Quiz 25: Corporate Directors, Officers, and Shareholders

Moving Company Information to the Internet Anyone who has ever owned shares in a public company knows that such companies often are required to distribute voluminous documents relating to proxies to all shareholders. Traditionally, large packets of paper documents were sent to shareholders, but in 2007 the Securities and Exchange Commission (SEC) permitted publicly held companies to voluntarily distribute electronic proxy (e-proxy) materials. In 2009, the SEC's e-proxy rules became mandatory. Now, all public companies must post their proxy materials on the Internet, although they may still choose among several options-including paper documents sent by mail-for actually delivering the materials to shareholders. Notice and Access: E-Proxy Rules Companies that want to distribute proxy materials only via the Internet can choose the notice and access delivery option. Under this model, the corporation posts the proxy materials on a Web site and notifies the shareholders that the proxy materials are available online. The notice and access model involves the following steps: 1. The company posts the proxy materials on its publicly accessible Web site. 2. Subsequently, the company sends a (paper) notice to each shareholder at least forty calendar days before the date of the shareholders' meeting for which the proxy is being solicited. 3. No other materials can be sent along with the initial notice (unless the proxy is being combined with the meeting notice required by state law). 4. The notice must be written in plain English, and it must include a prominent statement of the following: the date, time, and location of the shareholders' meeting; the specific Web site at which shareholders can access the proxy materials; an explanation of how they can obtain paper copies of the proxy materials at no cost; and a clear and impartial description of each matter to be considered at the share holders' meeting. 5. Next, the company must wait at least ten days before sending a "paper" proxy card to the shareholders. This ten-day waiting period provides shareholders with sufficient time to access the proxy materials online or to request paper copies. 6. If a shareholder requests paper proxy materials, the company must send them within three business days. 7. After receiving the initial paper notice, a shareholder can permanently elect to receive all future proxy materials on paper or by e-mail. Other Delivery Options Rather than using notice and access delivery, public companies can choose to deliver the full set of proxy materials to the shareholders in paper or electronic form, such as on a CD or DVD. They can also use a blend of these two options, as long as they also post the materials on a Web site. Many corporations choose one option for certain shareholders and another option for other shareholders, depending on the number of shares owned or whether the shareholders are domestic or foreign. The shareholder can always choose to receive paper documents rather than accessing materials online. Some corporate executives want the SEC to go even further and allow corporations to disseminate important information to the public via CEO blogs. Thus far, however, the SEC has not allowed companies to distribute proxy materials (or disclose material information to the public as required before issuing shares-see Chapter 26) via blogs. FOR CRITICAL ANALYSIS Why might a company or other party choose to solicit proxies the old-fashioned way-by providing paper documents instead of Internet access-despite the added costs?

Wonder Corporation has an opportunity to buy stock in XL, Inc. The directors decide that instead of Wonder buying the stock, the directors will buy it. Yvon, a Wonder shareholder, learns of the purchase and wants to sue the directors on Wonder's behalf. Can she do it? Explain. (See Shareholders.)

Answers to the even-numbered questions in this For Review section can be found in Appendix F at the end of this text. What are the duties of corporate directors and officers?

The five Learning Objectives below are designed to help improve your understanding of the chapter. After reading this chapter, you should be able to answer the following questions: What are the duties of corporate directors and officers?

Voting Techniques. Algonquin Corp. has issued and has outstanding 100,000 shares of common stock. Four stockholders own 60,000 of these shares, and for the past six years they have nominated a slate of candidates for membership on the board, all of whom have been elected. Sergio and twenty other shareholders, owning 20,000 shares, are dissatisfied with corporate management and want a representative on the board who shares their views. Explain under what circumstances Sergio and the twenty other shareholders can elect their representative to the board. (See Shareholders.)

David Brock is on the board of directors of Firm Body Fitness, Inc., which owns a string of fitness clubs in New Mexico. Brock owns 15 percent of the Firm Body stock, and he is also employed as a tanning technician at one of the fitness clubs. After the January financial report showed that Firm Body's tanning division was operating at a substantial net loss, the board of directors, led by Marty Levinson, discussed terminating the tanning operations. Brock successfully convinced a majority of the board that the tanning division was necessary to market the club's overall fitness package. By April, the tanning division's financial losses had risen. The board hired a business analyst, who conducted surveys and determined that the tanning operations did not significantly increase membership. A shareholder, Diego Peñada, discovered that Brock owned stock in Sunglow, Inc., the company from which Firm Body purchased its tanning equipment. Peñada notified Levinson, who privately reprimanded Brock. Shortly thereafter, Brock and Mandy Vail, who owned 37 percent of the Firm Body stock and also held shares of Sunglow, voted to replace Levinson on the board of directors. Using the information presented in the chapter, answer the following questions. 1. What duties did Brock, as a director, owe to Firm Body? 2. Does the fact that Brock owned shares in Sunglow establish a conflict of interest? Why or why not? 3. Suppose that Firm Body brought an action against Brock claiming that he had breached the duty of loyalty by not disclosing his interest in Sunglow to the other directors. What theory might Brock use in his defense? 4. Now suppose that Firm Body did not bring an action against Brock. What type of lawsuit might Peñada be able to bring based on these facts? DEBATE THIS Because most shareholders never bother to vote for directors, shareholders have no real control over corporations.

Nico is Omega Corporation's majority shareholder. He owns enough stock in Omega that if he were to sell it, the sale would be a transfer of control of the firm. Discuss whether Nico owes a duty to Omega or the minority shareholders in selling his shares. (See Shareholders.)

What must directors do to avoid liability for honest mistakes of judgment and poor business decisions?

What must directors do to avoid liability for honest mistakes of judgment and poor business decisions?

Liability of Directors. Starboard, Inc., has a board of directors consisting of three members (Ellsworth, Green, and Morino) and approximately five hundred shareholders. At a regular meeting of the board, the board selects Tyson as president of the corporation by a two-to-one vote, with Ellsworth dissenting. The minutes of the meeting do not register Ellsworth's dissenting vote. Later, during an audit, it is discovered that Tyson is a former convict and has openly embezzled $500,000 from Starboard. This loss is not covered by insurance. The corporation wants to hold directors Ellsworth, Green, and Morino liable. Ellsworth claims no liability. Discuss the personal liability of the directors to the corporation. (See Directors and Officers.)

What is a voting proxy? What is cumulative voting?

What is a voting proxy? What is cumulative voting?

Rights of Shareholders. Lucia has acquired one share of common stock of a multimillion-dollar corporation with more than 500,000 shareholders. Lucia's ownership is so small that she is wondering what her rights are as a shareholder. For example, she wants to know whether owning this one share entitles her to (a) attend and vote at shareholders' meetings, (b) inspect the corporate books, and (c) receive yearly dividends. Discuss Lucia's rights in these three matters. (See Shareholders.)

If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders compel the directors to act? If so, how?

The five Learning Objectives below are designed to help improve your understanding of the chapter. After reading this chapter, you should be able to answer the following questions: If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders compel the directors to act? If so, how?

Fiduciary Duties and Liabilities. Harry Hoaas and Larry Griffiths were shareholders in Grand Casino, Inc., which owned and operated a casino in Watertown, South Dakota. Griffiths owned 51 percent of the stock and Hoaas 49 percent. Hoaas managed the casino, which Griffiths typically visited once a week. At the end of 1997, an accounting showed that the cash on hand was less than the amount posted in the casino's books. Later, more shortfalls were discovered. In October 1999, Griffiths did a complete audit. Hoaas was unable to account for $135,500 in missing cash. Griffiths then kept all of the casino's most recent profits, including Hoaas's $9,447.20 share, and, without telling Hoaas, sold the casino for $100,000 and kept all of the proceeds. Hoaas filed a suit in a South Dakota state court against Griffiths, asserting, among other things, a breach of fiduciary duty. Griffiths countered with evidence of Hoaas's misappropriation of corporate cash. What duties did these parties owe each other? Did either Griffiths or Hoaas, or both of them, breach those duties? How should their dispute be resolved? How should their finances be reconciled? Explain. [ Hoaas v. Griffiths, 2006 SD 27, 714 N.W.2d 61 (2006)]

From what sources may dividends be paid legally? In what circumstances is a dividend illegal? What happens if a dividend is illegally paid?

The five Learning Objectives below are designed to help improve your understanding of the chapter. After reading this chapter, you should be able to answer the following questions: From what sources may dividends be paid legally? In what circumstances is a dividend illegal? What happens if a dividend is illegally paid?

Role of Directors. The board of directors of a property management corporation in Oregon meets on a regular basis. The company paid the directors $6,000 each in the third quarter of 2003. It did not report the payments as part of its payroll and did not pay unemployment tax on the payments. The Oregon Employment Department contended that the company owed $700 in unemployment taxes on the payments to the directors. The company protested. The administrative law judge (ALJ) for the Employment Department held that the company owed the taxes because directors' fees are the same as wages for employment. The company appealed. The court of appeals affirmed the ALJ's ruling. The company appealed again. Are payments to directors the same as wages for tax purposes? Explain. [ Necanicum Investment Co. v. Employment Department, 345 Or. 138, 190 P.3d 368 (2008)]

CASE PROBLEM WITH SAMPLE ANSWER: Duties of Directors and Officers. First Niles Financial, Inc., is a company whose sole business is to own and operate a bank, Home Federal Savings and Loan Association of Niles, Ohio. First Niles's directors included bank officers William Stephens, Daniel Csontos, and Lawrence Safarek; James Kramer, president of an air-conditioning company that serviced the bank; and Ralph Zuzolo, whose law firm served the bank and whose title company participated in most of its real estate deals. First Niles's board put the bank up for sale and received three bids. Farmers National Bank Corp. stated that it would not retain the board. Cortland Bancorp indicated that it would terminate the directors but consider them for future service. First Financial Corp. said nothing about the directors. The board did not pursue Farmers' offer, failed to timely respond to Cortland's request, and rejected First Financial's bid. Leonard Gantler and other First Niles shareholders fled a suit in a Delaware state court against Stephens and the others. What duties do directors and officers owe to a corporation and its shareholders? How might those duties have been breached here? Discuss. [ Gantler v. Stephens, 965 A.2d 695 (Del.Sup.Ct. 2009)]

Fiduciary Duty. Designer Surfaces, Inc., supplied countertops to homeowners who shopped at stores such as Lowe's or Costco. The homeowners paid the store, which then contracted with Designer to fabricate and install the countertops. Designer bought materials from Arizona Tile, LLC, on an open account. Designer's only known corporate officers were Howard Berger and John McCarthy. Designer became insolvent and could not pay Arizona Tile for all the materials it had purchased, including materials for which Designer had already received payment from the retail stores. Arizona Tile sued Designer and won a default judgment, but the company had no funds. Arizona Tile then sued Berger and McCarthy personally for diverting company funds that Designer had received in trust for payment to Arizona Tile. Arizona Tile argued that the use of the funds for other purposes was a breach of fiduciary duty. Berger and McCarthy argued that corporate law imposed neither a fiduciary duty on corporate officers nor personal liability for breach of a duty to suppliers of materials. Which argument is more credible and why? [ Arizona Tile, LLC v. Berger, 223 Ariz. 491, 224 P.3d 988 (2010)]

Rights of Shareholders. Stanka Woods was the manager and sole member of Hair Ventures, LLC, which owned 3 million shares of stock in Biolustre, Inc. For several years, Woods and other Biolustre shareholders did not receive notices of shareholders' meetings or financial reports. Nevertheless, Woods learned that Biolustre planned to issue more stock, and her boyfriend, Daniel Davila, proposed that they meet with other shareholders to discuss the company's operations and oppose the issue. To obtain information regarding what was going on at Biolustre, Woods, through Hair Ventures, sent Biolustre a demand to examine its books and records. Biolustre did not respond. Hair Ventures filed a suit in a Texas state court against the corporation, seeking an order to compel it to comply. Biolustre asserted that Hair Ventures' request was not for a proper purpose. Does a shareholder have a right to inspect corporate books and records? If so, what are the limits? Do any of those limits apply in this case? Explain. [ Biolustré Inc. v. Hair Ventures, LLC, __ S.W.3d __ (Tex.App.-San Antonio 2011)]

A Question of Ethics-Duties of Directors and Officers. New Orleans Paddlewheels, Inc. (NOP), is a Louisiana corporation formed in 1982. At that time, James Smith, Sr., and Warren Reuther were its only shareholders, with each holding 50 percent of the stock. NOP was part of a sprawling enterprise of tourism and hospitality companies in New Orleans. The positions on the board of each company were split equally between the Smith and Reuther families. At Smith's request, his son James Smith, Jr. (JES), became involved in the businesses. In 1999, NOP's board elected JES as president, in charge of day-to-day operations, and Reuther as chief executive officer (CEO), in charge of marketing and development. Over the next few years, animosity developed between Reuther and JES. In October 2001, JES terminated Reuther as CEO and denied him access to the offices and books of NOP and the other companies, literally changing the locks on the doors. At the next meetings of the boards of NOP and the overall enterprise, deadlock ensued, with the directors voting along family lines on every issue. Complaining that the meetings were a "waste of time," JES began to run the entire enterprise by taking advantage of an unequal balance of power on the companies' executive committees. In NOP's subsequent bankruptcy proceeding, Reuther filed a motion for the appointment of a trustee to formulate a plan for the firm's reorganization, alleging, among other things, misconduct by NOP's management. [In re New Orleans Paddlewheels, Inc., 350 Bankr. 667 (E.D.La. 2006)] (See pages 588-591.) 1. Was Reuther legally entitled to have access to the books and records of NOP and the other companies? JES maintained, among other things, that NOP's books were "a mess." Was JES's denial of that access unethical? Explain. 2. How would you describe JES's attempt to gain control of NOP and the other companies? Were his actions deceptive and self-serving in the pursuit of personal gain or legitimate and reasonable in the pursuit of a business goal? Discuss.

Henrichs v. Chugach Alaska Corp. Supreme Court of Alaska, 250 P.3d 531 (2011). government.westlaw.com/akcases FACTS The board of Chugach Alaska Corporation (CAC, a corporation of Alaska Natives) split into two factions-one led by Sheri Buretta, who had chaired the board for several years, and the other by director Robert Henrichs. A coalition of directors voted to remove Buretta and install Henrichs as the board's chair. During his term, Henrichs held miniboard meetings and made decisions with only his supporters present. He refused to comply with bylaws that required a special meeting of shareholders in response to a shareholder petition. In addition, he acted without board discussion or approval and ignored board rules in the conduct of meetings. He also personally mistreated directors, shareholders, and employees, as well as retaliated against directors who challenged his decisions by excluding them from the board and spending corporate funds to file meritless complaints against them with state authorities. After six months, the board voted to reinstall Buretta. CAC filed a suit in an Alaska state court against Henrichs, alleging a breach of fiduciary duty. A jury found Henrichs liable, and the court banned him from serving on CAC's board for five years. Henrichs appealed, claiming under the business judgment rule, he could not be found liable unless he had been "grossly negligent." ISSUE Does the business judgment rule protect Henrichs who acted in breach of his fiduciary duties? DECISION No. The Alaska Supreme Court affirmed the lower court's decision. The business judgment rule did not protect Henrichs. A director or officer can be held liable for a breach of fiduciary duty without a finding of gross negligence. REASON Henrichs contended that, under the business judgment rule, he could not be found liable unless he had been grossly negligent. The court agreed that the business judgment rule affords some protection for corporate directors, but added, "We have never measured the degree of protection afforded by the business judgment rule in terms of gross negligence." If there is evidence of bad faith, breach of a fiduciary duty, or acts in violation of public policy, the rule will not protect a director who makes bad business decisions from liability for those choices. The jury and the lower court had found that Henrichs committed a breach of fiduciary duty. The conduct was "volitional"-that is, Henrichs chose to act as he did and knew that his actions exceeded the rules. The misconduct was serious and egregious (outstandingly bad). In light of these findings, the business judgment rule did not protect Henrichs. FOR CRITICAL ANALYSIS-Ethical Consideration Does misbehavior such as the conduct at the heart of this case constitute a breach of business ethics? Discuss.

Guth v. Loft, Inc. Supreme Court of Delaware, 23 Del.Ch. 255, 5 A.2d 503 (1939). FACTS In the 1920s, Loft Candy Company was a publicly held company with a $13 million candy-and-restaurant chain. At the time Charles Guth became Loft's president in 1930, Guth and his family owned Grace Company, which made syrups for soft drinks in a plant in Baltimore, Maryland. Coca-Cola Company supplied Loft with cola syrup. Unhappy with what he felt was Coca-Cola's high price, Guth entered into an agreement with Roy Megargel to acquire the trademark and formula for Pepsi-Cola and form Pepsi-Cola Corporation. Neither Guth nor Megargel could finance the new venture, however, and Grace Company was insolvent. Without the knowledge of Loft's board of directors, Guth used Loft's capital, credit, facilities, and employees to further the Pepsi enterprise. At Guth's direction, a Loft employee made the concentrate for the syrup, which was sent to Grace Company to add sugar and water. Loft charged Grace Company for the concentrate but allowed forty months' credit. Grace charged Pepsi for the syrup but also granted substantial credit. Grace sold the syrup to Pepsi's customers, including Loft, which paid on delivery or within thirty days. Loft also paid for Pepsi's advertising. Finally, losing profits at its stores as a result of switching from Coca-Cola, Loft filed a suit in a Delaware state court against Guth, Grace, and Pepsi, seeking their Pepsi stock and an accounting. The court entered a judgment in the plaintiff's favor. The defendants appealed to the Delaware Supreme Court. ISSUE Did Guth violate his duty of loyalty to Loft, Inc., by acquiring the Pepsi-Cola trademark and formula for himself without the knowledge of Loft's board of directors? DECISION Yes. The Delaware Supreme Court upheld the judgment of the lower court. The state supreme court was "convinced that the opportunity to acquire the Pepsi-Cola trademark and formula, goodwill and business belonged to [Loft], and that Guth, as its president, had no right to appropriate the opportunity to himself." REASON The court pointed out that the officers and directors of a corporation stand in a fiduciary relation to that corporation and to its shareholders. Corporate officers and directors must protect the corporation's interest at all times. They must also "refrain from doing anything that works injury to the corporation." In other words, corporate officers and directors must provide undivided and unselfish loyalty to the corporation, and "there should be no conflict between duty and self-interest." Whenever an opportunity is presented to the corporation, officers and directors with knowledge of that opportunity cannot seize it for themselves. "The corporation may elect to claim all of the benefits of the transaction for itself, and the law will impress a trust in favor of the corporation upon the property, interest, and profits required." Guth clearly created a conflict between his self-interest and his duty to Loft-the corporation for which he was president and director. Guth illegally appropriated the Pepsi-Cola opportunity for himself and thereby placed himself in a competitive position with the company for which he worked. WHAT IF THE FACTS WERE DIFFERENT? Suppose that Loft's board of directors had approved Pepsi-Cola's use of its personnel and equipment. Would the court's decision have been different? Discuss. IMPACT OF THIS CASE ON TODAY'S LAW This early Delaware decision was one of the first to set forth a test for determining when a corporate officer or director has breached the duty of loyalty. The test has two basic parts-whether the opportunity was reasonably related to the corporation's line of business, and whether the corporation was financially able to undertake the opportunity. The court also considered whether the corporation had an interest or expectancy in the opportunity and recognized that when the corporation had "no interest or expectancy, the officer or director is entitled to treat the opportunity as his own."

Bezirdjian v. O'Reilly Court of Appeal of California, First District, 183 Cal.App.4th 316, 107 Cal.Rptr.3d 384 (2010). www.courts.ca.gov/1dca.htm FACTS Lawrence Bezirdjian was a shareholder of Chevron Corporation. In 2007, he filed a shareholder's derivative action against David O'Reilly and other members of Chevron's board of directors. The complaint included claims of breach of fiduciary duties, gross mismanagement, and waste of corporate assets in connection with illicit payments Chevron had allegedly made to Saddam Hussein in exchange for Iraqi oil from 2000 to 2003. In the complaint, Bezirdjian acknowledged that most of his factual allegations were derived from an article published by the New York Times. He also claimed that he was excused from making a prefiling demand on the board to institute this action because such a demand would be futile. Specifically, he stated that "the [board] cannot exercise independent objective judgment in deciding whether to bring this action or whether to vigorously prosecute this action because each of its members participated personally in the wrongdoing or are dependent upon other Defendants who did." The trial court stayed the action until Bezirdjian made a prefiling demand to give the board members an opportunity to decide whether to sue on behalf of the corporation. So the board formed a special committee of directors to consider and respond to this demand. The committee reported that it did not think it was in the best interests of Chevron or its stockholders to pursue the claims in the demand. The board decided not to sue. Subsequently, Bezirdjian submitted an amended shareholder's derivative complaint stating, among other things, that he had "made sufficient effort to get Chevron to bring this action and need do no more." The trial court granted Chevron's motion for judgment on the pleadings and dismissed the action. Bezirdjian appealed. ISSUE Did Bezirdjian present enough evidence to rebut the presumption that the board of directors' decision not to litigate was made in good faith and thus protected by the business judgment rule? DECISION No. The California appellate court affirmed the trial court's judgment. Bezirdjian failed to rebut the presumption that the board of directors' decision was made in good faith, and thus he could not go forward with the derivative action. REASON Chevron was incorporated in Delaware, and therefore, Delaware corporate law applied to this lawsuit. According to that state's law, "The decision to bring a lawsuit or to refrain from litigating a claim on behalf of a corporation is a decision concerning the management of thecorporation. Consequently, such decisions are part of the responsibilities of the board of directors." The court went on to apply the business judgment rule to the Chevron board's actions. "Because a conscious decision by a board of directors to refrain from acting may be a valid exercise of business judgment, where demand on a board has been made and refused, courts apply the business judgment rule in reviewing the board's refusal to act pursuant to a stockholder's demand to file a lawsuit." In this case, even though the allegations brought by Bezirdjian with respect to Chevron's alleged payments to Saddam Hussein suggested corporate wrongdoing, Bezirdjian had offered no specific facts that created a reasonable doubt as to the good faith of the board's investigation. He had thus failed to rebut the presumption created by the business judgment rule. In other words, "It was within the Board's power to refuse to undertake this lawsuit if it deemed the litigation would be contrary to the corporation's best interest." FOR CRITICAL ANALYSIS-Ethical Consideration Given that a shareholder's derivative suit is brought against the directors and not a party outside the corporation, is it fair to require that the shareholder first demand that the directors undertake the suit? Why or why not?