A recent Delaware Court of Chancery decision addressed claims that the CEO of a closely-held company breached the duty of loyalty in connection with unauthorized personal expenses charged to the company, and other actions, while he managed the company–that were not consistent with financial management in the best interest of the company. That decision, in Avande, Inc. v. Evans, C.A. No. 2018-0203-AGB (Del. Ch. Aug. 13, 2019), is most noteworthy for its recitation of the well-established principles of the duty of loyalty imposed on corporate directors and officers, as well as describing the burden of proof for such a claim, and the prima facie showing necessary to warrant the burden allocation.
Well-Known Articulation of Fiduciary Duties:
Although these well-worn corporate law principles have been repeated on these pages over the last 14-years on many occasions, they are such fundamental bedrock tenets that form the foundation of corporate law that they cannot be repeated too often.
The court explained that:
“The duty of loyalty requires that a corporate fiduciary act with undivided and unselfish loyalty to the corporation and there shall be no conflict between duty and self-interest. If corporate fiduciary stands on both sides of a challenged transaction, an instance where the directors’ loyalty has been called into question, the burden shifts to the fiduciaries to demonstrate the ‘entire fairness’ of the transaction. In a typical self-dealing transaction, the fiduciary is the recipient of an allegedly improper personal benefit, which usually comes in the form of obtaining something of value or eliminating a liability.”
See footnotes 104 through 106 for citations to underlying cases included in the original quote.
The court explained that once entire fairness applies, the defendants must establish to a court’s satisfaction that the transaction was the product of both fair-dealing and fair-price. See footnote 107.
The court added:
“The duty of loyalty includes a requirement to act in good faith. To act in good faith a director must act at all times with an honesty of purpose and in the best interest and welfare of the corporation. A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interest of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”
See footnotes 1 through 111 for citations to cases within that quote.
Key Cases Discussed by the Court:
The court addressed a line of cases beginning with the decision of the Court of Chancery in Technicorp Int’l II, Inc. v. Johnston, 2000 WL 713750, at * 2 (Del. Ch. May 31, 2000), regarding the issue of the prima facie showing necessary to shift the burden of proving the fairness of challenged expenses.
In the Technicorp case, the Court of Chancery found after a trial that two individuals had “systematically looted” over a 12 year period two companies that they exclusively managed and controlled and for which they had access to the corporate records such as to minimize or avoid the risk of being held accountable. In that case, the plaintiffs made a prima facie showing to warrant the allocation of the burden of proof.
The court addressed four other cases that applied Technicorp with different results, in deciding whether to order an accounting or to allocate to a fiduciary the burden of demonstrating the fairness of a series of disputed transactions. Those cases were Carson v. Hallinan, 925 A.2d 506, 536-37 (Del. Ch. 2006), in which the court found after trial that 2 fiduciaries who exercised exclusive control over the company funds and used them for personal benefits and never documented expenses, required an accounting to determine the extent of the misallocation and damages.
In Sutherland v. Sutherland, 2010 WL 1838968, * 4 (Del. Ch. May 3, 2010), the court found that the plaintiff did not establish a prima facie showing, and thus did not require them to account for funds.
In Zutrau v. Jansing, 2014 WL 3772859, at * 27-28 (Del. Ch. July 31, 2014), the court refused to shift the burden under Technicorp or Carlson, reasoning that the plaintiff did not make a prima facie showing that the challenged charges were improperly incurred.
The fourth case was CanCan Development, LLC v. Manno, 2015 WL 3400789, at * 16 (Del. Ch. May 27, 2015), where the court allocated to the fiduciary the burden of accounting for compensation and expenses that were self-interested transactions. Although the court noted that these expenses would be subject to the business judgment rule in most situations, based on the facts of that case, the court found that the fiduciary bore the burden at trial to establish the propriety of the disbursements regarding the self-interested transactions.
The court summarized those cases discussed above as showing that:
“This court may place on a fiduciary the burden to demonstrate the fairness of a series or group of expenditures, or may order an accounting of such expenditures, where–as in Technicorp, Carson, and CanCan–a plaintiff has made a prima facie showing based on a substantial evidence that the expenditures in question are self-interested transactions. The fiduciaries exercise of control over the corporation’s funds and records is a factor to be considered in the analysis. Where, by contrast, a plaintiff has failed to make such a prima facie showing–as in Sutherland and Zutrau–the court has refused to shift the burden of proof to the fiduciary or to order an accounting. In that event, potentially problematic transactions should be examined individually.”
The Court concluded in the instant case that an accounting was warranted for at least a portion of the amounts disputed.