Corporations Law

Corporations Law

Question No. 1

Issue

Can ABC rescind the 2006 purchase of XYZ stock?

Rules

        To purchase the stock of another corporation is a serious decision that must be made responsively by the board.  This becomes more serious if the purchase is done under a possible conflict of interest on the part of a director or directors.

       The law on Corporations provides guidelines for this kind of purchase particularly under Section 302A.255 on Director Conflicts of Interest[1].    Certain rules or procedures  are provided under the said section which must be carefully observed by the director or directors who may happen to encounter said situation.  The rule on conflict of interest therefore is concerned about a transaction between a corporation to one or more of its directors or one which involves the corporation and another corporation where the director of the first corporation has material interest to the second corporation because he/she or his/her family members happen  to have a financial interest with another corporation.  The presence of the directors in the board meeting during the authorization, approval or ratification of the contract will not in itself cause the contract to become void or voidable at the time if said director can comply with the requirements of the law.

        The first requirement that must be complied is that the contract or transaction must be fair and reasonable to the corporation when it was  authorized, approved or ratified. For a contract to be fair or reasonable, it must be free from bias for an intention for any director or directors to personally or indirectly  benefit from the same. Thus one standard of determining what is fair and reasonable is that it must at least approximate a transaction as if the parties to contract are independent to each other and each corporation will protect its own interest in the transaction.

       The second requirement is the obligation of the interested  director to make full disclosure about the material facts on the transaction and his or her interest on the matter. The disclosure is of course expected to be used as basis for decision making by the board. The board will act on the matter on a meeting duly called for the purpose where a majority of it will have the final say on whether the contract should proceed or not.  The vote of the then  the interested director will not be counted to determine quorum and also for the approval of the transaction contract as required by the law.[2]

      The third requirement is for the directors to act and approve the contract in good  faith.  This therefore presupposes  careful examination  of the details of the contract to afford the board of good information for evaluating whether the  contract is fair and reasonable to the corporation.

      The fourth requirement is still another full disclosure of the interest and material fact to all the stockholders outstanding and the there is a need to have two-third of the votes cast in order to approve the contract.

        For purposes of conflict of interest,  material financial interest means a state of affairs where a director or directors have financial interest in the other organization, XYZ, in this case where the sane director, or any member of his or her immediate family has a material financial interest.[3]

Application

      ABC Corporation was the victim of the purchase transaction since according to case facts  XYZ has been losing since the purchase. A loss suffered by XYZ is a financial damage to ABC stockholders. The stockholders had shown their ire to directors led by Adam by not reelecting them in 2007, after the questionable purchase.

      If Adam had good intention for ABC, the law on  Corporations does not make such contracts automatically void. Instead  conditions are set for the application of legal procedures in case there is conflict of interest by a director or directors of a corporation.  As it turned out however, the purchase was disastrous to ABC and going back to compliance of the conditions revealed the evil plan of Adam to personally or indirectly benefit from the transaction.

      The requirement of fairness and reasonableness at the time of its authorization, approval  or ratification was not established mainly due to non-disclosure of interest and material fact and lack of proper meeting called for the purpose as shown by individual discussion made by Adam.

      Adam as president opted to negotiate the purchase of XYZ stock instead of bringing first the issue to the ABC board for authorization.  He abused his being president by making first the purchase agreement with XYZ before getting the nod of the board. Fairness could only be further from what the law requires by acting as such in the given situation.  Adam’s seeking the nod of the other directors from the board afterward presupposes his knowledge that such was a requirement but he chose to do it after not before. He just wanted then ratification which was not proper in the case at hand as full disclosure of the material facts was a strict requirement of the law.

      There was no approval of the contract in good faith by the directors as required by the law to confer validity to the contract.   The lack of full disclosure of director’s interest and material fact to the board could not be taken as good faith.  Since directors other than Adam and Barry were not made aware about prior ownership of XYZ stock by the family members Adam, such a scheme is tantamount to hiding the evil plan.  Barry’s belief  that  the stock purchase of XYZ was beneficial to ABC, which he argued as the reason for not mention the issue to any other directors of ABC is bereft of  good judgment of a responsible director,  because he could have dug deeper to determine fairness of the transaction.  The approval by the four directors was still invalid due to lack of good faith applied.

      Another violation to merit non-granting of contract validity is the lack of full disclosure of director’s interest to all the holders of the outstanding shares, who would have to vote on the issue.  There was no meeting held by stockholders, hence there could have been no approval made on the purchase of XYZ stock.  The contract that was therefore executed between ABC and XYZ is not valid due to noncompliance with legal conditions as explained above.

  Conclusion

        Since there was failure to comply with legal requirements to sustain perfect validity of the contract, it could be deduced the contract is perfectly void or voidable. The issue on fairness and reasonableness at the time it was authorized, approved or ratified by the board was not determined. There was lack of  proper board meeting and as such, the contract was not approved in good faith by the directors since the there was no  full disclosure of director’s interest and material fact. Had they been made and directors would have been guided in making the responsible decision for ABC. The other directors outside the four who signed, were not notified of any meeting of the board about the purchase thus the absence meeting simply means lack of valid corporate act made on the issue.   Adam failed also to disclose fully his interest on the contract to all the holders of the outstanding shares of the corporation and there was failure to hold such shareholders’ meeting.    Therefore ABC is in a perfect position to validly rescind the 2006 purchase of XYZ stock by the previous directors led by Adam.

Question No. 2

Issue

      Can ABC recover damages for XYZ’s unprofitability from Adam, Barry or Charlie and David ?

Rules

       The law on Business Corporations[4] entails consequences of void or voidable contracts entered into by interested directors or directors for failure to follow the requirements prescribed therein.  A contract or transaction could come within the purview of conflict of interest  by company directors or in their individual capacity.

      Some transactions could in fact become valid and binding if conditions are complied with. One condition is that contract must be fair and reasonable to the corporation.  Another is that a director in a conflict of interest situation has the duty to fully disclose his interest to the board in a meeting to be properly called for the purpose where such interest will be deliberated upon and votes on the proposal should be recorded for purpose of authorizing, approving or ratifying the same.  The director is prohibited to vote on the proposal or his or presence in the meeting could not be used to establish a quorum in the  board for passing a valid act for the corporation The disclosure needs to be made  to the all the outstanding stockholders since two thirds of the outstanding shareholder will have to show their agreement or conformity with the proposal to purchase under the law on  Corporations.[5]

      If the conditions are not complied with, the contract is said to be void or voidable which could entitle the corporation to cancel the said contract and restore back the parties into their old situations before the purchase or convert altogether the liability of the other corporation or party to being just liable for damages.

      Holding a position or becoming an officer of a corporation in the US is a responsible act which is regulated by the law on  Business Corporations particularly on Standard of Conduct.[6]  Under the provision of said law, corporate officers such as directors are required to perform their duties in office in good faith by justifiably doing things in the best interest of the corporation. The ordinary prudent person framework is a standard that each officer is expected to exhibit under similar circumstances, thus they need to exercise the care as may be required in given circumstances.  Care in the performance of their functions could be seen by observing the results of these decisions in terms of meeting the objectives of the corporation, which among, other include being profitable.

Application

On Adam’s liability

         Adam, according to the case facts, was a director and president of the ABC when the purchase of XYZ stocks was made by ABC in 2006.  He was the very person who appeared to have caused directly the damage to ABC if the unprofitability of XYZ is to be evaluated under the facts of the case.  As such the liability for damages would attach to him under the principle that he who is the cause of the evil caused is liable for damages.  It is clear that he  had a material interest in the transaction by the purchase of XYZ stock since the acquired company entails ownership by his immediate family. This made the transaction fishy because he failed to comply with needed requirements of disclosure to both the board and stockholders. His action is considered bad faith to make him responsible for the consequences of the purchase contract.  If the transaction could be cancelled and  the original sellers could still be made to buy back the XYZ stocks, such should be done. If not the obligation of seller to buy back or pay damages will become the responsibility  of  Adam for damages.

On Barry’s liability

      Barry could be considered liable for acting negligently to perform his job as director with his ignorant belief that the contract is beneficial to ABC. He did not cause any deeper investigation that could have told him the truth that contract was not fair and reasonable.  He could have dug the records. His negligence has its consequence for liability for damages but it would be lower than that of Adam due to the deliberate intention of the latter to profit from the transaction and intention to not to disclose.  Barry could not be said to have interest in the case under the given state of facts but if he has profited from it, he must also restore the same. The law requires him still be careful and prudent, hence he is still liable.

On Charlie’s and David’s liability

         Charlie and David are still liable for damages to ABC because of their negligence in not trying to establish that the contract was fair and reasonable. The non-disclosure of material fact and material interest was discoverable by the use of proper diligence.  Since they failed  to do what is expected from them as directors,  their liability is in order but the same should not be higher than that of Barry who was more responsible because of his prior knowledge.

       Due to noncompliance of conditions required by the law on Corporations, as stated and discussed above, for the contract or transaction involving a conflict of interest of  Adam as director of ABC in relation to the acquisition of XYZ to be upheld for validity, ABC under the new board can lawfully rescind or cancel the contract on the purchase of XYZ shares.

Conclusion

          All of the parties are found liable but the liability each differs as to degree because of the differences in participation made in the decision to purchase.  The basis for the liability of the Adam was his obvious intention to profit from the transaction, thus he could be the only that could be perfectly held liable.   For Barry, Charlie and David, their liability is just based on their negligence or failure to practice the prudence required of them by the law on Corporations as officers or directors of ABC.

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

[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] Ibid [6] Ibid, see Section 302Q.361