purpose for which the corporation is organized is to conduct any and all lawful business for which corporations can be organized pursuant to _______________ statute, including but not limited to: iPhone Applications and associated hardware for measuring users’ skin conductivity and heartbeat to help diagnose symptoms of heart disease. ARTICLE IV Powers The corporation has the power to engage in any lawful activity under the corporation code of the State of Delaware, including opening and operating a bank account. ARTICLE V Initial Registered Agent 5.01 The name of the initial registered agent is: _________________________________________ 5.02 The street address of the registered agent is: ______________________________________ ______________________________________ ______________________________________ ARTICLE VI Statement of Acceptance by Registered Agent I, ___________________________, hereby acknowledge that the undersigned individual or corporation accepts the appointment as Initial Registered Agent of Family Business, the corporation which is named in these Articles of Incorporation. ____________________________________ Registered Agent ARTICLE VII Principal Office and Mailing Address 7.01 The complete street address of the initial designated principal office is: ________________________________________ ________________________________________ 7.02 The complete mailing address is: ______________________________________ ______________________________________ ARTICLE VIII Authorized shares 8.01 The number of shares of stock the corporation has the authority to issue is: ___________. 8.02 The class of stock issued shall be Class A Common stock. 8.03 Each share shall have a par value of $1.00. Article IX Directors and Officers The Corporations’ initial Board of Directors and Officers shall be comprised of the following persons: Name Title Address Sally Family, CEO, _________________________________ Ray Family, Director, __________________________________ Jared Family Director, __________________________________ Sharon Family, Director, __________________________________ Alisa Family Secretary, __________________________________ ARTICLE IX Bylaws The incorporator shall adopt the initial bylaws of the corporation. The stockholders may amend the bylaws at anytime by the provisions therein. ARTICLE X Dissolution Upon dissolution, assets shall be distributed by the Board of Directors according to the applicable State statute. Further provisions regarding distribution upon dissolution shall be stated in the Corporation’s bylaws. ARTICLE XI Indemnification The corporation does indemnify any directors, officers, employees, incorporators, and shareholders of the corporation from any liability regarding the corporation and the business of the corporation, unless the person fraudulently and intentionally violated the law and/or maliciously conducted acts to damage and/or defraud the corporation, or as otherwise provided under applicable state corporate statute. ARTICLE XII Incorporator I, _________________________, residing at ________________________________________, execute these Articles of Incorporation dated this __________day of ______________________, __________. _________________________________ Incorporator Correspondence Information is: _______________________________ _______________________________ _______________________________ Explanation: Article III establishes the objects of the corporation and while narrowly described at this point, those objects may be amended at a subsequent date should the directors decide to expand or change the original objects (Delaware General Corporation Law). At this point, the purpose for which the business is incorporated is related to iPhone applications related to reading and measuring skin conductivity and heart rate for the purpose of diagnosing heart disease. This does not mean that the company may only deal in those specific applications. Other ideas may have nothing to do with diagnosing heart disease and may for example be related to calculating fish locations or weather hazards. These applications will not be something new and extraneous to the original purpose of the corporation. However, should the directors decide however, that they want to expand the business to manufacture and sell articles of clothing, the objects should be amended to reflect this (Delaware General Corporation Law). When making any decision, you must refer to the bylaws of the company which are referred to in the Articles of Incorporation/Charter. The bylaws will set out the criteria for amending the objects/purpose of the business. It is important to note that at your first board of directors’ meeting, you will adopt the bylaws and it is therefore important that your bylaws set out what is required for approving corporate activities. It is also important to know that when a director is present at the first meeting and all other subsequent meetings, if he does not indicate an objection or a dissent at a proposed cause of action, he/she will be taken as registering approval (Delaware General Corporation Law). It is therefore important to speak up and indicate when there is an objection. This is particularly important because in most cases, unless otherwise stated in the bylaws, a quorum of directors will typically be enough to carry a resolution (Delaware General Corporation Law). For directorial action to be validated it is usually enough for a majority vote where a quorum is present at a meeting of the board of directors (Delaware General Corporation Law). With respect to a quorum Section 216 of Delaware General Corporation Law provides that the bylaws or the certificate of incorporation shall establish the quorum required for passing resolutions for any business transaction. However, the quorum cannot be made of a number that represents less than 1/3 of the shares that are entitled to vote at meetings, unless a specific class is required and in that case, a quorum shall not consist of less than one third of those particular classes of shares. Moreover, if bylaws do not specify the quorum, a majority of shares with a right to vote, either present personally or through a proxy will make up a quorum at a stockholders’ meeting. As for the election of directors, the directors shall be elected “by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors” (Delaware General Corporation Law, Section 216(3)). Be very careful when you make a decision to amend your bylaws relative to the method for voting for directors as such an amendment may not be further amended or “repealed by the board of directors” (Delaware General Corporation Law, Section 216). Moreover, when the directors amend the bylaws, the rebuttable presumption of the business judgment rule that the directors acted in good faith will apply (Am. Int’l Rent a Car, Inc. v Cross, C.A.). In regards to your bylaws, you may amend the bylaws at any time provided the stockholders approve the amendments. It is therefore important to note that the stockholders are holders of Class A Common stock which means that you each have voted in accordance with your share holdings. In a typical case each share is commensurate with one vote. All stockholders are entitled to one vote per share held. Moreover, each of the stockholders that are entitled to vote at a stockholders’ meeting or entitled to disapprove or approve of action taken by the corporation in writing absent a meeting, may appoint a proxy. However the proxy will expire at the end of three years from the date of appointment unless the proxy specifically establishes a different expiration data(Delaware General Corporation Law, Section 212). The Family Corporation is established as a Close corporation because of its size. Under Delaware General Corporation Law, a company with Close corporation status typically has less than 30 shareholders and is not a publically traded company subject to the securities regulations (Section 342). If by any chance the company grows and acquires more than 30 shareholders and it is determined that you want to be a publically traded company, you may change your status as a Close corporation by filing an amended certificate of incorporation with the Secretary of State (Delaware General Corporation Law, Section 345). However, an amendment changing the status of the corporation must be approved by not less than a two-thirds majority of outstanding shares (Delaware General Corporation Law, Section 346). Other Agreements Some of the family members have expressed a number of conditions and concerns relative to their becoming members of the company and investing their time and resources in the company. To accommodate these concerns and conditions, it is advised that the members sign a limited liability company agreement. The effect of a limited liability company agreement is to provide “that a peson shall be admitted as a member of a limited liability company, or shall become an assignee of a limited liability company interest or other rights or powers of a member to the extent assigned” (Delaware Limited Liability Company Act, 1992, Section 18-101(7)a). In this regard, a limited liability company interest is defined as a “member’s share of the profits and losses of a limited liability company” and the member’s “right to receive distributions of the limited liability company’s assets” (Delaware Limited Liability Company Act, 1992, Section 18-101(8)). Therefore the following limited liability agreements will have to be executed between the company designated members and these agreements should be ratified or adopted at the first meeting of the members: Limited Liability Agreement between Family Business and Jared and Sharon Family: Family Business Corporation (Hereinafter “the company) agrees to accept $100,000 each year for a five year period from Jared and Sharon Family in consideration of which Jared and Sharon Family will have the right to participate in the business planning and will receive 40% of the business’ equity should the business be sold. The Company also agrees to allow residents of Jared and Sharon’s adult-only living community to use applications free of charge. In acknowledging receipt of the sum of $500,000 at the end of the five year period, a guarantee will be provided to Jared and Sharon Family providing that $500,000 will be repaid to Jared and Sharon Family within 5 years. N.B. The guarantee may not be good idea at this time since the company does not have the funds or the capital to make such a guarantee. For example it was held in In re Reliable Mfg Corp. that guarantee made by a corporation at a time when capital was available was not illegal when the firm subsequently went into bankruptcy. By analogy, a company which makes a guarantee when there is no capital to support such a guarantee may be committing an illegal act. Thus the guarantee is suspended until such time as the funds have been invested. If at that time, the company has the available capital or the wherewithal to make such a guarantee it will be made. However, Jared and Sharon must bear in mind, that regardless of how profitable, Family Business may be after having received $500,000 from Jared and Sharon, the company’s financial situation may be quite different in five years. Therefore the company and Sharon and Jared are advised to proceed with extreme caution and to delay making any such guarantees until the initial five year period expires. An agreement between Ray Family and Family Business is not necessary as he is already appointed director of the company and will therefore have board voting and participatory rights. It will not be possible to confer upon Ray Family veto powers as there is only one class of stocks which confers upon the stock holders the right to vote pursuant to the number of shares that they have. It was held in Aldridge v Frando Wyoming Oil Co. that where a company issued shares which spoke to equity in terms of voting rights, to confer upon any shareholder a veto right was inconsistent with the intention behind the equitable distribution of shares and voting rights. Alisa was made secretary of the company which places her on the board of directors and she is therefore designated an officer of the company. Since she is only contributing talent and promises to secure contracts for the company. To offer her a share in the company’s equity at this point is premature since it is not known whether or not she will secure contracts for the company. Since this is a family business and she wants to be recognized for her contribution, appointing her as a secretary with remuneration rights appears to be fair at this point. However in order to meet her needs and to determine an outcome that is fair to her, the company and the other shareholders the following limited liability company agreement is recommended: This agreement is made on the day hereinbefore written between Family Business Corporation (hereinafter “the Company) and Alisa Family. It is hereby agreed that Alisa Family undertakes to secure certain contracts for the Company which are listed below. In consideration of these contracts, the Company’s directors will issue shares to Alisa Family in numbers that are proportionate to the contracts that she secures for the Company. Since Sally is committing her time to the corporation and giving up her job, she was appointed as the company’s CEO as this will give her the supervisory position that she requires in exchange for her initial commitment to the Family Business Company. Sally offers to mortgage her home to ensure that the company gets off to a good start and is ensured of a greater chance of becoming profitable. In exchange she wants a greater equity in the company. This is not an unreasonable request. In the event the remaining members of the corporation agree that she obtain a mortgage and increases her equity then she should commit the company to increasing her equity in the business. The following draft agreement is therefore applicable: This Agreement is made the date hereinbefore written between Family Business Company (hereinafter “the Company) and Sally Family. It is hereby agreed that in consideration of the sum of $_____________ paid by Sally Family, receipt of which is hereby acknowledge, the Company’s directors agree to issue ______________shares at a par value of $1 to Sally Family representing her increased equity in the company. N.B. the agreement will not be signed and the shares will not be issued unless and until Sally pays the money to the company. Sally’s comments relative to a buy/sell agreement and in particular her contention that she might buy back the shares of the company at a reduced rate must be reassessed. Any buy-sell agreement must be consistent with the fiduciary duty of good faith and the duty of loyalty in order to obtain the protection of the business judgment rule. In other words to avoid judicial review of the buy sell action, Sally will have to demonstrate that she acted in good faith and in the best interest of the company. If she is challenged by her siblings, they have the right to obtain appraisals which might demonstrate that what Sally proposes to pay is insufficient to justify the buy-sell (Lewis v Leaseway Transportation Corp). Therefore, Sally may want to rethink the possibility of a buy/sell agreement. Word count: 2,500. References Aldridge v Frando Wyoming Oil Co. 14 A2d 380 (1940). Am. Int’l Rent a Car, Inc. v Cross, C.A. No. 7593 (Del. Ch. May 9, 1984). Aronson v Lewis, 473 A. 2d 805 (Del. 1984). British Printing & Communication Corp. v Harcourt Brace Jovanovich, Inc. 664 F. Supp. 1519 (S.D.N.Y. 1987). Beard v Elster 160A.2d. 731 (Del. 1960). Cede & Co. v Technicolor Inc. 634 A.2d 345 (Del. 1993). Delaware General Corporation Law. Delaware Limited Liability Company Act, 1992. Dynamics Corp. of America v WHX Corp. 967 F. Supp. (D. Conn. 1997). Grand Metro, Public, Ltd. v Pillbury Co. 558 A.2d. 1049 (Del. 1989). Guth v Loft, Inc. 5 A.2d 503, (Del. 1939). In re Reliable Mfg Corp. 703 F2d 996 (7th Cir 1983). Lewis v Leaseway Transportation Corp, No. 8720 (Ch Ct. 6-12-87). Merrill Lynch. “How to Read A Financial Report.” (n.d.) http://ospflor63.stanford.edu/upload/handouts/Merrill_Lynch.pdf (Accessed May, 11, 2013). Model Business Corporation Act 1984. Moran v Household International, Inc. 500 A.2d 1346 (Del. 1985). Science Accessories Corp. v Summagraphics Corp. 425 A.2d 957 (Del. 1980). Smith v Van Gorkom, 488 2d. 585 (Del. 1985). Unocal Corp v Mesa Petroleum Co. 493 A.2d 946 (Del. Sup. 1985). Read More