Related party transactions or “self-dealing” is a legal concept in which a fiduciary (such as a director, or officer,) personally benefits in a transaction involving a company to which he or she owes the fiduciary duty. A common example of self-dealing occurs when a director is on both sides of a transaction. For example, if the company leases office space from a company owned by one director.
This post will discuss the considerations that companies and directors should have when engaging in “self-dealing” or related party transactions.
General Rule: A fiduciary may not place his own interests above the interests of the parties he owes a fiduciary duty.
One of the fundamental rules of corporate law is that an officer, director, or controlling shareholder of a closely held corporation has a duty to place the interests of the corporation and the other shareholders above their own. This constraint on acting in one’s own self-interest has been described as a fiduciary’s duty of loyalty. The fiduciary’s duty of loyalty is “to act solely for the benefit of the principal in all matters connected with the agency, even at the expense of the agent’s own interests.
Self-Dealing Is allowed When the fiduciary can demonstrate the Transaction was fair to the Corporation and other shareholders.
The duty of loyalty does not prohibit a director from self-dealing but the fiduciary has the burden to establish that transaction was fair to the corporation and other shareholders. Related party transactions are closely scrutinized to ensure that the transaction is fair. The self-dealing director must demonstrate that there was fair dealing and that the transaction was on fair terms—price.
Was There Fair dealing?
The “fair dealing” question asks how the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. It is immaterial even if the company suffers no harm as a result of the transaction. The director must provide full disclosure with respect to the circumstances of the transaction and cannot mislead the company. For example, even if the financial terms of the transaction are objectively fair, a director may still violate his fiduciary duty where he did not disclose that he had would personally benefit from the transaction.
Does The Transaction Represent a Fair price?
This question asks whether the economic and financial considerations of the transaction are fair to the company. Such factors would include the value of assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company. Again, the director who personally benefits has the burden to demonstrate that the transaction’s terms are financially fair.
Proving “Entire Fairness” can be a difficult task.
The burden of proving entire fairness of the transaction is often difficult when a transaction is scrutinized by the courts. A director must show the utmost good faith and the most scrupulous inherent fairness of the bargain. The “entire fairness” standard is considered very exacting and, therefore, is often outcome determinative.
Best Practices: for Self-dealing and related party transactions.
Companies do not need to avoid related-party transactions entirely as they are often beneficial to the company and its shareholders. But before engaging in the transaction the company and the interested fiduciary should take the following steps:
- The fiduciary should advise the company of its financial interest in the deal.
- The company should seek independent advice on whether the terms of the deal are fair.
- The interested director should abstain from voting on the transaction.
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