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Conflicts of Interest in Small Businesses

Conflicts of interest arise often in small businesses, so identifying them and having a policy in place to prevent them are crucial. Generally, a conflict of interest refers to a situation where a principal in the business, such as an officer or director, will or may derive a personal benefit from their position in the business. For example, kickbacks or gifts given to officers personally because they accept a contract on behalf of the company could give rise to a conflict of interest. Conflicts of interest often result in businesspeople putting their personal interests ahead of the company’s, as in choosing the contract because of the kickback, not because it is best for the company.

The California Corporations Code specifically prohibits many conflict of interest situations. It uses the term “self-dealing”, meaning businesspeople making choices that personally benefit themselves. For a transaction to be self-dealing, the corporation must be a party and one of its directors must have a material financial interest in the transaction. California Corporations Code § 5233(a).

However, a transaction will not be actionable as self-dealing if it was (a) a board decision on executive compensation, (b) a transaction as part of a corporate charitable program that meets certain other requirements, or (c) a transaction of which the interested director has no knowledge and which does not exceed the lesser of 1% of the corporation’s gross receipts or $100,000. California Corporations Code § 5233(b).

In addition, damages or other remedies may not be recovered for the transaction if the director can show that it was approved by the board. Approval requires a few steps, including:

  • Showing that the corporation entered into the transaction for its own benefit,
  • Showing that the transaction was “fair and reasonable as to the corporation at the time the corporation entered into the transaction”,
  • Obtaining a majority vote of the board in favor of the transaction, excluding the interested director. The board vote must be made in good faith and with “knowledge of the material facts concerning the transaction and the director’s interest in the transaction”, and
  • Determining that either under the circumstances or in fact, the board could not have obtained a “more advantageous arrangement with reasonable effort under the circumstances.”

A committee vote may take the place of a board vote if additional requirements are met. California Corporations Code § 5233(d).

Numerous courts have found fault with board approval processes that have not met all of these requirements. Further, self-dealing and conflicts of interest can arise in many circumstances, not all foreseeable by directors and officers. Small businesses may be more susceptible to self-dealing because family members are often involved in running the business.

If you are worried about a conflict of interest at your business, speaking to an attorney could help allay worries and better protect you. Michael Leonard, Esq., of San Diego Corporate Law, named a “Rising Star” for 2017 by SuperLawyers, tailors his business law advice to individual clients and businesses. To schedule a consultation, e-mail San Diego Corporate Law or call Mr. Leonard at (858) 483-9200.

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Schedule a Consultation: 858.483.9200