5.1.2 Disinterested board approval: The trusteeship strategy

Like mandatory disclosure, disinterested approval is a nearly universal requirement for self-dealing transactions. A manager who wishes to transact with the firm must generally receive consent from her (disinterested) superiors. When the interested manager is a CEO or director, however, the only superiors who can give consent are the disinterested members of the board itself. Thus, disinterested directors ordinarily evaluate high-level self-dealing transactions (regardless of their ability to do so), unless the magnitude of the transaction or the structure of the board subjects the company to another legal strategy, such as a requirement to obtain the approval of the general shareholders meeting.

23 Regarding proxy contests, see supra 3.1.1.4.

24 See, e.g., Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through

Pretrading Disclosure, 71 SOUTHERN CALIFORNIA LAW REVIEW 303 (1998).

25 Two authors estimate that 30% of French sociStes a responsabiUti IhniUe (SARL) and non-listed

SA, and 80%-95% of Germany's closely held corporations (Gesellschaften nut beschrdnkter

Haftung—GmbH), do not disclose their financial statements. See Maurice Cozian, Alain Viandier

and Florence Deboissy, DROIT DES SocrETEs N"413 (15th ed. 2002); Mathias Habersack,

EuROPAisCHES GESELLSCHAFTSRECHT N°90 (2nd ed. 2003). Under EU pressure, Germany has

recently adopted legislation to raise its compliance rates.

26 See 516.20(a) Revised Model Business Corporation Act (RMBCA).

5.1.2.1 The scope of board approval

Most jurisdictions make board review of conflicted transactions either mandatory or strongly advisable.27 Japan and much of continental Europe mandate approval by disinterested board members, especially when transactions involve directors of public corporations.28 French law, which is particularly stringent, requires disinterested board authorization for all transactions between a societe anonyme (SA) and its directors or general managers that are not both 'ordinary' and at market conditions.29 Japanese law is similarly stringent.30

Of course, continental European jurisdictions recognize certain limitations on the reach and effects of board approval. On the one hand, small, closely held corporations without outside board members (or even a board) are generally exempt from a board approval requirement. Thus, French law requires shareholders—but not boards—to approve conflicted transactions in closely held SARL, while German approval requirements are similarly targeted at larger companies with supervisory boards. On the other hand, approval marred by materially incomplete disclosure, bad faith, waste of assets, decisive voting by a conflicted director, or other defects fails to satisfy approval requirements in the case of public companies.31

Although Anglo-Saxon jurisdictions stop short of the continental European norm of mandating board approval of conflicted transactions, they strongly encourage board approval nevertheless. The UK, for example, makes shareholder approval of conflicted directorial transactions its default rule (various significant transactions excepted), which naturally encourages companies to substitute the less costly procedure of disinterested board approval in their charters.32 The U.S. encourages interested managers to seek board approval by according transactions that are authorized (or ratified) by the board strong protection from shareholder challenge. U.S. states that follow the Revised Model Business Corporation Act (RMBCA) give business judgment protection

27 See Klaus J. Hopt, Self-Dealing and Use of Corporate Opportunity and Information: Regulating

Directors' Conflicts of Interest, in Klaus J. Hopt and Gunrher Teubner (eds.), CORPORATE GOVERN-

ANCE AND DIRECTORS' LIABIIJTIES 285,289 (1985).

28 An exception is Switzerland, which does not require board approval for transactions between

managers and their companies. Sec Peter Bockli, SCHWEIZER AKTIENRECHT N°1628 (2nd ed. 1996).

However, a disinterested director must represent the company when it transacts with a board member:

Erbengemeinschaft J. M. v. K.AG, AMTLICHE SAMMLUNG (AS) 127TTI 332,334-5 (Federal Tribunal,

2001).

29 Art. L. 225-38 Code de commerce (also applicable to third parties acting for directors or general

managers) and Art. L. 225-39 {exempting transactions that are taken in the ordinary course of

business and reflect market conditions). Compare, for Germany, J114 Aktiengesetz {transactions

regarding the provision of significant services or work by supervisory board members must be

approved by the board); and $89 and $115 Aktiengesetz (requiring supervisory board approval for

loans to management and supervisory board members).

30 Art. 265(1) Commercial Code.

31 See, e.g., James Fanto, CORPORATE GOVERNANCE IN AMERICAN AND FRENCH LAW 61 (1997).

32 See Eiiis Ferran, COMPANY LAW AND CORPORATE FINANCE 169-70 (1999) {substitution of

disinterested board approval in the charter). Shareholder consent remains mandatory for, among

others, substantial property transactions: see infra 5.1.3.

to conflicted transactions after disinterested approval by the board (a doctrine that makes these transactions very difficult to challenge successfully),33 while even non-RMBCA states—including Delaware—permit such approval (at the very least) to shift the burden of proof of fairness (or unfairness) from the defending director to the challenger.34

In addition, both the UK and U.S. require directors to disclose their personal interests in company-related transactions to the board,35 which is only marginally different from requiring the board's explicit authorization or ratification. Indeed, the U.S.—together with Japan—appears to require the disclosure of all material information, an apparently higher standard than imposed by European jurisdictions. But this difference too is largely illusory. France mandates extensive disclosure prior to seeking shareholder approval, which must frequently be done for interested transactions;36 and the UK requires extensive disclosure whenever a company's charter substitutes board for shareholder approval of conflicted directorial transactions.37

Finally, regardless of the treatment of traditional self-dealing, all major jurisdictions (including the U.S.) require boards to approve the compensation of top executive officers.38 To be sure, judicial scrutiny of board performance in this respect has been loose—U.S. compensation decisions are generally protected by the business judgment rule,39 while German decisions require only an adequate relationship between the compensation levels and job characteristics.40 Nevertheless, as new forms of compensation such as stock options have emerged, regulatory and investor pressure have prompted listed companies to adopt self-regulatory measures, such as assigning compensation decisions to specialized committees on the board staffed entirely by independent directors— a trend that can only be reinforced by post-Enron reforms.41

33 See $$8.60 through 8.63 RMBCA. The transaction is binding unless the person challenging the

transaction proves that duectors simply went through the motions of board action {as an accommo-

dation to the involved director) or that their approval was not based upon a minimum of information

and rationality.

34 See $8.31 Model Business Corporation Act; Flteger v. Lawrence, 361 A.2d 218 (Delaware

Supreme Court 1976); Kahn v. Lynch Communications Systems, Incorporated, 638 A.2d 1110

{Delaware Supreme Court 1994).

ls For the UK, see $317 Companies Act (any interest in any transaction); Paul Davies, INTRODUCTION TO COMPANY LAW 174 (2002). For the U.S., see Comment to $5.02(a)(l} American Law Institute (ALI) Principles of Corporate Governance (1994); see also Black, supra note 10.

36 In addition, following recent statutory reform, directors and general managers must report all

but transactions of minor importance with the corporation to the chairman of the board, i.e. even

those that are not subject to shareholder approval (Art. L. 225-39 Code de commerce). The full board,

as well as auditors, are provided with a detailed list of the transactions thus reported,

37 See Davies, supra note 35, 175.

38 See $8.11 Model Business Corporation ACT.

39 Clark, supra note 4,192. One of the few cases where compensation has been judged unreason-

able is Rogers v. Hill, 289 U.S. 582 (1933).

40 $87 Aktiengesetz (supervisory board approval for compensation of executives that are members

of the Vorstand).

41 For the U.S., see Larry E. Ribstein, Market vs. Regulatory Responses to Corporate Fraud:

A Critique of the Sarbanes-Oxley Act of 2002, 28 JOURNAL OF CORPORATION LAW 1, 12 (2002);

5.1.2.2 Remedies for inadequate board approval

In all major jurisdictions, the remedy for a conflicted transaction concluded without effective approval is either to void the transaction or to compensate the company for any resulting harm. Jurisdictions diverge, however, in the extent to which they encourage one or another of these remedies. Nullification plays a greater role in the UK, whereas the damages remedy appears to be favored in the U.S.42 France and Japan walk a middle road by favoring nullification when conflicted transactions lack board authorization, but preferring a damages remedy when board authorization of a conflicted transaction is defective—for example, in French SA, because shareholders have not ratified it.43

We suspect that the preferred remedy for unapproved conflicted transactions varies among jurisdictions for several reasons. First, of course, nullification may injure not only the interested manager who failed to obtain approval, but also innocent third parties who have contracted with the interested manager in the aftermath of the conflicted transaction. In contrast, a damages remedy can be targeted directly against the culpable party.

Second, board approval is embedded in different ownership and governance structures across jurisdictions. Where ownership in public companies is concentrated, as in continental Europe, and where shareholder ratification has a long tradition, as in the UK, nullification encourages ex ante notice to shareholders of a conflicted transaction and thereby enables them to mobilize against it. Indeed, notifying the board (where controlling shareholders are normally represented) or asking for shareholder ratification (which implies institutional investor scrutiny) is the safe thing to do, given that nullification is a hard-edged remedy that offers little opportunity for renegotiation if a defective transaction is discovered ex post.44 By contrast, ex post damages are more congruent with dispersed U.S. shareholders, who are unlikely to block transactions ex ante and who rely heavily on shareholder suits financed by damage settlements to police conflicted transactions.

Third, judges differ across jurisdictions in their willingness to evaluate conflicted transactions. In Europe and some U.S. states, courts will refuse to disturb the judgment of disinterested boards on conflicted transactions, unless there is proof that directors acted with gross negligence or in bad faith—in essence, the judgments of disinterested directors receive the full protection of

for the EU, see Communication from the Commission, Modernizing Company Law and Enhancing Corporate Governance in the European Union {2003, available at europa.eu.int). See also Klaus J. Hopt and Eddy Wymeersch, COMPARATIVE CORPORATE GOVERNANCE—ESSAYS AND MATERIALS (1997).

42 For the U.S., see Bemhard Grossfeld, Management and Control of Marketable Share Com-

panies, in XJJJ INTERNATIONAL ENCYCLOPEDIA OF COMPARATIVE LAW 4-302 (1971). For the UK, see

Davies, supra note 1, 391-402, 426-7.

43 For France, see Art. L. 223-19 (SARL) and Art. L. 225-42 (SA) Code de commerce; Cozian etal.,

supra note 25, N°729, 1357. For Japan, see Art. 266(1) Commercial Code.

44 While ex post discovery does nor exclude shareholder ratification (see mfra 5.1.3), it makes it

rather unlikely.

the U.S. business judgment rule.45 But in many U.S. states, including Delaware, some level of substantive judicial review may be expected, even when conflicted transactions have been blessed by independent directors. In addition, both interested and disinterested directors face potential liability in Japan (cases being sparse) and most U.S. jurisdictions, for which even disinterested directors cannot always obtain full indemnification or insurance protection.46 By contrast, in Europe, the liability risk is generally confined to interested managers.47 Thus, the threat of potential liability for damages is more potent in most U.S. states than it is in our other major jurisdictions.