When the people approving a corporate transaction also stand to benefit from it, the transaction may deserve closer scrutiny. Companies regularly enter into transactions with vendors, landlords, lenders, consultants, and other businesses. But what happens when the person benefiting from the deal is also a director, officer, or controlling shareholder of the company?
A director might cause the corporation to hire another business they own. A controlling shareholder might lease property to the company. An executive might direct a lucrative contract to a company owned by a family member. Or the corporation might sell a valuable asset to an insider.
These arrangements, often called related-party transactions, are not necessarily improper. But when a corporate insider has a personal financial interest in a transaction, questions can arise about disclosure, fairness, board approval, self-dealing, and fiduciary duties. For shareholders who believe insiders are benefiting at the company’s expense, those questions can ultimately lead to corporate litigation.
Deals With Corporate Insiders
A related-party transaction generally involves a corporation doing business with someone whose relationship with the company or its decision-makers creates a potential conflict of interest. That relationship does not necessarily make the transaction improper. A shareholder who owns commercial property, for example, might lease that property to the corporation on favorable terms. A director’s separate company might legitimately be the best vendor for a particular service.
The concern arises when an insider uses their corporate influence to secure favorable treatment for themselves at the company’s expense. If the corporation pays above-market rates, sells assets below value, awards unusually favorable contracts, or enters transactions that primarily benefit insiders, shareholders may have reason to examine what occurred.
Disclosure of Personal Interests
Disclosure can be critical when a corporate insider stands to benefit from a proposed transaction. If a director owns the company seeking a significant corporate contract, the other decision-makers should generally be able to evaluate the transaction with that financial interest in mind. A later dispute may therefore focus on what the insider disclosed before the corporation approved the deal.
Board minutes, emails, financial records, contracts, and communications among directors can become important evidence regarding whether the insider disclosed the conflict and how the corporation evaluated the transaction. An undisclosed financial interest can look very different from a transaction that was openly presented to and evaluated by independent decision-makers.
The Board Approval Process
A board’s approval of a transaction does not always end the inquiry. How the approval occurred can matter. Questions may include whether the interested director disclosed the conflict, whether disinterested directors evaluated the transaction, what information was provided to the board, whether alternative transactions were considered, and whether the interested person participated in the decision. A board resolution stating that a transaction was approved may therefore tell only part of the story. When litigation arises, the process leading to that approval can become just as important as the transaction itself.
Did the Company Receive a Fair Deal?
The financial terms of the transaction are another important consideration. Suppose a corporation pays substantially above market rates to rent property owned by its controlling shareholder. Or the company sells a valuable asset to a director for significantly less than its apparent value. The question becomes whether the corporation received a fair deal or whether the insider received corporate value at the corporation’s expense.
Valuations, market rates, competing offers, financial statements, negotiations, and comparable transactions can all become relevant. A transaction that benefits an insider may be legitimate. A transaction structured so that the insider benefits substantially while the corporation receives inadequate value can present a very different issue.
Fiduciary Duties and Self-Dealing
Corporate directors and officers may owe fiduciary duties that restrict how they use their positions for personal benefit. The duty of loyalty is particularly important when a corporate fiduciary has a financial interest that conflicts with the corporation’s interests. Self-dealing can occur when someone uses their corporate position to cause the company to enter a transaction from which they personally benefit.
That does not mean every transaction involving an insider constitutes a breach of fiduciary duty. Disclosure, approval procedures, fairness, and the circumstances matter. Corporate litigation involving self-dealing therefore frequently examines both what the corporation received and how the corporation made the decision.
Shareholder Derivative Claims
When an improper insider transaction harms the corporation, the legal claim may belong to the corporation rather than directly to an individual shareholder. For example, suppose the corporation pays $500,000 more than fair value to purchase an asset from a company controlled by one of its directors. The corporation suffers the immediate financial loss. Depending on the circumstances, a shareholder seeking to challenge that conduct may therefore need to pursue a derivative claim on behalf of the corporation. The distinction between direct and derivative claims is important because it can determine who owns the claim, what procedural requirements apply, and who ultimately receives any recovery.
Using Corporate Records to Investigate the Transaction
Shareholders do not always know the full story when they first suspect self-dealing. They may see an unusual payment on a financial statement, learn that a director has an interest in a vendor, or discover that a corporate asset was transferred to someone connected with management. Corporate books and records can help determine what actually occurred.
Board minutes may reveal who approved the transaction, and contracts can show their terms. Financial records can establish how much money changed hands. Valuation materials may indicate whether the corporation received fair value. Depending on the circumstances, a shareholder may seek access to certain corporate books and records to investigate suspected misconduct before deciding whether broader litigation is warranted.
Injunctive Relief When the Deal Has Not Closed
Timing can become critical when the disputed transaction has not yet been completed. If the corporation is preparing to sell a valuable asset to an insider, enter a significant long-term agreement with an affiliated company, or complete another transaction that could be difficult to reverse, waiting until after the transaction closes may significantly change the available options.
In appropriate circumstances, a shareholder may seek injunctive relief designed to preserve the status quo while the court considers the dispute. Emergency relief is not available simply because a shareholder disagrees with a transaction. Specific legal requirements must be satisfied. But where an allegedly improper insider transaction is imminent, acting quickly can become an important part of the litigation strategy.
When an Insider Deal Becomes Corporate Litigation
A company doing business with one of its insiders is not inherently improper. The concern arises when a director, officer, or controlling shareholder may have used corporate authority to obtain a personal benefit at the company’s expense. The insider’s financial interest, disclosure of the conflict, the approval process, the fairness of the transaction, and the value received by the corporation can all matter in determining whether there are grounds for a legal challenge.
At Alisme Law, we represent shareholders, directors, executives, and businesses in corporate litigation throughout New York. When disputes involve self-dealing, insider transactions, conflicts of interest, fiduciary duties, derivative claims, or other corporate governance issues, we help our clients investigate what occurred, evaluate their legal position, and develop a litigation strategy designed to protect their interests.
Contact us to schedule a confidential case evaluation at 917-540-8432.
This article is for informational purposes only and does not constitute legal advice.