Enforcing the Guardrails on Transactions Involving Interested Directors of Close Corporations

Farrell Fritz, P.C.
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In my business divorce practice I deal with many closely held corporations that have only a few or perhaps just two shareholders, each of whom is actively involved in running the business. Within that category are many companies whose owners essentially ignore some if not all the corporate formalities mandated by New York’s Business Corporation Law.

Foremost among the neglected formalities is a functioning board of directors as required by BCL 701 (“the business of a corporation shall be managed under the direction of its board of directors”), the members of which “shall be elected” at “each annual meeting of shareholders” as required by BCL 703. At least while relations among the owners are copacetic, I’m sure I’d be met with incredulous looks if I were to recommend annual board elections and regular board meetings complete with meeting minutes to a small group of operating owners who are in regular if not daily contact with one another.

Relations among co-owners can sour for many reasons. One of the more common reasons for dissension is a co-owner’s self-interested transaction with the company. Apart from whether the transaction breaches a common-law fiduciary duty, when the actor is a director — even if only nominally so — enter the “Interested Directors” statute, BCL 713, which imposes a series of guardrails on the ability of a director to engage the corporation in a contract or other transaction with any other entity in which the director has a substantial financial interest.

Early Common Law

First, some historical context.

I refer to Section 713’s “guardrails” in counterpoint to the harsher common-law approach that preceded and eventually was displaced by BCL 713’s adoption in the early 1960s. As explored in this 1973 article in the Fordham Law Review (the several quotes that follow are from the article), at early common law, “a contract between a director and his corporation, or between corporations with interlocking directorates, was voidable at the option of either corporation.”

By the mid-19th century, courts across the land treated such transactions as voidable without regard to their intrinsic fairness and freedom from fraud or other iniquity. In the latter half of the 19th century, a majority rule evolved to soften the rigid voidability rule where the transaction was approved by a disinterested majority of the directors, provided the transaction “was fair, open, and free from fraud.” A minority of courts including New York’s bucked the trend in favor of maintaining the voidability rule.

In 1886, New York’s high court “further rigidified” this “inflexible rule” in a case called Munson v Syracuse, Geneva & Corning R.R., where the court wrote that it would “‘not stop to inquire whether the transaction was fair or unfair’ since the law ‘prevents frauds by making them impossible, knowing that real motives often elude the most searching inquiry'” (ellipses deleted).

According to the Fordham Law Review article, by the early 1900s, with a boost from Judge Benjamin Cardozo’s 1918 Court of Appeals opinion in Globe Woolen Co. v Utica Gas & Electric Co., Munson‘s hold on New York’s lower courts began to erode “with the growth of corporations and an increasing awareness on the part of courts that the best interests of the corporation may be furthered by transactions with its own directors.” A 1942 Court of Appeals ruling in Everett v Phillips, in which the court “refused to accept the argument that a transaction between corporations having common directors was voidable without regard to fairness,” nonetheless stopped short of overruling Munson “which continued to be cited favorably by the New York courts.”

Section 713 to the Rescue

In 1961, made effective in 1963, the New York legislature enacted the brand new Business Corporation Law to replace the old Stock Corporation Law. The legislative history specific to Section 713 commented that Section 713’s “sole” purpose was “‘to eliminate the Munson case as controlling precedent,’ in favor of the more flexible approach of Phillips.”

Section 713(a) eliminated any vestige of the Munson rule by declaring that a self-interested transaction with a director is not “void or voidable for this reason alone” so long as either (1) a majority of the disinterested directors approves the transaction “by vote sufficient for such purpose without counting the vote of such interested director,” or (2) approval of the transaction by vote of the disinterested shareholders. Both forms of approval must be accompanied by “good faith” disclosure to the directors or shareholders of “the material facts as to such director’s interest” in the transaction.

Under Section 713(b), if neither board nor shareholder approval is garnered,

the corporation may avoid the contract or transaction unless the party or parties thereto shall establish affirmatively that the contract or transaction was fair and reasonable as to the corporation at the time it was approved by the board, a committee or the shareholders.

Section 713 in Action

The following case synopses illustrate some of the issues that arise in Section 713 challenges to self-interested director transactions in close corporations.

Approval by Independent Board. Heller v Lewis, decided by Albany Commercial Division Justice Richard Platkin, involved a dispute among members of a family-owned business. The executor of the decedent one-third shareholder filed suit against the company’s previously terminated president following his election to the board and reappointment as president as part of the settlement of litigation involving claims that he had misappropriated company funds. The settlement, which included payments to the reinstated defendant, was approved at a special meeting of the board by his brother as the sole disinterested director, or so the defendants contended. Ruling on the plaintiff’s motion to preliminarily enjoin the disputed payment to president, Justice Platkin found that plaintiff established a likelihood of success on the merits of his claim that board approval was invalid under Section 713(a)(1) due to the approving director’s lack of independence, quoting precedent for the proposition that a director’s interest “can be either self-interest in the transaction at issue or [the result of] a loss of independence because a director with no direct interest in a transaction is controlled by a self-interested director.” The approving director, the court found, had a substantial interest in approving the settlement based on his desire to return to compensated employment with the company, a decision that rested with his brother as the reinstated president, as well as allegations that he had engaged in similar misappropriations with his brother. Justice Platkin ultimately denied preliminary injunctive relief based on there being an adequate damages remedy.

Failure to Obtain Required Voting Percentage. In Lewis v Steinhart, the Appellate Division, First Department, affirmed a lower court’s judgment invalidating the corporation’s redemption of a shareholder’s stock where the seller was an interested director who could not have voted in his capacity as such for acceptance of his offer at the challenged joint meeting of shareholders and directors, and the remaining two directors who voted to approve the sale did not meet the 75% supermajority voting requirement in the company’s charter and by-laws.

Invalid Vote by Interested Directors. The First Department also invalidated a self-interested director transaction in Sardanis v Sumitomo Corp. In that case, the corporation’s former chairman of the board of directors and his co-director son assigned certain legal claims owned by the corporation to a trust of which their family members were beneficiaries. The assigned claims constituted all or substantially all the corporation’s remaining assets. The court held the assignment invalid, writing: “In this case, without approval of three of the five-person board of directors and the shareholders, plaintiff and his son, in a transaction that was outside the scope of RST’s usual or regular course of business (commodities trading), caused RST to assign legal claims constituting ‘all or substantially’ all of RST’s assets at that time, to an entity (Blauinsel) in which plaintiff and his son had a substantial financial interest. Under these circumstances, the lack of approval from the board as well as shareholders rendered the assignment void.”

Fair and Reasonable Wins the Day. In Anderson v Blabey, the Appellate Division, Fourth Department, affirmed the lower court’s dismissal of a shareholder’s derivative action alleging breach of fiduciary duty and non-compliance with BCL 713 by effectuating a reverse stock split. The court found that defendants established that their methodology for pricing the corporation’s shares prior to the split was reasonable, and that even assuming defendants failed to obtain proper board approval under BCL 713(a)(1), the defendants established that the stock option plan was fair and reasonable as to the corporation at the time it was approved by defendants under Section 713(b). 

Worthless Asset Defense Falls Short. Finally, in Bastidas v Garcia, involving two 50/50 shareholders-directors of a dissolved restaurant business, Queens County Commercial Division Justice Leonard Livote denied dismissal of a Section 713 claim seeking to vacate the allegedly improper transfer by one of the shareholders, prior to dissolution, of the restaurant’s trademarked name, which the transferee then used to open new restaurants on his own. Justice Livote found that the defendant failed to present evidence of approval by the directors or the shareholders, or that it was fair and reasonable to the corporation. He also found that the corporation’s dissolution did not affect the remedies available to plaintiff before dissolution, and that the defendant failed to support his assertion that the trademark lacked value or that the corporation abandoned it.

The Takeaway. There are close corporations that have functioning boards, and there are those that do not. For the former, if a majority of the board is disinterested and there is good faith disclosure of the self-interested transaction, board approval under BCL 713(a)(1) is the surest bet in the face of potential shareholder dissension. Combine that with disinterested shareholder approval and you have double-barreled protection. For the latter, and particularly if it’s a two shareholder, 50/50 corporation, the proponent of the self-interested transaction likely will need to establish that the transaction was fair and reasonable to the corporation.

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