Corporations Law

Corporations Law

Can ABC rescind the 2006 purchase of XYZ stock?

Rules

       The rule on whether the contract entered by a corporate in the  purchase of another corporation's stock is governed by the provision of law on Business Corporations.[1]

       One particular part is under section 302A.255 on Director Conflicts of Interest.     Subdivision 1 of the said section provides for procedure to be followed when conflict arises. Normally, a contract or other transaction between a corporation and its director or directors [2] or “between a corporation and an organization in or of which one or more of its directors are directors…or have a material financial interest, is not void or voidable”[3] by the mere fact that “the director or directors… are present at the meeting of the shareholders or the board or the committee[4]” at the time of authorization, approval or ratification of  the contract or transaction under given conditions.

        One of the conditions was the contract or transaction was fair and reasonable to the corporation at the time during its authorization, approval or ratification. What is fair and reasonable presupposes a condition as that one obtained in an arm’s length transaction where the authorizing, approving or ratifying corporation is not place in a very disadvantageous position as would prejudice the interest of the corporation.[5]  The body that will authorize, approve or ratify this kind of transaction is the board and the stockholders in separate meetings duly called for the purpose. There are requirements for valid meeting such as the constitution of quorum which normally could be majority or two thirds of the actual numbers of board members or stockholders of the outstanding shares of the corporation.

       Another condition is the requirement to disclose the  material facts about contract or transaction and about the director’s or directors’ interest to the holders of all outstanding shares. After the disclosure is the approval of the contract or transaction in good faith by  the stockholders of representing two-thirds of the voting outstanding shares less the voting shares of the interested director or directors. Alternatively the approval of the contract or transaction could be done by the undisputed affirmative vote of the outstanding shareholders, which include those with voting and non-voting rights.

       Another condition or requirement in order the contract should not be considered void or voidable is that there is also the need to have full disclosure  of the material facts about the contract or transaction and the interest of the director or directors to the board or a committee who will authorize, approve, or ratify in good faith the same contract or transaction by a vote of majority of the same board or committee but counting out the presence of the interested director or directors for purposes of establishing a quorum and the same interested director or directors are not entitled to vote.

         The law on Business Corporation defines material financial interest as a situation where a director has a financial interest in each organization in which the director, or his or her immediate family has a material financial interest.[6]

Application

      ABC Corporation appeared to have suffered financial loss as result of purchasing XYZ stocks. This could be evident for wrong decisions in 2006 made by previous management led by Adam together with other directors representing then the majority of the seven-man board for ABC. The wrong decisions made may have in fact contributed to their non-reelection for the 2007 ABC shareholders’ meeting in sometime in November 2007 and replacement of Adam as president.

     The law on Business Corporations contains certain alternative conditions for the application of a procedure in case of conflict of interest that must be complied if transaction involving two corporation involving a director or directors of the will not be considered void or voidable. Obviously the conditions violated include the following:

     Specifically, the violated provisions are as follows:

     a. The contract or transaction could not be determined as to fairness and reasonableness at the time it was authorized, approved or ratified by the board.

     Case facts say that Adam as president negotiated the purchase of XYZ stock by ABC and it was him alone as the president of latter company to have caused the execution of the purchase agreement. By acting as such, Adam was acting as if he alone determined that fairness and reasonableness of the transaction without any basis.  Since Adam eventually sought the approval of the other directors from the board, it could be inferred that he knew that the contract or transaction requires an approval of the board. What he has done was therefore akin to ratification since the approval was by the other members of the  board was done after Adam’s decision to  purchase the same via negotiation.

      There could be therefore no basis to determine fairness of the reasonableness due to the absence of explanation by Adam that the transaction could approximate an arm’s length transaction. In fact the intention of Adam to keep secret any basis for fairness or reasonableness was very obvious when Adam caused the signing of the purchase documents after he has discussed the ‘proposed’ acquisition with Barry, Charlie, and David separately or individually. Since discussion was done in the absence of the other directors, it may be inferred that there was no valid board meeting to make a valid act for the corporation.  Thus, the approval by the board, as believed by Adam, could not be considered a valid corporate act and does not bind ABC as a  corporation.

       The determination of fairness and reasonableness is therefore far from what is required by the law on the matter because of the lack of proper basis to determine the same from the agenda that would have been prepared and scheduled by Adam and the absence of a proper board meeting duly called for the purpose.

b.  The contract or transaction was not approved in good faith by the directors due to absence of full disclosure of director’s interest.

      Case facts provide that  ABC directors, other than Adam and Barry were not informed of the previous ownership of XYZ stock by Adam’s family members. Although Barry believed that the stock purchase was beneficial to ABC which caused him not to mention the issue to any other directors of ABC, his knowledge of the prior ownership of XYZ stock by members of Adam’s family could not to cure the defect of lack of full disclosure as required.  Even if the existence of such prior ownership could have been discovered by a review of the XYZ’s corporate records, the same could not also be used to justify lack of disclosure of the director’s conflict on interest as required by law.

      As stated earlier, the approval was invalid because the directors were not properly performing their function to decide due to lack of proper meeting called for to discuss the issue and the timing of knowledge by the other directors was made after the negotiated purchase. It is therefore impossible to that approval in good faith could be done under the circumstances.

c. There was no full disclosure of director’s interested to all the holders of the outstanding shares of the corporation.

     A contract or transaction with conflict of interest in one or more of the directors require the knowledge of all  the holders of outstanding shares of ABC and this was not complied with in the case at hand. There was no indication of any stockholders meeting duly called for the purpose.

  Conclusion

        It could be concluded that the contract or transaction between ABC and XYZ was void or voidable due to undetermined fairness and reasonableness at the time it was authorized, approved or ratified by the board due lack of proper board meeting, the contract not having approved in good faith by the directors due to absence of full disclosure of director’s interest and the not counted vote Adam for quorum determination or in approving the proposal and the lack of full disclosure of director’s interest to all the holders of the outstanding shares of the corporation.   Therefore ABC could validly rescind the 2006 purchase of XYZ stock.

Second Question

Issue

      Can ABC recover damages for XYZ’s unprofitability from of any the following: (a) Adam (b) Barry or (c) Charlie and David?

Rules

      Chapter 302A of the law on Business Corporations[7] provides for case of consequences of void or voidable contracts or transactions entered into in case non-compliance with the conditions or procedural requirements where such contracts or transactions contain conflict of interest on the part of directors.  While not all contracts or transactions entered into are not in themselves void or voidable there are conditions that must be fulfilled before they could be enforceable and perfectly valid.

       A director who is found to have material interest in such transaction involving the corporation is bound to make full disclosure of his interest not only to the board but also to all holders of the corporation’s outstanding shares. Such interested director cannot vote in determining quorum and in approving such kind of proposal.  Cancellation or nullification of void or voidable contract would cause bringing back the parties into their original conditions and if no longer possible, the persons responsible for non-compliance with requirements of such kind of contracts are liable to the corporation.

       Section 302Q.361 on Standard of Conduct under the law on Business Corporations[8] requires and officers which include directors to discharge their duties in office in good faith by reasonably acting in the best interest on the corporation. They are expected to exercise the care used by an ordinary prudent person in doing things under similar circumstances.

Application

a. As to Adam

         Adam was the director and president of the ABC in 2006 when the purchase of XYZ stocks was made. Since, Adam was the person who caused the damage to ABC due to unprofitability of XYZ, then he can be held liable for damages. Adam was a director and by his having a material interest in the transaction by the purchase of XYZ stock owned by his immediate family, which was actually not good purchase due to not having been fully disclosed to the board and to all the outstanding shareholders, has caused damage to the company.   The same amounts to lack of good faith on his part and as such he should be held responsible for the consequences of the purchase transaction. Since the transaction could be cancelled and if the sellers could not made to buy back the XYZ stocks, then it should  be Adam who should be made to pay  ABC in the form of damages.

b. As to Barry

       As for Barry, it appears that he was negligent for also not making the proper disclosures to the other directors and he could be deemed to have acted in connivance with Adam. However case facts say that he believed that transaction was beneficial to the company, yet he should  be deemed to have either studied carefully the proposal based on records if indeed it was fair and reasonable.  He could be considered to have acted negligently for ABC for failing to check the records.  The consequences of his negligence is however lower than the deliberate intention of Adam to profit from the transaction.  Since there is no evidence that he benefited from the approved purchase transaction, his liability to the corporation for damages should be tempered by his honest belief the transaction was involved since the same could be considered expansion by the company. His prudence and diligence is expected under the law thus his failure to act in the best interest of the corporation makes him still liable for damages.

c.  As to Charlie and David

        These other two directors also approved of the purchase although, being part of the majority board of directors. Their liability for damages to the corporation could only come from exercising their functions in a disloyal manner and in case of their negligence that cause damaged to the corporation.

       The non-disclosure of material interest could have been discovered if these two directors exercised diligence since the same could be discoverable from the records. Their liability therefore damages could still be in order for approving what they should not have approved in the first place. Since they failed to check the records to determine the conflict of interest, then they could still be declared negligent. Their liability for damages however should be mitigated by the fact that they expected to have  been notified about the conflict of interest.  Their diligence as ordinary prudent persons is expected thus their failure to act in the best interest of the corporation makes them still liable for damages.

Conclusion

         It can be concluded that among the four former directors of ABC, each has its own responsibility to answer for damages to the corporation.  Adam is the guiltiest of them all since it was him who initiated the contract and just had directors  Barry , Charlie and David to sign the documents in approving the purchase that he has negotiated.  He could be made therefore liable for the damages suffered by ABC due to XYZ unprofitability.

       For Barry, his liability could come from his negligence for approving a contract with conflict of interest without evaluating the same as to fairness and reasonableness. His honest belief that it beneficial to the company could not fully excuse him from his responsibility to decide what is beneficial to ABC based on other sources.

      Charlie and David may appear to be the least guilty among the directors due to lack of knowledge on conflict of interest caused by non-disclosure. But since they are expected to exercise diligence in the exercise of their functions as directors, they could still be held liable for damages but should be to a lesser degree than Barry and of course Adam.

References:

Minnesota Office of Revisor of Statures, 2007 Minnesota Statutes:  Chapter 302A on Business Corporations, 2007 {www document } URL,  https://www.revisor.leg.state.mn.us/statutes/?id=302A&view=chapter, Accessed August, 9,2008

Tatum, M., What is an Arm’s Length Transaction, 2008 {www document} URL, http://www.wisegeek.com/what-is-an-arms-length-transaction.htm,  Accessed August 9,2008

[1]Minnesota Office of Revisor of Statures, 2007 Minnesota Statutes:  Chapter 302A on Business Corporations, 2007 {www document } URL,  https://www.revisor.leg.state.mn.us/statutes/?id=302A&view=chapter, Accessed August, 9,2008 [2] Ibid [3] Ibid [4] Ibid [5] Malcolm Tatum, What is an Arm’s Length Transaction, 2008 {www document} URL, http://www.wisegeek.com/what-is-an-arms-length-transaction.htm,  Accessed August 9,2008 [6] Minnesota Office of Revisor of Statutes, 2007, see above [7] Ibid [8] Ibid