The Director Who Voted on Her Own Deal
Sentinel Devices Inc. is a closely held corporation with five directors and nine shareholders. Three directors are also officers. The board considered acquiring a sensor supplier owned in part by director Karen, who holds 30 percent of the supplier. Karen disclosed her stake, recused herself from the discussion, and left the room. The remaining four directors voted 3-1 to approve the $4.2 million purchase; the dissent came from a director who wanted a lower price. The board relied on a valuation memo Karen had commissioned before joining Sentinel's board, which used projected growth rates the company later missed by 40 percent. The purchase consumed most of Sentinel's cash. Two shareholders, holding 15 percent between them, demand that the transaction be unwound.
1. What standard of review applies to the acquisition, and does Karen's recusal resolve the conflict?
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Because Karen is a director with a material interest in the transaction, the deal is a conflicted director transaction. Under Delaware-style analysis, such a transaction is protected by the business judgment rule only if it was approved by a majority of disinterested directors who were fully informed, or by disinterested shareholders, or if it was entirely fair.
Karen's recusal helps but does not resolve the matter. The four remaining directors appear disinterested, and a 3-1 vote is a majority. But the protection depends on the disinterested directors being fully informed, and here the key valuation memo was commissioned by Karen, the interested party, and rested on growth assumptions that proved badly wrong. If the board accepted the memo without independent scrutiny, the approval may not count as an informed disinterested decision, which shifts the burden to the defendants to prove entire fairness of both price and process.
Entire fairness is a demanding standard requiring fair dealing and fair price. The process here is weak: the interested director supplied the valuation, no independent advisor was engaged, and the dissent questioned price.
2. If the transaction is reviewed for entire fairness, what facts support and undermine the defendants?
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Supporting fairness: Karen disclosed her 30 percent stake in advance and recused herself from discussion and vote; the board debated the price and one director voted no, showing genuine deliberation rather than a rubber stamp; and there is no allegation of fraud or self-dealing by the other directors, who had no personal stake.
Undermining fairness: the valuation was commissioned by the interested party, creating an obvious bias problem; the growth assumptions missed by 40 percent, which suggests the projections were overly optimistic and the board failed to test them; no independent fairness opinion or market check is mentioned; the deal consumed most of the company's cash, a concentration risk the board should have weighed; and the board apparently did not negotiate price down despite an internal dissent.
The burden is on the defendants. Their strongest move is to obtain an independent retrospective valuation and show the price fell within a reasonable range on information available at the time. The shareholders' strongest point is process: the board outsourced its analysis to the person on the other side of the table.
3. What procedural safeguards should Sentinel adopt for future related-party transactions?
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First, a written related-party transaction policy: any director or officer with an interest must disclose it in writing, and the transaction must be approved by disinterested directors or disinterested shareholders.
Second, independent advice: for transactions above a stated dollar threshold, the company should retain its own valuation or fairness advisor, selected by the disinterested directors, not by the interested party. This alone would have changed the outcome here.
Third, information protocol: the interested party should provide factual data but not control the analysis, and the disinterested directors should meet separately and document their deliberations, including any dissent and the reasons for the final price.
Fourth, a market check: solicit competing bids or benchmark comparable transactions where feasible.
Fifth, liquidity and risk review: require board approval when a transaction would consume more than a set percentage of cash reserves.
Finally, minutes should record the disclosure, the recusal, the materials reviewed, and the basis for the decision. Good records are what allow a board to invoke business judgment protection later.