FIDUCIARY DUTIES AND OTHER
RESPONSIBILITIES OF CORPORATE
DIRECTORS AND OFFICERS
Morrison & Foerster LLP
Christopher M. Forrester
Celeste S. Ferber
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FIDUCIARY DUTIES AND
OTHER RESPONSIBILITIES
OF CORPORATE
DIRECTORS AND
OFFICERS
MORRISON & FOERSTER LLP
Christopher M. Forrester
Celeste S. Ferber
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About This Handbook
This Handbook is designed to assist directors and officers of public and private corporations in fulfilling their duties to their corporate constituents. The Handbook is intended to
provide both an authoritative resource and a practical hands-on tool for addressing various
situations faced by directors and officers. To that end, the Handbook combines a discussion of the law and case studies and practice pointers that illustrate application of the
law to the real world challenges faced each day by directors and officers of U.S. corporations.
Given that a majority of publicly traded U.S. corporations are incorporated in Delaware
and that courts in other jurisdictions often look to Delaware court decisions for guidance,
the information provided in the Handbook is premised principally on Delaware law, unless
otherwise noted. This handbook is limited to the laws that affect corporations, as compared
to other forms of business entities, such as partnerships and limited liability companies.
None of the information contained in this Handbook is intended to constitute legal advice
or establish an attorney-client relationship with Morrison & Foerster LLP or any of its
attorneys, and you should not rely on any of the information in this Handbook without
checking with your legal counsel as to your specific circumstances.
This handbook was prepared and published as of December 2008 and does not reflect
developments or events occurring after that time.
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About the Authors
Christopher M. Forrester
Mr. Forrester is a partner in Morrison & Foerster’s Corporate and Securities Group. His
practice focuses on representing emerging growth and established companies in all aspects
of corporate matters. Mr. Forrester has considerable experience representing the boards
and special committees of public corporations in complex merger and acquisition transactions, as well as investigations and related-party matters. Mr. Forrester also has substantial experience in public offerings, having been involved in over 50 public offerings of
equity and debt securities. He is a recipient of the American Jurisprudence Award for
Securities Regulation. Mr. Forrester was named to the 2007 Top 40 Under 40 persons in
the finance industry by Investment Dealers Digest in December 2007.
Mr. Forrester received his B.A. from St. Mary’s College in 1993, his J.D., with distinction,
from the University of the Pacific, McGeorge School of Law in 1996, where he also served
as managing editor of the law review, and his LL.M. in Securities and Finance Regulation
in 2002 from Georgetown University Law Center. Mr. Forrester has been a partner with
Morrison & Foerster since 2006. Prior to joining Morrison & Foerster, Mr. Forrester was a
partner with Pillsbury Winthrop Shaw Pittman LLP.
Celeste S. Ferber
Ms. Ferber is a senior associate in the Business Department of Morrison & Foerster’s San
Diego office. Her practice focuses on general corporate, transactional and securities matters. She has extensive experience in public and private securities offerings, mergers and
acquisitions, securities law compliance and general corporate matters. Ms. Ferber began
her legal career as an associate at Fenwick & West LLP in San Francisco.
Ms. Ferber received her B.A. in Economics from Bucknell University in 1997 and her J.D.
from University of California, Hastings College of the Law in 2001. She is a member of
the State Bar of California.
Contributing Authors
The following Morrison & Foerster partners provided assistance in the editorial process for
this work: Jay de Groot, G. Larry Engel, Jordan Eth, Katherine I. Johnstone, Adam A.
Lewis, Sean T. Prosser, Darryl P. Rains, Steven Rowles, Scott M. Stanton and Robert S.
Townsend.
The following Morrison & Foerster associates provided substantial contributions to the preparation of this Handbook: Jeannette V. Filippone, Kimberly Harbin, J. Nathan Jensen, R. Matthew Steiner, Ramin Tohidi, Ryan Gunderson, Nathan Cooper, James Krenn and Yonatan
Hagos. The Authors also wish to thank Lisa Holcombe, Ying Huang and Jennifer Steiger,
each of whom assisted in the editorial process of preparing this Handbook.
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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
TABLE OF CONTENTS
Page
OVERVIEW OF THE HANDBOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
MANAGING THE BUSINESS AND THE ROLES OF DIRECTORS
AND OFFICERS
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Interaction Among the Board, the Chief Executive Officer and the Other Officers . . . .
Board Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appointment to Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Identifying the Constituents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Governing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mitigating Liability Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii
CHAPTER 1
GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OF
DIRECTORS AND OFFICERS
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Determining the Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duty of Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duties of Loyalty and Good Faith . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duty to Disclose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Entire Fairness Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Director Liability and Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
2
4
7
9
10
11
CHAPTER 2
FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESS
COMBINATION TRANSACTION
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Board Considerations When a Sale or Break-Up of the Corporation is Not Implicated . . . . .
Additional Considerations in Any Business Combination Transaction . . . . . . . . . . . . . . . . .
Revlon and a Sale or Break-Up of the Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Review of Directors Duties in the Context of a Business Combination Transaction . . . . . . .
Unocal and Defending Against Hostile Takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Special Case: Use of a Poison Pill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Special Case: Director Duties in the Face of Activist Stockholder Demands . . . . . . . . . . . . .
13
13
15
19
28
29
32
CHAPTER 3
FIDUCIARY DUTIES IN THE CONTEXT OF A GOING PRIVATE
TRANSACTION
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common Transaction Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
SEC Requirements and Scrutiny of Going Private Transactions . . . . . . . . . . . . . . . . . . . . . . .
Procedural Safeguards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
34
35
37
37
41
42
47
50
CHAPTER 4
i
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56
60
61
FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
TABLE OF CONTENTS
Page
CHAPTER 5 THE USE OF SPECIAL COMMITTEES
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Committee Composition: Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Committee Charter: Be Informed and Active . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Committee’s Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Legal Duties of Special Committee Members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Overview–When Should a Special Committee be Considered? . . . . . . . . . . . . . . . . . . . . . . .
FIDUCIARY DUTIES IN THE CONTEXT OF A DISSOLUTION OR
INSOLVENCY
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Determining When a Corporation Has Become Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duties to Creditors When the Corporation is Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duty of Loyalty Considerations in the Context of Insolvency—Delaware’s Rejection of
Deepening Insolvency Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duties During Bankruptcy Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Duties After Dissolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Things to Remember When Managing a Business on the Verge of Insolvency . . . . . . . . . . .
63
64
66
67
68
69
70
CHAPTER 6
71
72
73
77
79
80
82
CHAPTER 7 ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXT
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Scope of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Types of Privileged Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Privilege Versus Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Waiver of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Examples of Waiver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Privilege in Derivative Suits and Class Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Role of Attorney in Special Investigations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
CHAPTER 8 INDEMNIFICATION AND INSURANCE
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Indemnification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
CHAPTER 9 PERSONAL LIABILITY AND PIERCING THE CORPORATE VEIL
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Instrumentality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Alter Ego Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Estoppel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Alternative Theory of Stockholder Liability: Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Veil Piercing in the Context of Fiduciary Duty Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii
129
130
131
132
134
134
136
OVERVIEW OF THE HANDBOOK
Chapter 1 discusses the general relationship of directors and officers with their
corporation, including reviewing the process surrounding election and appointment to
their positions, their general powers, authorities and responsibilities, the rules that
govern their actions, the constituents served by directors and officers and potential
liabilities that they face.
Chapter 2 provides an overview of the business judgment rule, and the duties of
care, loyalty, good faith and fair dealing and disclosure. The rule is a court-developed
doctrine that is designed to provide directors and officers with the latitude to exercise
their judgment in furtherance of managing the corporation’s business and affairs without fear of having every one of their actions second-guessed by litigious stockholders
and courts.
Chapter 3 provides a more detailed application of the business judgment rule to
specific transactions and other situations, such as mergers and acquisitions, hostile
takeovers and activist stockholder demands.
Chapter 4 addresses fiduciary duties in the context of going private transactions,
which implicate complicated disclosure and conflict of interest considerations.
Chapter 5 discusses how special committees can be used to mitigate against
claims of a breach of the duty of loyalty and to safeguard against potential conflicts of
interest.
Chapter 6 addresses the duties of directors and officers when a business becomes
insolvent and the particular duties that directors owe not only to the corporation and its
stockholders, but also in some cases to the creditors of the corporation.
Chapter 7 provides an overview of the attorney-client privilege and a discussion
of the work product doctrine. It explains the complicated relationships between the
corporation, its counsel and the directors, particularly in the context of derivative suits,
class actions and special investigations.
Chapter 8 introduces indemnification and liability insurance. It provides essential
information on who can be indemnified by a corporation and special issues that should
be considered in selecting director and officer liability insurance.
Chapter 9 discusses the concepts of piercing the corporate veil and agency, two
theories by which stockholders may be liable for any lawsuits brought against the
corporation if the corporate form is not properly respected.
For a list of additional reference guides and publications available from RR
Donnelley, please visit financial.rrd.com.
iii
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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
CHAPTER 1
MANAGING THE BUSINESS AND THE ROLES OF DIRECTORS
AND OFFICERS
INTRODUCTION
U.S. corporate laws provide that the board of directors is responsible for the
management of the corporation’s business and affairs. In managing such business and
affairs, boards typically act in a supervisory role, and delegate the details of the
day-to-day management of the business to the officers of the corporation. This construct provides a balance between the managers (officers) who have actual and apparent authority to direct and control the daily activities of the business and the overseers
(directors) who have the ultimate responsibility for the corporation and the power and
responsibility to supervise the managers. While the officers are clearly agents of the
corporation in the strict legal sense and so have the power individually to bind the
corporation to obligations and take actions, the directors in their capacity as such are
not agents and generally can act only as a group. Nevertheless, the directors clearly
are fiduciaries of the corporation and as a group
The officers are charged
have the ultimate power and authority over the
with managing the
management of the business through their ability to
day-to-day operations of
hire, supervise and replace the managers.1
the corporation while the
board is responsible for the
In addition to having the responsibility to
overall management of the
supervise and, if necessary, replace the managers,
corporation and superthe board is also charged by law with the power and
vision of the officers.
responsibility to approve major corporate actions,
such as issuing securities, entering into a merger, converting the form of the business
from a corporation to a limited liability company, partnership or other form, disposing
of substantially all of the assets of, or dissolving the corporation. Further, through their
supervisory powers, boards frequently require the managers to obtain board approval
for events that are not fundamental to the business, but are nevertheless sensitive or
material – for example, entering into a significant acquisition, licensing, financing or
other contractual arrangement. In contrast, officers are charged with the daily
management of the business and have the power under the Delaware General Corpo1
8 Del. C. §141(a).
1
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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
ration Law (the “DGCL”) to bind the corporation; however, they do not have the
authority, acting without board approval, to cause the corporation to take the type of
fundamental corporate actions described above.2
This balance between the directors and the officers is created by the DGCL and
Delaware case law, which together provide that every corporation shall have a board of
directors, and establish the responsibility of that board to manage the affairs of the
corporation. The DGCL also provides for the appointment of certain officers – which
commonly include a president, treasurer, secretary and one or more vice presidents – to
manage the daily activities of the corporation.3 However, the DGCL also provides a
corporation with latitude to customize various aspects of its governance structure
through its charter documents (i.e., its certificate of incorporation and bylaws).4 One
common example is that many U.S. corporations appoint a chief executive officer as
their most senior officer in lieu of a president pursuant to bylaw provisions.
It is important to note that each corporation may approach the roles of, and interaction between, management and the board somewhat differently. The decision as to
how much power and authority to vest in the management and what level of involvement the board will have in the activities of the business is a decision for each board to
make, which is then memorialized in the corporation’s charter, bylaws and corporate
resolutions, as well as board practices and meeting agendas.
THE INTERACTION AMONG THE BOARD, THE CHIEF EXECUTIVE OFFICER
AND THE OTHER OFFICERS
Although the board bears responsibility
In general, most boards seek to for supervising the activities of all of the
fulfill their obligation to supervise officers in managing the business, typithe managers primarily by consult- cally, the chief executive officer reports to
ing with the corporation’s most the board, and the other “C-level” officers,
senior officer (usually the chief including the chief operating and chief
executive officer) on major deci- financial officers and vice presidents,
sions affecting the business, and report to the chief executive officer.
reviewing, guiding and ultimately
supervising the performance of the chief executive officer. The chief executive officer,
2
See, e.g., 8 Del. C. §§151, 152, 251-66, 271-85.
8 Del. C. §142.
4 See, e.g., 8 Del. C. §142.
3
2
RR DONNELLEY
FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
in turn, will generally be charged with the power and authority to supervise the other
officers, who will report directly to the chief executive officer rather than the board.
Notwithstanding this practical chain of command, most corporations’ bylaws provide
that senior officers are selected by the board, meaning that while practical reporting
chain considerations dictate that typically the officers other than the chief executive
officer report to the chief executive officer, the board will remain actively involved in
establishing and evaluating the duties and performance of those officers. Beyond the
chief executive officer, typical officer positions and their general responsibilities are as
follows:
5
•
President. The president generally is the most senior position in the organization absent the presence of a separate chief executive officer. The president is responsible for the supervision of the other officers and the
day-to-day management of the business.
•
Secretary. The secretary is the person responsible for keeping the books
and records of the corporation, including the corporate minute book.5 As
such, the secretary attends board meetings to keep minutes, although outside
counsel is sometimes charged with preparing the initial draft of the minutes.
As the official keeper of the books and records, the secretary is generally
responsible for certifying the accuracy of corporate documents to third parties, such as banks, financing sources and acquirers.
•
Treasurer. The office of treasurer is generally Officer positions and
the most senior financial position in the corpo- responsibilities are
ration, although companies often use the title generally established
chief financial officer as the most senior level by the corporation’s
financial position. The treasurer is charged with bylaws and the board
maintaining the corporation’s funds as well as is free, to a large
supervising the accounting functions of the degree, to customize
business. In larger companies, it is common not those provisions
only to have a chief financial officer who
under Delaware law.
serves the role of treasurer, but also to have
a controller who performs the accounting functions and a vice president of
finance who is in charge of the financing aspects of the business.
8 Del. C. §142(a).
3
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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
•
Vice President. Vice presidents can be appointed to oversee specific business functions, such as sales, marketing, research and development, finance,
etc. Although generally vice presidents are appointed by and report to the
board, the bylaws may provide that certain vice presidents may be appointed
by (and report to) the officers of the corporation, such as the chief executive
officer or president.
•
Other Officers. The DGCL contemplates that the corporation may create
additional officers and it is quite frequent that companies create such positions in their bylaws, such as chief technology officer or chief marketing
officer. If these positions are designated by the bylaws as officer positions in
the corporation, then they will have the authority as such, and their specific
duties and reporting structure will be specified in the bylaws. However,
many companies draw distinctions between executive officers and officers,
the latter generally being viewed as the primarily corporate officers while
the former is considered a class of junior officers but without the same
powers or responsibilities. As noted above, in order to truly ascertain the
power, responsibility and reporting authority of officers of a particular
corporation, it is necessary to consult its bylaws.
•
Executive Chairperson. It is notable that although the DGCL contemplates that directors are not officers and therefore cannot act to bind the
corporation, in some states by law and in many companies by virtue of their
bylaws, the chairperson of the board also is specifically designated as an
officer position.6 Again, to ascertain whether the chairperson of a particular
corporation is or is not an officer, one must consult the bylaws of such
corporation, unless the state of incorporation provides by law that the
chairperson is an officer.
BOARD DYNAMICS
Just as a president or chief executive officer is responsible for the daily management of the business, the chairperson of the board is generally responsible for managing the affairs of the board. Most corporations provide in their bylaws that the
chairperson of the board is empowered to call board meetings, set the agenda for the
board meetings and preside over board meetings. The specific manner and timing of
6
See, e.g., Cal. Corp. Code §312.
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calling board meetings is specified in a corporation’s bylaws, but many corporations
use as a default rule that board meetings can be called on some minimum advance
notice (e.g., four days’ notice if the notice is given by mail or 48 hours’ notice if the
notice is given by telephone or other electronic means, such as email). Further, notice
of meetings may always be waived by directors at any time either in writing or by their
presence at a meeting. The agenda for meetings and supporting materials should be
distributed in advance whenever possible so that the directors have an opportunity to
prepare for the meeting and provide meaningful contributions.
Convening a board meeting requires that a quorum of directors be present at the
meeting. Generally, the specific number of directors required for a quorum will be
specified in the bylaws (but in no event will be less than
The chairperson of
one third of the total number of directors); in the absence
of a specific quorum requirement, the DGCL provides a
the board is generally
default rule of not less than a majority of the board
responsible for
members.7 Once a board meeting is duly convened and a
managing the affairs
quorum is present, in the absence of a specific provision
of the board, includin the bylaws otherwise, the vote of a majority of the
ing calling meetings
directors present and voting at the meeting will be
and setting agendas.
sufficient to constitute an action of the board.8 In addition
to taking action at a properly convened meeting, a board may take action by signing a
written consent, which must be signed by all directors. Unanimous written consents
are effective on the date upon which all signatures have been obtained.9
Not infrequently board members may speak of having the power to vote by
proxy. Unlike stockholders, however, board members may not vote by proxy.10 The
essence of the board’s effectiveness is its ability to engage in meaningful discussions
in which all members of the board can be heard and can hear one another. The concept
that one or more board members may be individually briefed on a topic privately and
then deliver their vote privately by proxy is antithetical to the concept of a robust
board deliberation.
7
8 Del. C. §141(b).
Id.
9 8 Del. C. §141(f).
10 In re Acadia Dairies, Inc., 15 Del. Ch. 248 (1927).
8
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Extra care should always be given to trying to arrange for meeting schedules that
permit the attendance of all or as many of the board members as possible, particularly
for sensitive and important matters. The importance of directors’ participation and
attendance at board meetings is underscored by the fact
that the rules and regulations of the U.S. Securities and Attendance at board
Exchange Commission require that reporting companies meetings is critically
under the Securities Exchange Act of 1934 (the “Exchange important and board
Act”) disclose the attendance records of their boards in members may not act
by proxy.
their annual proxy statements or on their websites.11
In addition to acting as a whole, many boards designate (and in fact, public corporation boards are required to designate) one or more committees or sub-committees.
The most notable example of this is the audit committee. The Exchange Act specifically requires that reporting companies maintain an audit committee composed entirely
of “independent directors.”12 Independent directors are defined as directors who,
among other things, are not part of management and who do not otherwise have a role
or relationship with the corporation that has the potential of creating any conflict of
interest. In addition, members of a public
Although the Exchange Act
company’s audit committee are expected,
requires a board to have an audit
through formal education or experience, to
committee, many corporations
have enhanced skills in reading and underalso utilize nominating and comstanding financial statements and in accountpensation committees composed
ing matters generally. The audit committee is
of independent directors. Use of
charged with approving the corporation’s
independent directors on these
auditors, supervising the chief accounting
committees satisfies stock
officer of the corporation in the preparation
exchange rules as well.
of the corporation’s financial statements,
monitoring complaints by employees regarding financial matters, and other important
financial and accounting-related matters.13
In addition to the audit committee, many companies utilize a nominating and/or
corporate governance committee and compensation committee to help to manage the
11 17 C.F.R. 229.407; 17 C.F.R. 240.10A; See Commission Guidance on The Use of Company Websites, Release Nos. 34-58288 (Aug. 1, 2008).
12 17 C.F.R. 240.10A-3.
13 Id.; See also 15 U.S.C.S. §78j-m.
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affairs of the corporation. Generally, the members of the nominating committee
and the compensation committee are independent directors within the meaning of
specific definitions established by any applicable stock exchange rules. Nominating
committees generally evaluate directors’ performance and interview and nominate
director candidates for board and stockholder consideration. Compensation committees are charged with establishing and reviewing the compensation policies and procedures for the senior officers, as well as administering the corporation’s compensation
and equity incentive plans. In addition, approval of compensation packages by
compensation committees composed of non-employee directors can provide certain
required approvals under the Internal Revenue Code necessary to make certain of the
corporation’s compensation payments tax-deductible. Boards may also delegate other
duties and functions to committees of the board, with certain limitations in the DGCL.
Generally, each committee is managed by a chairperson. Similar to the role of the
chairperson of the board, the chairperson of the committee is charged with calling
committee meetings, setting the agenda, and reporting
Being designated as the
back to the board on the business of the committee.
“audit committee finanThough directors who serve on one or more
cial expert” does not
committees
or as a chairperson of the board or a
place additional liability
committee
take
on additional responsibilities in those
on the individual desroles,
they
are
subject to the same fiduciary duties
ignated.
applicable to regular directors.14
APPOINTMENT TO POSITIONS
Directors
Directors are elected to hold office by the stockholders of the corporation at an
annual stockholders meeting, or by written consent of the stockholders if not prohibited by the corporation’s certificate of incorporation.15 Vacancies on the board may
also be filled by a vote of the board pending the next annual meeting of stockholders.
14
Lyman P.Q. Johnson, Corporate Compliance Symposium: The Audit Committee’s Ethical and Legal
Responsibilities: The State Law Perspective, 47 S. Tex. L. Rev. 27, 39 (2005). Similarly, although public
companies are required under the Exchange Act to designate at least one member of the audit committee
as the “audit committee financial expert,” such designation does not place additional liability on the
individual designated. 17 C.F.R. 229.407(d)(5)(iv)(B).
15 8 Del. C. §211(b).
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The default rule under the DGCL is that the slate of directors receiving the most votes
(a plurality) at a properly convened meeting of stockholders or by written consent of
stockholders, if applicable, will be elected
to office. Recently, many public companies Although the default rule under
have modified their charters to require that the DGCL is that directors who
directors must actually receive a majority of receive a vote of the plurality of
the outstanding votes, or at least a majority the shares voted (i.e., the most) are
of the shares voted at the meeting in order elected to office, many public
to be elected or, alternatively, if a director corporations are modifying their
receives fewer votes for reelection than bylaws to specifically require that
withheld votes, the director must submit a directors must receive a specified
minimum number of shares
resignation for consideration by the board.
approving their candidacy before
Although the default rule under Dela- they will be elected.
ware law is that directors hold office for
one-year terms, the DGCL permits the stratification of a board into two or three
classes, with each class having terms that expire in successive years.16 This is commonly referred to as a classified or staggered board. The most frequent example is a
board of three classes with each class having a three-year term and expiring on successive years. Some believe that classified boards provide stability by ensuring that at any
one election, only a portion of the board will be re-elected. On the other hand, classified boards have been used as a device to resist hostile takeovers, and many stockholder rights activists believe that classified boards unduly impair the stockholders’
fundamental right to change the board if they believe the corporation is not being
managed appropriately. Use of classified boards in the context of takeover defenses is
discussed further in Chapter 3 of this Handbook.
Officers
As noted above, the board has the power, authority and responsibility under the
DGCL to appoint the officers of the corporation.17 Many boards feel, and rightly so,
that in order to effectively discharge their duties to manage the business and affairs of
the corporation, they should regularly evaluate, counsel and supervise the entire
management team to some degree. For this reason, although a board may delegate the
16
17
8 Del. C. §§141(d), 211.
8 Del. C. §142.
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management and performance review of the lesser officers of the corporation to the
chief executive officer, most boards exercise some level of supervision over the most
senior officers of the corporation including the chief financial officer, chief operations
officer, president, vice presidents, and the other so-called “C-level” officers.
IDENTIFYING THE CONSTITUENTS
One of the most difficult tasks for a board and management team is to balance the
competing interests of multiple constituents of a business. There are employees,
vendors, creditors, contract counterparties, and, of course, stockholders to consider.
Whom do you serve first? So long as a particular decision benefits all parties equally,
the decision of a board and management team is quite easy. The difficulty arises when
decisions do not affect all parties equally.
Although not always easy in application, there is a clear legal answer to the question: a corporation’s board and management owe a fiduciary duty as their primary
obligation, above all others, to the stockholders, to maximize the value of the equity of
the corporation. Fiduciary duty is a core legal concept, perhaps the most fundamental
legal concept that underlies the manner in
which U.S. corporations are managed. A In a solvent business, directors
fiduciary owes an utmost duty of care, candor and officers are bound by a
and confidence to its constituent. A fiduciary fiduciary duty to manage the
must act with a high standard of care with business in order to maximize
respect to its constituent and must avoid the interests of the stockholders
conflicts of interests, including taking actions first and foremost.
that would advantage the fiduciary to the
disadvantage of the constituent.
Directors and officers of a corporation are fiduciaries of the stockholders. Consequently, decisions made in furtherance of managing the business should first and
foremost focus on what is in the best interests of the stockholders. Notwithstanding the
apparent oversimplification, it is frequently advisable to consider what might be the
impact on other constituents of the business, for example, its employees, vendors,
creditors and contract counterparties, in order to maximize the long-term value of the
stockholders. Indeed, a daily focus of the managers of a business is to ensure that the
business meets its contractual obligations, satisfies its creditors, cares for its employees and vendors, and pleases its customers. Fortunately, doing these things generally
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will result in building the business for the stockholders, so that the interests of
constituents are aligned.
Unfortunately, as business conditions change, boards and managers may be
unable to make decisions that satisfy all constituents and instead must focus on maximizing value for the stockholders. These decisions may be difficult and may involve
damaging long-standing and important personal relationships—for example, substantial lay-offs for the benefit of the business and mergers or acquisitions that may
result in the shutdown or wind-up of business units. When these challenging decisions
must be made, it is critical to remember the board’s fundamental obligation to act in
the best interest of the stockholders. After all, it is the stockholders who have selected
the directors and the directors who have selected the officers who are entrusted to
manage the corporation for the stockholders’ benefit.
The duties of directors and officers to care for the interests of stockholders
change dramatically when a business falters and becomes insolvent. When a business
is insolvent, the creditors become the residual risk-bearers (the position typically held
by stockholders). Therefore, the primary duties of the
board and management shift from protecting the
The duties of the board
shift from stockholders to interests of the stockholders to protecting the interests
creditors when a business of the corporation’s creditors. These situations present
boards and managers with some of the most difficult
becomes insolvent.
decisions. The specific and complicated duties and
demands placed on boards and managers when a corporation becomes insolvent are
discussed in detail in Chapter 6 of this Handbook.
GOVERNING RULES
In addition to the DGCL, there are myriad rules that must be observed in managing a corporation. Managers must be aware of federal and state statutes and regulations
as well as local ordinances that may affect the facilities and local activities of the business. For example, state employment laws can be complex and provide for substantial
penalties and fines if they are disregarded. Federal and state laws affecting employee
benefits and healthcare often are Byzantine and implicate corporate, employment and
tax considerations as well as frequently complicated contractual obligations with thirdparty insurers and administrators.
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Many states, such as California, seek to impose their corporate laws on
corporations domiciled in other states but that engage in substantial business activities
in the concerned state.18 Federal, state and foreign income tax and state sales tax laws
apply to corporations in varying degrees and are aggressively enforced. Federal and
state securities laws affect the manner in which a corporation markets and sells its
equity and debt securities to investors. Disclosure laws also affect the manner and
extent to which corporations communicate with their investors.
There are many other federal and state statutes and regulations, as well as court
decisions and local ordinances that may affect individual businesses, including but not
limited to laws pertaining to environmental, foreign corrupt practices, anti-trust, disability, copyright, trademark, patent, property and criminal matters. Application of
these and other laws varies widely from business to business. It is important that a
corporation familiarize itself with the laws to which it may be subject and tailor its
operations accordingly.
Beyond the realm of statutes, regulations, ordinances and court decisions, there are
also industry standards and guidelines that have a substantial impact on a corporation.
The books and records of a U.S. corporation typically must comply with Generally
Accepted Accounting Principles, or GAAP. Further, many corporations doing business
outside the United States must also maintain their books and records in accordance with
the International Financial Reporting Standards or other local requirements. Stock
exchange rules require companies to establish various committees and promulgate and
police procedures and canons. On top of these demands, many companies also seek to
implement best practices.
MITIGATING LIABILITY CONCERNS
Managers and boards face the tough challenge of navigating a path to profitability
while making various nuanced business decisions. The last thing that directors and
officers should have to worry about is a court second-guessing their decisions with the
benefit of hindsight, particularly given that such decisions are frequently tough and
must be made under stressful conditions in real time on imperfect information. Fortunately, there are several protections that have developed to provide directors and
officers with some assurance that their decisions will be respected in the future.
18
See, e.g., Cal. Corp. Code §2115.
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The most fundamental of protections for directors and officers is the business
judgment rule. The business judgment rule is a judicially developed doctrine that
recognizes that directors and officers are generally best situated to make difficult decisions that affect the rights of stockholders, and provides strong deference to the
integrity of those decisions in the face of claims of malfeasance or negligence. Given
the central importance of the business judgment rule, most of this Handbook is
devoted to discussing the applicability of the business judgment rule to various situations. Directors and officers would be well counseled to learn about the business
judgment rule in some level of detail and to ensure that their actions are best situated
to enjoy the protection of the business judgment rule. The business judgment rule is
discussed generally beginning in Chapter 2 of this Handbook and specifically in several further chapters.
Additional protections potentially available for directors and officers include
certificate of incorporation provisions that can eliminate or limit directors’ personal
liability to the corporation and its stockholders as permitted by the DGCL, mandatory
and permissive indemnification protections available under the DGCL, indemnification
provisions contained in a corporation’s certificate of incorporation and bylaws, contractual indemnification agreements, and directors’ and officers’ insurance policies.
These protections are designed to provide further assurance to directors and officers so
that they feel comfortable exercising their business judgment in a manner that they
believe best advances the interests of the corporation’s stockholders, without
unnecessary fear of personal liability. These devices are also discussed in greater detail
in Chapter 8 of this Handbook.
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CHAPTER 2
GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OF
DIRECTORS AND OFFICERS
INTRODUCTION
The business judgment rule is a judicially developed doctrine that recognizes that
directors and officers are generally best situated to make difficult decisions that affect
the rights of stockholders, and provides strong deference to the integrity of those decisions in the face of claims of malfeasance or negligence.19 The business judgment rule
is a critical component of corporate jurisprudence that is designed to assist companies
in attracting talented directors and officers to operate the corporation by limiting the
circumstances in which those persons can be liable for the corporation’s activities.
DETERMINING THE STANDARD OF REVIEW
Generally, so long as directors and officers comply with their basic fiduciary duties – the duty of care The business judgment
and the duty of loyalty – they are entitled to the pro- rule presumes that directections of the business judgment rule.20 The business tors acted on an informed
judgment rule contemplates that directors’ and officers’ basis, in good faith and
with the best interests of
decisions are “presumed to have been made on an
the corporation in mind.
informed basis, in good faith and in the honest belief
that the action taken was in the best interests of the corporation.”21 When the business
judgment rule applies, a court will not substitute its own views for those of directors or
officers or second-guess the outcome of business decisions by holding a director or
officer personally liable for a mistake in judgment.
19 The business judgment rule historically has protected the actions and decisions of directors; however,
there has been some recognition by courts and commentators that the business judgment rule should also
be applied to actions and decisions of officers. See, e.g., Selcke v. Richard Bove, et al. 629 N.E. 2d 747
(1994); Rosenfield v. The Metals Selling Corporation, 643 A. 2d 1253 (Conn. 1994); Kelly v. Bell, 254 A.
2d 62 (Del. Ch.1969). For purposes of this Handbook, the authors assume that the principles of the business judgment rule would be extended to officers.
20 Some courts and commentators describe fiduciary duties as three separate duties — the duties of
care, loyalty and good faith, while others describe the duties as two separate duties — the duties of care
and loyalty, with the duty of good faith being a subset of the duty of loyalty. See, e.g., In re Walt Disney
Co. Derivative Litigation, 906 A.2d 27 (Del. 2006).
21 Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1341 (Del. 1987).
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When the business judgment rule applies, it is the plaintiff’s burden to rebut the
presumption and establish that a fiduciary duty was breached. This requires the plaintiff to produce evidence and persuade the court that the evidence demonstrates that the
board members breached their fiduciary duties. In contrast, when the business judgment rule is inapplicable, courts will closely examine the circumstances surrounding
any challenged business decision and require the directors and officers to demonstrate
that the particular challenged action was “entirely fair” to the corporation and its constituents. The entire fairness standard is a much more exacting standard requiring the
directors and officers to demonstrate fair price and fair dealing, as discussed in detail
below under the caption “Entire Fairness Review.”22 Directors and officers who are
unable to meet the applicable standard of review can be personally liable to the corporation and its constituents for their actions.
In certain instances, the business judgment rule will not apply automatically to the
actions of directors and courts may apply a more enhanced level of scrutiny to challenged actions. For example, courts may not apply the business judgment rule when:
22
23
•
The subject transaction or challenged item involves interested directors and
approval of the fully informed disinterested directors or stockholders has not
been obtained;23
•
The subject transaction or challenged item involves a sale of control of the
company or a change of control of the company;
•
A company initiates an active bidding process to sell itself;
•
A company abandons a long-term strategy and seeks an alternative transaction involving a break-up or sale after having received a purchase offer;
•
An unsolicited third-party bid after a transaction with respect to the company
has been announced; or
•
The company adopts defensive tactics or provisions that are not reasonable
in relation to a threat posed to the company or that otherwise constitute an
abuse of discretion.
Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983).
See, e.g., Marciano v. Nakash, 535 A.2d 400, 405 n3 (Del.1987).
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In these instances, courts will impose a more rigorous standard, which may
involve requiring the directors to demonstrate the entire fairness (discussed below) of
their actions to the stockholders or applying the heightened review standards of Revlon
or Unocal. The Revlon and Unocal standards are discussed in Chapter 3 of this Handbook.
It is also important to note that although directors’ fiduciary duties are generally
described as consisting of two (or sometimes three) separate duties—the duty of care
and the duty of loyalty (some courts and commentators also consider the duty of good
faith and fair dealing to be a separate duty while other courts and commentators
consider the duty of good faith and fair dealing to be a subset of the duty of loyalty).
Nevertheless, courts may evaluate the duties more fluidly, and acts that may constitute
a breach of the duty of care may be found to be sufficiently egregious to constitute a
breach of the duty of loyalty as well.
DUTY OF CARE
The duty of care requires directors and officers to act prudently in light of all
reasonably available information in overseeing the corporation’s business and making
decisions on its behalf. Specifically, directors and officers
should employ the following practices, among others, to The duty of care
requires directors to
the extent appropriate:
fully inform them• Obtain and consider all relevant information;
selves and deliberate
• Take time to evaluate corporate actions;
carefully before
making corporate
• Consider the advice of experts;
decisions.
• Ask questions and test and probe assumptions;
•
Understand the terms of transactions;
•
Make deliberate decisions after candid discussion;
•
Understand the corporation’s financial statements and monitor related controls;
•
Review and monitor the performance of the chief executive and other senior
officers;
•
Remain informed about the corporation’s operations, performance and challenges; and
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•
Implement and monitor reporting and information systems to check for failures to comply with laws and regulations.
Breaches of the duty of care are typically not found where directors and officers
merely fail to follow best practices. Rather, breaches of the duty of care occur when
directors and officers engage in conduct that is grossly negligent, act with reckless
indifference to stockholders’ concerns or act in a manner that is completely irrational
with respect to their decision-making process.24 Further, as noted above, courts are
increasingly finding that sufficiently egregious breaches of the duty of care may also
constitute a breach of the duty of loyalty. Consider, for example, several prominent
cases:
•
•
24
25
Breach of Duty of Care Where Directors Take Substantially No Actions to
Inform Themselves Regarding a Potential Merger. In Smith v. Van Gorkom, the court found that the directors breached their duty of care in approving a merger agreement where:
O
Before the board meeting approving the merger, most of the directors
were unaware that a merger was even contemplated, although the deadline imposed by the proposed buyer for signing the merger agreement
was the next day;
O
During the chief executive officer’s short oral report regarding the terms
of the deal, the directors did not question the role that he had played in
orchestrating the sale and were unaware that he had suggested the per
share purchase price to the buyer; and
O
The board approved the agreement in a two-hour long meeting, during
which they neither reviewed the agreement nor questioned the determination of the purchase price.25
No Breach of Duty of Care Where Directors Approved a Substantial
Severance Arrangement for an Executive Without Following Best
Practices or Consulting a Compensation Consultant. In In re Walt Disney
Co. Derivative Litigation, no breach of the duty of care was found in
connection with the directors’ approval of an employment agreement that
Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).
Id.
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resulted in a $130 million severance payment to a president terminated after
only one year of employment even though the court found that the board
failed to take actions consistent with best practices, including informing
themselves of the estimated severance payments for each year of
employment or conferring with the compensation expert who had assisted in
preparing compensation figures for the president. The court determined that
the directors had acted on an informed basis, in good faith and in the honest
belief that they were taking action in the best interests of the company.26
•
No Breach of Duty of Care When Directors Failed to Detect Violations of
Law by Employees Where Directors Had Preventative Systems in Place
and Had No Reason to Know About the Violations. In In re Caremark
International Inc. Derivative Litigation27, no breach of the duty of care was
found where the directors failed to detect violations of laws by employees of
the corporation – specifically, employees had been compensating health care
practitioners who referred Medicare and Medicaid patients to Caremark
facilities in violation of the law.28 The court noted that generally a director
will be liable only if he or she knew or should have known about violations
of the law, he or she did nothing to address or remedy those violations, and
those violations were the cause of the losses to the corporation complained
of in the lawsuit.29 Further, the court stated that a director may be liable if he
or she failed to ensure that systems were put in place to check compliance
with applicable laws or failed to monitor those systems even where there
were no red flags indicating violations.30 The court determined that, had it
been presented with the question, it would not have found the Caremark
directors liable because they did not and had no reason to know of the violations and had systems in place to check for violations.31
26
906 A.2d 27 (Del. 2006).
698 A.2d 959 (Del. Ch. 1996).
28 Id. at 961-62.
29 Id. at 971.
30 Id. at 970.
31 Id. at 971-72.
27
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•
Breach of Duty of Loyalty (as Opposed to Just Duty of Care) Where Directors Fail to Install and Monitor Systems to Police Legal Compliance. In
Stone v. Ritter,32 the court held that directors may breach their duty of loyalty
where they fail to implement any reporting or information system controls,
or having implemented such a system fail to monitor or oversee its
operations.33 Significantly, the court held that such directors breached the
duty of loyalty (as opposed to their duty of care) by failing to institute a legal
compliance system because such failure constituted a failure to act in good
faith.33 This is notable because corporations cannot indemnify directors and
officers for breaches of the duty of loyalty where the director or officer has
acted in bad faith as they can for breaches of the duty of care.
•
Breach of Duty of Care When Directors Were Given Sufficient Notice of
Safety Violations and Failed to Act. In In re Abbott Labs Derivative
Shareholders Litigation, the court
found a breach of the duty of care The decisions in Caremark,
when the FDA repeatedly served Stone, Abbott Labs and Bridgenotices of safety violations over a 6- port suggest that if directors
year period and the directors took no have failed to act in good faith
steps to remedy the violations, result- in adhering to their duty of
ing in large monetary losses to the care obligations, they may be
company. The court determined that, found to also have violated
due to a set of facts indicating their their duty of loyalty and have
awareness of the problem, the board’s personal liability for which
inaction appeared to be intentional indemnification is not
and, consequently, the directors’ deci- available.
sions were not made in good faith.34
•
Breach of Duty of Loyalty Where Directors Abdicated Responsibilities to
Management and Engaged in Rush Sale of Business. In the recent case of
In re Bridgeport Holdings, Inc., directors were held to have breached their
duty of loyalty by abdicating crucial decision-making authority in the sale of
the company to an officer of the company, failing to monitor the officer’s
32
911 A.2d 362 (Del. 2006).
Id. at 370.
34 325 F.3d 795 (7th Cir. 2003).
33
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execution of an abbreviated and uninformed sale process, and ultimately,
approving the sale of the business for grossly inadequate consideration. The
court held that the board’s actions were tantamount to an intentional disregard of their duty of care, and thus constituted a breach of their duty of
loyalty, notwithstanding the fact that the plaintiff did not allege self-dealing
by the board or a lack of independence.35
Reliance on Experts
In discharging the duty of care, directors and officers are often encouraged to
seek the advice of experts, such as accountants, investment bankers and attorneys.
Under Delaware law, directors and officers are entitled to rely on the advice and
recommendations of such experts so long as such reliance is reasonable and in good
faith.36 However, if a director has reason to know that the information presented by the
expert is incorrect, then such reliance is not reasonable and the duty of care may not be
satisfied. Also, experts should be selected with reasonable care – an expert’s qualifications and experience should be considered in detail. Additionally, an expert’s
independence should be evaluated – experts who stand to earn significant fees based
on the success of a transaction may not be able to deliver an unbiased opinion.37
Finally, directors must not blindly rely on experts’
findings. Directors should probe and test an expert’s The duty of loyalty
requires directors to put
assumptions, analysis and conclusions.
the corporation’s interests
DUTIES OF LOYALTY AND GOOD FAITH
above their personal
interests in evaluating
The Duty of Loyalty
opportunities.
Directors owe a fiduciary duty of loyalty to the corporation and to its stockholders. The duty of loyalty requires directors and officers to
act in good faith, to act in the best interests of the corporation and its stockholders, and
to refrain from receiving improper personal benefits as a result of their relationship
35 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008); see also Ryan v. Lyondell
Chemical Company, C.A. No. 3176-VCN (July 29, 2008).
36 8 Del. C. §141(e).
37 In its decision in In re Tel-Communications, Inc. Shareholders Litigation, No. 16470, 2005 Del. Ch.
LEXIS 206, *41. (Del. Ch. Dec. 21, 2005), the court specifically questioned whether an investment bank’s
advice to a special committee would be considered independent when the bank’s entire fee was contingent
in nature on the transaction economy. Fairness opinion fees are generally bifurcated so that the fee for the
opinion is payable regardless of whether a transaction proceeds.
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with the corporation. The duty of loyalty prohibits self-dealing and usurpation of corporate opportunities by directors without the informed consent of the corporation,
through either its disinterested directors or stockholders. “Essentially the duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and
not shared by the shareholders generally.”38
Duty of loyalty issues typically arise in various contexts, including:
•
A conflict of interest – where any director or officer has an interest in a
transaction contemplated by the corporation;
•
Misappropriation of corporate opportunities – where a director or officer
exploits an opportunity that should have been made available to the corporation;
•
Competition with the corporation – where the director or officer is competing with the corporation without the express informed consent of the disinterested directors or stockholders;
•
Misappropriation of corporate assets – where corporate assets or information
are used by an officer or director for non-corporate purposes; or
•
Egregious Conduct – conduct that is deemed to be sufficiently egregious to be
viewed as not having been taken in good faith, including completely abdicating
the director’s responsibilities to the corporation.
Note that, unlike the duty of care, liability for breaches of the duty of loyalty
cannot be limited by a provision in the corporation’s certificate of incorporation, and
directors and officers may not have access to contractual indemnification for breaches
of the duty of loyalty that involve bad faith.39
38
39
Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993).
8 Del. C. §102(b)(7).
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What Defines a “Conflict of Interest”?
A director is “interested” in a particular transaction or corporate decision when
his or her exercise of judgment with respect to such transaction or corporate decision is
compromised by the presence of one or more
external factors relating to the transaction. Such One of the most fertile
“interests” most commonly exist when a director grounds for breach of fiduhas a material economic interest in a particular ciary duty claims is in
transaction or decision, such as when a director has instances in which directors
a financial stake in another party with which the have a potential conflict of
interest, and thus their duty
corporation is seeking to do business, when a
of loyalty is implicated.
director stands to receive a financial payment arising out of a transaction (such as a finder’s fee) or where a director or officer stands to
benefit from a continuing relationship with the other party to a transaction (such as an
employment relationship following the transaction). Conflicts of interest also can exist
in interlocking or overlapping governance arrangements – for example when a director
approves compensation for a chief executive officer who in turn sits on the board of a
corporation that employs that director. However, interested party transactions are not
inherently detrimental to a corporation. As long as a transaction is fair to the corporation, no confidential relationship is betrayed, and there is no misappropriation of
corporate property, the duty of loyalty may not breached, regardless of whether certain
corporate directors and officers will profit as a result of it.
“[The Delaware] Court has never held that one director’s colorable interest in a
challenged transaction is sufficient, without more, to deprive a board of the protection
of the business judgment rule presumption of loyalty. . . . To disqualify a director, for
rule rebuttal purposes, there must be evidence of disloyalty. Examples of such misconduct include, but certainly are not limited to, the motives of entrenchment, fraud
upon the corporation or the board, abdication of directorial duty, or the sale of one’s
vote (citations omitted).”40
40
Cede, 634 A.2d at 363.
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Mitigating Duty of Loyalty Issues
Duty of loyalty issues can be mitigated if actions involving potential conflicts are
approved by an independent decision-making body, which serves to mitigate the risk
that the decision in question is motivated by an improper purpose. The independent
decision-making body can be a majority of disinterested directors (even if less than a
quorum) or a majority of the stockholders. To neutralize duty of loyalty issues, the independent deciDuty of loyalty concerns
sion-maker must be fully informed of the conflict of
can often be mitigated by
interest as well as the terms of the corporate action
obtaining approval of
and must act in good faith.41 Boards commonly utidisinterested directors or
lize disinterested director approval mechanisms or
stockholders of a subject
special committees comprised of disinterested and
transaction.
independent directors in an effort to mitigate duty of
loyalty concerns and to try to preserve the application of the business judgment rule to
the maximum degree possible. In such an instance, use of a properly formed and functioning independent decision-maker may operate to shift the burden of proof of any
potential breach of fiduciary duty back to the plaintiff. Where no independent
decision-maker is present and where the business judgment rule does not apply, duty
of loyalty challenges can be overcome where the directors and officers can demonstrate that a challenged transaction was “entirely fair” to the corporation and its stockholders.42 However, entire fairness can be difficult, time-consuming and costly to
establish, as discussed in detail in this Chapter. The use of special committees is discussed further in Chapter 5 of this Handbook.
The Corporate Opportunity Doctrine
The corporate opportunity doctrine governs the appropriation of business opportunities by directors and officers of corporations. Generally, the corporate opportunity
doctrine provides that corporate directors and officers are prohibited from exploiting
business opportunities that might be of interest to the corporation that they serve.
Corporate opportunity issues often arise when corporate officers or directors are
involved with multiple corporations, including affiliated entities or entities that compete or operate in related markets; these scenarios can be particularly complicated
because such officers or directors have a duty of loyalty to each entity. Corporate
41
42
8 Del. C. §144.
Id.
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opportunity issues also arise where an officer or director has personal business interests that compete with the corporation’s business interests in certain business opportunities. Directors who are industry experts and serve as directors, promoters and
principals at multiple entities must be particularly sensitive to this issue.
What Constitutes a Corporate Opportunity?
A corporate opportunity exists, and a corporate officer or director is prohibited from
taking such business opportunity for his or her own without first offering it to the corporation, if:
Many corporations build
• The corporation has an interest or
extensive guidelines into their
expectancy in the opportunity;
employee conduct codes in an
• The corporation is financially able to effort to avoid potential conflicts
exploit the opportunity;
of interest and corporate oppor• The opportunity is within the corpo- tunity issues with their executives and directors.
ration’s line of business; and
•
By taking the opportunity for his or her own, the corporate fiduciary will
thereby be placed in a position inimical to his or her duties to the corporation.
The corollary to the above rule is that a director or officer may generally take a
corporate opportunity without breaching the duty of loyalty, if:
•
The opportunity is presented to the director or officer in his or her individual
and not his or her corporate capacity;
•
The opportunity is not essential to the corporation;
•
The corporation holds no interest or expectancy in the opportunity; and
•
The director or officer has not wrongfully employed the resources of the
corporation in pursuing or exploiting the opportunity.43
Of course, the safest course of action with respect to a transaction involving a
potential conflict over a corporate opportunity is to have the subject transaction
approved by the disinterested directors or stockholders after the full disclosure of its
terms.
43
See Guth v. Loft, Inc., 5 A.2d 503, 509 (Del. Ch. 1939). See also Broz v. Cellular Info. Sys., 673 A.2d
148 (Del. 1996).
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Mitigating Corporate Opportunity Issues
Corporations employ a wide range of practices in dealing with issues of corporate
opportunity. Some alternatives include the following:
•
Limit fields of interest in which directors and officers can participate outside
of their activities on behalf of the corporation to avoid potential overlaps
with the corporation’s business;
•
Define the activities and duties of the affected director or officer. For example, each of the corporation and any competing entity with which an officer
or director is affiliated could adopt a policy on confidentiality that would
release the affected director or officer from any obligation to disclose overlapping opportunities, and would prohibit members of the board of directors
of each entity from bringing to the other opportunities learned of through
participation in its meetings and deliberations;
•
Renounce the corporation’s interest or expectancy in a particular field or
opportunity as permitted under the DGCL such that directors and officers do
not have an obligation to refrain from participating in, or an obligation to
offer the corporation the right to participate in, such activities if presented to
the directors or officers;
•
Recuse the director or officer from deliberations with the corporation or the
other entity that implicate any areas of overlap between the competing businesses; or
•
Ask that the affected director or officer step down from his or her position
with the corporation or the other entity.
In all events, whatever limits are placed on a potentially affected director or officer, or whatever relief such director or officer receives from bringing opportunities to
the corporation or the other entity, there should be full disclosure of the potential conflicts to the board of directors of each of the corporation and such competing entity.
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Duty of Good Faith
The duty of good faith is a subset of the duty of loyalty requiring directors and
officers to act in the best interests of the corporation and its stockholders at all times.44
However, bad faith is not simply bad judgment or negligence, but rather implies the
conscious doing of a wrong because of a dishonest purpose or a state of mind
affirmatively operating with furtive design or ill will. Breaches of the duty of good
faith have been found in the following circumstances:
•
Directors knowingly or deliberately
withheld information they knew to be
material for the purpose of misleading
stockholders;45
The duty of good faith is a
subset of the duty of loyalty.
Duty of good faith violations
occur when directors consciously disregard their duty
to act in the best interests of
the corporation and its
stockholders.
•
A transaction was authorized for purposes other than to advance corporate
welfare and in violation of applicable
laws;46
•
A director’s decision was primarily
motivated by personal interest and not the best interests of the corporation;47
•
Actions were consciously taken with a dishonest purpose or moral obliquity;48
and
•
Directors failed to prevent waste or self-dealing by another director or
corporate officer.49
There has been ambiguity surrounding the duty of good faith in recent years,
including some confusion regarding whether the duty of good faith is an independent
duty or an element of the duty of loyalty. Two recent Delaware Supreme Court cases
44
Guth, 5 A.2d at 509; Stone v. Ritter, 911 A.2d 362 (Del. 2006).
Emerald Partners v. Berlin, 1995 Del. Ch. LEXIS 128 (Del. Ch. Sept. 22, 1995); see also Potter v.
Pohlad, 560 N.W.2d 389, 395 (Minn. Ct. App. 1997).
46 Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 n.2 (Del. Ch. 1996).
47 Washington Bancorp. v. Said, 812 F. Supp. 1256, 1269 (D.D.C. 1993).
48 Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1208 n.16
(Del. 1993).
49 In re Nat’l Century Financial Enterprises Inv. Litigation, 504 F. Supp. 2d 287, 313 (S.D. Ohio 2007).
45
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have settled the issue. In In re Walt Disney Co. Derivative Litigation,50 the court outlined three categories of behavior that are candidates for bad faith:
•
Category 1 – Fiduciary conduct motivated by an actual intent to do harm.
This would include actions taken by the directors with the intent to harm the
corporation or with ill will (subjective bad faith).51
•
Category 2 – Grossly negligent conduct, without more.52
•
Category 3 – The fiduciary intentionally acts with bad faith dereliction of
duty, a conscious disregard for one’s responsibilities.53 For example, the
fiduciary acts with a purpose other than that of advancing the best interests
of the corporation; the fiduciary acts with the intent to violate applicable
positive law; or the fiduciary intentionally fails to act in the face of a known
duty to act, demonstrating a conscious disregard for his or her duties.54
While the court decided that Categories 1 and 3 described behaviors that would
be classified as bad faith, grossly negligent conduct, without more (Category 2), could
not constitute a breach of the fiduciary duty to act in good faith.55
Following the 2006 Disney decision, the Delaware Supreme Court again
addressed the duty of good faith in Stone v. Ritter.56 In Stone, the Court clarified that
the duty of good faith is an element of the duty of loyalty, not an independent fiduciary
duty. Specifically, the Stone court said that “the obligation to act in good faith does not
establish an independent fiduciary duty that stands on the same footing as the duties of
care and loyalty.”57
50
906 A.2d 27 (Del. 2006).
Id. at 64.
52 Id.
53 Id. at 66.
54 Id. at 67.
55 Id. at 64.
56 911 A.2d 362 (Del. 2006).
57 Id. at 370.
51
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Consider, for example, the following cases regarding the duties of loyalty and
good faith:
•
No Breach of Fiduciary Duty When Decisions Are Made in Good Faith
Without Self-Dealing or Improper Motive. In Gagliardi v. TriFoods
International, no breach of fiduciary duty was found when a shareholder
alleged mismanagement and waste by the corporation. The court held that
without a showing of self-dealing or improper motive, a corporate officer or
director cannot be held liable for losses suffered as a result of a decision
made by the officer or authorized by the director unless the facts indicate
that no person would authorize the transaction in good faith.58
•
No Breach of Fiduciary Duty for Losses Due Solely to Errors in Judgment. In Kamin v. American Express, no breach of fiduciary duty was found
when shareholders filed suit to enjoin a distribution of special dividends that
would cause the corporation to lose $8,000,000 in tax savings, claiming
waste of corporate assets. The court held that the directors were protected by
the business judgment rule. The court refused to interfere with the decisions
of the board unless powers had been illegally or unconscientiously executed
or the acts were fraudulent, collusive, or destructive to shareholders’ rights.
Errors in judgment, without more, were not sufficient grounds for judicial
interference.59
•
Breach of Fiduciary Duty When Directors Knowingly Committed Illegal
Activities. In Miller v. AT&T, the court found a breach of fiduciary duty
when the company had given an illegal campaign contribution in violation of
federal law. The business judgment rule does not insulate directors from
liability after they knowingly committed illegal activities.60
58
683 A.2d 1049 (Del. Ch. 1996).
383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976).
60 507 F.2d 759 (3d Cir. 1974).
59
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•
Breach of Duty of Loyalty Where Directors Abdicated Responsibilities to
Management and Engaged in Rush Sale of Business. In the recent case of
In re Bridgeport Holdings, Inc. case, directors were held to have breached
their duty of loyalty by abdicating crucial decision-making authority in the
sale of the company to an officer, failing to monitor the officer’s execution
of an abbreviated and uninformed sale process, and ultimately approving the
sale of the business for grossly inadequate consideration. The court held that
the board’s actions were tantamount to an intentional disregard of their duty
of care, and thus constituted a breach of their duty of loyalty, notwithstanding the fact that the plaintiff did not allege self-dealing by the board or a lack
of independence.61
Summary
Delaware courts still recognize a triad of director duties, including care, loyalty and
good faith; however, following Disney and Stone v. Ritter, it appears that the duty of
good faith is not always viewed on the same level as the duties of care and loyalty. The
Delaware Court of Chancery has observed that by definition, a director cannot simultaneously act in bad faith and loyally towards the corporation and its stockholders because
“bad faith conduct. . . would seem to be other than loyal conduct.”62 Today, directors are
advised to demonstrate their good faith (and loyalty) by documenting the business purposes or stockholder-oriented reasons for their decisions and/or recusing themselves if
there is the potential appearance of impropriety.
DUTY TO DISCLOSE
Stemming from their fiduciary duties of care, loyalty and good faith, corporate
directors also have a duty of disclosure or candor.63 Disclosure violations constitute a
breach of the duty of care when the misstatement or omission was made as a result of a
director’s erroneous judgment, but was nevertheless made in good faith. If the board
lacks good faith in approving a disclosure, the violation also implicates the duty
of loyalty.64 When directors do seek to make a disclosure, such as in seeking
61
In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008).
In re ML/EQ Real Estate Partnership Litigation, No. 15741, 1999 Del. Ch. LEXIS 238 (Del. Ch.
Dec. 20, 1999).
63 Malone v. Brincat, 722 A.2d 5, 11 (Del. 1998).
64 In re Tyson Foods, Inc. Consol. Shareholder Litigation, 919 A.2d 563, 597-98 (Del. Ch. 2007).
62
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stockholder approval, Delaware courts have held that they need to “disclose fully and
fairly all material information within the board’s control.”65 Further, the court said that
when directors recommend stockholder action, they have an affirmative duty to disclose all information material to the action being requested and “to provide a balanced,
truthful account of all matters disclosed in the communications with stockholders.”66
Likewise, directors have a duty of candor that requires that they disclose to the board
information known to them that is relevant to the board’s decision making process.
Not all information requires disclosure under the duty of candor, but when a
corporation does speak to its investors, the directors need to be sure that any disclosure
of material information is truthful, accurate and complete. Consistent with federal
securities law, information is material if there is a substantial likelihood that a reasonable stockholder would consider it important in deciding how to vote. In addition,
there must be a substantial likelihood that such information would significantly alter
the ‘total mix’ of information available.67
ENTIRE FAIRNESS REVIEW
Overview
In situations in which the presumption of the business judgment rule is not available, directors will be required to establish the entire fairness of the transaction in
question. When engaging in an entire fairness review, a court will determine whether The entire fairness test requires
the transaction is entirely fair to stock- directors to produce evidence that
holders and should therefore be upheld, demonstrates that the subject
transaction was the product of fair
notwithstanding any deficiencies on the part
dealing and produced a fair price
of the board.68 This standard of review is
for the stockholders.
rigorous and the board bears the burden of
not only providing the evidence to the court but also persuading the court that the
evidence demonstrates that the directors have met their burden. The practical
implication of a rebuttal of the business judgment rule is that the chances that a trans65
Malone, 722 A.2d at 10 (Del. 1998).
Id.
67 Shell Petroleum, Inc. v. Smith, 606 A.2d 112 (Del. 1992); Arnold v. Soc’y for Sav. Bancorp, Inc., 650
A.2d 1270, 1277 (Del. 1994).
68 See, e.g., Citron v. E.I. Du Pont de Nemours & Company, et al., 584 A.2d 490 (1990).
66
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action may be set aside are greatly increased. As a result, it is of the utmost importance
that boards try to manage their actions and the circumstances surrounding them to
have the best chance of preserving application of the business judgment rule.
As noted previously, a rebuttal of the business judgment rule most frequently
occurs when a director may have an interest in the transaction, or when there is evidence that the directors may have breached their fiduciary duties. In addition, the
entire fairness test will be applied when a corporation consummates a transaction with
a controlling stockholder, unless the corporation obtains the approval of disinterested
directors, disinterested stockholders, or both. Although such disinterested approval
may result in the board receiving the benefit of the business judgment rule, a court
may nonetheless require a defendant controlling stockholder to demonstrate the entire
fairness of the challenged transaction. Absent a disinterested approval process, the
defendant may be required to bear the burden of providing evidence and convincing
the court that the transaction was entirely fair to the minority stockholders. If a disinterested approval process was used, a court may shift the burden of proof from the
defendant controlling stockholder to the plaintiff (who would then be required to
demonstrate that the transaction was not entirely fair).69 A shift in the burden of proof
can have a meaningful impact on whether the court ultimately declares that the transaction was entirely fair.
Fair Dealing and Fair Price
In order to satisfy an entire fairness review of a challenged transaction, a board
must demonstrate that the transaction was the product of both fair dealing and fair
price. This analysis is not necessarily bifurcated.70 A court considering the issue of
whether the board has met its obligations under the entire fairness test may blur the
lines between the two tests, and the results of one test may influence whether the other
test was satisfied.
69
70
See Weinberger v. UOP, Inc., 457 A.2d 701 (Del 1983).
Id. at 711.
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Fair Dealing
In determining whether a board engaged in fair dealing, Delaware courts will
carefully examine the board’s actions. Specifically, in assessing entire fairness, Delaware courts will consider:
•
•
•
The process the board followed – for example:
O
Was the process initiated by a related party or by an independent subset
of the board?
O
Did the board take care to ensure that the negotiation process was free
of any taint of related-party concerns?
O
Was the structure designed so as to be unduly advantageous to one
party or another?
O
Was the board fully apprised of all material facts surrounding the
transaction, including any material relationships?
O
Was a methodical, fully informed, disciplined approval process
followed for the board’s approval, and stockholders’ approval, if
required?
The quality of the result the board achieved – for example:
O
On balance did the end result provide a fair treatment to the
stockholders?
O
Did the directors satisfy their fiduciary duties of care, loyalty and good
faith in recommending the transaction?
The quality of the disclosures made to the stockholders to allow them to
exercise such choice as the circumstances could provide.71
71
See Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1140 (Del. Ch. 1994), aff’d 663 A.2d 1156
(Del. 1995).
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Fair Price
In addition to evaluating whether the board engaged in fair dealing, the Delaware
courts will consider whether a fair price was obtained. A fair price does not mean the
highest price financeable or the highest price that a fiduciary could afford to pay. At
least in the non-self-dealing context, it means a price that a reasonable seller, under all
the circumstances, would regard as within a range of fair value; one that such a seller
could reasonably accept.72 In the context of competing bids, the directors would be
expected to consider not only the absolute price offered by competing bidders, if any,
but also the likelihood that the stockholders would actually receive the price.
DIRECTOR LIABILITY AND PROTECTIONS
Delaware law permits a corporation to include a provision in its certificate of
incorporation eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty, provided
that the provision cannot eliminate or limit the liability of a director for:
•
Any breach of the director’s fiduciary duty of loyalty to the corporation or its
stockholders;
•
Acts or omissions that are not in good faith or that involve intentional misconduct or a knowing violation of law;
•
Unlawful dividends, stock purchases and redemptions by the corporation; or
•
For any transaction from which the director derived an improper personal
benefit.73
Exculpation provisions such as these provide substantial comfort to directors and may
directly impact their willingness to serve in that capacity, and as a result the certificates of incorporation of both publicly and privately held corporations commonly
contain them. Directors and persons contemplating accepting a directorship should
carefully consider whether and to what extent their liability to the corporation and its
stockholders is eliminated or limited under the corporation’s certificate of
incorporation.
72
73
Id. at 1143.
8 Del. C. §102(b)(7).
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In the event a board becomes subject to an entire fairness review, the board’s
failure to demonstrate entire fairness under the analysis discussed above is a basis for
a finding of substantive liability.74 If the breach that triggered application of the
entire fairness standard was a breach of the duty
A director who has been found of care, provisions in a corporation’s certificate
to have breached his duty of
of incorporation eliminating or limiting the perloyalty or good faith may not
sonal liability of directors for breaches of this
be entitled to indemnification
fiduciary duty would likely shield directors from
from the corporation under
personal liability.75 However, as noted above, a
Delaware law.
breach of the duty of loyalty or the related duty
of good faith may not be eligible for these protections.76 To further complicate matters,
the Delaware courts have sometimes blurred the distinction between what constitutes a
breach of the duty of care versus the duty of loyalty or the duty of good faith.
Delaware law also permits a corporation to indemnify its directors under its
bylaws in circumstances where they have acted in good faith and in a manner which
they reasonably believe is in the best interest of the corporation. Directors also may
have in place indemnification agreements providing contractual rights to
indemnification, and may be protected under an insurance policy (commonly known as
“D&O insurance”). However, as already noted, the availability of these protections in
favor of directors may be limited when they breach their duties of good faith and
loyalty. Indeed, many indemnification agreements specifically provide that a director
is not entitled to indemnification if he or she is ultimately determined to have acted
with gross negligence or willful disregard of his or her duties. Indemnification of
directors and officers and D&O insurance are discussed in detail in Chapter 8 of this
Handbook.
74
Cinerama, 663 A.2d at 1164.
See 8 Del. C. §102(b)(7).
76 See id.
75
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CHAPTER 3
FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESS
COMBINATION TRANSACTION
INTRODUCTION
Generally, when a board of directors is presented with a business combination, its
actions will be reviewed against the standard of the traditional business judgment rule,
assuming the directors have observed their duties of care and loyalty. Thus, when presented with a transaction, directors are advised to take a number of steps to best position
themselves to receive the benefit of the business judgment rule.
•
First, directors should inquire diligently with all parties as to any relationships with the potential counterparty so as to ensure that if facts give rise to
potential duty of loyalty considerations, they are identified and mitigated.
•
Second, directors should collect as much
relevant information regarding the potential transaction as reasonably possible,
review the information carefully, and
consider seeking the advice of experts,
including lawyers, bankers and accountants, if necessary, to ensure that the directors have a complete understanding of the
materials that have been presented.
•
Third, directors should investigate, to a
reasonable extent, the assumptions and
information provided to the directors.
Although directors are absolutely permitted to rely on information provided to them by management and outside
advisors, they cannot do so blindly and will be expected to have, at a minimum, probed and tested the assumptions and information provided to give
themselves a level of comfort and assurance as to its accuracy, veracity and
completeness.
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When faced with a potential transaction, directors
should always:
• Inquire as to potential
conflicts;
• Investigate and fully
inform themselves of
the facts;
• Test assumptions used
by experts and
management; and
• Deliberate before
making a decision.
FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
•
Fourth, directors should carefully consider their options and deliberate among
themselves. Robust discussion will bring issues to the surface and promote
thorough consideration by the board in making its decision.
These steps, taken together, will best position the board to enjoy the benefits of
the business judgment rule. Nevertheless, as noted in Chapter 2, there are instances in
which the business judgment rule may not apply. In these instances, greater judicial
scrutiny may be applied to the directors’ decision-making process. Specifically,
•
Where directors may have been found to have violated their duty of care or
duty of loyalty, they may be required to demonstrate the entire fairness of
the transaction to the stockholders;
•
When contemplating a sale or break-up of the corporation, directors will be
held up to the so-called Revlon duties;77 and
•
When defending against a change in control of the corporation, directors’
actions may be reviewed against the heightened standard set forth in the
Unocal decision.78
BOARD CONSIDERATIONS WHEN A SALE OR BREAK-UP OF THE
CORPORATION IS NOT IMPLICATED
In general, in reviewing a proposed business combination, directors should
consider multiple factors, including the following:
77
78
•
An assessment of a merger partner (in the case of a share-for-share transaction) and the prospects of the combined corporation (including synergies
of the combination, composition of the management team and the board and
factors affecting stock price and performance);
•
The “price” or “merger consideration” in the transaction;
•
The opinion of a financial advisor as to the fairness of the transaction consideration from a financial point of view;
Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
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•
The advice of advisors concerning the terms of the transaction;
•
Alternative proposals and the “standalone” prospects for continuing business
without undertaking a transaction;
•
The impact of the transaction on the corporation’s long-term strategic plans;
•
Integration risks of the transaction;
•
The legal terms of the proposed business transaction, including pricing,
conditions to closing, restrictions prior to closing and any other key terms of
the transaction;
•
Deal protection terms including “no shop” provisions, “break up” or termination fees, etc.;
•
Accounting and tax treatment of the transaction;
•
The right of the corporation’s stockholders, if applicable, to vote on the transaction;
•
Conditions to the proposed transaction and the risk that conditions, such as
financing for the transaction, may not be fulfilled;
•
Circumstances of the corporation’s business and industry;
•
The impact of the transaction on various other constituencies, such as
employees, suppliers and customers;
•
The results of due diligence review for the proposed transaction; and
•
The legal or other approval requirements needed to complete the transaction,
such as antitrust clearances.
There can be no “one size fits all” solution to the issues that a board may consider
in its deliberations for a particular transaction. Certain factors will have much greater
weight assigned to them depending on the circumstances of the particular project. For
instance, price may be a paramount consideration in a sale of control transaction,
whereas longer-term strategic considerations might be more relevant in the case of
some share-for-share business combination transactions.
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ADDITIONAL CONSIDERATIONS IN ANY BUSINESS COMBINATION
TRANSACTION
In addition to the factors discussed above, directors should always take into
account the following important considerations in the context of any potential business
combination:
•
The path of considering one or more possible business combination transactions is highly confidential. All aspects of information flow and disclosure
need to be tightly coordinated;
•
Care should be taken to avoid trading by any insiders in the securities of the
corporation or any counterparty;
•
Efforts should be made to coordinate communications with members of the
board, management and the corporation’s advisors so as to assure the most
effective overall process;
•
Discussions with investors, the press and securities market professionals
should not be undertaken except where approved as part of the overall transaction process; and
•
Notes that directors choose to keep, if any, should be carefully prepared not
only to assure accuracy, but also to avoid comments that can be taken out of
context in the event of litigation or other proceedings concerning the transaction.
REVLON AND A SALE OR BREAK-UP OF THE CORPORATION
Introduction
Once a board makes the decision to sell the corporation, Revlon duties are
invoked that require the board to change its focus from the preservation of the corporation as a corporate entity to the maximization of the corporation’s value at a sale for
the stockholders’ benefit.79 In its most basic form, Revlon duties can be described as
the duty of the board to maximize the value to be received by stockholders. Once
Revlon duties apply, instead of relying on the business judgment of the directors,
79 See Revlon, 506 A.2d 173; Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del.
1989); Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994).
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courts will more closely scrutinize the board’s process and actions in order to ensure
that the directors took the steps necessary to maximize stockholder value.80
Applicability of the Revlon Duties
Whenever a sale of control is implicated, Revlon duties will likely apply. Generally, sale of control is implicated in any transaction in which corporate control passes
to a third party, including:
•
A sale or merger for cash or debt securities;
•
A merger for securities (even a strategic merger) that transfers control to a
private corporation or to a public corporation with a majority stockholder;
•
A transaction or business reorganization that will cause a clear break-up of
the corporation; or
•
A sale of equity securities by a controlling stockholder that results in a
change of control.
In contrast, Revlon duties do not apply in the following situations:
•
•
•
•
80
Where a board rejects an unsolicited offer as not in the best interest of its
stockholders;
In a merger or business combination Unless a board has otherwise
transaction in which sale of control of subjected itself to Revlon
duties, it has no legal duty to
the corporation is not implicated;
engage in discussions or to
In a merger or business transaction in negotiate with respect to a
which sale of control of the corporation hostile or otherwise
is implicated if the transaction is a unsolicited takeover offer.
“merger of equals.” A “merger of
equals” involves a merger of two companies with large and diverse stockholder bases where following the transaction, a majority of the voting securities of the combined company remain in the hands of investors in the
public markets;
In a situation in which a board is considering acquiring another business and
that acquisition would not involve a change of control to the acquirer.
See id.
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Revlon duties arise at the time that the directors have or are deemed to have
decided to sell a controlling interest in the corporation.81 For example, Revlon duties
may attach when the directors have authorized corporate officers or a board committee
to negotiate a sale, or when the directors have formally resolved to conduct a sale. In
contrast, Revlon duties typically will not apply if the directors never authorize the sale
of the corporation, never indicate any inevitable
Once implicated, Revlon
commitment to sell the corporation to anyone, or
duties require directors to:
merely authorize the exploration of a variety of
• Obtain the highest value;
alternatives intended to enhance profitability,
• Act with neutrality
including a possible sale. As most sales are prebetween bidders;
ceded by such informal investigations, directors
• Ensure a fair auction
should be aware of Revlon duties when such a
or sale process; and
process commences and avoid commitments that
• Conduct a reasonable
might make it difficult to meet their Revlon duties
market check.
if they should arise later.
Revlon Duties and Guidelines
Once Revlon duties arise, the board of directors should adhere to the following
guidelines:
•
81
82
Highest Value. The responsibility of the directors is to get the highest possible value reasonably attainable for the stockholders. There is “no single
blueprint” that directors must follow in seeking the highest value.82 In evaluating competing offers where differing consideration is offered, a board is
not limited to considering only the amount of cash involved, and may take
into account the future value of the strategic alliance. For example, if
acquirer A is offering all cash, and acquirer B is offering a mixture of cash
and stock or other consideration, directors should consider the aggregate
value of each of the proposed transactions. In addition, directors should
consider the likelihood that a potential acquirer is financially capable of
completing the transaction, as well as other factors that could affect the likelihood of a particular transaction being completed. In short, directors
considering competing transactions should analyze the entire situation and
evaluate the consideration being offered from each transaction in a disciplined manner with the objective of maximizing value for the stockholders.
See id.
Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 44 (Del. 1994).
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•
Neutrality. The board must act in a neutral manner to encourage the highest
possible price for the stockholders. Furthermore, courts have repeatedly
highlighted that the active involvement of a corporation’s independent
directors is critical to satisfying a board’s Revlon duties.
•
Deal Protection Measures. Although deal protection measures are common in
business combination transactions, these measures are frequently subjected to
heightened scrutiny. Common measures include lock-ups, no-talk, force-thevote and no-shop provisions, commitments to recommend, stock option
grants, break-up and termination fees, voting agreements and similar
arrangements. In contrast, many recent transactions have utilized go-shop
provisions in an effort to ensure that maximum value has been achieved.
These provisions permit the target after executing the acquisition agreement to
affirmatively seek a potential alternative acquirer for a specific period of time.
Deal protection provisions or any other defensive tactic that might impair the
auction process, unfairly favor one bidder over another, or preclude
stockholders from having a meaningful opportunity to determine whether to
approve the transaction may be carefully scrutinized in considering whether
the board met its Revlon duties. In addition, preclusive or aggressive deal
protection measures may violate the Unocal standard described below.
•
Market Check. A market check, meaning an exploratory review of whether
other potential bidders exist and if so, what price they might pay, may be
required where the board is considering a single offer and no bidding contest
is present. A “market check” may assist the board in considering whether a
proposed change of control transaction maximizes stockholder value.
No Obligation to Sell or Negotiate
It is important to emphasize that a board is not obligated to put a corporation up
for sale or to negotiate with a party that indicates an interest in acquiring the corporation so long as the board is acting in good faith. Similarly, a board is not obligated to
sell the corporation, even if a premium price is offered, if the board makes a good
faith, informed decision that it is in the best interests of the corporation to reject the
offer. If a board does elect not to put a corporation up for sale in response to an
unsolicited offer, care should be taken that the directors have engaged in a thoughtful
analysis of why they believe stockholder value can be enhanced by not selling the
corporation and should appropriately document that thought process.
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REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF A BUSINESS
COMBINATION TRANSACTION
In light of the foregoing discussion, directors should consider the following in
connection with a business combination transaction:
•
•
•
•
Educate Yourselves:
O
Obtain input and reports of senior management and experts;
O
Rely upon experienced counsel and financial advisors;
O
Familiarize yourself and make independent inquiry with respect to
all material aspects of the transaction and key documents;
Make Good Disclosures:
O
Disclose all actual and potential conflicts of interest;
O
Take care to ensure complete and accurate disclosure to stockholders
whose approval of a particular transaction is sought;
Deliberate:
O
Engage in robust and extensive deliberations with the board in order
to surface and consider issues and perspectives;
O
Create a record of the decision-making process, including
correspondence with third parties discussing the merger;
Act in Good Faith:
O
Always act in the very best interests of the stockholders;
O
Avoid taking any actions (i.e., adopting deal protection devices) that
limit the board’s ability to exercise its fiduciary duties;
O
Avoid making any decisions that would favor one group of
stockholders over another; and
O
Avoid taking any action that might have the effect of favoring a
related party over the stockholders.
In addition, if Revlon duties apply, directors should redouble their efforts to
maximize stockholder value and follow the guidelines discussed previously in this
chapter.
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UNOCAL AND DEFENDING AGAINST HOSTILE TAKEOVERS
Introduction
In contrast to situations where a board’s actions contemplate the sale or break-up of
a corporation (i.e., where Revlon duties apply), in circumstances where a board
receives a hostile or unsolicited acquisition proposal and resists the proposal by Defensive measures adopted by a
adopting a defensive takeover measure, board in the face of a hostile bid must
the Unocal standard will apply. Defensive be reasonable and proportionate to
takeover measures are myriad and include the threat posed and the board must
stockholder rights plans (or “poison pills,” have reasonable grounds to believe
more fully discussed below), protective the threat to corporate policy and
provisions in the corporation’s charter and effectiveness actually exists.
by-laws, such as a classified board,
limitations on stockholders’ rights to act by written consent, call special meetings and
remove directors, and supermajority vote requirements. Boards may also seek to stop a
hostile takeover by implementing an alternative transaction with a friendly acquirer or
a separate transaction making the capitalization of the corporation undesirable to the
hostile party. Several of these techniques can be implemented either in direct response
to a hostile bid or in preparation for the possibility of a future hostile bid. In cases
where such measures are adopted in the absence of an existing threat (i.e., a pending or
threatened hostile offer), the actions of the board in adopting such measures should be
entitled to the protections of the business judgment rule; however, where such measures are adopted in response to a threat, the heightened standard of Unocal will be
applied by a court reviewing challenged actions of the board.83 Nevertheless, a board
adopting a poison pill even in the absence of an existing threat should be mindful of
the Unocal standard.
Under the Unocal standard, a board must show that its actions satisfy a
two-pronged test. First, the board must demonstrate that it had reasonable grounds for
believing that a danger or threat to corporate policy and effectiveness existed.84 Second, the board must demonstrate that its response was reasonable and proportionate to
the threat.85
83 As discussed in greater detail below in the section “Special Case: Use of a Poison Pill,” institutional
shareholders typically oppose defensive measures.
84 See Unocal, 493 A.2d at 955.
85 See id.
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Reasonableness Test
Under the reasonableness inquiry of the Unocal Standard, the board must demonstrate that it had reasonable grounds for believing that a danger or threat to corporate
policy and effectiveness existed.86 A threat to corporate policy can exist from, among
other things, inadequate or coercive tender offers, or offers timed so as to disrupt
strategic goals. This prong could be established by a board’s showing that it engaged
in a reasonable investigation of the facts surrounding the takeover offer. This showing
will be buttressed if the majority of the board was independent and disinterested.87
In examining the threat posed in connection with a hostile takeover bid, directors
should take into account, among other considerations:
•
The inadequacy of the price offered;
•
The nature and timing of the offer;
•
Questions of illegality;
•
The impact on “constituencies other than stockholders”;
•
The risk of non-consummation;
•
The quality of securities being offered in the exchange, if any;
•
The loss of the opportunity for the corporation’s stockholders to select a
superior alternative;
•
The risk that disparate treatment of non-tendering stockholders may distort
their tender decisions; and
•
The risk that stockholders will mistakenly accept an under-priced offer
because they disbelieve management’s representation of intrinsic value.88
86
See id.
See Unitrin Inc. v. American General Corp., 651 A.2d 1361, 1375 (Del. 1995).
88 See Unocal, 493 A.2d 946; Unitrin, 651 A.2d 1361.
87
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Proportionality Test
Proportionality requires that the board’s actions to thwart a hostile takeover bid
be a reasonable response to the threat presented. This analysis has two parts:
First, the board must show that its response was neither “preclusive” nor
“coercive,” and therefore not “draconian.”89 A response will be “preclusive” if it
deprives stockholders of the right to receive all tender offers or precludes a bidder
from seeking control by fundamentally restricting proxy contexts or otherwise.90 A
response will be “coercive” if it forces a management-sponsored alternative upon
stockholders.91
Second, assuming the response was not draconian, the board must prove that it
was within a “range of reasonableness.”92 When determining whether an action is
within the “range of reasonableness,” the court will look to, among other things,
whether the action was (i) a statutorily authorized form of business decision which a
board may routinely make in a non-takeover context, (ii) limited and corresponded in
degree or magnitude to the degree or magnitude of the threat, and (iii) responded to the
needs of stockholders.93
Under Delaware law, boards should be given some level of deference in showing
proportionality.94
Consider the following court decisions regarding reasonableness and proportionality of defensive measures:
•
A defensive measure is reasonably related to the takeover threat if the
measure does not force a management-sponsored plan on stockholders. In
Paramount Communications, Inc. v. Time Inc., the court refused to enjoin
Time’s consummation of a tender offer to its stockholders made in response
89
Unitrin, 651 A.2d at 1367.
Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 935 (Del. 2003).
91 Id.
92 Id.
93 Unitrin, 651 A.2d at 1389.
94 See id. at 1388.
90
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to a competing merger offer when the offer was not aimed at “cramming
down” a plan on stockholders, but rather had as its goal continuing a preexisting transaction in an altered form.95
•
Defensive measures may be both preclusive and coercive if the measures
constitute a fait accompli. In Omnicare, Inc. v. NCS Healthcare, Inc., deal
protection devices approved by the board of directors operated in concert to
have a preclusive and coercive effect because the defensive measures made
it mathematically impossible and realistically unattainable for any alternative
proposal to succeed, no matter how superior the proposal.96
•
A defensive measure may be found to be disproportionate if anti-takeover
provisions cannot be unilaterally revoked by the board of directors. In Air
Line Pilots Ass’n, International v. UAL Corp. an embedded defense—a term
embedded in a contract with a nonstockholder counterparty that has an antitakeover effect—was found to be unreasonable and therefore disproportionate
because the takeover defense could not be rescinded by the company.97
95
571 A.2d 1140, 1154-1155 (Del. 1989).
818 A.2d 914 (Del. 2003).
97 897 F.2d 1394 (7th Cir. 1990).
96
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REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF
RESPONDING TO A HOSTILE TAKEOVER
In light of the foregoing discussion, the board should consider the following in
connection with responding to a hostile takeover:
•
Act in good faith and on an informed basis;
•
Consider and evaluate factors that bear on the existence of a threat to
corporate policy or effectiveness;
•
Respond to threats in a reasonable and proportionate manner;
•
Obtain approval of the transaction from a majority of outside independent
directors; and
•
Avoid deal protection measures or actions that unduly limit ability to
exercise fiduciary duty.
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SPECIAL CASE: USE OF A POISON PILL
Overview and Mechanics
There are several options available to a corporation that is seeking to discourage
the threat of abusive takeover attempts, particularly when there is no known takeover
attempt on the horizon.98 One of the most common of these options is a stockholder
rights plan, also known as a “poison pill.”
Over the past twenty years or so, stockholder rights plans have been a commonly
used agreement adopted by companies for discouraging and fending off undesirable
and abusive advances from hostile offerors. However, in recent years stockholder
rights plans have fallen into disfavor as activist stockholder groups have argued that
the plans facilitate the entrenchment of management and deprive stockholders of the
ability to receive maximum value for the business. Poison pills generally are designed
to deter certain abusive takeover devices and tactics. These devices and tactics include:
•
Acquisitions of a controlling interest without paying a premium or at a
market price which may not reflect actual value; and
•
Partial or two-tier tender offers in Stockholder rights plans, or
which all of the stockholders of a so-called “poison pills,” have been
corporation are not treated equally used by boards for many years to
(i.e., where the hostile bidder increase leverage for boards in
offers cash for a controlling por- negotiating potentially hostile
tion of the shares but a lower per acquisitions.
share amount, possibly in the
form of securities rather than cash, for the remaining shares which are taken
out in a merger following the tender offer).
A stockholder rights plan can be very useful because it may afford the board time
to consider unsolicited offers. In addition, if such offers are deemed to be inadequate,
the stockholder rights plan may provide a board with the opportunity to seek alter98 As noted above and below under the caption “Fiduciary Duties,” a board’s determination to adopt a
defensive measure in the absence of a threat (i.e., a pending or hostile offer) is more likely to receive the
benefit of being reviewed under the business judgment rule standard of review whereas a board’s adoption
of such measures in response to a threat will be subject to the heightened Unocal standard of review by a
court considering a challenge to the board’s action.
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natives to such an offer, thereby enhancing the board’s negotiating power and its corresponding ability to promote equality for all stockholders of the corporation.
A stockholder rights plan can be adopted by a corporation’s board of directors
without stockholder approval. The basic feature of a stockholder rights plan is the distribution of rights to all holders of common stock to purchase additional shares of
either the same class of stock or a class of preferred stock. Certificates evidencing the
rights are issued, but not exercisable, upon the earlier of either:
•
A public announcement that a person or group of affiliated or associated
persons owns or has the right to own a “designated ownership limit”
(typically 15% to 20%) of the then outstanding shares of the corporation’s
common stock; or
•
A certain period of time following the commencement of a tender offer or
exchange offer that would result in a person surpassing the designated
ownership limit. Such person or group of affiliated persons that successfully
acquires beneficial ownership that meets or exceeds the designated ownership limit is typically referred to as an “acquiring person.” The rights have
no real economic value, and are not exercisable, unless and until there is a
triggering event, which is deemed to occur when a party actually becomes an
acquiring person.
The rights generally expire somewhere between five and ten years from the establishment of the stockholder rights plan.
The exercise price of a right is typically 200%–500% of the market value of the
underlying common stock at the time the stockholder rights plan is adopted. The
rights, therefore, are “out of the money” at the time of issuance. Upon a triggering
event, the rights become exercisable for the purchase of securities, either common
stock or preferred stock of the target or the acquirer, at a significant discount (usually
50%) to the then-current market price. Any rights held by an acquiring person are not
exercisable. Thus, the effect of a triggering event is to substantially dilute the acquiring person’s interest in the target and make any acquisition prohibitively expensive.
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Fiduciary Duties
Given the recent rise in activist stockholder activity regarding stockholder rights
plans, directors should proceed prudently when enacting or maintaining such plans.
While the general legality of poison pills has been well established by Delaware case
law, courts have given increasing scrutiny to instances in which boards have used rights
plans to interfere with stockholder choice at the conclusion of an auction99 or where use
of the plan violates another principle of takeover law (i.e., utilizing a rights plan in a
discriminatory manner favoring one change-in-control transaction over another).100
Delaware courts believe that, while a board’s actions in the face of a hostile takeover attempt should be scrutinized carefully due to the threat posed to the directors
themselves and the possibility that they will act in their self-interest, a board’s planning for a hostile takeover defense in advance can benefit the well-being of the corporation and its stockholders. Therefore, courts are more likely to give a board the
deference that is given to most routine corporate decisions under the business judgment rule when defensive measures such as stockholder rights plans are adopted at a
time other than in the face of a hostile offer. On the other hand, if a stockholder rights
plan is enacted in response to a hostile takeover bid, or if a board refuses to terminate
the plan when such a bid is presented, the heightened Unocal standard will likely
apply. Boards considering such a situation should carefully consider the adequacy of
the offer and the effect enacting the plan would have on stockholder value.
One notable exception to the general rule is the adoption in advance of a hostile
takeover attempt of a “dead hand pill.” In its customary form, a “dead hand” stockholder rights plan will, by its terms, prevent directors appointed by a hostile acquirer
from terminating the plan (and by doing so, impede the potential acquisition), or may
restrict the time period in which such termination can take place. Dead hand pills have
99 Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261 (Del. 1989); City Capital Associates Ltd.
Partnership v. Interco, Inc., 551 A.2d 787 (Del. Ch.), appeal dismissed, 556 A.2d 1070 (Del. 1988);
Grand Metropolitan Public Ltd. v. Pillsbury Co., 558 A.2d 1049 (Del. Ch. 1988) (note that this line of
cases was criticized in Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989) as
“substituting [the court’s] judgment as to what is a ‘better’ deal for that of a corporation’s board of
directors”).
100 Paramount Communications Inc. v. QVC Network, Inc., 637 A. 2d 34 (Del. 1994).
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been struck down by Delaware courts on several occasions for a variety of reasons,
including under the Unocal standards.101
SPECIAL CASE: DIRECTOR DUTIES IN THE FACE OF ACTIVIST
STOCKHOLDER DEMANDS
In the past few years, directors have increasingly faced a new challenge – activist
stockholders and their demands. Activist stockholders are stockholders who typically
place significant demands on a corporation’s board and officers to take actions that
may not have been within the strategic plan of the corporation prior to the demand by
the activist.
Who are Activist Stockholders and What do They Want?
Activist stockholders include, among others, hedge funds, corporate governance
organizations, state pension funds and corporate raiders. When attempting to effect
change at a corporation, activist stockholders are more likely to focus on specific key
issues and exert pressure to acquire influence, rather than control of a company.
Common demands include:
•
Change the composition and members of the board of directors;
•
Change the strategy or management of the company;
•
Effect dividend payments, a stock repurchase, or a divestiture of assets;
•
Direct corporate governance changes;
•
Force a sale of the company; or
•
Initiate or stop a strategic transaction.
A common goal of activist stockholders is to force an event to trigger value creation
for the stockholders.
101 See e.g., Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998); Mentor Graphics Corp. v.
Quickturn Design Systems, Inc. 728 A.2d 25 (Del. Ch. 1998), aff’d 721 A.2d 1281 (Del. 1998).
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Arguments For and Against Stockholder Activism
Supporters of stockholder activism argue that activists force companies to be
accountable for their actions and provide the catalyst for value-enhancing strategic and
financial actions. Further, supporters argue that activist stockholders are better aligned
with stockholders’ interests than with management’s interests. Critics of stockholder
activism note that activists often focus on measures, such as stock price, that emphasize
results in the short term and prevent the board of directors from focusing on and directing the long-term success of the company. In addition, critics argue that stockholder
activism does not usually create value for the other stockholders unless the company is
put up for sale and even then there is little change in the stock performance of a company in the months following the appearance of an activist stockholder.
Tactics Used by Activist Stockholders
There are myriad tactics employed by activist stockholders to achieve their
objectives, including:
•
Proxy contests;
•
Withhold-the-vote campaigns;
•
Negative press and other activism to influence analysts, press and
RiskMetrics Group;
•
“Wolf packs;”102
•
Stockholder proposals;
102 The “wolf pack” is a hedge fund phenomenon that typically consists of multiple hedge funds sharing
ideas and acquiring several small positions in a company quickly and stealthily. In this scenario, small
networks of hedge funds direct the activism and it can result in the rapid destabilization of the stockholder
base. Similarly, hedge funds have historically avoided the ownership disclosure requirements of the
Exchange Act by utilizing equity swaps instead of acquiring the securities of the target company. Notably,
a recent decision by the United States District Court in the Southern District of New York held that stockholders accumulating interests in a corporation through the purchase of equity swaps are subject to the
reporting requirements of Section 13(d) of the Exchange Act, and the failure to disclose those positions
was fraudulent. CSX Corp. v. The Children’s Investment Fund Management, 08Civ. 2764, 2008 U.S. Dist.
LEXIS 46039 (S.D.N.Y. June 11, 2008).
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•
Attacks on executive compensation;
•
Private letters requesting to talk with management or the board of directors;
•
Public letters;
•
Tender offers; and
•
Litigation.
Delaware courts are demonstrating receptiveness to proposals by activist stockholders at least to the extent that they are focused on a legitimate subject matter for
stockholder input, such as the process of corporate governance, and so long as the
proposal does not preclude the directors’ ability to exercise their fiduciary duties. For
example, in a recent decision, the Delaware Supreme Court considered whether stockholders have a right to require a corporation to include in its proxy for consideration by
stockholders a proposed modification to the corporation’s bylaws requiring the corporation to reimburse stockholders for costs associated with nominating directors who
are subsequently elected, with certain exceptions. The corporation’s board resisted the
proposal on the basis that it infringed on the board’s right to manage the business and
affairs of the corporation under Section 141 of the DGCL and that it would preclude
the directors from exercising their fiduciary duties in determining whether it was a
legitimate use of corporate funds to reimburse a stockholder group that had successfully nominated a slate of directors. The court held that the process for electing directors is a subject in which stockholders have a legitimate and protected interest, and as
such, the bylaw did not infringe on the directors ability to manage the business and
affairs of the corporation; however, the court also found that the bylaw had the effect
of precluding the directors from exercising their fiduciary duty to deny reimbursement,
in the event that the intentions of the stockholder group were not in the legitimate best
interest of the corporation.103
103 CA, Inc. v. AFSCME, (Del. 2008) No. 329, 2008. This decision arose out of a request from the SEC
under a new certification procedure.
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What Should Directors and Officers Do When Confronted with an Activist
Stockholder Demand?
When so confronted, it is imperative that boards react quickly but thoughtfully to
stockholder demands. To fulfill their duty of care obligations, members of the board
must carefully consider the demands made by the stockholder and their potential
implications on the short- and long-term business goals of the corporation. While
doing so, the board must be very sensitive to any implication that the judgment of
individual directors or officers may be compromised by duty of loyalty considerations
if the stockholder proposals could be viewed as conflicting with the personal interests
of the board or officers. By definition, many activist investor demands may place the
board and the officers of the corporation in a situation in which their duties of loyalty
may be implicated.
Further, many activist investors request a change in the board composition, either
by replacing directors that they view as not functioning in accordance with their perceived agenda for the corporation, or by adding new director positions to the board.
Many other demands seek to institute significant corporate governance changes, such
as requiring stockholder approval of officer compensation plans, effecting dividend
payments or making other divestitures.
Boards facing demands from activist stockholders, particularly demands that
involve the replacement of directors or management, may consider the advisability of
establishing a working subset of the board (whether acting as a formal committee or
not) of individuals who are disinterested and independent and who can investigate the
proposal. This step is intended to substantially mitigate against any claims by the activist stockholder of management or board entrenchment. Extra care should be taken to
ensure that these directors have access to the corporation’s management, as well as
outside and independent legal counsel, accountants and investment bankers, as needed.
In addition, the directors should have access to other experts as needed, including a
proxy solicitation firm and a public relations firm to manage and address any activist
stockholder matters.
The directors should educate themselves on the proposal put forth by the activist
stockholder, and on the potential benefits and risks to the corporation’s stockholders of
pursuing that proposal. If there are competing proposals by the officers of the corporation or others, the directors should also carefully consider those proposals. The
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directors should also consider whether there are any alternative courses of action, and
how the proposal and each alternative may benefit the long-term interests of the stockholders. In these considerations, the directors should meet frequently
so that they may share their views with each other as well as collect information from
the corporation’s management and advisors.
Additional factors the directors may consider include the credibility, reputation
and ownership level of the activist stockholder. Attention should be given to the
stockholder’s past behavior, track record and any possible relationships or alliances the
stockholder may have with other stockholders of the corporation.
As part of this process, the directors should consider meeting with the activist
stockholder to discuss any proposals and how they differ, if at all, from the long-term
strategies and goals being pursued by the board. Ultimately, the directors should
recommend a concrete response plan to the demand for full board consideration.
How Should the Corporation Apprise its Stockholder Base of the Demand and Its
Reaction to the Demand?
Communication is critical when dealing with activist stockholders. In addition to
communicating with the activist stockholder, the corporation should consider whether
it should communicate generally with its stockholder base regarding the demand, the
board’s response to the demand, and the reasons for the response. If the board decides
not to comply with the demand, robust disclosure of the reasons why the board has
determined not to accede to the demand should be considered. Specifically, boards
may consider explaining why the demand is not, in the view of the board, in the best
long-term interests of the stockholders of the corporation.
Ultimately, activist stockholder demands may prove to be expensive and timewasting exercises for a board, or may prove to be useful exercises to increase value for
the corporation’s stockholders. In any event, boards and officers will want to ensure
that they act responsibly in adequately addressing a particular stockholder demand.
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REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF
RESPONDING TO ACTIVIST STOCKHOLDER DEMANDS
In light of the foregoing discussion, the board should consider the following in
connection with responding to activist stockholder demands:
•
Establish and provide resources for a disinterested and independent working board subset or special committee to analyze the issue;
•
Investigate the basis, benefits and risks for the demands;
•
Identify the proposal’s implications on the corporation’s short and long
term business goals;
•
Evaluate alternative courses of action;
•
Consider meeting with proposal’s proponents to discuss available options;
•
Recommend a concrete response plan for full board consideration; and
•
Consider disclosing reasoning for recommended action to stockholders at
large.
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CHAPTER 4
FIDUCIARY DUTIES IN THE CONTEXT OF
A GOING PRIVATE TRANSACTION
INTRODUCTION
A “going private” transaction is generally one in which an individual or group
(often a controlling stockholder or outside investor and/or the corporation’s management team) acquires all of a public corporation’s shares not already owned by the
individual or group. Once the number of registered
stockholders is reduced to less than 300, the corpo- Going private transactions
ration can deregister under the Exchange Act. Going present complex fiduciary
duty and disclosure issues
private transactions frequently implicate complifor the board, management
cated fiduciary and disclosure issues for the board,
and the buying group.
the management and the buying group. In addition
to state law fiduciary duty concerns, going private transactions are also subject to
extensive regulation under Rule 13e-3 of the Exchange Act. As such, if a corporation
is considering a going private transaction, it would be well counseled to proceed judiciously in order to minimize the potential for any exposure to the parties involved.
The most popular structures for going private are a tender offer followed by a shortform merger or a cash-out merger. Another, less popular option, is going private through
a reverse stock split. Each of these approaches has its own fiduciary duty risks.
COMMON TRANSACTION STRUCTURES
Tender Offer
One popular approach to going private is to structure the transaction as a tender
offer by a controlling stockholder, followed by a short-form merger after at least 90%
of the outstanding shares are tendered. In a series of recent cases, Delaware courts have
provided important guidelines for going private transactions structured as controlling
stockholder tender offers.104 These cases provide that the business judgment rule will
apply to a going private transaction effectuated by a tender offer followed by a shortform merger as long as the transaction is not coercive and all applicable disclosure
104
See In re Pure Resources, Inc. Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002); Glassman v.
Unocal Exploration Corp., 777 A.2d 242 (Del. 2001); In re Siliconix Inc. Shareholders Litigation, No.
18700, 2001 Del. Ch. LEXIS 83 (Del. Ch. June 19, 2001).
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obligations are fulfilled. If the transaction is considered coercive or disclosure obligations are not met, the more demanding entire fairness standard of review may apply.
A tender offer by a controlling stockholder has been held not to be coercive when
all three of the following conditions were met:
•
It is subject to a non-waivable majority of the minority tender provision (in other
words, at least a majority of the shares held by stockholders other than the controlling stockholder are tendered);
•
The controlling stockholder agrees to complete a short-form merger, at the same
price and as soon as practicable after completion of the tender offer, if it obtains
90% of the shares; and
•
The controlling stockholder has not made any retributive threats.105
In addition, the target and controlling stockholder must provide full disclosure of
information that a reasonable investor would consider important in tendering his or her
stock. This would include, for example, disclosing the content and background of any
fairness opinion that may have been delivered to the parties in connection with negotiating the particular transaction.106
Tender offer transactions
Tender offers by controlling stockholders may by controlling stockbe pursued either with or without prior approval of holders that do not meet
the board of directors of the target. As described specific standards will
above, a tender offer may not be considered coercive likely be considered
despite failing to obtain approval of the target’s board
coercive and subject to
or an independent committee thereof. Although a
the entire fairness stantender offer need not be negotiated or approved by an
dard of review.
independent committee,107 the target must make full
disclosure of all relevant information regarding the transaction to its stockholders,
including whether the tender offer was considered by the board of directors or by a
committee and whether or not the target recommends it to its stockholders. The rules
and regulations of the Securities and Exchange Commission also require that boards
prepare a written recommendation to the stockholders in response to a tender offer and
file the recommendation with the Securities and Exchange Commission.
105
In re Pure Resources, 808 A.2d at 445.
Id. at 449.
107 In re Siliconix, 2001 Del. Ch. LEXIS 83.
106
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In one recent case, a Delaware court proposed that, contrary to the current
standard, the entire fairness standard should be imposed on controlling stockholder
tender offers unless they receive approval of the target’s independent directors.108 As
such, going private transactions are an
The use of special committees
example of a situation where the use of a
composed of independent and
special committee or group of otherwise
disinterested directors can subdisinterested and independent directors may
stantially benefit a going private
work to mitigate the risk of a court
process.
invalidating a transaction.
Cash-Out Merger
In a going private transaction effectuated through a cash-out merger, a majority
stockholder typically seeks to acquire the minority interest in the target through a
merger of a newly formed corporation with the target. The acquirer engages in direct
negotiations regarding the transaction with the target and enters into a merger agreement with the target. Shares are typically acquired for cash. The merger requires the
approval of the majority of the outstanding shares of the target.
Although the end result (going private) is the same in a transaction structured as a
merger transaction as in the tender offer structure, Delaware courts have not applied
the same standard of review to controlling stockholder
tender offers and controlling stockholder mergers.109 In Boards should consider
the case of going private transactions structured as utilizing protective
mergers requiring stockholder approval, Delaware measures, such as a
courts have typically applied the entire fairness stan- majority of the minority approval requiredard.110 There are certain procedural protections that the
ment.
target and acquirer can take, however, to try to shift the
burden of showing that the transaction is unfair back to the minority stockholders.
Most importantly, the burden of proof will be shifted to the plaintiffs if the transaction
was evaluated and approved by a well-functioning independent committee of the board
108See
In re Cox Communications, No. 613-N, 2005 Del. Ch. LEXIS 79 (Del. Ch. June 6, 2005).
id. where V.C. Strine discusses the “jarring doctrinal inconsistency” in the standards applied to
the two types of transactions. See also In re Pure Resources, 808 A.2d at 441.
110Kahn v. Lynch Communication Systems, 638 A.2d 1110 (Del. 1994).
109See
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of directors.111 The independent committee should have the power to negotiate and
approve a merger transaction with the controlling stockholder and should be provided
with adequate resources and the ability to hire its own independent legal and financial
advisors. In addition, the board of directors or independent committee should evaluate
whether the merger consideration is fair to the stockholders and consider whether to
solicit additional proposals for the sale of the corporation.112
One recent Delaware case proposed that Delaware courts should consider applying the business judgment rule to going private transactions effectuated by a merger if
the merger is approved by both the target’s independent directors and a majority of the
minority stockholders.113 If this were to become the law, it would represent a promising development for boards of directors that are considering going private transactions.
Reverse Stock Split
A corporation may also use a reverse stock split to reduce the number of stockholders of record to below the applicable deregistration threshold, suspending the
corporation’s Securities and Exchange Commission reporting requirements. If the
acquirer’s interest in the corporation is larger than any other unaffiliated holder, the
acquirer may attempt to execute a reverse stock split, in which the corporation issues
one new share in exchange for a number of old shares in excess of the largest
unaffiliated block of shares. Completion of a reverse stock split typically involves cash
payments for unaffiliated holders in lieu of fractional shares, generally without the
availability of appraisal rights for such stockholders. However, because the charter of
the target corporation must be amended, a reverse stock split requires approval by
holders of a majority of the corporation’s stock.
Delaware law permits the cashing out of stockholders through the mechanism of a
reverse stock split.114 The compensation of cashed-out stockholders must be at a fair
price and the reverse stock split must be designed in good faith and have a legitimate
business purpose.115 Delaware courts have held that the business judgment rule applies
with respect to board recommendations for a charter amendment, in the absence of a
111
Id. at 1117.
In re Cysive Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003).
113 In re Cox Communications, 2005 Del. Ch. LEXIS 79.
114 8 Del. C. §155.
115 Id.; Applebaum v. Avaya, Inc., 812 A.2d 880, 886-87 (Del. 2002).
112
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violation of fiduciary duty.116 Although it is not entirely clear how a challenge to a
going private transaction effected through a reverse stock split would be treated by
Delaware courts, it is advisable to utilize any procedural protections reasonably available in implementing such a transaction, for example, requiring approval by an
independent committee or subset of the board of directors comprised of disinterested
and independent directors.117
SEC REQUIREMENTS AND SCRUTINY OF GOING PRIVATE TRANSACTIONS
Acquirers in going private transactions must satisfy disclosure requirements pursuant to Rule 13e-3 under the Exchange Act, which is designed to protect minority
stockholders in a going private transaction by requiring disclosure as to the fairness of
the transaction and any related material information. In addition to the acquirer’s tender offer filing obligations, the target corporation is required to file a Schedule 14d-9
as to whether it believes that the transaction is fair to the minority stockholders and
any factors supporting that belief and any reports, opinions and appraisals by financial
advisers. It also may have to file a Schedule 13e-3 if its board of directors or a special
committee of directors recommends the acquirer’s
tender offer to stockholders. If stockholder approval Boards should be mindful
is required for a cash-out merger transaction or a that Securities and
reverse split, the corporation will generally be Exchange Commission
required to file a proxy statement to solicit proxies for requirements mandate
a vote at a special meeting. The proxy statement will extensive disclosure of the
entire process involved in
require similar disclosures.
negotiating and approvThe Securities and Exchange Commission careing a going private transfully reviews filings made in connection with going
action.
private transactions, and companies should consider
allocating appropriate time to provide for responses to any SEC review. Among other
things, the Securities and Exchange Commission will review disclosures relating to
valuation, fairness of the transaction price, transaction background and history, and the
independence of directors and any independent committee recommending or approving the transaction.
116
117
Williams v. Geier, 671 A.2d 1368 (Del. 1996).
See, e.g., Applebaum, 812 A.2d 880; Williams, 671 A.2d 1368.
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PROCEDURAL SAFEGUARDS
When a going private transaction is challenged in court, the manner in which the
transaction was negotiated among the interested parties will be viewed critically with
regard to fiduciary duties and fair dealing. For this reason, the parties to a going private transaction are well advised to implement procedural safeguards, including,
among others, those described below during the negotiation process.
First, boards should consider the advisability of creating a working subset of the board composed of disinterested
and independent directors or a special committee composed
of independent and disinterested directors to deal with offers
by potential acquirers. The use of a working group of disinterested and independent directors may not only assist in
meeting the fair dealing requirement but may also result in a
higher negotiated purchase price for the minority stockholders. The special committee or subset of independent and
disinterested directors should be established early in the negotiation process, before,
for instance, a decision to focus on a particular subset of buyers is made or the deal is
heavily negotiated.118 Extra care should be taken to ensure that interested directors and
management are isolated from the negotiation, deliberation and decision-making process of the disinterested and independent directors. The disinterested and independent
directors should be empowered with real bargaining power in the process and access to
the resources they need, including access to management, information about the business and the potential acquiring group and the ability to choose independent legal
counsel, financial advisers, accountants and other experts. In that regard, the
disinterested and independent directors will likely seek to obtain a fairness opinion
from an independent investment bank as to the consideration to be paid in the transaction. The use of a working group of disinterested and independent directors may not
only assist in meeting the fair dealing requirement but may also result in a higher
negotiated purchase price for the minority stockholders.
Boards should
strongly consider
obtaining a fairness
opinion from an
investment bank
before approving a
going private
transaction.
118
See In re Lear Corporation Shareholder Litigation, 2007 WL 1732588 (Del. Ch.) (where the court
criticized the board for forming a special committee only after the CEO had negotiated a private deal with
the leader of a private equity fund) and In re Netsmart Technologies, Inc. Shareholder Litigation, 2007
WL 1576151 (Del. Ch.) (where the court criticized the board for forming a special committee only after
the company had chosen to focus on private equity bidders to the exclusion of strategic buyers).
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Second, approval of a going private transaction by a vote of a majority of the
minority stockholders also helps to address any charges of unfairness to the minority
stockholders. As discussed above, in the case of a tender offer, boards should consider
making the tender offer subject to a non-waivable requirement that the majority of the
shares held by minority stockholders are tendered.
Third, extra care should be taken to ensure that all material information necessary
for an informed investment decision concerning the transaction is made available to
the stockholders.
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CHAPTER 5
THE USE OF SPECIAL COMMITTEES
INTRODUCTION
Transactions between a controlling party and the controlled corporation are subject to careful scrutiny by Delaware courts because of the inherent risk of self-dealing
where one person or group is on both sides of a transaction. Although there is no
requirement under Delaware law that a
board of directors utilize a special commit- Transactions involving a corpotee comprised of independent119 and disin- ration and a related party are
terested120 directors when considering a subject to careful scrutiny by
related-party transaction, Delaware courts Delaware courts – boards are well
have indicated that the absence of such a advised to consider utilizing a
committee (or a group of the board’s disin- special committee comprised of
terested and independent directors function- independent and disinterested
directors when considering such
ing in an equivalent manner) in connection
transactions.
with a related-party transaction may
evidence the transaction’s unfairness. Not only might a controlling party have a fiduciary duty to the minority in this context, but in the event of an alleged breach of fiduciary duty, it is the controlling party that generally bears the burden of proving the
entire fairness of the transaction (the entire fairness test is discussed more fully in
Chapter 2).
119
The concept of “independence” in the context of approval of a related-party transaction pertains to
whether the director is capable of making an independent decision not influenced by extraneous consideration or influences other than the corporate merits of the subject before the board. This definition differs
from the concept of “independence” contemplated by stock exchange rules requiring that a majority of a
board be composed of independent directors.
120 The concept of “disinterested” in the context of approval of a related-party transaction pertains to
whether the director would derive any personal benefit from the subject transaction not shared by all
stockholders.
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While the defendant generally bears the burden of proof under the entire fairness
test, under Delaware law the burden of proving entire fairness can be shifted to the
plaintiff if the defendant can show that the corporation was represented in the transaction by a disinterested and independent, fully informed committee of directors that
actively negotiated the transaction on an arm’s-length basis.121 In assessing whether
the burden should be shifted, Delaware courts have considered a variety of factors,
including:
•
Whether the committee members were disinterested and independent;
•
Whether the committee and its representatives were informed and actively
engaged in a negotiation process; and
•
The extent of the powers granted to the committee.
COMMITTEE COMPOSITION: DISINTERESTED AND INDEPENDENT
In order to be effective, the committee members should be disinterested and
independent.
Disinterested
Delaware courts have found that directors are interested where they personally
receive a material benefit as a result of the challenged transaction that is not shared by
all stockholders. A benefit is considered material if it makes it improbable that the
director could perform his or her fiduciary duties without being influenced by a
personal interest. Delaware courts have also found that a director is interested where
the director stands on both sides of the challenged transaction. Directors may be interested even though they do not receive a benefit in the challenged transaction if they
receive a benefit that relates to the transaction – for example, further business or other
deals with the other party that would not be available but for the challenged transaction.
121 The
approval of the transaction by informed stockholders holding a majority of the outstanding
shares (excluding, for that purpose, the controlling party) also can have the effect of shifting the burden of
proof on the issue of fairness from the defendant to the plaintiff. See also, e.g., Citron v. E.I. Du Pont de
Nemours & Company, et al., 584 A.2d 490 (1990).
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Independent
Even if a director is disinterested, he may still be deemed to be incapable of
making an independent decision if his decision would be based on extraneous
considerations or influences rather than the merits
of the transaction being considered by the board. To be effective, special
In this regard, courts often look to whether the committees should:
• Be composed of
director is controlled by or beholden to another
person or entity, or whether other outside
independent and
influences affect his business judgment. For
disinterested directors;
example, in In re Maxxam, Inc./Federated
• Be informed as to the
Development Shareholders Litigation,122 special
process and terms of the
committee members were found to lack
transaction; and
independence where they received significant
• Be active in the
compensation from employment by entities
negotiations process.
controlled by the individual who controlled the
corporation’s major stockholder. In contrast, the Delaware Court of Chancery has
found that a personal friendship between a special committee member and an
interested party, without more, will not result in such special committee member
lacking independence.123
In addition to ensuring that the members of the special committee are independent
and disinterested, the committee should carefully consider whether any of the advisors
it selects have a material relationship with the related parties in the transaction.
Delaware courts have expressed reservations about a special committee’s
independence where the committee’s advisors had financial ties to the controlling
party.124 Although such financial ties are only one of a number of factors considered
by the courts, they are likely to cause greater scrutiny of the committee’s process. A
special committee may rely on the corporation’s existing advisors and utilizing one or
more of the corporation’s existing advisors may be justified depending on the facts and
circumstances; however, the committee’s perceived independence may be enhanced if
122
In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760 (Del. Ch. 1995).
Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002); Beam v. Stewart, 845 A.2d 1040 (Del. 2004).
124 See, e.g., In re Tele-Communications, Inc. Shareholders Litigation, No. 16470, 2005 Del. Ch.
LEXIS 206 (Del. Ch. Dec. 21, 2005).
123
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it retains advisors with no prior relationship with the corporation and125 use of the
corporation’s existing advisors may be viewed by a court as detracting from the
committee’s independence.126 Finally, although the DGCL permits a committee to be
composed of one member, it is advisable that boards consider appointing more than
one member to a committee.127
COMMITTEE CHARTER: BE INFORMED AND ACTIVE
To be informed, the committee must be knowledgeable concerning the corporation’s business and must be involved in or kept abreast of the ongoing negotiations.
To be active, the members should either be involved in the negotiations or frequently
communicate with the person designated to negotiate the transaction. Further, the
committee should meet and consult with its advisors frequently to ensure that it has
knowledge of the essential aspects of the transaction.128 Situations where Delaware
courts have held that committees were not informed and active include where:
•
The committee never negotiated for a better price;129
•
The committee failed to choose its own independent advisors;130
•
The committee members failed to attend the informational meetings with the
committee’s special advisors;131
•
The committee did not understand its mandate, relied on the corporation’s
legal and financial advisors and was not informed about the corporation’s
historical trading price or the premium to be paid to the high-vote stock;132
and
•
The committee failed to consider an important alternative to the proposed
transaction, failed to critically evaluate and compare reports, and failed to
use the corporation’s leverage to negotiate the lowest available price.
125
Citron v. E.I. Du Pont de Nemours & Company, 584 A.2d 490 (Del. Ch. 1990).
See, e.g., Kahn v. Tremont Corp., 696 A.2d 422 (Del. 1997).
127 The laws of some states, for example, California, prohibit committees of only one member. See, e.g.,
Cal. Corp. Code § 311.
128 Kahn v. Tremont, 696 A.2d 422, 430 (Del. 1997).
129 In re Maxxam, Inc.,/Federated Development Shareholders Litigation, 659 A.2d 760, 768-70.
130 Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261 (Del. 1989).
131 Kahn v. Tremont Corp., 696 A.2d 422, 429-30 (Del. 1997).
132 In re Tele-Communications, Inc. Shareholders Litigation at 49.
126
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In contrast, Delaware Court of Chancery held that committees were informed and
active where:
•
The committee bargained hard, held out to get a higher price and ensured that
the committee retained sufficient flexibility to accept a higher bid;133 and
•
The committee was advised by competent and independent legal and financial experts, acted deliberately and in a fully informed manner, and met more
than twenty times, including a two-day meeting prior to final approval of the
proposed merger.134
THE COMMITTEE’S POWERS
A special committee must have real bargaining power in order to be effective.
Delaware courts have found a committee’s power to say “no” to be particularly
important to establishing its
Special committees should:
independence.135 However, the
• Have access to independent financial,
power to say “no” alone may not
legal and accounting advisors;
be sufficient to shift the burden on
• Have access to management and other
entire fairness. The committee
experts; and
should be empowered to actively
• Have real bargaining power, including
negotiate with the related party in
the ability to say “no.”
a manner that approximates
136
an arms length transaction. For example, in In re Republic American Corporation
Litigation,137 the Delaware Court of Chancery held that a special committee that had
only been empowered to pass on the fairness of the transaction price did not have
sufficient power to shift the burden on entire fairness. In addition, a board should consider the following when granting authority to a special committee:
•
Whether the committee may recommend to the full board the action, if any,
that the board should take with respect to the transaction;
133
In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 546 (Del. Ch. 2003).
Kohls v. Duthie, 765 A.2d 1274, 1285 (Del. Ch. 2000).
135 In re First Boston, Inc. Shareholders Litigation, No. 10338, 1990 Del.Ch. LEXIS 74 (June 7, 1990).
136 Rabkin v. Olin Corp., 1990 Del. Ch. LEXIS 50.
137 1989 Del. Ch. LEXIS 31, (Del. Ch. Apr. 4, 1989).
134
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•
Whether the board will agree not to recommend the proposed transaction to
the stockholders (or otherwise approve the transaction) without the favorable
recommendation from the committee;
•
Whether the committee may consider only one transaction, or whether it has
broader discretion to pursue alternative transactions; and
•
Whether the committee may utilize defensive measures.
In general, the board action creating the special committee should include resolutions
that empower the committee to do such other acts as are necessary or advisable in
carrying out its duties, and provide sufficient authority for the committee to have a
meaningful say in determining whether, and how, to proceed with any transaction.138
While it is clear that a special committee must have power to negotiate as if negotiating an arms-length transaction, uncertainty regarding how aggressively a committee
must exercise that power remains. Specifically, the extent to which a special committee is permitted or required to implement defensive measures under certain circumstances is still an open question. However, Delaware courts have suggested that a
special committee must aggressively defend against a transaction that they deem unfair
to the minority, which may involve considering whether to implement a poison pill or
other deterrent.139
LEGAL DUTIES OF SPECIAL COMMITTEE MEMBERS
The legal obligations of directors serving on the special committee are no different than their duties as directors generally. They are under a duty of care which obligates them to act as an ordinary prudent person would under the circumstances. In this
regard, directors may rely on the opinions of experts, including financial advisors and
legal counsel, as to matters which are reasonably within the professional or expert
competence of such experts.
138 It is notable, however, that special committees cannot be granted unlimited power. Specifically, the
DGCL and Delaware court decisions limit the extent of authority that can be granted to a committee. For
example, a committee cannot be granted authority to recommend to the stockholders for their approval
that the corporation consummate a merger—rather the full board of directors must act to approve a merger
and provide the necessary board function of recommending the merger to the stockholders for approval.
See, e.g., 8 Del. C. §142(c)(2); Krasner v. Moffett, 826 A.2d 277 (Del. 2003).
139 In re Pure Resources, Shareholder Litigation, 808 A.2d 421 (Del. Ch. 2002).
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Directors serving on a special committee are also under a duty of loyalty, which
obligates them not to use their position for personal advantage. The duty of care,
including reliance on experts in discharging such duty, and duty of loyalty are discussed in detail in Chapter 2 of this Handbook.
SUMMARY
In essence, the role of a special committee is to replicate a transaction between
the corporation and an unrelated third party. The utilization of a properly functioning
special committee provides “powerful evidence of fairness.”140 The legal benefits
resulting from special committee approval of a transaction will accrue, however, only
if the special committee is independent, active, informed and has real bargaining
power. Also, when considering whether to form a special committee, boards should
consider whether a working subset of the board composed of disinterested and
independent directors can provide the same services as a distinct special committee.
140
In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 550 (Del. Ch. 2003).
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OVERVIEW–WHEN SHOULD A SPECIAL COMMITTEE BE CONSIDERED?
Whenever a board is considering a transaction that may involve a counterparty
with whom one or more of the directors have a material interest, boards should
consider whether use of a special committee might enhance the process. If a special committee is to be used, it will be viewed as being most effective if it operates under the following guidelines:
•
Committee Formation: The board should authorize the creation of the
committee but it is recommended that the members of the committee be
chosen solely by independent and disinterested directors.
•
Committee Composition: Directors chosen to serve on the committee
should be independent and disinterested in the transaction.
•
Committee Resources: The committee should be empowered to have
access to management, outside (and independent) legal, accounting,
financial and other advisors and any other resources it needs. In addition,
the committee should have full power, authority and resources to select its
own advisors in lieu of using the company’s advisors.
•
Committee Power and Authority. Within the limits of Delaware law, the
committee should be empowered with real bargaining power, including
the power to say “no” to a particular transaction.
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CHAPTER 6
FIDUCIARY DUTIES IN THE CONTEXT OF
A DISSOLUTION OR INSOLVENCY
INTRODUCTION
The challenges that directors face when the corporation is under financial distress
become increasingly complex. In addition to their efforts to turn around the corporation’s flagging financial condition or to buy time to allow previously implemented
strategies a chance to succeed, directors often find themselves answering the pointed
calls of increasingly vocal corporate constituents, such as creditors and stockholders,
seeking to recover their investments. At times such as these, it is critical that directors
focus on the scope and beneficiaries of their efforts as fiduciaries of the corporation.
At the outset, it is important to note that directors’ fiduciary duties do not change
when a corporation approaches or enters insolvency. Indeed, directors continue to owe
the same fiduciary duties of care and loyalty
when a corporation approaches and enters Directors’ fiduciary duties do
insolvency, and directors can still be held liable not change when the corpofor actions or omissions that breach those duties ration approaches or enters
or are otherwise tortious or illegal. However, the insolvency, but when the
corporation enters
beneficiaries of those duties expands from the
insolvency, the beneficiaries
stockholders of the corporation to include the
of the duties do expand.
creditors of the corporation, when the
corporation becomes insolvent. Because actions that directors may take when trying to
manage the business during solvency for the benefit of stockholders may differ from
actions they may take to maximize value for creditors, it is important to be able to
identify when the corporation has become insolvent and, thus, when the recipient of
the fiduciary duties changes.
While some variations may occur in best practices for these purposes, directors
should generally do what best protects the corporation as a whole. For example, directors generally can decide to preserve for sale the going concern value of the business
by cost-effective operations, without becoming ensnared in debates about who would
benefit or not benefit from particular activities. On the other hand, if the directors of an
insolvent corporation are perceived as gambling funds that could pay creditors on a
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“long shot” for the sole benefit of equity holders, that could create liability for those
directors. In making informed decisions on such issues, directors usually benefit from
the advice of qualified distress professionals. However, directors cannot abdicate their
duties to those professionals by excessively deferring to them.
DETERMINING WHEN A CORPORATION HAS BECOME INSOLVENT
Determining when a corporation has become insolvent is complicated and imprecise. Frequently, as the corporation’s financial condition worsens, it is increasingly
difficult for directors to obtain current and accurate information on a real-time basis.
Management is often frantically trying to save the business during these times and is
not always able to know the precise financial condition of the business on a minute-byminute basis. Further, the fact that most companies account for their operations on an
accrual basis as required by Generally Accepted Accounting Principles means that
management may not even know what liabilities the business is accruing until statements are sent by vendors after the close of a particular billing cycle. Similarly, customers who have promised to pay for services or products delivered by the corporation
may delay payment or not pay at all. Nevertheless, in the midst of this chaos, directors
are expected to know when the corporation crosses the line from solvency to
insolvency under applicable laws.
Delaware courts have traditionally used one of two tests to determine whether an
entity is insolvent at a particular point in time:
•
Balance Sheet Test – A corporation is insolvent when its total liabilities
exceed the fair market value of its total assets; and
•
Equitable Insolvency Test – A corporation is insolvent when it is unable to
pay its debts as they become due.
Additional tests employing other criteria, as well as modifications of these traditional
tests, are used from time to time by Delaware courts, depending on the particular circumstances of the case. Furthermore, recent Delaware decisions have seemingly added
an additional requirement to the balance sheet test, defining insolvency as “a deficiency of assets below liabilities with no reasonable prospect that the business can be
successfully continued in the face thereof.”141
141 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 Del. Ch.
LEXIS 164, at *47 (Del. Ch. Sept. 1, 2006), aff’d 931 A.2d 438 (Del. 2007).
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Because there is no bright-line test of what constitutes insolvency under Delaware
law, directors should closely monitor the financial status of their corporation if there is
any question as to its solvency. They should also recognize that a plaintiff (and court)
may take a different view of the corporation’s solvency, if it becomes an issue in litigation. It is important to remember that plaintiffs and courts are likely to evaluate the
solvency question, with the benefit of hindsight.
While facts apparent at the time of decision should not be second-guessed from
hindsight, the reality is that solvency generally is decided with finality and particularity in a subsequent bankruptcy case. The bankruptcy case typically liquidates both
the amount of the liabilities and the assets (either by sale or court valuation in the plan
confirmation process). Having determined that reality, it is often challenging to persuade that same court (or even another court) of different facts for the solvency calculation as to litigation against the directors and officers.
Distressed corporations often engage experienced bankruptcy/restructuring
advisers to assist them in making more sophisticated assessments of solvency than
reflected in normal accounting and financial reporting. Experienced distressed company advisers are also helpful in supporting directors regarding many other business
judgment questions, although directors cannot delegate their duties to such professionals.
DUTIES TO CREDITORS WHEN THE CORPORATION IS INSOLVENT
The Introduction of the Vicinity of Insolvency Concept
Although the question of when directors’ fiduciary duties shift from stockholders
to creditors is now settled, Delaware and bankruptcy courts introduced significant
uncertainty into this question in the early 1990s in a series of decisions that focused on
the so-called “vicinity of insolvency” test.
The Delaware Court of Chancery first introduced the “vicinity of insolvency”
concept in its 1991 decision in Credit Lyonnaise Bank Nederland, N.V. v. Pathe
Communications Corp.142 In addressing the question of to whom directors of financially distressed companies owe their fiduciary duties, the Court of Chancery
observed: “At least where a corporation is operating in the vicinity of insolvency, a
board of directors is not merely the agent of the residual risk bearers, but owes its duty
142
No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991).
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to the corporate enterprise.”143 The court noted that “[t]he possibility of insolvency can
do curious things to incentives, exposing creditors to risks of opportunistic behavior
and creating complexities for directors.”144 Directors must realize that to manage the
business affairs of a solvent corporation in the vicinity of insolvency, circumstances
may arise when the right (both the efficient and the fair) course to follow for the
corporation may diverge from the choice that the stockholders (or the creditors, or the
employees, or any single group interested in the corporation) would make if given the
opportunity to act.145
Unfortunately, the courts did not provide clarity as to when exactly a corporation
would be deemed to have entered into the vicinity of insolvency. There was simply no
bright-line test to determine when a director became legally obligated to look after the
best interests of the corporation’s creditors or reconcile that obligation with the
requirement that the director also look after the best interests of the corporation’s
stockholders. In the case of distressed companies, the interests of creditors and stockholders are often at odds due to the simple fact that stockholders of a corporation that
is on the verge of bankruptcy would generally be more favorably disposed to the
corporation taking risky actions in the short or long term to salvage the enterprise.
Creditors of the same corporation would often prefer a more conservative approach
designed to preserve existing assets, despite the fact that it is unlikely that those
actions would ultimately turn around the corporation’s fortunes.
Clarification of Direct Claims Versus Derivative Claims
Delaware courts later provided directors of financially distressed corporations
significant peace of mind by flatly rejecting the idea that additional direct fiduciary
duties to creditors are imposed when a corporation is in the vicinity of insolvency. In
2006, the Delaware Court of Chancery decided North American Catholic Educational
Programming Foundation, Inc. v. Gheewalla,146 holding that “no direct claim for
breach of fiduciary duties may be asserted by creditors of a solvent corporation operating in the zone of insolvency.”147
143
Id. at *108.
Id. n.55.
145 Id.
146 2006 Del. Ch. LEXIS 164.
147 Id. at *65.
144
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In its analysis, the court noted that “the notion that creditors of an insolvent corporation are permitted standing to maintain derivative claims for breach of existing fiduciary duties on behalf of the corporation is relatively uncontroversial. Indeed, the idea
that an insolvent corporation’s creditors (having been effectively placed ‘in the shoes
normally occupied by the shareholders—that of residual risk bearers’) should be granted
standing because they are the principal remaining constituency with a material incentive
to pursue derivative claims on behalf of the corporation has significant intuitive and
persuasive merit.”148 However, the court did not address the merits of those particular
arguments due to the simple fact that the plaintiffs’ case was based on a direct claim of
breach of fiduciary duty (i.e., a breach of a duty owed directly to the creditors) and not a
derivative claim of breach of fiduciary duty (i.e., a breach of a duty owed to the corporation, but brought on behalf of the corporation by the creditors).
The Court of Chancery noted that the court “has traditionally been reluctant to
expand existing fiduciary duties, including the range of persons by whom those duties
may be enforced and, therefore, whom fiduciaries might feel
compelled to consider.”149 Since creditors have existing Operating in the
protections afforded by other sources, additional protection zone of insolvency
through direct claims of breaches of fiduciary duty is does not change
directors’ fiduciary
ineffecient.
duties.
On appeal, the Delaware Supreme Court affirmed the
trial court’s holdings, noting that “the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be
asserted by the creditors of a solvent corporation that is operating in the zone of
insolvency. When a solvent corporation is operating in the zone of insolvency, the focus
for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its stockholders by exercising their business judgment
in the best interests of the corporation for the benefit of its stockholder owners.”150
148
Id. at *55-56.
Id. at *62.
150 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92,
101 (Del. 2007).
149
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The Delaware Supreme Court Provides Additional Clarity
The Delaware Supreme Court provided further guidance to directors, reasoning
that “when a corporation is solvent [fiduciary] duties may be enforced by its
stockholders, who have standing to
When a corporation becomes insolvent,
bring derivative actions on behalf of
creditors take the place of stockholders as
the corporation because they are the
the residual beneficiaries of any increase
ultimate beneficiaries of the corporation’s growth and increased value.
in value. Consequently, creditors of an
When a corporation is insolvent,
insolvent corporation have standing to
however, its creditors take the place
bring derivative claims against directors
of the stockholders as the residual
for breaches of fiduciary duty.
beneficiaries of any increase in
value. Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of
fiduciary duties.” The Supreme Court held that “individual creditors of an insolvent
corporation have no right to assert direct claims for breach of fiduciary duty against
corporate directors. Creditors may nonetheless protect their interest by bringing
derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim that may be available for individual creditors.”151
The Gheewalla decisions have greatly clarified directors’ duties when their corporation is insolvent or operating in the difficult-to-define zone of insolvency. While
plaintiff creditors of a solvent corporation clearly have no standing to sue other than on
direct claims under contractual or other obligations, creditors of an insolvent corporation have the added ability to sue the corporation’s directors in a derivative capacity.
However, it should be remembered that the recovery in derivative actions goes not to
the individual plaintiffs, but to the corporation for the benefit of its stakeholders generally (stockholders when it is solvent, and creditors when it is insolvent). Hence, as a
practical matter, it may only be rational for an individual creditor to bring a derivative
claim against the directors, where the recovery would go to the corporation itself
(ostensibly for the benefit of all creditors), instead of to the plaintiff creditor, in a fairly
151 Id. at 103. It is also noteworthy that if a corporation files for bankruptcy, the U.S. Trustee for the
corporation may waive the corporation’s attorney-client privilege for the benefit of corporation’s estate,
including creditors. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1985).
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unique set of circumstances, such as where the plaintiff creditor had a relatively large
stake in the outcome vis-a-vis other creditors.152
It may also be worth noting, however, that since there is no warning bell when
insolvency occurs, directors and officers of a distressed, but not yet insolvent, corporation in the zone of insolvency, while not facing any derivative liability in creditor
actions after Gheewalla, still should be thinking carefully about what they choose to
do in terms both of their duties to stockholders and the possibility that those duties will
expand to include creditors at some unknown moment if and when the corporation
slips into insolvency. In addition, there are other potential pitfalls for directors to consider as the business approaches insolvency. For example, directors can be personally
liable for the payment of withholding taxes if those taxes are not withheld and paid by
a corporation. Consequently, close monitoring of the corporation’s financial condition
as it approaches insolvency is critical.
DUTY OF LOYALTY CONSIDERATIONS IN THE CONTEXT OF INSOLVENCY—
DELAWARE’S REJECTION OF DEEPENING INSOLVENCY CLAIMS
Directors of financially distressed companies are often torn between attempts to
turn around the corporation’s fortunes or terminate the corporation’s existence through
a sale of the corporation or, in particularly dire
situations, liquidation and dissolution or bank- Deepening insolvency is no
ruptcy. The threat of deepening insolvency longer recognized by Delaware
claims would influence directors to terminate courts as an independent cause
their corporation’s existence, rather than pro- of action, but it may be
long its life with the hope of providing a greater permitted as a measure of
damages on other claims.
benefit to stockholders in the long run.
In 2001, the Third U.S. Circuit Court of Appeals recognized153 for the first time
the deepening insolvency claim. The crux of the claim is that creditors of a corporation
are harmed when the life of a hopelessly insolvent corporation is prolonged in an illconsidered attempt to salvage the company, resulting in further decline in the corporation’s net worth and the creditors’ ability to recover from the corporation.
152 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 Del. Ch.
LEXIS 164, at *47 (Del. Ch. Sept. 1, 2006).
153 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001).
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In 2006, the Delaware Court of Chancery flatly rejected deepening insolvency
claims and consequently clarified the state of fiduciary duties of directors of financially distressed Delaware corporations. In Trenwick America Litigation Trust v.
Ernst & Young, L.L.P., the court held that “even when a firm is insolvent, its directors
may, in the appropriate exercise of their business judgment, take action that might, if it
does not pan out, result in the firm being painted in a deeper hue of red. The fact that
the residual claimants of a firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand
the inadequate pie such that the firm’s creditors get a greater recovery. By doing so,
the directors do not become a guarantor of success.”154
Strategies that result in continued or even deepening insolvency do not in
themselves give rise to a cause of action. “Rather, in such a scenario the directors are
protected by the business judgment rule.”155
The court did, however, specifically note that “[t]he rejection of an independent
cause of action for deepening insolvency does not absolve directors of insolvent
corporations of responsibility. Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.”156
Furthermore, while Delaware courts have expressly rejected deepening
insolvency as an independent cause of action (and do not recognize duty of care and
other claims that are merely disguised deepening insolvency claims), subsequent
bankruptcy cases have allowed deepening insolvency to be argued as a theory of
damages for valid causes of action (e.g., a breach of the duty of loyalty).157 As a result,
directors of Delaware corporations should be mindful of the deepening insolvency
concept and the possibility that it could be invoked to measure a plaintiff’s alleged
damages on another cause of action.
154
906 A.2d 168, 174 (Del. Ch. 2006), aff’d 931 A.2d 438 (Del. 2007).
Id. at 205.
156 Id.
157 See, e.g., In re Brown Schools, 2008 Bankr. LEXIS 1226 (Bankr. D. Del. Apr. 24 2008).
155
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DUTIES DURING BANKRUPTCY PROCEEDINGS
The directors of a corporate debtor-in-possession in a bankruptcy proceeding pursuant to Chapter 11 of Title 11, United States Code (the “Bankruptcy Code”) have two sets
of fiduciary duties: those prescribed by state corporate law and those prescribed by federal
bankruptcy law. In instances where the two conflict, a director’s federal bankruptcy law
duties are paramount. The following discussion focuses on these federal bankruptcy law
duties as they have been articulated in the Bankruptcy Code and case law. The standard
state law fiduciary duties (i.e., duty of care and duty of loyalty) remain as described in
Chapter 2 and elsewhere in this Handbook.
Unless a trustee has been Debtors-in-possession owe fiduciary duties
appointed in a Chapter 11 case, the under state and federal bankruptcy law to
existing
corporate
governance both creditors and stockholders.
remains in place and the directors
assume the fiduciary duties of a debtor-in-possession.158 Pursuant to Section 1107(a) of the
Bankruptcy Code, a debtor-in-possession functions as a trustee, and is given all of the
powers and duties of a trustee, with the exception of certain investigative functions.159
Thus the various statutory provisions and legal doctrines defining the fiduciary duties of a
Chapter 11 trustee are equally applicable to a debtor-in-possession.160 It should be noted,
however, that some courts have indicated that a Chapter 11 trustee running the business of
a debtor may be subject to less court oversight than a debtor-in-possession.161
A debtor-in-possession owes a fiduciary duty to all interested parties, creditors
and stockholders alike.162 The substance of these federal bankruptcy law fiduciary
158
In re FSC Corp., 38 B.R. 346, 349 (Bankr. W.D. Pa. 1983).
11 U.S.C.S. §1107(a) (1984).
160 In re Tobago Bay Trading Co., 112 B.R. 463, 467 (Bankr. N.D. Ga. 1990); In re Zerodec Mega
Corp., 39 B.R. 932, 934 (Bankr. E.D. Pa. 1984); S. Rep. No. 989, 95th Cong., 2d Sess. 116 (1978). See
also Ford Motor Credit Co. v. Weaver, 680 F.2d 451, 461 (6th Cir. 1982) (duties of a debtor-inpossession under Chapter XI of the former Bankruptcy Act are similar to a trustee in bankruptcy); In re
Happy Time Fashions, Inc., 7 B.R. 665, 669 (Bankr. S.D.N.Y. 1980) (debtor-in-possession under Chapter
XI is in “same position” as a trustee in bankruptcy).
161 See In re Lifeguard Industries, Inc., 37 B.R. 3, 17 (Bankr. S.D. Ohio 1983); In re Airlift
International, Inc., 18 B.R. 787, 789 (Bankr. S.D. Fla. 1982); In re Curlew Valley Associates, 14 B.R.
506, 510 n. 6 (Bankr. D. Utah 1981).
162 Pepper v. Litton, 308 U.S. 295, 307 (1939); In re Lionel Corp., 722 F.2d 1063, 1071 (2d Cir. 1983);
In re Integrated Resources, Inc., 147 B.R. 650, 658-59 (S.D.N.Y. 1992).
159
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duties is drawn from the duties of care and loyalty found in state law. Under federal
bankruptcy law, a debtor-in-possession is held to a standard of care, skill and diligence
that an ordinarily prudent person would exercise under similar circumstances.163 The
debtor-in-possession has a duty of loyalty to “maximize the value of the estate,”164
refrain from self-dealing, and treat all parties fairly in “resolv[ing] the tension which
results from the sometimes conflicting objectives of [the diverse] constituencies.”165
Since virtually any corporate transaction that is not strictly in the ordinary course
of business requires court approval in bankruptcy, the corporation’s directors and officers may have the protection of court approval of any transaction that they bring
before the court for approval on proper disclosure. This feature of bankruptcy argues
for erring on the side of treating a transaction as out of the ordinary course – that is,
seeking court approval – if there is any doubt whether such approval is required.
Indeed, it always is possible (though not necessarily feasible or practical) to seek court
approval (and protection) for any transaction.
DUTIES AFTER DISSOLUTION
Upon the dissolution of a Delaware corporation, directors continue to owe their
standard fiduciary duties to both the corporation’s stockholders and its creditors. The
corporation’s assets are essentially held
in trust for the benefit of its stockholders Directors of a corporation can miniand creditors.166 Directors that serve after mize their personal liability exposure
the dissolution of a corporation will thus by relying on statutory procedural
safeguards in the dissolution process.
continue to have potential liability for
breaches of fiduciary duty, as well as liability commonly arising from distributions of
assets to stockholders without payment or making inadequate provisions to repay all
known liabilities of the corporation, or continuing the corporation’s business in violation of their statutory duty as trustees to liquidate and distribute the corporation’s
163 In re Rigden, 795 F.2d 727, 730 (9th Cir. 1986); In re Schwen’s, Inc., 20 B.R. 638, 641 (D. Minn.
1982); In re Haugen Constr. Service, Inc., 104 B.R. 233, 240 (Bankr. D.N.D. 1989); In re Reich, 54 B.R.
995, 998 (Bankr. E.D. Mich. 1985); In re Happy Time Fashions, Inc., 7 B.R. 665, 670 (Bankr. S.D.N.Y.
1980).
164 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 352 (1985).
165 In re Integrated Resources, Inc., 147 B.R. 650, 658 (S.D.N.Y. 1992). See also In re Cochise College
Park, Inc., 703 F.2d 1339, 1357 (9th Cir. 1983) (duty of fairness).
166 8 Del. C. §§278, 279.
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assets. Directors can minimize their potential liability in connection with distributions
of the corporation’s assets as part of a plan of dissolution following the procedural
safeguards contained in Section 280 of the DGCL (which requires notice to known
creditors and claimants as well as establishing a court-approved reserve fund for pending lawsuits or other proceedings to which the corporation is a party as well as other
contingent liabilities). Directors can also minimize their potential liability stemming
from dissolution by seeking the appointment of trustees or receivers to execute the
dissolution and liquidation under court supervision.167 This allows the appointed trustees to reduce their risk of personal liability by seeking express court approval of
actions during the dissolution and winding up of the corporation.
167
Del. C. §§279, 291.
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THINGS TO REMEMBER WHEN MANAGING A BUSINESS ON THE VERGE OF
INSOLVENCY
What to Do When the Corporation Is Near Insolvency
•
Tighten financial controls.
•
Increase communications with management and create a good record of
informed decision-making.
•
Open channels of communication with creditors.
•
Seek advice of bankruptcy counsel and other experienced distressed business advisers of various options.
•
Remember that fiduciary duties continue to apply to stockholders. Creditors may also bring direct claims for breach of contract against the corporation, but cannot bring derivative claims against directors and officers
while the corporation remains solvent.
What to Do When the Corporation Has Become Insolvent
•
Take care to insure that your actions are designed to maximize return to
the residual beneficiaries of the corporation, which are creditors until they
have been repaid in full, and stockholders thereafter.
•
Continue to act in the same manner as to your fiduciary duties. The duties
have not gone away when the corporation became insolvent. You should
continue to exercise your business judgment for the benefit of maximizing
the corporation’s estate.
•
Make informed decisions and keep a good record of the decisions and the
decision-making process.
•
Continue to seek advice from bankruptcy counsel and other experienced
distressed business advisers. However, take care to ensure that the board
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does not abdicate its duties by excessively deferring to those persons or
improperly delegating the board’s duties.
•
Duly consider all reasonable options.
•
Focus on maintaining sufficient liquidity to preserve value and a responsible resolution.
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CHAPTER 7
ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXT
INTRODUCTION
Attorney-client privilege, one of the oldest of the privileges known to common
law, protects confidential communications between a lawyer and his or her client.168
The essence of the privilege is that communications between a lawyer and his or her
client are not subject to discovery in litigation, with certain exceptions.
SCOPE OF PRIVILEGE
Attorney-client privilege “encourage[s] full and frank communication between
attorneys and their clients and thereby promote[s] broader public interest in the
observance of law and administration of justice.”169 In addition, “privilege exists to
protect not only the giving of professional advice to those who can act on it, but also
the giving of information to the lawyer to enable him to give sound informed
advice.”170 Attorney-client privilege applies
to verbal statements as well as documents The privilege protects only the disand tangible objects conveyed by the client closure of the communications
to an attorney in confidence for the purpose between the client and the lawyer,
of legal advice.171 Privilege applies to both and not the disclosure of the underoral and written confidential communica- lying facts.
tions, either originating from the client or
from the lawyer in response to a client’s inquiries.172 However, privilege protects only
the communications, and not the underlying facts that have been communicated.173 In
addition, attorney-client privilege is inapplicable to the information the attorney
receives from independent non-client sources.
168
8 JOHN H. WIGMORE, EVIDENCE §2290 (John T. McNaughton rev. ed., 1961).
Upjohn v. United States, 449 U.S. 383, 389 (1981).
170 Id. at 390.
171 Haines v. Ligget Group, 975 F.2d 81, 90 (3d Cir. 1992).
172 Upjohn v. United States, 449 U.S. 383, 389 (1981).
173 Id. at 395.
169
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There are certain exceptions that can result in the loss of the attorney-client privilege. The attorney-client privilege can be waived either intentionally or by inadvertent
disclosure of privileged information. The attorney-client privilege cannot be asserted
to protect communications that further an ongoing crime or fraud, known as the crimefraud exception. In the context of a derivative stockholder action, a claim of attorneyclient privilege can be defeated upon a showing of “good cause,” as described
below.174
When Does the Privilege Apply
In general, the attorney-client privilege applies:
•
When legal advice of any kind is sought from a professional legal advisor in
his or her capacity as such;
The attorney-client privilege
is designed to protect the
relationship between the
lawyer and the client by
providing that communications between the lawyer
and client are not subject to
discovery, with certain
exceptions.
•
174
175
•
When the communications relate to the purpose of receiving legal advice;
•
When the communications are made in confidence by the client;
•
When the communications are, at the client’s
insistence, permanently protected from disclosure by himself or by the legal advisor;
and
When the protection is not waived.175
Garner v. Wolfinbarger, 430 F. 2d 1093 (5th Cir. 1970).
8 JOHN H. WIGMORE, EVIDENCE §2292 (John T. McNaughton rev. ed., 1961).
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Attorney-client privilege in the corporate context is difficult to define. When a
lawyer is representing a corporation, the lawyer’s professional duties are owed to an
entity, rather than to any officer, director, employee, stockholder
In general, when
or other constituent of the corporation. A lawyer representing a
dealing with a
corporation must communicate with, and receive direction from,
corporation, the
the client through its officers, directors and employees.176 In
privilege belongs
addition, “an otherwise privileged communication by a lawyer
to the corpoto a corporate agent does not lose its protected status simply
ration. It cannot
because the agent then conveys the attorney’s opinion to a
be asserted by
corporate committee charged with acting on such issues.”177
officers or direcOver time, the state and federal courts have developed the foltors for their
lowing three different methods to determine whether certain
personal benefit.
communications are considered privileged in the corporate context:
•
•
Control Group Test. This test supports the idea that privilege in the corporate context is limited to members of the corporation who are in a position of
control and are able to direct the action the corporation might take in
response to the legal advice they receive.178 As noted in the discussion of the
Upjohn test below, this test has been
criticized by Federal courts as too nar- In the context of a corporation, the scope of the
row179 and inadequate.180
attorney-client privilege
Subject Matter Test. The subject matter may be limited and may not
test extends privilege to communications extend to all employees.
with lower-level employees or corporate
agents, so long as the communication with legal counsel is related to the
subject matter of representation.181
176
William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 97 (2005).
177 Shriver v. Baskin-Robbins Ice Cream Co., 145 F.R.D. 112, 114 (D.Colo. 1992).
178 Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D.Pa. 1962).
179 Upjohn v. United States, 449 U.S. 383, 392 (1981).
180 Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 491 (7th Cir. 1970).
181 Id.; Diversified Industries v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977).
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•
Upjohn Test. The Upjohn test provides that attorney-client privilege in the
corporate context is determined on a case-by-case basis and involves
evaluating the following factors:182
O
whether the communications are made by employees to corporate counsel in order for the corporation to secure legal advice;
O
whether the employees are cooperating with corporate counsel at the
direction of corporate supervisors;
O
whether the communications concern matters within the employee’s
scope of employment; and
O
was the information available from upper-echelon management.183
In Upjohn v. United States, a corporation, through
its chairperson, instructed its general counsel to carry
out an internal investigation into certain payments made
to foreign government officials by the corporation’s
subsidiary. During the investigation, the general counsel distributed confidential questionnaires to managers
seeking information regarding the payments and interviewed corporate personnel. The corporation then disclosed certain of the information to the Securities and
Exchange Commission. Subsequently, the Internal Revenue Service commenced its
own investigation and issued summons requiring production of all files relating to the
corporation’s internal investigation, specifically including the questionnaires. The
corporation claimed that the attorney-client privilege applied to the files of the internal
investigation. The Appellate Court applied the control-group test and held that privilege did not apply to communications with middle management employees who could
not direct the corporation’s response to the legal advice received. However, the
Directors and officers
should take extra precautions when dealing
with sensitive legal
communications to
preserve the maximum
scope of the attorneyclient privilege.
182
Upjohn, 449 U.S. at 396-7.
Id. at 394. While the Upjohn definition is not as clear as to when specific communications are
considered privileged in the corporate context, the concurring opinion provides an additional checklist:
(1) an employee or former employee; (2) speaks at the direction of management; (3) regarding conduct or
proposed conduct within the scope of employee’s employment; (4) with an attorney who is authorized by
the management to inquire into the subject; and (5) when the attorney is seeking information to assist him
or her in either (a) evaluating whether the employee’s conduct is binding on the corporation; (b) assessing
the legal consequences of the employee’s conduct; or (c) preparing legal responses to actions of others
regarding that conduct. Id. at 403.
183
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Supreme Court reversed, finding the control-group test too limited, and held that the
communications by the corporation’s employees to counsel were covered by the
attorney-client privilege insofar as the responses to the questionnaires and any notes
reflecting responses to interview questions were concerned.184
While state courts have used both the control group test and subject matter test in
the past, the Upjohn test is the prevailing test used by federal courts and many state
courts to evaluate when the attorney-client privilege applies in the corporate context.
TYPES OF PRIVILEGED COMMUNICATIONS
Given that corporations are entities and not individuals, courts have had to
determine which corporate agent’s communications are worthy of the protection of the
attorney-client privilege. Information provided by certain corporate agents to the lawyer in the course of seeking legal advice on behalf of the corporation typically is considered privileged.185 Corporate attorney-client privilege applies only to the corporate
entity. Communications involving personal or individual concerns of a corporate agent
often are not entitled to the privilege because they are independent from the concerns
of the corporation and are considered separate from the engagement of the lawyer.186
The benefits of attorney-client privilege in
the corporate context belong to the corpo- Disclosing confidential and privration. Accordingly, an individual cannot ileged communications to
assert the attorney-client privilege and prevent individuals outside the corporation, such as the corporation’s
disclosure of communications between himself
accountants or investment
and the corporation’s counsel if the corpobankers, likely may result in
ration has waived privilege.187 In a few
loss of the privilege.
circumstances, if an employee of a corporation
seeks legal advice from the corporation’s counsel for himself or if that corporate counsel acts as a joint attorney and dual representation may exist, the employee may be
able to invoke the privilege.188
184 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 111 (2005).
185 Id. at 392-93.
186 Id. at 112.
187 Diversified Industries v. Meredith, 572 F.2d 596, 611 n.5 (8th Cir. 1977).
188 Id.
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Usually if communications are disclosed to third parties, not for the purpose of
assisting the attorney in rendering legal advice, the privilege is lost.189 However, under
the joint defense theory, in the context of an internal corporate investigation, disclosure by in-house counsel of privileged communications to present and former
employees, or other co-defendants and their attorneys would not result in the loss of
the confidentiality protections of the attorney-client privilege.190 Effectively, the joint
defense theory is meant to support the “advantages of, and even, the necessity for, an
exchange or pooling of information between attorneys representing parties sharing
such common interest in litigation, actual or prospective.”191
Work Product Doctrine
Similar to the doctrine of attorney-client privilege, the work product doctrine also
protects the confidentiality of certain materials related to a client and a corporate
investigation. Federal Rule of Civil Procedure 26(b)(3), codifying the work product
doctrine as it was set forth in Hickman v. Taylor,192 outlines the elements of the work
product doctrine for federal courts as follows:
“[A] party may obtain discovery of documents and tangible things . . . prepared in
anticipation of litigation or for trial by or for another party or by or for that other party’s representative only upon a showing that
The work product doctrine is
the party seeking discovery has substantial
designed to protect the attorney’s
need of the materials in the preparation of the
drafts and notes that reflect the
party’s case and that the party is unable withattorney’s considerations and
out undue hardship to obtain the substantial
strategies. It cannot be used to
equivalent of the materials by other means. In
shield facts from discovery.
ordering the discovery of such materials when
the required showing has been made, the court shall protect against disclosure of the
mental impressions, conclusions, opinions, or legal theories of an attorney or other
representative of a party concerning the litigation.”193
189 Thomas R. Mulroy & Eric J. Muñoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM.
L.J. 49, 61-62 (2002).
190 Id. at 61-62.
191 Id. at 62. See also Transmirra Prods. Corp. v. Monsanto Chem. Co., 26 F.R.D. 572, 579 (S.D.N.Y.
1960).
192 329 U.S. 495 (1947).
193 Fed. R. Civ. P. 26(b)(3).
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The purpose behind the work product doctrine is to “preserve a zone of privacy in
which a lawyer can prepare and develop legal theories and strategy ‘with an eye
toward litigation,’ free from unnecessary intrusion by his adversaries.”194 In general,
the work product doctrine protects documents or tangible things prepared in anticipation of litigation, or for trial by or for another party or that party’s representative,
unless the party seeking discovery demonstrates both substantial need for those
materials and inability, without undue hardship, to obtain the equivalent of those materials.195
In-House Counsel
Recently there have been additional concerns regarding the applicability of
attorney-client privilege to communications between the corporation and in-house
counsel. Generally, internal communications between
in-house counsel and corporate employees may be In-house counsel should
covered by attorney-client privilege if the exercise extra care to
communications concern matters within the scope of ensure that their confidential communicathe employee’s corporate duties and the employees are
tions are entitled to the
sufficiently aware that questions posed to them by
privilege.
in-house counsel are for the purpose of the corporation
obtaining legal advice.196 In-house counsel typically communicate with a broader
range of corporate agents than outside counsel, including agents who are involved in
the daily implementation of corporate policies and are most likely to be aware of
issues and problems that may arise (rather than only upper-level management).
Attorney-client privilege works to promote free communication between employees
and in-house counsel in the corporate context; without such protection, internal corporate counsel could face difficulty in assisting the corporation with resolving and remedying legal matters.197
194
United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998).
Fed. R. Civ. P. 26(b)(3).
196 Upjohn v. United States, 449 U.S. 383, 403 (1981).
197 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 128-29 (2005).
195
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PRIVILEGE VERSUS CONFIDENTIALITY
General
The attorney-client relationship alone does not create a presumption of confidentiality. The client must intend that the communication with the attorney remain
confidential. If the client intended that the
information be published or distributed to The attorney-client privilege is
only intended to protect
others, the privilege will not apply.198
disclosure of confidential
Maintaining Confidentiality
information. If the information is
not maintained in confidence, the
In general, concerns regarding the conprivilege will be lost as to that
fidentiality of corporate attorney-client
information.
communications emerge following the
inadvertent disclosure of privileged information by the corporation, such as in discovery during litigation. A corporation can be forced by the court to support its claims of
confidentiality by setting out the steps it took to ensure confidentiality; for example,
showing who had access to documents and how they were stored in order to maintain
and preserve attorney-client privilege.199 Courts also have determined that a person
may relay a confidential communication through or in the presence of a third person
without breaching its confidentiality only “if the [third] person’s participation is
reasonably necessary to facilitate the client’s communication with a lawyer or another
privileged person and if the client reasonably believes that the person will hold the
communication in confidence.”200
Differences Between a Lawyer’s Duty of Confidentiality and Attorney-Client
Privilege
There are important differences between evidentiary privilege given to attorneyclient communications and the broader duty of confidentiality that lawyers owe to their
198
In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984).
Scott Paper Co. v. United States, 943 F. Supp. 489, 499 (1996); see also 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:12 (2007).
200 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §70(f) (2000). see also United States v.
Kovel, 296 F.2d 918 (1961).
199
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clients.201 “[T]he chief difference between the professional duty of confidentiality and
the evidentiary attorney-client privilege is that the former applies to virtually all
information coming into a lawyer’s hands concerning a client, and forbids virtually all
disclosures, whereas the latter only applies when the question is whether a lawyer can
be compelled to testify about [his or] her proAs a fiduciary, a lawyer’s
fessional communications with a client.”202 Privobligation to maintain the
ilege exists to protect specific types of
communications between a client seeking legal
confidentiality of a client’s
advice and the lawyer from whom such advice is
confidential information is
sought and may be waived intentionally or
much broader than the
inadvertently by a client.203
attorney-client privilege.
The lawyer’s ethical obligation pertains to the information relating to the representation, whether disclosed by the client or brought to the lawyer’s attention from
another source.204 Disclosures contrary to the ethical obligation of confidentiality may
be made only in those limited circumstances permitted under relevant ethical rules (or
in compliance with other legal rules) or with the informed consent of the client.205 In
general, the professional duty of confidentiality remains a central part of the lawyer’s
ethical obligations, and continues to encompass far more, and to be more broadly
applicable, than the attorney-client privilege.206
201 William
W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 101 (2005).
202 Id.
203 Id.
204 Id.
205 Id.
206 Id. at 102.
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WAIVER OF PRIVILEGE
General
Attorney-client privilege can be intentionally or inadvertently waived.207 Because
the attorney-client privilege belongs to the corporation, only the corporation can assert
the privilege.208 Typically, in the corporate context,
the ability to waive attorney-client privilege lies Although the attorneywith the corporation’s management.209 In addition, client privilege belongs to
waiver can be asserted by a corporate representative the corporation, it can be
who is authorized to do so under the laws of waived, even inadvertently,
agency.210 However, an officer acting within the by an officer or director
scope of his or her authority may waive the acting within the scope of
privilege by his or her deliberate actions, even his or her duties.
though waiver of privileged information was not the
officer’s intention.211 One common example of this type of waiver occurs when
officers share legal advice with other members of a corporation’s advisory team, such
as investment bankers or accountants. Also, former employees are usually not
considered agents of the corporation and typically do not have the authority to waive
privilege.212
When control of a corporation passes to new management—through a sale, foreclosure on stock, or bankruptcy—the authority to assert and waive the corporation’s
attorney-client privilege passes as well.213 Only the new managers may assert or waive
the privilege, even as to communications made by former directors and officers.214
Similarly, the power to assert and waive a subsidiary’s privilege passes to new owners;
207 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 73-74 (D. Md. 1998); 1 JOHN K.
VILLA, CORPORATE COUNSEL GUIDELINES §1:21 (2007).
208 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:22 (2007).
209 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 348 (1985).
210 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §78; Sicpa North America, Inc. v.
Donaldson Enterprises, Inc., 430 A.2d 262, 264 (N.J. Super. Ct. Law Div. 1981).
211 Computer Network Corp. v. Spohler, 95 F.R.D. 500, 502 (D.D.C. 1982).
212 United States v. Chen, 99 F.3d 1495, 1502 (9th Cir. 1996).
213 Commodity Futures Trading Comm’n, 471 U.S. at 349.
214 Id.
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once control of the subsidiary passes, the parent corporation can no longer prevent the
subsidiary from waiving privilege.215
EXAMPLES OF WAIVER
Inadvertent Waiver
An inadvertent waiver usually occurs during litigation, when a corporation fails to
assert the privilege when a question is asked about a written communication or mistakenly includes a privileged document in response to a request.216 However, most
courts conclude that such inadvertent and mistaken disclosure of information does not
result in waiver if the company or client took reasonable precautions to keep the
information confidential.217 Other courts hold that because a client is the only one who
can waive the privilege, the accidental and inadvertent disclosure of confidential
information alone is insufficient to constitute a waiver.218 Federal rules and most state
ethics rules require that when an attorney receives materials that relate to another
attorney’s representation of his or her client and knows or reasonably should know the
materials were sent inadvertently, that person should promptly notify the other party of
such disclosure so he or she can take protective action. 219 In the event a document is
inadvertently produced, the lawyer can move for return of the document and that it be
banned from use in the litigation in order to maintain privilege. 220
Deliberate Waiver
Occasionally, a corporation may decide to deliberately breach the confidentiality
of a communication and waive privilege in order to further a corporate objective. For
example, corporations may choose to disclose such normally protected information
when responding to a government investigation, renewing insurance, responding to an
auditor inquiry, supplying information to a government agency, negotiating a merger,
or filing a registration statement with the Securities and Exchange Commission.221 In
215
Id. at 349.
1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:23 (2007).
217 Id.
218 Id.
219 Id.
220 Id.
221 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 72 (D. Md.1998).
216
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addition, if a corporation does disclose privileged information to an entity with which
it does not share a common legal interest (government or public), most courts, for
reasons of fairness, will find that the disclosure waives privilege.222
Crime-Fraud Exception
Attorney-client privilege does not apply to communications by a client with his or
her lawyer that furthers ongoing criminal activities. This is known as the crime-fraud
exception. The crime-fraud exception to privilege
The attorney-client
attempts to protect legitimate inquiries for legal advice,
privilege may not be
without permitting clients to use their attorneys as knowused to shield dising or unknowing participants in ongoing criminal activclosure of information ity. Attorney-client privilege is designed to encourage
that is provided to
clients to make full disclosure of past crimes in order to
counsel as part of a
obtain complete legal advice; it does not justify protecting
plan or scheme to
communications that are designed to facilitate an ongoing
engage in wrongful or
or future crime or fraud.223 Most courts follow a twoillegal conduct.
pronged test to overcome the privilege, including:
•
A prima facie showing that the client was engaged in “wrongful conduct”
when he or she sought advice of counsel, that he or she was planning such
conduct when seeking the advice of counsel, or that he or she committed a
crime of fraud subsequent to receiving the benefit of counsel’s advice; and
•
A showing that the attorney’s assistance was obtained in the furtherance of
the criminal or fraudulent activity or was closely related to it.224
Selective Waiver
The doctrine of selective waiver works to preserve attorney-client privilege and
work product protection against third parties on certain privileged documents or
materials that have been previously disclosed to a government agency.225 Selective
waiver was recognized in Diversified v. Meredith when the court asserted that the right
222
United States v. Billmyer, 57 F.3d 31, 36-37 (1st Cir. 1995).
In re Grand Jury Proceedings (Corporation), 87 F. 3d 377, 381 (9th Cir. 1996).
224 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §82.
225 David R. Wolfe, “The Future of Selective Waiver of Attorney-Client Privilege and Work-Product
Protection After Qwest [In re Qwest Commc’ns Int’l Inc. Sec. Litig., 450 F.3d 1179 (10th Cir. 2006)],” 46
Washburn L.J. 479 (2007); see also Diversified Indus., Inc. v. Meredith, 572 F. 2d 596, 611 (8th Cir.
1977).
223
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to disclose investigative material to a federal agency should result in the limited
waiver of the attorney-client privilege for that purpose.226 However, the view in
Diversified v. Meredith is the minority view. The majority of the U.S. courts have
refused to recognize selective waiver of attorney-client privilege. Most recently, in
2006 the court in In re Qwest Communications International Inc. Securities Litigation227 rejected Qwest’s assertion that it did not have to produce thousands of
documents in a class action litigation simply because it had previously produced such
documents to the Securities and Exchange Commission and the Department of Justice
under confidentiality agreements that provided for selective waiver during an investigation. The court in Qwest rejected the selective waiver argument and found that the
company had waived its attorney-client privilege by producing such documents to the
Securities and Exchange Commission and the Department of Justice.228
PRIVILEGE IN DERIVATIVE SUITS AND CLASS ACTIONS
Attorney-client privilege applies in the context of derivative suits and class
actions. A derivative suit is a legal action brought by a constituent in the name of the
corporation against one or more of its officers
or directors seeking a recovery on behalf of the A derivative suit is a legal action
injured corporation for wrongful conduct by brought by a constituent in the
such officer or directors. The purpose of the name of the corporation against
derivative action is to enforce a corporate right one or more of its officers or
that the corporation has refused to assert.229 In directors seeking a recovery on
behalf of the injured corpoorder for a derivative suit to be brought by a
ration for wrongful conduct by
stockholder under Delaware law:
such officer or directors.
•
The plaintiff must be a stockholder of the defendant corporation at the time
of the wrong complained of and remain so through the duration of the
derivative suit;
•
The derivative plaintiff must make a demand on the directors of the corporation to assert the corporate claim unless such demand would be futile; and
226
Diversified Industries, 572 F.2d at 611 (8th Cir. 1977).
450 F.3d 1179 (10th Cir. 2006).
228 Id.
229 1 R. FRANKLIN BALOTTI & JESSIE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND
BUSINESS ORGANIZATIONS §13.10 p. 13-20.
227
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•
The derivative plaintiff must be an adequate representative of the corporation’s other stockholders.230
In comparison, in a class action suit, the claims of a number of affected parties
are prosecuted as if they were before the court. A class action is a “procedural device
so that mere numbers would not disable
A class action is a legal action
large groups of individuals, united in
brought against the corporation by a
interest, from enforcing their equitable
group of plaintiffs together seeking a
rights.”231 A class action is nothing more
recovery as a result of wrongful
than an aggregation of individual claims
conduct of the corporation.
being prosecuted by one or more persons
232
on behalf of the entire group. “Aggregated individual claims are to be contrasted
with a derivative action, which is brought to redress alleged wrongs to the corporation
directly, rather than wrongs to the stockholders.”233
The Garner Doctrine and Privilege in Derivative Actions
Garner v. Wolfinbarger concerned a stockholder derivative suit charging
management with fraud and a direct suit charging
fraud and violation of the securities laws.234 When In derivative actions,
stockholders sought discovery of communications directors and officers who
between management and the corporation’s attorneys, have been charged with
the corporation asserted the attorney-client privilege. wrongdoing are unlikely
to be able to use the privThe court noted tensions between protecting the
ilege to avoid disclosure
integrity of management’s decision-making process of communications with
and the stockholders’ interest. The court articulated the corporation’s counsel.
the need to balance “the injury that would inure to the
relation by the disclosure of the communications” against the benefit gained “for the
correct disposal of litigation.”235 Further, the court stated “the corporation is not
barred from asserting [privilege] merely because those demanding information enjoy
230
Id. at 13-21; 8 Del. C. §327.
Schneider v. Wilmington Trust Co., 310 A.2d 897, 902 (Del. Ch. 1973).
232 1 R. FRANKLIN BALOTTI & JESSE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND
BUSINESS ORGANIZATIONS §13.20, p. 13-109.
233 Id.
234 430 F.2d 1093, 1103 (5th Cir. 1970).
235 Id. at 1100.
231
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the status of stockholders. But where the corporation is in suit against its stockholders
on charges of acting inimically to stockholders’ interests, protection of those interests
as well as those of the corporation and of the public require that the availability of the
privilege be subject to the right of the stockholders to show cause why it should not be
involved in this particular instance.”236
The court established a list of factors to consider in the balancing process to
determine if there is “good cause” to disregard the attorney-client privilege that has
been asserted, including:
•
The number of stockholders and the percentage of stock they represent;
•
The bona fides of the stockholders;
•
The nature of the stockholders’ claim and whether it is obviously colorable;
•
The apparent necessity or desirability of the stockholders having the
information and the availability of it from other sources;
•
Whether, if the stockholders’ claim is of wrongful action by the corporation,
it is of action that is criminal, or illegal but not criminal, or is of doubtful
legality;
•
Whether the communication is related to past or to prospective actions;
•
Whether the communication is of advice concerning the litigation itself;
•
The extent to which the communication is identified versus the extent to
which the stockholders are blindly fishing; and
•
The risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons.237
In general, Garner asserts that there is a sufficient mutual interest between management and stockholders in communications with attorneys to bar any assertion by
management of an absolute privilege against the stockholders.238 Therefore, in a
236
Id. at 1103-4.
Id. at 1104.
238 Ward v. Succession of Freeman, 854 F.2d 780, 784 (5th Cir. 1988).
237
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derivative action shareholders can gain access to privileged corporate communications,
so long as there is “good cause” to waive the attorney-client privilege and disclose the
information, such information should be disclosed. Even though the Garner test is
flexible, there are generally accepted limitations to the rule, including, among other
things, that Garner does not allow for disclosure of privileged communications that
result in remedial measures or privileged communications made during the course of
the derivative suit. 239
Sandberg v. Virginia Bankshares, Inc.
In Sandberg v. Virginia Bankshares, Inc.,240 the court considered a claim of privilege for communications made during a meeting between officers of a corporation and
its counsel where the counsel and officers for a third-party corporation were also present at the meeting. The meeting was called to discuss a stockholder’s action to stop a
proposed merger between the corporation’s subsidiary and the third party. Assuming
that the corporate parties had common interest sufficient to permit such a meeting
without loss of privilege,241 the court held Garner required the production of the notes
taken at the meeting and indicated “the shareholders’ interest is particularly strong”
where the communications at issue were shared with counsel for a third party “whose
interests are potentially adverse to those of the executive’s stockholders.”242
ROLE OF ATTORNEY IN SPECIAL INVESTIGATIONS
Government Investigations
In internal investigations, corpoSection 307 of the Sarbanes-Oxley Act of
rations may voluntarily elect to
2002 requires the Securities and Exchange
waive the privilege in order to
Commission to issue rules setting forth minibetter situate themselves with
mum standards for professional conduct of
government investigators.
attorneys appearing and practicing before the
Securities and Exchange Commission, including such rules requiring attorneys to
“report-up” within the organization any evidence of a material violation of securities
239
1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1.27 (2007).
979 F.2d 332 (4th Cir. 1992).
241 Id. at 350-51.
242 Id. at 354.
240
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law or fiduciary duty (or similar duty) by an issuer or any agent thereof.243 The rulemaking under Section 307 demonstrates the increased surrounding pressures placed on
the rights of attorney-client privilege and related confidentiality concerns.244
When a corporation is being investigated for alleged criminal or fraudulent activity, a normal reaction of the board and managers may be to announce an intention to
cooperate fully with the investigation.245 Frequently, prosecutors demand that corporations make a determination as to whether they intend to cooperate with the investigation early on, which poses concerns for attorney-client privilege.246 Specifically, in
past years the Department of Justice has evaluated whether a corporation has chosen to
cooperate based on its willingness to waive attorney-client privilege and work product
protections. These positions originated in internal memoranda of the Department of
Justice, commonly referred to as the Holder Memorandum, the Thompson Memorandum and the McNulty Memorandum. However, as a result of pressure from Congress, the Department of Justice announced on August 28, 2008 that it has
significantly changed its policies regarding cooperation with an investigation. Under
the new policies, cooperation is measured on whether a corporation voluntarily discloses relevant facts as opposed to whether it agrees to waive its privileges. Discussed
below are the prior Department of Justice memorandums as well as the newly
announced guidelines and the Congressional response.
Holder Memorandum247
In June 1999 Deputy Attorney General Eric Holder issued a memorandum to
Department of Justice personnel and U.S. Attorneys stating that: “[I]n determining
whether to charge a corporation [with federal criminal violations], that corporation’s
timely and voluntary disclosure of wrongdoing and its willingness to cooperate with
the government’s investigation may be relevant factors. In gauging the extent of the
243
15 U.S.C.S. §7245 (2002).
William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 115 (2005).
245 Id.
246 Id.
247 Memorandum from Eric H. Holder, Deputy Attorney General, to Component Heads and United
States Attorneys (June 16, 1999), http://www.abanet.org/poladv/priorities/privilegewaiver/
1999jun16_privwaiv_dojholder.pdf.
244
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corporation’s cooperation, the prosecutor may consider the corporation’s willingness
to identify the culprits within the corporation, including senior executives, to make
witnesses available, to disclose the complete results of its internal investigation, and to
waive the attorney-client and work product privileges.”248 Adhering to the suggestions
of the Holder Memorandum results in the corporation’s effective waiver of privileges
that would likely provide a viable defense in a potential action, leaving the corporation
vulnerable.
Thompson Memorandum249
In January 2003, Deputy Attorney General Larry D. Thompson issued a revised
statement that focused on proposed revisions to the principles set forth in the Holder
Memorandum. These revisions, in particular, increased the emphasis on and the scrutiny of the authenticity of a corporation’s cooperation with the investigation.250 “Too
often business organizations, while purporting to cooperate with a Department investigation, in fact take steps to impede the quick and effective exposure of the complete
scope of wrongdoing under investigation.”251 The Thompson Memorandum provided
support for the corporation’s voluntary disclosure, identification of culpable corporate
agents and waiver of applicable privileges that were originally encouraged by the
Holder Memorandum.252
McNulty Memorandum253
In December 2006, Deputy Attorney General Paul J. McNulty announced a formal
procedure for prosecutors to follow when seeking waiver of the attorney-client and
work-product protections. The McNulty Memorandum revised and superseded the
Holder and Thompson Memoranda. Under the McNulty guidelines, before asking
248
Id.
Memorandum from Larry D. Thompson, Deputy Attorney General, to Heads of Department
Components and United States Attorneys (Jan. 20, 2003), http://www.usdoj.gov/dag/cftf/
business_organizations.pdf.
250 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 116 (2005).
251 Memorandum from Larry D. Thompson, Deputy Attorney General, to Heads of Department
Components and United States Attorneys (Jan. 20, 2003), http://www.usdoj.gov/dag/cftf/
business_organizations.pdf.
252 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW, 95, 116 (2005).
253 Memorandum from Paul J. McNulty, Deputy Attorney General, to the Heads of Department
Components and United States Attorneys (Dec. 12, 2006), http://www.usdoj.gov/dag/speeches/
2006/mcnulty_memo.pdf.
249
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corporations for a waiver of privilege, prosecutors were required to find that there is a
“legitimate need” for the information based on the following factors:
•
The likelihood and degree to which the privileged information will benefit
the government’s investigation;
•
Whether the information sought can be obtained in a timely and complete
fashion by using alternative means that do not require waiver;
•
The completeness of the voluntary disclosure already provided; and
•
The collateral consequences to a corporation of a waiver.254
If a “legitimate need” existed for disclosure of protected information, the prosecutor was required to seek the least intrusive waiver necessary to conduct a complete
and thorough investigation. Also, before requesting a privilege waiver from the corporation, the prosecutor was required to obtain formal written approval to make the
request. Formal approval was not needed if the corporation voluntarily offered privileged documents without a government request.
The specific procedure for obtaining approval differed depending on the type of
information sought, which the McNulty Memorandum segregated into two categories.
Category I information was factual information relating to the underlying misconduct
and includes, for example, copies of key documents, witness statements, factual interview memoranda and factual summaries or reports documenting facts uncovered during an internal investigation by counsel. To request a corporation’s waiver of privilege
for Category I information, prosecutors were required to obtain written authorization
from their United States Attorney. After receiving approval, the United States Attorney
was required to communicate the waiver request to the corporation in writing.
Category II information consisted of attorney-client communications or
non-factual work product, and included legal advice given to the corporation “before,
during, and after the underlying misconduct occurred.”255 Prosecutors were required to
seek a further disclosure of Category II privileged information if the factual
information provided an incomplete basis to conduct an investigation. To request a
254
255
Id.
Id.
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waiver of privilege for Category II information, the United States Attorney was
required to obtain written authorization from the Deputy Attorney General and then
communicate the request for a waiver to the corporation in writing.
Excluded from Category II information were certain communications between
counsel and the corporation where a privilege would not apply or may have been
waived, including:
•
Legal advice contemporaneous to the underlying misconduct when the
corporation or an employee relies upon an advice-of-counsel defense; and
•
Legal advice/communications furthering a crime or fraud.
In these two instances, a request for disclosure would be subject to the procedure
for Category I information.
The McNulty Memorandum allowed prosecutors to consider a corporation’s
response to the government’s request for a waiver of privilege regarding Category I
information in determining whether a corporation has cooperated in the government’s
investigation. However, the McNulty Memorandum emphasized that prosecutors could
not count a corporation’s refusal to provide a waiver for privileged Category II
information against them. Nevertheless, “[p]rosecutors may always favorably consider
a corporation’s acquiescence to the government’s waiver request in determining
whether a corporation has cooperated in the government’s investigation.”256
The McNulty Memorandum has been widely criticized as being coercive and
unfair. In particular, it has been suggested that “the environment created by prosecutorial pressure for early waivers—whether or not such pressure is ‘fair’ in a philosophical sense—has certainly contributed to the increasing perception that the
attorney-client privilege has become, as a practical matter, irrelevant in a significant
corporate investigation.”257 Further, the “slippery slope toward diminution or even
elimination of the corporate attorney-client privilege insofar as it relates to governmental investigations and prosecutions may well have a chilling effect on
communications between corporate client representatives and corporate lawyers,
256
Id.
William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 119 (2005).
257
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which is likely to lead in turn to less effective lawyering in the corporate and transactional context and diminished legal compliance by corporations.”258
Congressional Intervention and the Newly Issued Guidelines Under the Filip
Memorandum
In response to criticism of the McNulty Memorandum, the U.S. Senate Judiciary
Committee commenced deliberations as to whether legislation should be enacted to
provide a set of guidelines for the handling of attorney-client privilege in corporate
fraud investigations. In response, the Department of Justice indicated that such legislation is unnecessary and that internal changes to its policies are preferable to legislation.259
In an effort to head off legislation, the Department of Justice wrote a letter to the
Senate Judiciary Committee in July 2008 indicating that it intended to change the
McNulty Memorandum. Subsequently, on August 28, 2008, the Department of Justice,
in the Filip Memorandum announced significant changes to its policy regarding application of the attorney-client privilege in government investigations as follows:
•
First, cooperation with a government investigation will no longer be measured on whether a corporation under criminal investigation chooses to waive
attorney-client privilege – rather it will depend on whether the corporation
has timely disclosed relevant facts;
•
Second, federal prosecutors may no longer demand privileged attorneyclient communication or attorney work product (so called Category II,
information under the McNulty Memorandum);
•
Third, the Department of Justice will no longer consider whether a corporation has advanced attorneys’ fees to its employees in evaluating cooperation;
•
Fourth, the Department of Justice will not penalize corporations that have
entered into joint defense agreements, provided they refrain from sharing
information the Department of Justice disclosed in confidence; and
258
Id. at 126.
See, e.g., Update to McNulty Memo Criticized, (July 16, 2008) The Recorder, Vol. 132, No. 167; see
also Mukasey Hints That McNulty Memo Could Be Revised (July 11, 2008), The Recorder, Vol. 132, No.
134; see also Joe Plazzolo DOJ to Overhaul the McNulty Memo The National Law Journal July 11, 2008;
see also Remarks Prepared for Delivery by Deputy Attorney General Mark R. Filip at Press Conference
Announcing Revisions to Corporate Charging Guidelines, August 28, 2008.
259
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•
Fifth, the Department of Justice will not evaluate cooperation on a company’s action against its employees.260
Although these are significant changes from the McNulty Memorandum, it
remains to be seen whether the Senate Judiciary Committee will refrain from enacting
any legislation pending an opportunity for the Department of Justice to evaluate the
effectiveness of the new policy.
Internal Investigations
A corporation may initiate an internal investigation in response to a stockholder
lawsuit, government agency investigation, subpoena; or through either a complaint or
grievance from an employee or group of employees.261 Regardless of whether the
investigation begins from inside or outside of the corporation, the corporation has a
significant interest in protecting the confidentiality of counsel’s findings in the investigation.262 In the context of an internal investigation and in order to maintain the
attorney-client privilege, corporate counsel should always consider, regardless of the
nature of their work, that their participation in the investigation must be seen chiefly as
a provider of legal advice to the corporation. Otherwise, there is a risk that the attorney-client privilege will not apply.263 Corporate counsel is in a much stronger position
to assert privilege as to communications and other investigative material which,
although representing factual and non-legal information, has as its main purpose the
rendering of legal advice.264 Finally, the documentation by counsel that the particular
communications at issue were made in order to obtain legal advice increases chances
of maintaining privilege. In addition, investigative material that is the product of an
attorney-client relationship should be protected; this is supported by the Upjohn
opinion.265
260
Id.
Thomas R. Mulroy & Eric J. Munoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM.
L.J: 49 (2002).
262 Id. at 49.
263 Id. at 58.
264 Id.
265 Id.
261
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CONCLUSION
In the corporate context, the courts continue to explore different methods for
determining when attorney-client privilege applies and who can assert or waive such
privilege. With the increased scrutiny of corporate disclosure and willingness of
corporations to cooperate in government investigations, it is important for corporate
counsel, directors, officers and other employees to be informed and implement corporate policies that enable the corporation to be in the best position to assert the attorneyclient privilege.
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CHAPTER 8
INDEMNIFICATION AND INSURANCE
INTRODUCTION
Indemnification and directors’ and officers’ (“D&O”) liability insurance are two
interrelated and indispensable devices to protect the personal assets of directors and
officers from claims arising from their service for the corporation. Indemnification
allows a corporation to reimburse its directors and officers for losses they incur as a
result of certain claims regarding their service, with certain exceptions. While
indemnification is not permitted in all circumstances (e.g., with breaches of the fiduciary duty of loyalty where the director or officer acted in bad faith), it is permitted in
a wide variety of circumstances and generally provides the affected officer or director
with the most expedient and reliable form of relief. In addition, in certain instances,
indemnification is mandatory under the DGCL.
For situations in which indemnification is not Indemnification and
D&O insurance protect
available (e.g., due to statutory prohibition or
directors and officers
insolvency of the corporation or because it was not
against incurring
granted by the corporation), D&O insurance can propersonal liability for
vide a last line of defense. While D&O insurance is their actions on behalf of
generally subject to numerous exceptions and the corporation.
exclusions, it provides directors and officers with an
added level of risk management comfort in a wide variety of circumstances and is
indispensable when the corporation either cannot or will not provide direct
indemnification. Companies should carefully evaluate their indemnification and D&O
insurance programs on a regular basis, and revise and update them when necessary to
reflect the changing needs and circumstances of the corporation and its directors and
officers.
INDEMNIFICATION
Statutory Indemnification Under the DGCL
Section 145 of the DGCL permits, and in some situations mandates, corporations
to indemnify their directors and officers as part of an underlying policy to induce the
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most capable and responsible persons to serve in corporate management.266 A corporation generally has the statutory authority267 to indemnify any person who was or is a
party or is threatened to be made a party to any threatened, pending or completed
direct legal proceeding (civil, criminal or otherwise)
The DGCL provides the
by reason of the fact that the person is or was a
corporation with the abildirector, officer, employee or agent of the corpoity to indemnify directors
ration (or who serves in certain capacities with
and officers, with certain
another entity at the request of the corporation), as
exceptions.
long as the person acted in good faith and in a
manner the person reasonably believed to be in the best interests of the corporation (or,
in the case of criminal proceedings, had no reasonable cause to believe the person’s
conduct was unlawful).
If the relevant action is a derivative proceeding (meaning that it is brought on
behalf of the corporation against one of its directors or officers by a third party such as
a stockholder or creditor) no indemnification is permitted with respect to any claim,
issue or matter as to which the person is judged to be liable to the corporation unless
and only to the extent that the court determines that, despite the adjudication of
liability but in view of all the circumstances of the case, the person is fairly and
reasonably entitled to indemnity for such expenses that the court deems proper. Section 145 provides that indemnification in either of the foregoing circumstances can be
made only upon a determination – generally by the board of directors, but sometimes
by independent legal counsel – that the potential
indemnitee has met the applicable standards of The DGCL also provides
conduct required by Section 145. The importance of mandatory indemnification
for an officer or director
D&O insurance is heightened in such cases where
who has successfully
indemnification is not allowed because of an
defended against claims of
adverse finding. While typically insurers resist
misconduct.
paying any amounts in a settlement that would flow
directly to the nominal plaintiff corporation, they typically do stand up to pay attorneys’ fees and, ultimately, could be responsible for paying a judgment levied against
the officer or director defendant.
266
267
Merritt-Chapman & Scott Corp. v. Wolfson, 264 A.2d 358, 360 (Del. Super. Ct. 1970).
All references to statutory authority or requirements in this chapter are to 8 Del. C. §145.
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To the extent a present or former director or officer of a corporation has been
successful on the merits or otherwise in the defense of any direct or derivative action,
suit or proceeding arising from the person’s service as an officer or director, then the
corporation must indemnify him or her against expenses actually and reasonably
incurred in connection with the suit. Indemnification under Section 145, whether permissive or mandatory, can cover expenses (including attorneys’ fees), judgments, fines
and settlement amounts actually and reasonably incurred by the indemnitee in connection with the proceeding.
Section 145 also permits corporations to advance expenses (including attorneys’
fees) to directors or officers if the director or officer agrees to repay the advanced
funds if it is ultimately determined that the person is not entitled to indemnification.
The ability to advance expenses can be very important because the costs of litigating a
case, regardless of its merit or ultimate outcome, can be prohibitively expensive in
relation to the resources a typical officer or director might have at his or her personal
disposal. The Delaware Court of Chancery is vested with exclusive jurisdiction to hear
and determine all actions for advancement of expenses or indemnification. Additionally, the Court of Chancery is permitted to summarily determine a corporation’s
obligation to advance expenses (including attorneys’ fees), which provides an avenue
whereby a person seeking advancement of expenses can obtain a relatively speedy
judicial determination of their request. The indemnification and advancement of
expenses provided by the DGCL and the corporation’s charter and bylaws will generally continue in effect as to a person who has ceased to be a director, officer,
employee or agent and will inure to the benefit of their heirs, executors and administrators. However, if the expense provision is removed from the charter or bylaws
after a former director or officer has left office and before the former director or officer
has been named in an action for which expense reimbursement is sought, the former
director or officer may not be entitled to such reimbursement unless he or she has an
affirmative contractual right to the reimbursement – for example, by reason of an
indemnification agreement.268
268
See, e.g., Schoon v. Troy Corp., 948 A. 2d 1157 (Del. Ch. 2008) appeal pending.
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Additional Sources of Indemnification Rights
In addition to the mandatory indemnification provided by the DGCL, most corporations provide for indemnification to the maximum extent allowed by Delaware law
in their charter and bylaws. In addition, many corpoGiven the proliferation rations enter into specific indemnification agreements
of suits against corpor- with their directors and officers. Due to the significant
ations, the vast
risks of stockholder lawsuits and other potential liabilities
majority of qualified
that directors and officers face as a result of their roles
director and officer
with their corporations, the vast majority of qualified
candidates expect that
director and officer candidates expect, and oftentimes
a corporation provide
will not serve without, robust indemnification and related
for robust
rights.
indemnification rights.
Directors and officers should be familiar with the
various provisions of the corporation’s charter documents and their individual agreements with the corporation that address their indemnification rights. Those provisions
and agreements should be reviewed by the corporation and the directors and officers
(as well as legal counsel or other appropriate advisors) from time to time as circumstances merit to evaluate whether the indemnification rights and obligations they contain continue to be appropriate and adequate in light of the parties’ needs and
circumstances.
Indemnification provisions are often drafted broadly to provide for
indemnification to the fullest extent permitted by law. However, care should be taken
to ensure that the applicable provisions provide (or at least do not foreclose the
implication) that if the law is amended in the future to expand permitted
indemnification beyond that which was permitted on the date of the particular contract
or charter provision, then the directors and officers will get the benefit of that
expansion in the law. Additionally, care should be taken to ensure that the
indemnification provisions in various documents do not conflict with each other.
Certificate of Incorporation Provisions
Most corporations include provisions in their certificate of incorporation that
provide for indemnification of directors and officers to the full extent permitted by
Section 145. While these provisions are not required to permit a corporation to
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indemnify its directors and officers in situations where Section 145 provides for permissive indemnification, they provide a level of comfort and certainty to directors and
officers because they cannot be modified or
rescinded without stockholder action to amend Indemnity provisions contained
the certificate of incorporation. Without such a in a corporation’s charter canprovision or other contractual right to not be modified without a
indemnification, the availability of indemni- stockholder vote, and therefore
fication for directors and officers would be at provide greater protection for
directors and officers than
the discretion of the board. Whether a board
provisions contained in the
would grant indemnification under particular
corporation’s bylaws.
circumstances may depend on a number of
factors, and cannot be guaranteed. Broad indemnification provisions contained in a
corporation’s certificate of incorporation, in addition to provisions eliminating or
limiting a director’s liability to the corporation and its stockholders for certain breach
of fiduciary duty claims, can provide directors with significant protections against
liability so long as the directors have acted in good faith.
Bylaw Provisions
Many corporations also include provisions in their bylaws that provide for
indemnification of its directors and officers to the full extent provided by Section 145.
Bylaw provisions, unlike provisions in the corporation’s certificate of incorporation,
can often be amended or repealed through action by the board of directors alone,
which presents problems for directors or officers if those provisions are subsequently
narrowed or rescinded altogether. For example, one recent Delaware case held that a
former director was not entitled to the benefit of an expense reimbursement provision
when the bylaws were amended to remove the right to receive the reimbursement
before the former director was named in an action for which reimbursement was
sought (this case is currently on appeal).269
Contractual Indemnification Rights
Many corporations enter into indemnification agreements with directors and officers that provide an additional layer of comfort above and beyond the statutory provisions and provisions contained in the charter and bylaws. These agreements typically
269Schoon
v. Troy, 948 A.2d 1157 (Del. Ch. 2008), appeal pending.
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provide for indemnification and advancement of expenses to the fullest extent permitted by Delaware law. These direct contractual arrangements most commonly take the
form of a stand-alone indemnification agreement between the corporation and the
individual, but can sometimes be found in employment agreements and similar
arrangements as well. Typically a corporation has a standard form of indemnification
agreement. If the corporation enters
Corporations should consider obtaining into indemnification agreements with
stockholder ratification of
its directors and executive officers, it
indemnification agreements with offishould consider seeking stockholder
cers and directors so as to reduce chalapproval of those agreements in
lenges to the enforceability of such
accordance with the interested director
related party agreements.
transaction provisions of the DGCL to
reduce the ability of third parties to challenge their enforceability on that basis. Applicable listing requirements of the New York Stock Exchange, NASDAQ and other
stock exchanges further require that indemnification arrangements, as well as many
other arrangements between the corporation and its directors and officers and other
related parties, be approved or recommended for approval by the corporation’s audit
committee or another committee of independent directors.
Well-crafted indemnification agreements directly between the corporation and the
affected individual provide the individual with the greatest level of comfort and certainty as to his or her indemnification rights. Assuming the corporation does not enter
bankruptcy (in which case appropriate D&O
Contractual agreements with
insurance, as discussed below, takes on an
directors and officers providing
added measure of significance), if the director
for indemnification rights
or officer has an indemnification agreement
generally provide the highest
directly with the corporation, the corporation
level of comfort for the direcwill generally be obligated to fulfill its
tors and officers because they
indemnification obligations to that individual
cannot be modified without
as set forth in the contract, regardless of
their consent.
whether the indemnification provisions of the
corporation’s certificate of incorporation or bylaws are subsequently modified by
actions of the corporation’s board of directors or stockholders in a manner adverse to
the corporation’s directors and officers. Indemnification agreements generally include
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very specific procedural mechanisms (regarding advancement of defense costs, etc.)
and other provisions (e.g., imposing on the corporation an obligation to maintain directors’ and officers’ insurance on behalf of the indemnitee) that provide added comfort
to the affected individual.
Securities and Exchange Commission Position on Indemnification for Securities
Law Violations
The Securities and Exchange Commission maintains a long-standing position that
the indemnification of directors and officers of a corporation for liabilities arising
under the Securities Act of 1933 (the “Securities Act”) is against public policy as
expressed in the Securities Act and is therefore unenforceable. While not universally
accepted by courts throughout the country, this Securities and Exchange Commission
interpretation has been judicially affirmed on occasion. As a result, directors and officers should not assume that their indemnification rights will be upheld if challenged by
the Securities and Exchange Commission even if Delaware law would otherwise permit indemnification.
D&O INSURANCE
Overview
A corollary to Delaware’s statutory indemnification provisions is its position with
respect to D&O liability insurance. The DGCL permits a corporation to purchase and
maintain insurance on behalf of any person who is or
was a director, officer, employee or agent of the corpo- D&O insurance is an
ration or who serves in certain capacities with another essential part of
entity at the request of the corporation. The underlying managing the risk that
public policy stems from the fact that, as discussed directors and officers
expose themselves to
above, a corporation is not legally permitted to
through their service to
indemnify its directors and officers in certain circumthe corporation.
stances (e.g., to pay adverse judgment or settlement
amounts in the event of a derivative claim on behalf of the corporation against the
individual directors and officers). D&O insurance thus assists corporations to attract
talented directors and officers by providing an additional layer of comfort from fear
that their personal assets would be at risk from their actions on behalf of the corporation.
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D&O insurance should be evaluated in light of the corporation’s indemnification
obligations under its certificate of incorporation, bylaws and other contractual
arrangements. While the existence of D&O insurance provides significant comfort to
directors and officers, they will generally find it much easier and more expeditious to
seek redress directly from the corporation through indemnification. As a result, D&O
insurance should be viewed by directors and officers as a fallback for situations where
their corporation either cannot or will not indemnify them against particular losses, or
where available indemnification is insufficient to cover the losses incurred.
D&O insurance policies are complex documents and the market for D&O
insurance, including the products offered and their related costs, is constantly evolving. A corporation seeking to implement or renew a D&O insurance policy should plan
to invest a significant amount of time (30 to 60 days is generally necessary) and effort
in seeking competing proposals from
Careful upfront negotiation of a
reputable insurers and carefully reviewing
D&O policy may pay substantial
and negotiating the terms and conditions of
dividends when a claim is prethe policy that they ultimately purchase.
sented by reducing the risk that
Like all forms of insurance, the real value of
the claim is denied by the carrier.
a D&O policy is often not realized until
the insured needs the insurer to cover a claim. Time and effort spent negotiating a
good policy at the outset will be well worth the expense if it means that the insured can
avoid the unpleasant surprise of finding out that a particular claim that they thought
would be covered is in fact not. It is important to remember that employees of an
insurance company’s claims department are paid to find ways to avoid coverage.
Corporations can minimize the risk of having coverage denied by negotiating carefully
crafted policy provisions that provide broad coverage.
While it is often possible to purchase endorsements or other riders to expand the
scope of coverage after a policy is implemented, it is generally less expensive to negotiate that coverage at the outset. Accordingly, it pays to try to craft the initial policy with
some foresight and to negotiate coverage of claims that, while they may seem unlikely
at the time, may come to pass in the future. For example, a corporation that is financially
sound at the time it purchases its D&O policy would be well-advised to consider the
policy’s bankruptcy exclusions despite the fact that bankruptcy is unlikely at the time. A
corporation that has to reopen negotiations with its insurance carrier after its circumstances have worsened may find that its risk profile has changed such that the expanded
coverage is simply unavailable or prohibitively expensive.
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Furthermore, a D&O policy should be reviewed by the corporation at least
annually to determine whether the coverage is sufficient (in both its terms and coverage limits) under the corporation’s present circumstances, as well as in light of
foreseeable circumstances in which the corporation may find itself. Directors and officers should personally familiarize themselves with their corporation’s D&O insurance
program and regularly review that program to determine whether changes are merited.
While public companies should con- Although virtually essential to a
sider D&O insurance to be indispensable, public company, private compaprivate companies should consider purchas- nies are increasingly considering
ing D&O insurance as well, particularly if purchasing D&O policies as well.
they are engaged in mergers and acquisitions
or capital raising through securities offerings. These activities can expose their directors and officers to substantial litigation risks from acquirers, minority stockholders
and securities purchasers. Most D&O carriers offer policies geared specifically to
private companies that have lower coverage limits and lower retentions (deductibles).
They do, however, typically exclude from coverage claims in connection with a corporation’s initial public offering, so if the corporation anticipates going public it will
likely need to obtain an endorsement providing IPO coverage or a new D&O policy
prior to commencing its IPO.
Basic Structure of a D&O Policy
A public corporation’s D&O liability insurance program typically contains three
types of coverage in one policy, commonly referred to as “Side A,” “Side B” and
“Side C.” It is also becoming more common for directors to insist on receiving an
additional “stand-alone” Side A policy issued by the insurer directly to them as a
means of ensuring that, regardless of what may happen to the corporation (e.g.,
bankruptcy), they will continue to have adequate D&O coverage. In addition to claims
expressly covered under the applicable base policy, for an additional fee almost all
D&O carriers offer endorsements that can broaden the definition of claims covered by
the policy such as to cover ERISA or employment-related claims, and otherwise
increase the scope or coverage of the policy in a way that is beneficial to the insureds
in their particular circumstances.
Coverage limits under a typical D&O policy are shared. In other words, the limits
of coverage under the Side A, Side B and Side C components of the policy are shared
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and are subject to the retention applicable to the policy. Thus, each insured should be
aware that claims made by other insureds could exhaust a policy before their claim
arises and thereby leave them without coverage.
Side A Coverage
Side A coverage generally covers costs and expenses incurred by directors and
officers in maintaining their defense and as a result of payouts under settlements and
judgments, in each case where they are not indemnified by the corporation for those
costs and expenses (e.g., in a situation where state law prohibits indemnification due to
the insolvency of the corporation or the claim being made derivatively on behalf of the
corporation).
Side B Coverage
Side B coverage generally provides reimbursement to the corporation in the event
it is permitted or required to indemnify an applicable director or officer in connection
with a claim. Due to the fact that most claims against directors and officers are
indemnifiable, Side B coverage is the most commonly invoked portion of a D&O
policy.
Side C Coverage
Side C coverage, which is also often referred to as “entity coverage,” covers the
corporation itself. For public companies, Side C coverage typically only covers claims
arising out of alleged violations of securities laws.
Stand-Alone Side A DIC Coverage
Insurers often offer, in addition to traditional Side A, Side B and Side C coverage,
what is known as “Side A DIC” or “difference in conditions” coverage. While the
terms and conditions of these policies vary from
Directors and officers should
insurer to insurer, they generally provide covercarefully review the D&O
age in situations where other coverage would
policy to educate and familiarnot be available to the individual insured direcize themselves as to the scope
tor or officer (e.g., when the primary D&O
and amount of coverage.
insurer improperly refuses to provide coverage
or where the primary D&O policy has been exhausted or rescinded). Side A DIC policies contain their own exceptions and exclusions (e.g., they often exclude claims
against fiduciaries under employee benefit plans and other ERISA claims), so these
policies should be carefully scrutinized as well. Because stand-alone Side A DIC
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coverage can only be used when the director’s or officer’s two primary sources of
recourse – indemnification from the corporation and the primary D&O policy – are
unavailable, they are oftentimes not worth the additional cost of the coverage. Additionally, the benefits of stand-alone Side A DIC coverage can be further reduced if the
Side A coverage in the primary D&O policy has the added reliability of being
non-rescindable.
Employment Practices Liability Insurance
In addition to, and in connection with a D&O policy, many corporations are
purchasing Employment Practices Liability Insurance (“EPLI”) to protect against
employment related claims. An EPLI policy can insure against employment related
claims and may serve to provide a director or officer with legal representation.
Employment related claims may include sexual harassment, discrimination claims,
wrongful termination and/or discipline, breach of employment contract, negligent
evaluation, failure to employ or promote, deprivation of career opportunity, wrongful
infliction of emotional distress, and mismanagement of employee benefit plans.
When selecting an EPLI policy it is important for a corporation to seriously evaluate its current needs, and to anticipate its future needs. One important consideration is
determining who will represent the corporation and its executives if covered litigation
occurs. Prior to purchasing the policy, the corporation can generally negotiate to have
such matters handled by its firm of choice. Further, while EPLI policies can vary
greatly, certain terms such as a “duty to defend” and a “hammer clause” should be
carefully considered. A “duty to defend” clause requires the EPLI carrier to defend
against claims brought under the policy, regardless of whether the deductible amount
or out-of-pocket expense amount has been met. A “hammer clause” permits the carrier
to recommend settlement at a certain amount. If the carrier’s recommendation is not
followed, the carrier’s liability is capped at the recommended amount. If the claim settles or is adjudicated for a larger amount, the company must cover the difference.
There are other “hammer clauses” that permit a carrier to recommend an alternative
dispute resolution to the claim.
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Retentions and Coverage Limits
D&O policies, like other insurance policies, require that a retention (deductible)
be paid by the corporation before the insurer is required to fund claims. Generally, the
higher the retention applicable to the policy, the
lower the premium. The amount of the retention Companies should regularly
review their D&O policies to
applicable to the policy is negotiable, but the
analyze the scope of coverage,
corporation should typically negotiate its
retention and exclusions.
retention considering the worst-case scenario.
Regardless of the corporation’s financial situation at the time it obtains the policy, it is
possible that at the time it needs to make a claim under the D&O policy its financial
wherewithal may be significantly taxed (i.e., insurance claims are often made when
things are not going particularly well and the corporation’s financial resources are
more limited). The appropriate retention amount under a particular policy can only be
determined with reference to the facts and circumstances applicable to a particular
insured, but when determining the appropriate amount companies (particularly public
companies), should consider the deductible amount they anticipate they would be able
to pay within a particular period without causing an unacceptable negative effect on
their financial condition and operating results.
Insureds Under the Policy
The specific language of the term “Insured” or “Insured Person” (or a similar
applicable term) should be carefully evaluated to determine who is covered under the
D&O policy. Most D&O policies cover all past, present and future directors and officers of the corporation. The policies also sometimes cover some other employees with
respect to specified claims (e.g., employment). Whether an in-house lawyer acting in
the capacity of a lawyer (as opposed to in the capacity of an officer) will be included
among the insureds is generally subject to negotiation. The applicable definitions and
other provisions in the policy that delineate who is covered as an insured should be
carefully scrutinized and negotiated to ensure that it fits the corporation’s particular
needs and circumstances.
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Claims Made
D&O policies are “claims made” policies, which generally means that the time
that the particular claim is made dictates which D&O policy, if any, is applicable to
the claim. As a result, it does not typically matter when the particular events or
circumstances giving rise to the claim occurred – it only matters when the claim is
made. However, the underlying events and circumstances giving rise to the claim are
not irrelevant because almost all D&O policies specify that, regardless of whether a
claim is made, the policy will not cover the claim if its underlying events and circumstances occurred on or before a designated date in the past, which is typically some
period of years prior to the effective date of the policy.
Due to the “claims made” nature of D&O policies, it is essential that insureds be
familiar with their claim reporting obligations under the policy (including what constitutes a “claim” that must be reported, as the definitions are often broadly written
such that some events that would not generally be considered a “claim” in common
parlance are deemed to be such for purposes of the policy). In addition, the corporation
should implement adequate controls and procedures to ensure that claims are properly
reported up the chain within the corporation so that they can be timely reported to the
insurance carrier. Insureds typically have a specified period of time after they receive
or become aware of a claim (which can be as short as 30 days) to report the claim to
the insurer. Claim reporting requirements in D&O policies are subject to negotiation,
so companies should seek to negotiate provisions that minimize the potential for failures in the claims reporting process that could lead to a denial of coverage. Oftentimes,
insurers are willing, subject to specified conditions, to require notice only after certain
individuals within the corporation become aware of potential claims.
Tail Policies
Under certain circumstances, a corporation may purchase a “tail” insurance
policy to extend the coverage period of time coverage for claims arising out of events
that occurred while the original D&O policy was in effect (despite the fact that the
claims themselves arise afterwards). For example, D&O policies insure against claims
made prior to the effective date of a merger or other acquisition, but if the corporation
consummates a merger or is otherwise acquired, it may need to obtain a tail insurance
policy to cover itself and the directors and officers against wrongful acts that occurred
prior to the completion of the merger or acquisition. Some D&O policies have automatic tail coverage available at the insured’s option in the event of a merger or acquisition.
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Additionally, if a corporation is acquired and its employees and assets do not
exceed certain limitations contained in the acquiring corporation’s D&O policy, the
target corporation may be treated as a
subsidiary and have coverage under the Many D&O policies do not survive
acquiring corporation’s D&O policy. significant corporate events such as a
Directors and officers of a target corpo- merger or bankruptcy filing. When
ration engaged in acquisition negotia- contemplating such an event, the
tions should consider who will bear the policy should be carefully reviewed to
cost of a necessary tail policy, and your determine whether a “tail” policy will
D&O carrier should be consulted well be needed and allot sufficient time and
in advance of the transaction closing to funds to timely acquire such a policy.
ensure that there is no gap in coverage.
Directors and officers also should be mindful of situations where their D&O policy
will lapse or otherwise terminate. If a new, replacement D&O policy will not be in
place at the time of termination of the old policy, they should carefully consider
whether a tail policy is appropriate and, if so, take necessary measures to ensure that
one is obtained in a timely manner.
Policy Term
A typical D&O policy has a one year policy period before renewal is required.
Companies should carefully reevaluate their changing D&O insurance needs and circumstances a least a couple of months prior to the expiration of their current policy so
that they have sufficient time to negotiate new or revised terms with their current carrier or negotiate and purchase a new policy from a different carrier.
Considerations When Evaluating Your D&O Policy
As noted above, D&O insurance policies are complex documents that require
careful consideration, negotiation and periodic review. Below are summaries of several areas of particular concern. However, these are by no means the only areas of
concern, and directors, officers and their companies should always seek the guidance
of an expert in D&O insurance matters when evaluating or purchasing a D&O policy.
D&O policies are not generally off-the-shelf, unchangeable form documents
offered by insurers. Depending on the market and the particular insurers there may be
significant latitude in negotiating and revising the specific language of particular
provisions in the initial form of the policy the insurer proposes. Because the specific
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language of each provision in the D&O policy can be the difference between receiving
and being denied coverage in the future, it is well worth the expense to negotiate a
policy before buying it and obtain the guidance of an expert in D&O insurance issues
in connection with your negotiation of the policy.
Order of Payments Issues
As noted above, most D&O policies include Side A, Side B and Side C coverage.
As a result, the corporation’s directors and officers will essentially share the policy’s
limits with the corporation and other directors and officers. If claims by other insureds
deplete the limits of the policy, a director will generally find himself or herself without
coverage. This problem can be alleviated by ensuring that the policy contains an order
of payments provision, which basically provides that, with respect to a particular
claim, the payments due under Side A (i.e., directly to the insured directors and officers) are paid before the corporation receives any coverage under Side B
(reimbursement to the corporation for indemnification amounts paid to directors and
officers) or Side C (coverage for the corporation itself). Another way of addressing
this issue is through a stand-alone Side A DIC policy as described above, which would
provide the affected insured with a separate, stand-alone policy that would not be
affected by the exhaustion of coverage under the primary D&O policy.
Severability Issues
D&O insurance policies are issued by insurers based on their evaluation of an application submitted by the person or entity seeking insurance. Applications for D&O
insurance are generally very extensive in the amount and type of information they
require from the applicant corporation. In addition to requiring extensive information
about the nature of the corporation’s business, its recent claims history, and the members
of its board and management team, applications by public companies also generally
require the corporation to attach its financial statements and certain Securities and
Exchange Commission filings, thereby including them in the information the insurer is
entitled to consider when reviewing the application. Furthermore, while a broad group of
directors and officers are generally beneficiaries under D&O insurance policies, the
applications typically are submitted and signed by one or two of the corporation’s top
management members (generally the chief executive officer and chief financial officer).
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As with other forms of insurance, misstatements or omissions in the corporation’s
application, including in any Securities and Exchange Commission filings or other
documents the corporation is required to attach to, or incorporate into, the application,
can form the basis for the insurer to seek to rescind the policy and void the coverage.
For example, consider a corporation and its directors and officers that are being sued
by stockholders who allege that the corporation’s publicly filed financial statements or
other Securities and Exchange Commission filings contained material misstatements
or omissions that caused the stockholders to lose all or a significant portion of their
investment when the corporation’s stock price plummeted after a recent release of
negative financial results. If the financial statements and Securities and Exchange
Commission filings that are the subject of the plaintiffs’ lawsuit were also submitted as
part of the corporation’s application for D&O insurance, the directors and officers may
face a situation where their D&O coverage is void based on the very set of factual
circumstances that gives rise to the insured’s claim for coverage.
While rescission is generally only permitted in the case of material misstatements
and omissions that, if known, would have affected the insurer’s willingness to provide
the insurance, the materiality of misstatements and omissions is necessarily evaluated
in hindsight and in the face of a pending claim, and information in the application can
take on new significance under those circumstances. Furthermore, misstatements and
omissions do not need to be intentional in order to form the basis for rescission, which
means that even unintentional errors can lead to a catastrophic voiding of coverage.
Similar issues are raised by misconduct exclusions contained in almost all D&O
policies. These exclusions generally provide that the insurer is not obligated to provide
coverage for claims based on fraud or other misconduct of any of the insureds. In
essence, a broad misconduct exclusion could create a situation where the misconduct
of one key officer or director could lead to the denial of coverage for all the directors
and officers, even if the others had no knowledge of the misconduct. Most securities
class action lawsuits, as well as many other claims against the directors and officers of
a corporation (e.g., claims based on alleged options backdating and similar improper
practices with respect to the timing of equity awards), are based on allegedly fraudulent or other inappropriate conduct by one or more of the corporation’s directors and
officers. Since it is often the case that the allegedly improper conduct did not in fact
extend to all of the directors and officers, those “innocent” insureds have an obvious
interest in ensuring that their D&O coverage is not denied as a result of the bad acts of
someone else.
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The risk of material misstatements and omissions in the corporation’s application,
and the resulting possibility that the policy would be rescinded and its coverage voided
can be mitigated by the inclusion of a strong severability clause. If a broad severability
clause cannot be negotiated into the policy, a severability clause applicable to the
misconduct exclusion can have the same prophylactic effect. Good severability clauses
generally provide that, in the event that the insurance application contained misstatements or omissions or particular insureds are guilty of misconduct, the policy is only
rescinded or coverage denied as to the insureds that had knowledge of the misstatements and omissions in the application or committed or were aware of the bad acts.
It should be noted that the knowledge of certain persons (e.g., the corporation’s
chief executive officer and chief financial officer), may be imputed to other insureds
regardless of whether the other insureds had any actual knowledge of the misstatements or omissions in question. As a result, it is worth the time and effort for the other
insureds to review the application and talk with anyone whose knowledge will be
imputed to them to increase the likelihood that the application is correct and complete.
It is also sometimes possible to avoid an application altogether, or to submit an abbreviated application, if the corporation is simply renewing its D&O policy with its current carrier. Companies should generally seek to minimize the amount of information
required to be included in or appended to the application in order to reduce the risk of
inadvertent misstatements or omissions.
In addition to negotiating a broad severability provision in a D&O policy, the
concern that the policy may be rescinded due to application misstatements or omissions caused by someone else, or that coverage will be denied due to the misconduct
exclusion applying to the bad acts of someone else, can also be alleviated through a
stand-alone Side A DIC policy. Some D&O carriers also offer non-rescindable Side A
coverage that will not be affected if the remainder of the policy is rescinded.
Insured vs. Insured Issues
Almost all D&O policies contain what is commonly referred to as an “insured vs.
insured” exclusion. Most insured vs. insured exclusions provide, at their essence, that
the insurer will not be required to cover claims where there is one or more insureds
acting as or working in concert with the person making the claim. The rationale of the
insured vs. insured exclusion is relatively clear and non-controversial – the insurer
wants to avoid being required to, and few companies would argue that the insurer
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should have to, cover a claim where one insured is suing another insured (or the corporation) in a collusive manner.
The difficulty and controversy surrounding the insured vs. insured exclusion, as is
typical with most D&O policy provisions, arises from the often very broad language
that applies to the exclusion and the fact that it can be triggered in many situations
where there is no collusion between insureds. For instance, insured vs. insured
exclusions often extend to void coverage when an insured assists the plaintiffs in the
claim, which in some situations may entail somewhat tangential assistance as a witness.
Furthermore, a broad definition of who constitutes an “insured” under the policy,
which is generally considered a benefit to the corporation and its officers, directors and
others who are insured under the policy, can inadvertently create additional situations
in which the insured vs. insured exclusion would apply and end up voiding coverage
altogether as to the applicable claim. For instance, because former directors and
officers are generally considered to be insureds under a typical D&O policy, if one of
those persons (who is also likely a stockholder of the corporation) either acts as named
plaintiff in a derivative claim against the corporation and its current directors and
officers or provides material assistance to the named plaintiffs by supplying
information or otherwise, the insurer will likely seek to invoke the insured vs. insured
exclusion to deny coverage. Issues can also arise in connection with claims in merger
and acquisition, whistleblower and bankruptcy contexts. As a result, it is very
important to closely scrutinize the language of the insured vs. insured exclusion in a
corporation’s D&O policy, and to seek to narrow the applicability of the exclusion to
the extent possible.
Defense Costs Provisions
While most D&O policies provide that defense costs and expenses, including
attorneys’ fees, are covered under the policy, the terms of policies can vary widely as
to when those costs are reimbursed. Some policies provide that the costs and expenses
are only paid by the insurer after the matter is fully resolved. This type of a provision
could create a significant burden on a corporation or particular directors or officers,
including those of substantial means, due to the simple fact that lawsuits can cost
hundreds of thousands of dollars or more to defend and can take years before a final
resolution is reached. Essentially, in addition to paying its own defense costs, the
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corporation would be required to advance all defense costs to its officers and directors,
and could have to wait for an extended period of time to be reimbursed by the insurer.
As a result, insureds should seek to negotiate a “pay as you go” clause in their D&O
policy, such that the insurer is required to pay defense costs as they are incurred,
generally on a monthly or quarterly basis. For public companies, “pay as you go”
clauses take on added significance due to prohibitions contained in the Sarbanes-Oxley
Act of 2002 against corporate loans to directors and officers, because in some situations, the advancement of legal expenses to directors and officers could be construed
as prohibited loans.
Bankruptcy Issues
Bankruptcy can have significant adverse effects on coverage available under a
D&O policy. Bankruptcy courts have held, although not frequently, that a D&O policy
is an asset of the bankruptcy estate and should therefore be available to pay creditors’
claims against the bankrupt corporation. In order to preserve the bankrupt corporation’s assets, these courts have denied the requests of directors and officers to have
their defense costs advanced. As a result, D&O carriers now generally require that a
bankruptcy court issue an order permitting them to advance defense costs to the directors before they will do so. Such an order can, unfortunately, sometimes take a significant amount of time to obtain.
One way to address this situation is to ensure that the D&O policy contains an
appropriate order of payments provision, as described above, that provides that the
directors and officers take priority over the corporation with respect to payments under
the policy. This helps support an argument, if necessary, that the corporation’s rights
in the D&O policy are subordinate to the rights of the directors and officers, and that
the policy is therefore not an asset that must be used to satisfy the claims of the corporation’s creditors in bankruptcy. Additionally, if a bankruptcy trustee chooses to sue
the bankrupt corporation’s former directors and officers, the insurer may seek to assert
the insured vs. insured exclusion discussed above to deny coverage on the theory that
the trustee is asserting the rights of one insured (the corporation) against other
insureds. Many D&O insurance carriers offer policies that expressly provide coverage
in this type of situation, but the particular language should be closely scrutinized to
ensure that it is sufficiently broad.
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Directors and officers of a corporation that is contemplating bankruptcy should
carefully review their D&O policy, with assistance from an expert with regard to D&O
insurance matters. They will often find that their policy does not provide them with the
coverage they expected to have in connection with the bankruptcy, and the time to
obtain that coverage is prior to filing the bankruptcy petition. Due to the corporation’s
increased risk profile on the eve of a potential bankruptcy, the cost of that additional
coverage could be significant.
Venue, Choice of Forum and Other Boilerplate Provisions
D&O policies contain extensive provisions that most insureds would consider to
be mere boilerplate. However, all of those boilerplate provisions should be carefully
scrutinized, and negotiated if necessary,
before purchasing the D&O policy. For Boilerplate provisions in D&O
example, there are generally provisions Policies should be carefully
specifying the applicable venue and forum in reviewed as they may contain
the event of a dispute under the policy. If important substantive provisions.
resolving a dispute in the insurer’s preferred
locale would present significant burdens for insureds located long distances from that
place (including the costs of paying for travel and other expenses of witnesses and
experts required to attend the proceedings), the corporation should seek to negotiate a
more convenient venue and forum. Sometimes the boilerplate provisions also require
arbitration of disputes before arbitrators with insurance expertise (read: people who
will likely have ties to the insurance industry). Furthermore, most D&O policies
require that disputes be resolved under New York law, which is generally more favorable to insurers. The corporation’s ability to negotiate these and other boilerplate
provisions of the policy will, as with any other provisions, be significantly dependent
on the market for D&O insurance is at the time of purchase.
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D&O Insurance Terms to Consider
In considering the terms of a D&O Policy, a company would do well to
evaluate its current and future needs as regularly as possible in determining the
importance and applicability of the following terms to their particular situation:
•
Retention & Coverage Limits: A company should be aware that generally, the higher the retention amount, the lower the policy premium.
•
Insureds Under the Policy: This term controls exactly who is covered
under the policy; directors and officers, or other employees.
•
Claims Made: Under a “claims made” policy the relevant time period is
not when the action in question took place, but when the claim is made.
Thus, a company should be clear as to what its reporting obligations are
under the policy.
•
Tail Policy: A tail policy extends the period of coverage for claims arising out of events that occurred while the D&O policy was in effect.
•
Order of Payments: This term dictates to whom the policy limit will be
paid, and in what order. Directors and officers will want to ensure that
their claims are paid before claims of the company, or else there might
not be any coverage remaining.
•
Severability Issues: Severability refers to the ability of the insurance
provider to rescind coverage of other (and sometimes all) insureds
based on misstatements or omissions on the application, or due to misconduct or fraud of one or more individuals. If the severability
definition is too broad, a misstatement or fraud committed by only one
officer or one director could potentially lead to the denial of coverage
for all other insureds.
•
Insured v. Insured: This term refers to the fact that the insurer will typically not cover claims where there is one or more insureds acting as, or
working in concert with, the person making the claim.
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•
Defense Cost Provisions: This term determines when attorneys’ fees
and defense costs are reimbursed. If these costs are reimbursed after
resolution of the claim, rather than advanced, the financial burden of
funding a legal defense may fall upon the company or other defendants.
•
Bankruptcy Issues: Because some bankruptcy courts have held that
creditors can attack D&O insurance if the company files for bankruptcy, the company must ensure that the order of payment specifies
that directors and officers take priority over the company. If not, creditors can use the policy to relieve the company’s debts, leaving nothing
to cover the claims against directors and officers.
•
Venue & Choice of Forum: Venue and choice of forum refer to where a
claim is to be adjudicated. A company would be wise to require claims
be defended in close proximity to their headquarters to avoid paying for
travel and other travel related expenses.
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CHAPTER 9
PERSONAL LIABILITY AND PIERCING THE CORPORATE VEIL
INTRODUCTION
Chapters 2 and 3 of this Handbook present several situations in which directors
and officers can be held personally liable for their actions, even if purportedly conducted on behalf of a corporation. It is also possible that a stockholder may be held
liable for the actions of a corporation, notwithstanding the fact that the corporation was
created to avoid such liability.
Stockholder liability for actions of a properly functioning corporation are rare, and
are premised on the “piercing the corporate veil” theory. In general, liability for the acts
of the corporation under a piercing the corporate veil theory involves a flagrant disregard and disrespect for the corporate entity and its formalities or the presence of
fraud. Classic examples are co-mingling of assets and failure to obtain any corporate
approvals. Although piercing claims are brought most frequently against parent corporations of wholly owned subsidiaries,
individual stockholders (such as sole or When the corporate existence is
majority stockholders) are also sometimes flagrantly disregarded or abused,
it is possible that parent corposued under this theory.
rations or substantial stockholders
By asserting that a court should pierce of a corporation may be found to
the corporate veil, a plaintiff is requesting be liable for the actions of the
the court to ignore the separate existence of corporation under a theory
a corporation, because of fraud or other referred to as “piercing the corposimilar injustice, and hold the stockholders rate veil.”
personally liable for any damages sustained
by the plaintiffs. A court will uphold this request if it would be inequitable or unfair
not to do so. “Persuading a Delaware court to disregard the corporate entity is a difficult task,” and therefore corporate veil piercing is rarely successful.270 Because it is so
rare, interpretations of the theory vary among the Delaware federal and state courts.
The reasoning of the cases that discuss whether a parent corporation will be held liable
for the obligations of its subsidiary has not always been uniform or clear. Some courts
have referred to a subsidiary as the mere instrumentality or alter ego of the parent,
270 Harco National Insurance Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114 at *10
(Del. Ch. Sept. 19, 1989).
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others have referred to an agency relationship between the two corporations, while still
others have referred to “piercing the corporate veil.”271 Regardless of the term used by
different courts, the presence of fraud is generally one of the court’s main considerations when deciding whether or not to “pierce the corporate veil.”
FRAUD
Delaware courts have stated that “fraud has traditionally been a sufficient reason
to pierce the corporate veil.”272 For example, in Gadsden v. Home Preservation Company, Inc.,273 the plaintiff sued the defendant corporation for failure to perform home
repairs pursuant to a contract. The plaintiff obtained a judgment, but was unable to
enforce it when she learned that the
corporation had no assets. She
A court held a stockholder liable under a
sought to pierce the corporate veil so
fraud theory in a situation where:
that she could enforce the judgment
• The corporation held no money in its
against the defendant sole stockaccounts;
holder, who was also the sole director and employee of the corporation.
• The stockholder withdrew all amounts
The court held that the “business
placed in the corporation’s accounts;
practices of [the defendants] con• All assets used by the corporation
stituted a fraud, contravention of
belonged to the stockholder;
contract, and a public wrong” and
found
the sole stockholder liable for
• The stockholder always presumed that
274 Several factors
the
judgment.
he would be liable for the acts of the
supported the court’s decision in the
corporation; and
Gadsden case, including the
• The plaintiff was an individual.
following facts:
•
The corporation had no funds in its bank account, and any money that was
placed there was quickly withdrawn by the stockholder;
•
The corporation had no assets – all tools and equipment used to perform home
repairs were owned by the stockholder. Nonetheless, the corporation continued to fraudulently guarantee its repairs for 10- and 20-year periods;
271
Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 839 (D. Del. 1978).
Harco National Insurance, 1989 Del. Ch. LEXIS at *10.
273 No. 18888, 2004 Del. Ch. LEXIS 14 (Del. Ch. Feb. 20, 2004).
274 Id. at *18.
272
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•
The stockholder testified that he always intended to be personally responsible for the obligations of Home Preservation; and
•
The plaintiff was a homeowner rather than a more sophisticated and knowledgeable creditor.275
After considering these factors, the court held the defendant stockholder personally
liable because “to uphold the corporate status of Home Preservation in these circumstances would be tantamount to blessing a scheme for business owners to defraud
creditors routinely.”276
INSTRUMENTALITY
Alleging that a corporation is a mere instrumentality of an individual stockholder
or a parent corporation is another way plaintiffs may attempt to make stockholders
liable for a corporation’s wrongs. This theory can be successfully asserted without a
showing of fraud.277 Two cases provide an illustration of this theory of liability.
•
In Equitable Trust Co. v. Gallagher, the defendant president and predominant stockholder of the corporation set up a trust consisting of shares of the
corporation’s stock for an employee,
with the corporation serving as Where a stockholder uses a
trustee.278 In an attempt to replace corporation solely as an
the trust, the defendant, rather than instrumentality or an alter ego
the trustee corporation, entered into and does not respect its
existence, courts have found the
an agreement with the employee to
stockholder to be liable for the
make an outright gift of the shares.
acts of the corporation.
The actual shares were never
transferred, and after the employee’s death, the defendant refused to give the
shares to her executor because he argued that the gift was not an enforceable
promise. The court ignored the existence of the trustee corporation, not only
because of the number of shares that he owned and the tremendous control
he exercised over the corporation, but also because his testimony indicated
that “he considered himself as the trustee and, both directly and indirectly. . .
275
Id. at *16.
Id. at *18.
277 Walsh v. Hotel Corp. of America, 231 A.2d 458, 461 (Del. 1967).
278 99 A.2d 490 (Del. 1953), modified, 102 A.2d 538 (Del. 1954).
276
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regarded himself as the corporation.”279 The court found the promise
enforceable because the employee had given up the trust in consideration of
the outright gift. It did not matter that the offer was made by the defendant
rather than the trustee corporation because the corporation was considered an
instrumentality of the defendant.
•
In Walsh v. Hotel Corp. of America, the court allowed the plaintiff to amend
her complaint to assert that the defendant was liable for the acts of its wholly
owned subsidiary.280 The plaintiff was injured while staying at a motel operated by the subsidiary and sued the defendant parent corporation. Given that
the defendant’s name was the only one displayed in the lobby and on the
motel’s stationary and that the defendant was listed as the operator of the
motel in a reputable financial handbook, the court held that there were sufficient facts to permit the amendment and allow additional investigations in
support of the instrumentality theory of liability.
ALTER EGO THEORY
The alter ego theory of liability has been characterized as another name for the
instrumentality theory,281 as a method of piercing the corporate veil, and as a close
relative of the veil-piercing theory.282 Regardless of the way it is described, the elements of the theory generally are similar to the instrumentality or veil-piercing theories. Before a court will ignore the corporate form and hold stockholders liable on this
ground, it will consider the following factors:
•
Whether the corporation had adequate access to the capital needed for the
corporate undertaking;
•
Whether the corporation was solvent;
•
Whether dividends were paid;
•
Whether corporate records were kept;
•
Whether directors and officers functioned properly;
279
Id. at 493-94.
Walsh, 231 A.2d at 461.
281 Id.
282 Harper v. Delaware Valley Broadcasters, Inc., 743 F. Supp. 1076, 1085 (D. Del. 1990).
280
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•
Whether other corporate formalities were observed;
•
Whether the dominant stockholder siphoned corporate funds; and
•
Whether, in general, the corporation simply functioned as a façade for the
dominant stockholder.283
Furthermore, it is important to note that “no single factor could justify a decision
to disregard the corporate entity, but that. . . an overall element of injustice or unfairness must always be present as well.”284 This “element of injustice” does not need to
equate to a finding of fraud, but without it, a plaintiff cannot successfully assert the
alter ego theory.
Harper v. Delaware Valley Broadcasters, Inc.
provides an example of a court’s analysis of the
alter ego theory.285 In Harper, an independent contractor was hired by Delaware Valley Broadcasters
Limited Partnership, and after the partnership failed
to compensate him fully, he sued the partners along
with the defendant Delaware Valley Broadcasters,
Inc. under an alter ego theory. In support of the
theory, he alleged that the only directors of the
defendant were the partners, one of which was also
a majority stockholder of the defendant; that the
partnership was the only source of funds for the defendant, and that the defendant’s
only business was to provide management services to the partnership. Without discussing the sufficiency of these factors, the court determined that the element of injustice
was not present in this case. Like the court in Gadsden, the court focused its attention
on the sophistication of the plaintiff. Here, the plaintiff was a stockholder and director
of the defendant and was aware of the relationship between the partnership and the
defendant. Beyond the loss of compensation, no other injustices existed, and the court
refused to ignore the separate legal existence of the defendant.
In addition to indicia of
disregard of the corporate
entity, an element of
injustice must nearly
always be present before a
court is likely to determine
that piercing is appropriate under the alter ego
or fraud theories of
liability.
283
Harco National Insurance Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *11-12
(Del. Ch. Sept. 19, 1989) (quoting United States v. Golden Acres, Inc., 702 F. Supp. 1097, 1104 (D. Del.
1988)).
284 Id.
285 743 F. Supp. 1076 (D. Del. 1990).
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ESTOPPEL
Equitable estoppel is another theory that courts have relied upon in finding a
stockholder liable for the acts of a corporation. For example, in Mabon, Nugent & Co.
v. Texas American Energy Corp,286 the court held that when “a party by his conduct
intentionally or unintentionally leads another, in reliance upon that conduct, to change
position to his detriment,”287 the party cannot later avoid liability by denying responsibility for the unpaid debt obligations of its wholly owned subsidiary. In reaching its
decision, the court noted that:
•
The consolidated assets and liabilities of both the parent and subsidiary
companies were identical;
•
The parent and subsidiary companies were jointly managed, financed by a
joint agreement and had entered into several inter-corporate transfers;
•
The parent corporation’s Form 10-K and various credit rating services stated
that the debt obligations of the subsidiary were the obligations of the parent
corporation; and
•
The plaintiffs actually relied on these factors.288
As a result, the court refused to allow the defendants to deny their responsibility for
the debt obligations of the subsidiary.
ALTERNATIVE THEORY OF STOCKHOLDER LIABILITY: AGENCY
Parent corporations may also be held liable for the acts of their subsidiaries on a
theory of agency. For example, if a court finds that a parent controls its subsidiary
such that the subsidiary is in essence only an agent of the parent, then the parent may
be found liable for any wrongdoing by the subsidiary. Factors that may support a
showing of control are common:
•
Stock ownership;
•
Directors and officers;
286
No. 8578, 1988 Del. Ch. LEXIS 11 (Del. Ch. Jan. 27, 1988).
Id. at *11 (quoting Wilson v. American Ins. Co., 209 A.2d 902, 904 (Del. 1965)).
288 Id. at *10-11.
287
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•
Financing arrangements;
•
Responsibility for day-to-day operations;
•
Arrangements for payment of salaries and expenses; and
•
Origin of the subsidiary’s business and assets.289
No single factor is sufficient to prove that an agency relationship exists, but the
fact that a parent holds out to the public that a subsidiary is a department of its own
business can increase the parent’s liability exposure for
Agency is an alternative
the subsidiary’s acts.290
theory of parent liability
Importantly, some courts have held that holding a
for a subsidiary corpoparent
company liable for the acts of the subsidiary does
ration that does not
not require a showing of fraud or other inequity, as
generally require a
would be required for a showing of liability under a
showing of fraud or
theory of corporate veil piercing.291 However, demoninequity.
strating that a subsidiary is an agent of a parent is a
difficult burden for a plaintiff. For example, in Japan Petroleum Co., the court held that
a subsidiary was not the agent of a parent company despite the facts that:
•
The companies had joint operations;
•
The companies shared common directors and officers; and
•
The parent exerted control over the subsidiary’s finances.292
289
Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 841 (D. Del. 1978).
Id.
291 Id. at 840.
292 Id. at 840-45.
290
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VEIL PIERCING IN THE CONTEXT OF FIDUCIARY DUTY BREACH
This chapter discussed the circumstances by which a stockholder, who may or
may not be a director, could be found liable for the actions of a corporation. The doctrine of corporate veil piercing has only been explicitly used in stockholder liability
cases, but the idea behind it, that of ignoring a corporation’s separate existence, has
also surfaced in director liability cases. For example, in Grace Brothers, Ltd. v. UniHolding Corp.,293 a court rejected claims by defendant directors that they could not be
liable for acts of a subsidiary because they were directors of a parent corporation. In
reaching this decision, the court noted that one director was the chairperson of the
subsidiary and that all directors knew about the challenged transaction of the subsidiary and could have acted to cause the subsidiary to avoid the action. While Grace
Brothers should not be viewed as a traditional corporate veil piercing case, it does
show how the doctrine plays a role in more traditional director liability cases and sets
forth the responsibilities directors have with regard to their subsidiary corporations.
293
No. 17617, 2000 Del. Ch. LEXIS 101 (Del. Ch. July 12, 2000).
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