How conflicts of interest in transactions and contracts between a corporation and its interested directors are handled has changed over the years. This is due, in part, to a shift in legislative thinking regarding how directors can and should interact with the companies they serve and whether such conflicts were inherently harmful. In 1966, 1972, and again in 1988, the Pennsylvania legislature codified this way of thinking, that, despite the presence of a conflict of interest, it may not actually harm the corporation and might therefore be acceptable.
Conflicts of interest in transactions and contracts arise when a director officer has “a financial or other interest” and may execute or authorize a transaction or contract whereby the director benefits and the corporation may or may not. This benefit could be monetary, inter-personal, or inter-institutional. In other words, the conflict could benefit the director’s bank account, his or her relative, or a charity or organization that he or she either works for or supports. Traditionally, shareholders could bring an action to set aside the transaction or contract on the basis of a director’s conflict of interest alone. Conflicts were subject to the strictest scrutiny and were almost always set aside. The conflict would void the transaction and the interested director may also need to provide an accounting for the board of directors and/or the shareholders to disgorge any benefit received from the deal.
The legislature recognized that not all conflicts of interest between directors and the corporations they serve are inherently unfavorable. Under certain conditions, such conflicts can be beneficial for both parties involved and, therefore, should not face a categorical ban. Section 1728 of the Pennsylvania Business Corporation Law of 1988 (“PBCL”), 15 Pa. C.S. § 1728, recognizes that, under certain circumstances, a conflicted transaction may not be as harmful as originally feared.
The general rule under the statute is that a transaction between a corporation and one or more of its directors, officers, or any entity in which such directors or officers have a vested interest is not void or voidable solely because of the conflict. Likewise, the contract or transaction is not voided or voidable solely because the conflicted director or officer is present or participates in the board of directors’ meeting that authorizes the contract or transaction. The officer or director may also have his or her votes counted to authorize the conflict. These general rules apply only if one of three conditions are met.
First, the interested director or officer must disclose all facts material to the transaction in terms of the relationship or interest he or she has. Further, all material facts regarding the contract or transaction itself must be disclosed to the board of directors. The board must then authorize the contract or transaction by an affirmative vote of a majority of the disinterested directors. The vote will be valid even if the disinterested directors make up less than a quorum. All directors present are counted for purposes of determining a quorum, even if some directors are interested.
Second, the interested director or officer must disclose all material facts regarding his or her relationship or interest to the shareholders with voting power within the entity. As with required disclosures to the board of directors, interested corporate officers must also disclose the material terms of the contract or transaction to the voting shareholders where they are entitled to vote on such transactions or contracts. The contract or transaction must be specifically approved in good faith by a vote of those shareholders.
Third, the contract or transaction must be fair to the corporation at the time it is authorized, approved, or ratified by the board of directors or the voting shareholders. Note that the section of the PBCL applicable to “interested shareholders,” 15 Pa. C.S. § 1770, was repealed in 1990 except as to Pennsylvania corporations registered with a Stock Exchange. 15 Pa. C.S § 2538. Although the legislature is more willing to allow conflicted transactions and dropped the “good faith” requirement of prior law, the Legislative Notes remind a reader that directors, both interested and disinterested, and officers still have a fiduciary duty to the corporation in approving such transactions or contracts set forth in 15 Pa. C.S. §§ 1712, 1715, or 1716
The more flexible approach requires examining the totality of the circumstances presented to determine whether the conflicted transaction was truly detrimental to the corporation. If the effect of the contract or transaction on the entity and its shareholders was fair, it is more likely to receive court approval. While still facing a strict review process, given the high standards of care and fiduciary duties owed by officers and directors, it appears as though there is no longer a blanket ban on interested dealing.
The liberal provisions of the statute giving the green light to certain conflicted transactions are, however, still subject to an entity’s bylaws. This means that if a corporation did not wish to allow any of its officers or directors to engage in any kind of conflicted transaction or contracting, it could prevent them from doing so by disallowing such deals in its bylaws.
With contribution from Sarah Rothermel, J.D. Widener Law Commonwealth.