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Founders as Directors Must Avoid Self-Dealing

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Corporate founders who are also directors should avoid the appearance of self-dealing in utilizing corporate assets. An October 28, 2013, memorandum opinion by the Delaware Court of Chancery is a cautionary reminder of potential conflicts of interests giving rise to shareholder litigation (TVI Corp. v. Gallagher). Shareholders in this closely held corporation sued the directors (derivative action) asserting that the directors made wasteful employment agreements and retroactively approved financing on preferential terms to themselves to the detriment of the corporation and the shareholders. This comment will ignore the procedural aspects of the decision.

In short overview, several founders were major shareholders and members of the Board of Directors while other shareholders had provided nearly 50 percent of the paid-in capital. Shareholders could only elect directors that the founders nominated. The judge stated that "the facts alleged in the Complaint support a reasonable inference that the founders may have leveraged their control over the company to benefit one another in an 'I'll scratch your back, you scratch mine' type of relationship."

The judge cited prior Delaware decisions that an officer's or director's duty of loyalty requires them to "scrupulously" place the interests of the corporation and shareholders before their own. Directors have two central fiduciary duties: the duty of care and the duty of loyalty. Within these duties, the judge indicated, are the duties of proper oversight, candid disclosure of certain information to shareholders and avoiding wasting the corporation's assets.

The duty of care is procedural in nature. Directors must not be grossly negligent or uninformed when making decisions. Since these directors are not factually shown to have violated these procedural requirements, the judge dismissed the duty of care complaint.

Allegations that the directors made decisions motivated by self-interest in bad faith involve the duty of loyalty. This complaint could not be so easily dismissed. Directors must have "an undivided and unselfish loyalty to the corporation." The business judgment rule typically prevents second guessing board decisions but will not shield decisions made in violation of the duty of loyalty. When the facts indicate self-dealing, the burden of proof is on the directors to justify their decision and demonstrate the "entire fairness" of the transaction. Hence, a lesson from this case is that directors must carefully avoid the appearance of self-dealing. Full disclosure and not voting on board resolutions that provide personal benefit are typical ways of avoiding this problem.

An assertion that the directors failed to exercise proper oversight requires proof that the directors failed to create an information system or controls or, having an information system, consciously failed to monitor corporate operations. The judge dismissed this complaint.

The judge indicated that it is difficult to prove that directors wasted corporate assets. There must be proof of an unconscionable one-sided transaction or that the directors irrationally squandered, or gave away corporate assets. Since the founding directors provided their management expertise and experience in exchange for their employment contracts, the judge dismissed this complaint as well. Generous employment terms do not rise to the level of waste.

However, there was some evidence in this case that the directors failed to comply with required notice and quorum requirements in making certain decisions. This raises factual issues and calls into question the validity of these decisions. Consequently, another lesson is that directors must carefully observe all corporate formalities.

Founders may be accustomed to exercising broad managerial authority. When non-founder shareholders become part of the corporation, founder directors should anticipate potential appearances of conflicts of interest and be especially careful in preventing this.