Concept and Basic Rule
Dealings between corporations with interlocking directors arise when one or more persons sit in the boards of two or more corporations that enter into a contract with each other. The interlock creates a conflict-of-interest risk because the same fiduciary may participate in the corporate decision of both contracting sides.
The Revised Corporation Code does not treat an interlocking directorship as a prohibited relationship. A contract between two or more corporations having interlocking directors is not invalidated on that ground alone, except in cases of fraud and provided that the contract is fair and reasonable under the circumstances.
The statutory policy is practical. Business groups, joint ventures, lenders, suppliers, affiliates, and investors often share directors. The law therefore preserves corporate transactions that are substantively fair, while giving the corporation a remedy when the interlock is used to impose an unfair bargain, conceal an adverse interest, or manipulate board action.
The rule applies to the contract between the corporations, not merely to the conduct of the common director. The existence of an interlock is relevant because directors and trustees owe fiduciary duties of loyalty, diligence, and obedience to the corporation they serve. A director cannot use one board seat to prejudice another corporation whose interests he is also bound to protect.
Meaning of Interlocking Directors
An interlocking director is a person who is a director or trustee of two or more corporations that transact with each other. The interlock is based on board membership, not on share ownership. A person may be an interlocking director even if he owns no shares in either corporation.
Stock ownership becomes important only in determining whether the interlocking director's interest in a corporation is substantial or merely nominal. That classification determines whether the transaction remains governed by the general interlocking-director rule or is treated, as to one corporation, under the stricter rule on self-dealing directors.
Interlocking director situations commonly appear in leases, loans, supply contracts, service agreements, asset sales, guarantees, distribution agreements, management contracts, and transactions between parent and subsidiary corporations. The form of the contract is less important than the presence of a common fiduciary who may influence the decision of each contracting corporation.
Requisites for Validity Under the General Rule
A contract between corporations with interlocking directors remains valid when two substantive safeguards are present: there is no fraud, and the contract is fair and reasonable under the circumstances. These requirements operate together. Absence of fraud does not save a contract that is plainly unfair, and a contract cannot be considered fair if it was procured through deceit or concealment of material facts.
- No fraud. Fraud includes concealment of the interlocking director's adverse interest, misrepresentation of material terms, manipulation of the board process, diversion of corporate opportunity, or use of confidential information to secure an improper advantage for one corporation.
- Fair and reasonable terms. Fairness concerns the substance of the transaction, including price, consideration, risk allocation, security, payment terms, duration, market comparability, and whether the corporation received value reasonably equivalent to what it gave.
- Fair process. Although the rule speaks in terms of fraud and fairness, corporate records should show disclosure of the interlock, informed deliberation, and approval by directors capable of exercising independent judgment.
The contract is not invalid merely because the common director attended the meeting, participated in discussions, or had influence in both corporations. However, those facts may become relevant in determining whether the transaction was tainted by fraud, whether approval was independent, and whether the terms were fair when the contract was made.
Substantial and Nominal Interest
The special rule applies when the interlocking director has a substantial interest in one corporation and only a nominal interest in the other corporation. In that situation, the contract is treated, with respect to the corporation where his interest is merely nominal, as a self-dealing transaction subject to the stricter requirements governing dealings of directors, trustees, or officers with their own corporation.
For stock corporations, stockholdings exceeding 20% of the outstanding capital stock are considered substantial. Stockholdings not exceeding 20% are considered nominal. Outstanding capital stock refers to issued shares that remain outstanding and are not treasury shares.
| Director's Interest | Classification | Effect on Contract |
|---|---|---|
| More than 20% of outstanding capital stock | Substantial interest | The director is presumed to have a significant proprietary stake in that corporation. |
| 20% or less of outstanding capital stock | Nominal interest | The corporation where the director has only this interest receives the protection of the self-dealing rule when the other corporation is where his interest is substantial. |
| No shareholding but board membership exists | Interlock without stock interest | The general rule on interlocking directors still applies because the interlock is created by board membership. |
The 20% threshold is applied to the director's stockholdings, not to the value of the transaction, the percentage of the corporation's assets involved, or the voting weight of the director at the board meeting. A holding of exactly 20% is nominal; only a holding exceeding 20% is substantial.
When more than two corporations are involved, the analysis is made corporation by corporation. A director may have a substantial interest in one corporation, a nominal interest in another, and no shareholding in a third, while still being an interlocking director in all of them.
When the Stricter Self-Dealing Rule Applies
The stricter rule applies only when the interlocking director's interest is substantial in one corporation and merely nominal in the other. The reason is that the director's stronger economic stake in one corporation may make him adverse to the corporation where his interest is slight, even though he sits on both boards.
In that case, the contract is examined as if the interlocking director were dealing with the corporation where his interest is nominal. As to that corporation, the transaction is voidable unless the statutory safeguards for self-dealing contracts are satisfied.
The usual safeguards are directed at preventing the conflicted director from supplying the quorum, carrying the vote, or concealing the adverse interest. They also require that the contract be fair and reasonable under the circumstances. Where the corporation is vested with public interest and the contract is material, higher board approval and independent-director participation may be required.
| Requirement | Purpose |
|---|---|
| The interested director's presence is not necessary to constitute a quorum. | The board must be able to act without depending on the conflicted director's attendance. |
| The interested director's vote is not necessary for approval. | The contract must be approved by disinterested directors whose votes are legally sufficient. |
| The contract is fair and reasonable under the circumstances. | Substantive fairness remains indispensable despite formal board approval. |
| If an officer is involved, the contract has prior board authorization. | Management cannot bind the corporation to an interested transaction without board control. |
If the quorum or voting requirements are not met, the contract may still be ratified by the stockholders representing at least two-thirds of the outstanding capital stock, or by at least two-thirds of the members in a nonstock corporation, in a meeting called for that purpose. Ratification requires full disclosure of the adverse interest and the contract must remain fair and reasonable.
Ratification cures the defect in approval; it does not cure fraud or substantive unfairness. A knowingly oppressive or grossly disadvantageous contract cannot be validated merely by routing it through a formal vote if the approving body was misled or deprived of material information.
Distinguishing Interlocking Contracts from Self-Dealing Contracts
Interlocking-director contracts and self-dealing contracts both involve fiduciary conflict, but they are not identical. In an interlocking contract, the transaction is between two corporations that share a director. In a self-dealing contract, the director, trustee, or officer deals directly or indirectly with the corporation in which he serves.
| Point of Comparison | Interlocking Directors | Self-Dealing |
|---|---|---|
| Parties to the transaction | Two or more corporations with a common director or trustee. | The corporation and one of its own directors, trustees, or officers, directly or indirectly. |
| Basic effect | Not invalidated by interlock alone if there is no fraud and the terms are fair and reasonable. | Voidable at the corporation's option unless statutory safeguards are present. |
| Trigger for stricter treatment | Substantial interest in one corporation and nominal interest in the other. | Personal or adverse interest in the corporation's own transaction. |
| Central concern | The common director may favor one corporation over another. | The fiduciary may prefer his own interest over the corporation's interest. |
The distinction matters because the ordinary interlocking rule begins with validity, subject to fraud and fairness review. The self-dealing rule begins with voidability unless approval, disinterested decision-making, disclosure, and fairness requirements are met.
Fairness of the Contract
Fairness is assessed in light of the circumstances existing when the contract was approved, not merely by hindsight. A transaction may be fair even if it later becomes unprofitable, provided that the corporation received reasonable consideration and the board acted on adequate information at the time of approval.
- Price fairness requires comparison with market rates, appraised value, replacement cost, or other objective benchmarks available for the type of transaction.
- Procedural fairness requires disclosure of the interlock, identification of the director's interest, access to relevant information, and genuine board deliberation.
- Commercial fairness considers whether credit terms, default remedies, collateral, warranties, termination rights, and risk allocation are commercially reasonable.
- Corporate benefit asks whether the transaction serves a legitimate corporate purpose and not merely the private benefit of the interlocking director or the favored corporation.
In affiliated corporations, fairness does not require that each corporation receive identical benefits. It requires that each corporation's board consider the transaction from that corporation's own standpoint and that the corporation not be sacrificed to advance the interest of another entity in the group.
Fraud, Bad Faith, and Fiduciary Breach
Fraud defeats the protective rule for interlocking-director contracts. A director who conceals his interlock, suppresses material information, causes the corporation to approve a transaction on false assumptions, or uses confidential information for the advantage of another corporation breaches the fiduciary duty of loyalty.
Bad faith may exist even without a false statement if the director knowingly allows one corporation to enter into a transaction that is manifestly prejudicial while advancing the interest of another corporation in which he has a stronger stake. The fiduciary duty requires active fairness, not passive silence in the face of divided loyalty.
A director who acquires profits through the misuse of his position may be required to account for them. If the transaction diverts a corporate opportunity, the affected corporation may seek the appropriate fiduciary remedies, including recovery of gains, damages, rescission, or other relief consistent with the nature of the breach.
Board Approval and Corporate Records
Proper board action is important because corporations act through their boards in ordinary business decisions. The minutes should reflect the identity of the interlocking director, the nature of his interest, the material terms of the contract, and the basis for concluding that the contract is fair and reasonable.
Where the stricter self-dealing rule applies, the minutes should also show that the interested director was not needed for quorum and that his vote was not needed for approval, unless the transaction is later ratified by the required stockholder or member vote after full disclosure.
Abstention by the interlocking director is not always a statutory condition under the general interlocking rule, but it is a strong indicator of fair process when the director's divided loyalty is material. Abstention does not by itself prove fairness, because the substantive terms of the contract must still be reasonable.
Consequences of an Invalid or Unfair Transaction
If the contract is infected with fraud or is not fair and reasonable, the affected corporation may seek to avoid the transaction, recover damages, demand restitution, or pursue fiduciary remedies against the responsible directors, trustees, or officers. The precise remedy depends on the injury, the status of performance, and the benefit wrongfully obtained.
If the stricter self-dealing rule applies and its safeguards are not satisfied, the contract is voidable at the option of the corporation protected by the rule. Voidability means the corporation may affirm or reject the contract, subject to the rules on ratification, estoppel, restitution, and protection of rights that may have intervened in good faith.
The interlocking director may also incur personal liability when he assents to a patently unlawful act, acts in bad faith or with gross negligence, acquires a personal or pecuniary interest in conflict with his duty, or consents to an unfair transaction that damages the corporation. The liability arises from breach of fiduciary duty, not from the mere fact of sitting on more than one board.
Practical Operation of the Rule
The analysis begins by identifying the corporations that are parties to the contract and the director or trustee who sits on more than one board. It then asks whether the common director has stockholdings in the contracting corporations and whether those holdings are substantial or nominal under the 20% threshold.
If the director's interest is not substantial in one corporation and nominal in another, the general rule applies: the contract is not invalidated by the interlock alone, but it must be free from fraud and fair and reasonable. If the director's interest is substantial in one corporation and nominal in the other, the contract is tested under the stricter self-dealing rule as to the corporation where his interest is nominal.
The ultimate inquiry is whether the corporate decision was made for the corporation's own benefit through a fair process and on fair terms. Interlocking directors are permitted, but divided loyalty is controlled by disclosure, disinterested approval where required, substantive fairness, and the availability of remedies when the fiduciary relationship is abused.