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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
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 trans-
actions are not inherently detrimental to a corporation. As long as a transaction is fair
to the corporation, no protected confidences are betrayed, and there is not a mis-
appropriation 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 . . .
there must be evidence of disloyalty. Examples of such misconduct include, but cer-
tainly 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.”43
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 reduces 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 neu-
tralize duty of loyalty issues, the independent
decision-maker must be fully informed of the conflict
of interest as well as the terms of the corporate action
and must act in good faith.44 Boards commonly uti-
lize disinterested director approval mechanisms or
special committees comprised of disinterested and
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 func-
tioning 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 demon-
strate that a challenged transaction was “entirely fair” to the corporation and its stock-
43 Cede, 634 A.2d at 363.
44 8 Del. C. §144.
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Duty of loyalty concerns
can often be mitigated by
obtaining approval of
disinterested directors or
stockholders of a subject
transaction.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-38-2048.jpg)
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Notwithstanding the historical notion that Revlon does not apply to a “merger of
equals” transaction87, the Delaware Chancery Court has held that Revlon may apply
when the transaction is mixed cash and stock consideration, depending on the circum-
stances. In In re Smurfit-Stone Container, the court held that Revlon would likely
apply even though target stockholders would own approximately 45% of post-closing
buyer stock with the balance of the stock held by a diverse stockholder base. The court
reasoned that enhanced judicial scrutiny was in order because a significant portion “of
the stockholders’ investment . . . will be converted to cash and thereby deprived of its
long-run potential,” and that the transaction “constitutes an end-game for all or a sub-
stantial part of a stockholder’s investment.” The court twice noted, however, that the
issue remains unresolved by the Delaware Supreme Court, and that the “conclusion
that Revlon applies [to a mixed-consideration merger] is not free from doubt.”88
Revlon duties arise at the time that the directors have or are deemed to have
decided to sell control of the corporation.89 Generally, Revlon duties do not arise when
the directors merely have authorized corporate officers or a board committee to nego-
tiate a sale, but may arise when the directors have formally resolved to conduct a sale.
Thus, Revlon duties typically will not apply if the directors never authorize the sale of
the corporation or indicate any inevitable commitment to sell the corporation to a par-
ticular buyer, or if they merely authorize the exploration of a variety of alternatives
intended to enhance profitability, including a possible sale. As most sales are preceded
by such informal investigations of alternatives, directors should be aware of Revlon
duties when such a process commences and avoid commitments that might make it
difficult to meet their Revlon duties if they should arise later. The Delaware Supreme
Court clarified in Lyondell Chem. Co. v. Ryan that the Revlon duties apply only when a
corporation embarks upon a transaction – on its own initiative or in response to an
unsolicited offer – that will result in a change of control.”90 Until the board decides
87 The Delaware Court of Chancery recently reinforced this notion by noting that Revlon did not apply
to a stock-for-stock merger of equals transaction in which ownership of [the corporation] would remain
“in a large, fluid, changeable and changing market” following the merger. See In re TriQuint Semi-
conductor, Inc. Stockholders Litigation, C.A. No. 9415-VCN (Del. Ch. June 13, 2014).
88 In re Smurfit-Stone Container Corp. S’holder Litig., C.A. 6164-VCP (May 20, 2011).
89 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).
90 Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242 & n.23 (Del. 2009).
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tion110 or where use of the plan violates another principle of takeover law (e.g., utiliz-
ing a rights plan in a discriminatory manner favoring one change-in-control transaction
over another).111
Delaware courts believe that, while a board’s actions in the face of a hostile take-
over attempt should be scrutinized carefully due to the possibility that “entrenched”
directors will act in their own self-interest, a board’s planning for a hostile takeover
defense in advance, in the context of a corporate environment in which hostile or
unsolicited takeover attempts are not uncommon (but prior to the actual commence-
ment of such an attempt), will generally be evaluated under the business judgment
rule. On the other hand, if a stockholder rights plan is enacted in response to a partic-
ular hostile takeover bid, or if a board refuses to terminate the plan (including by
redeeming the rights) in the face of such a bid, the heightened Unocal standard likely
will apply. Because the judicial standard applicable to the adoption of a rights plan in
the face of a hostile bid is identical to the standard applicable to the refusal of a board
to terminate an existing plan at such time, many boards in recent years, rather than
actually adopting rights plans when no threat to corporate independence exists, have
adopted the alternative strategy of putting all of the documents together for a stock-
holder rights plan but then placing the plan “on the shelf,” keeping it ready for quick
adoption in the future as needed. The benefit of this course of action is that an “on the
shelf” plan does not invoke the ire of shareholder rights organizations that are gen-
erally opposed to these types of defensive measures.
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” stock-
holder rights plan will, by its terms, prevent directors appointed by a hostile acquirer
110 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. 1988), 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”).
111 Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994). However, in
Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182 (Del. 2010), the Delaware Supreme Court upheld a
board’s refusal to redeem a rights plan, thus successfully blocking a hostile takeover attempt at a price that
was a significant premium to market price. A key factor behind the decision was an independent and
knowledgeable board with a long-term business plan.
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DUTIES TO CREDITORS WHEN THE CORPORATION IS INSOLVENT
The Introduction of the Zone of Insolvency Concept
Although the question of when directors’ fiduciary duties shift from stockholders
to creditors is now settled in favor of insolvency as the test, Delaware and bankruptcy
courts introduced significant uncertainty into this question in the early 1990s in a ser-
ies of decisions that focused on the so-called “zone of insolvency” test creating an ear-
lier trigger.
The Delaware Court of Chancery first introduced the “zone of insolvency” con-
cept in its 1991 decision in Credit Lyonnaise Bank Nederland, N.V. v. Pathe
Communications Corp.162 In addressing the question of to whom directors of finan-
cially 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
to the corporate enterprise,” which includes both stockholders and creditors.163 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.”164 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.165
Unfortunately, the courts did not provide clarity as to when exactly a corporation
would be deemed to have entered into the zone 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 stock-
holders 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
162 No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991).
163 Id. at *108 and n.55.
164 Id. n.55.
165 Id .
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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.”169 The court noted that because creditors have existing protections afforded
by other sources, such as the credit documents, additional protection through direct
claims of breaches of fiduciary duty is inefficient.
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.”170
169 Id. at *62.
170 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92,
101 (Del. 2007). An intermediate appellate court in California also held that there is not a duty to creditors
when a corporation is in the “zone of insolvency,” but after insolvency, creditors are entitled to protection
under the “trust fund doctrine” to prevent dissipation, diversion or undue risk to assets that might other-
wise be used to pay creditors. Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020, 1041
(2009). Similarly, the United States District Court for the Southern District of New York has held that
“New York State’s corporate directors do not owe a duty of care to a corporation’s creditors when the
corporation is arguably operating within the ‘zone of insolvency.’” RSL Commc’ns PLC v. Bildirici, 649
F. Supp. 2d 184, 203 (S.D.N.Y. 2009), aff’d sub nom. RSL Commc’ns PLC, ex rel. Jervis v. Fisher, 412 F.
App. 337 (2d Cir. 2011). However, the United States Bankruptcy Court for the Eastern District of Virginia
has held that “once a [Virginia] corporation enters the zone of insolvency, the fiduciary duties owed by
the Directors extend also to the corporation’s creditors.” In re James River Coal Co., 360 B.R. 139, 170
(Bankr. E.D. Va. 2007).
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Operating in the
zone of insolvency
does not change
directors’ fiduciary
duties.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-102-2048.jpg)
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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 bring derivative
actions on behalf of the corporation
because they are the ultimate benefi-
ciaries of the corporation’s growth
and increased value. When a corpo-
ration is insolvent, however, its cred-
itors take the place of the
stockholders as the residual
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 fidu-
ciary duties.” The Supreme Court held that “individual creditors of an insolvent corpo-
ration 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 non-
fiduciary claim that may be available for individual creditors.”171
The Gheewalla decisions have greatly clarified directors’ duties when their corpo-
ration 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 corpo-
ration 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 gen-
erally (stockholders when it is solvent, and creditors when it is insolvent). As a prac-
tical matter, outside of bankruptcy, 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
171 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 the corporation’s
estate, including creditors. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1985).
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When a corporation becomes insolvent,
creditors take the place of stockholders as
the residual beneficiaries of any increase
in value. Consequently, creditors of an
insolvent corporation have standing to
bring derivative claims against directors
for breaches of fiduciary duty.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-103-2048.jpg)
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terminate their corporation’s existence, rather than prolong its life with the hope of
providing a greater benefit to stockholders in the long run.
In 2001, the Third U.S. Circuit Court of Appeals recognized174 for the first time a
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 ill-
considered attempt to salvage the company, resulting in further decline in the corpo-
ration’s net worth and the creditors’ ability to recover from the corporation.
In 2006, the Delaware Court of Chancery flatly rejected deepening insolvency
claims and consequently clarified the state of fiduciary duties of directors of finan-
cially 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 direc-
tors 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.”175
Strategies that result in continued or even deepening insolvency do not in them-
selves give rise to a cause of action. “Rather, in such a scenario the directors are pro-
tected by the business judgment rule.”176
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 tradi-
tional toolkit, which contains, among other things, causes of action for breach of fidu-
ciary duty and for fraud.”177
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 bank-
174 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001).
175 906 A.2d 168, 174 (Del. Ch. 2006), aff’d, 931 A.2d 438 (Del. 2007); see also Berg & Berg Enter-
prises, LLC v. Boyle, 178 Cal. App. 4th at 1041 (duty is to avoid “actions that divert, dissipate, or unduly
risk corporate assets that might otherwise be used to pay creditor claims”) (emphasis in original).
176 Id. at 205.
177 Id.
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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
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that a Chapter 11 trustee running the business of a debtor may be subject to less court
oversight than a debtor-in-possession.182
A debtor-in-possession owes a fiduciary duty to all interested parties, creditors
and stockholders alike.183 The substance of these federal bankruptcy law fiduciary
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.184 The
debtor-in-possession has a duty of loyalty to “maximize the value of the estate,”185
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.”186
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 offi-
cers would 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.
182 See In re Lifeguard Industries, Inc., 37 B.R. 3, 17 (Bankr. S.D. Ohio 1983); In re Airlift Interna-
tional, 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).
183 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).
184 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).
185 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 352 (1985).
186 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).
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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
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 made
for the purpose of obtaining legal advice.189 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.”190 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 [or her] to give sound informed
advice.”191 Attorney-client privilege applies
to both oral and written confidential
communications provided for the purpose of
legal advice, either originating from the client
or from the lawyer in response to a client’s
inquiries.192 However, privilege protects only
communications, not the underlying facts communicated.193 In addition, attorney-client
privilege is generally inapplicable to the information the attorney receives from
independent non-client sources.
There are exceptions to the attorney-client privilege that result in otherwise priv-
ileged communications losing their privileged status. For example, in the context of a
derivative stockholder action, a claim of attorney-client privilege can also be defeated
upon a showing of “good cause,” as described below.194 The attorney-client privilege
189 8 JOHN H. WIGMORE, EVIDENCE §2290 (John T. McNaughton rev. ed., 1961).
190 Upjohn v. United States, 449 U.S. 383, 389 (1981).
191 Id. at 390.
192 Id. at 389.
193 Id. at 395.
194 Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970).
The privilege protects only the
communications between the client
and the lawyer, and not the under-
lying facts.
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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
Attorney-client privilege in the corporate context exists but can be 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 or other constituent of the corporation.
A lawyer representing a corporation must communicate with,
and receive direction from, the client through its officers,
directors and employees.196 Accordingly, “[a]n otherwise priv-
ileged communication by a lawyer to a corporate agent does
not lose its protected status simply because the agent then
conveys the attorney’s opinion to a corporate committee
charged with acting on such issues.”197 Over time, the state and
federal courts have developed the following three different
methods to determine whether certain communications are
considered privileged in the corporate context:
• Control Group Test. This test supports the idea that privilege in the corpo-
rate 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.198 As noted in the discussion of the
Upjohn test below, this test has been
criticized by Federal courts as too nar-
row199 and inadequate.200
• Subject Matter Test. The subject matter
test extends privilege to communications
with lower-level employees or corporate
agents, so long as the communication with legal counsel is related to the
subject matter of representation.201
196 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A
Jeremiad for Upjohn, 61 BUS. LAW. 95, 97 (2005).
197 Shriver v. Baskin-Robbins Ice Cream Co., 145 F.R.D. 112, 114 (D. Colo. 1992).
198 Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D. Pa. 1962).
199 Upjohn, 449 U.S. at 392.
200 Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 491 (7th Cir. 1970).
201 Id.; Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977).
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In general, when
dealing with a
corporation, the
privilege belongs
to the corpo-
ration. It cannot
be asserted by
officers or direc-
tors for their
personal benefit.
In the context of a corpo-
ration, the scope of the
attorney-client privilege may
be limited and may not
extend to all employees.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-112-2048.jpg)
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documents or materials that have been previously disclosed to a government agency.228
Selective waiver was recognized in Diversified v. Meredith when the court asserted
that the right to disclose investigative material to a federal agency should result in the
limited waiver of the attorney-client privilege for that purpose.229 However, selective
waiver is reviewed by courts on a case-by-case basis. Unlike in Diversified, many
courts have refused to recognize selective waiver of attorney-client privilege. For
example, in 2006 the court in In re Qwest Communications International Inc. Secu-
rities Litigation230 rejected Qwest’s assertion that thousands of documents in a class
action litigation were protected by the attorney-client privilege where it had previously
produced such documents to the SEC and the Department of Justice under con-
fidentiality agreements that provided for selective waiver during an investigation.
Crime-Fraud Exception
Attorney-client privilege does not apply to communications by a client with his or
her lawyer that further ongoing criminal activities. This is known as the crime-fraud
exception. The crime-fraud exception attempts to protect legitimate inquiries for legal
advice, without permitting clients to use their attorneys as
knowing or unknowing participants in ongoing criminal
activity. Most courts follow a two-pronged test to over-
come 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 or 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.231
228 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., 572 F.2d at 611.
229 Diversified Indus., Inc., 572 F.2d at 611.
230 450 F.3d 1179 (10th Cir. 2006).
231 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §82.
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The attorney-client
privilege may not be
used to shield dis-
closure of information
that is provided to
counsel as part of a
plan or scheme to
engage in wrongful or
illegal conduct.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-118-2048.jpg)
![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
PRIVILEGE VERSUS CONFIDENTIALITY
General
The attorney-client relationship alone does not create a presumption of con-
fidentiality. The client must intend that the communication with the attorney remain
confidential. If the client intended that the information be published or distributed to
others, the privilege will not apply.232
Maintaining Confidentiality
Most commonly, concerns regarding the
confidentiality of corporate attorney-client
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.233 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.”234
232 In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984).
233 Scott Paper Co. v. United States, 943 F. Supp. 489, 499 (1996); see also 1 JOHN K. VILLA,
CORPORATE COUNSEL GUIDELINES §1:12 (2007).
234 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §70(f) (2000). See also
United States v. Kovel, 296 F.2d 918 (1961).
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The attorney-client privilege is
only intended to protect dis-
closure of confidential
information. If the information
is not maintained in confidence,
the privilege will be lost as to
that information.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-119-2048.jpg)
![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
Work Product Doctrine
Similar to the doctrine of attorney-client privilege, the work product doctrine protects
the confidentiality of certain materials related to the legal representation of a client. 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.”240 Federal Rule of Civil
Procedure 26(b)(3), codifying the work product doctrine as it was set forth in Hickman v.
Taylor,241 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 antici-
pation 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
party seeking discovery has substantial need
of the materials in the preparation of the par-
ty’s case and that the party is unable without
undue hardship to obtain the substantial
equivalent of the materials by other means. In
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.”242
Recently, the Court of Appeals for the District of Columbia expanded the pro-
tections afforded by the work product doctrine, holding that (i) a document prepared
by an outside auditor “because of” the prospect of litigation was protected by the work
product doctrine, and (ii) there was no waiver of those protections when the company
shared certain work product with the outside auditor.243 The court reasoned that the
company had not disclosed the work-product to an adversary or a conduit to an adver-
sary since the outside auditor was not a potential adversary in the dispute at question
and the outside auditor had a duty of confidentiality to the company.
240 United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998).
241 329 U.S. 495 (1947).
242 Fed. R. Civ. P. 26(b)(3).
243 United States v. Deloitte LLP, 610 F.3d 129 (D.C. Cir. 2010) (Although the court found that the
work product doctrine had not been waived, the court noted that such voluntary disclosure did waive the
attorney-client privilege).
The work product doctrine is
designed to protect the attorney’s
drafts and notes that reflect the
attorney’s considerations and
strategies. It cannot be used to
shield facts from discovery.
107
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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
Holder Memorandum252
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
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.”253 Adhering to the suggestions
of the Holder Memorandum results in the corporation’s effective waiver of privileges
that may otherwise be available in a potential action, leaving the corporation vulner-
able.
Thompson Memorandum254
In January 2003, Deputy Attorney General Larry D. Thompson issued a revised
statement emphasizing changes to the ways in which the Department of Justice would
assess the authenticity of a corporation’s cooperation.255 “Too often business orga-
nizations, 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.”256 Like the Holder Memorandum, the Thompson Memorandum
urged voluntary disclosure, identification of culpable corporate agents, and waiver of
applicable privileges.257
252 Memorandum from Eric H. Holder, Deputy Attorney General, to Heads of Department Component
Heads and United States Attorneys (June 16, 1999), http://www.abanet.org/poladv/priorities/
privilegewaiver/ 1999jun16_privwaiv_dojholder.pdf.
253 Id.
254 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.
255 Horton, 61 BUS. LAW. at 116.
256 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.
257 Id.
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![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
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 con-
ducted 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 in part 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 fla-
grant disregard and disrespect for the corporate entity and its formalities, or the pres-
ence 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 sub-
sidiaries, individual stockholders (such as
sole or majority stockholders) are also
sometimes sued under this theory.
By asserting that a court should pierce
the corporate veil, a plaintiff is requesting
the court to ignore the separate existence of
a corporation, because of fraud or other
similar injustice, and hold the stockholders personally liable for any damages sustained
by the plaintiff. A Delaware court will uphold this request if it would be inequitable or
unfair not to do so. “[P]ersuading a Delaware court to disregard the corporate entity is
a difficult task,”283 and therefore corporate veil piercing is rarely successful.
Interpretations of the theory of piercing the corporate veil vary among the 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;
283 Harco Nat’l Ins. Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *10 (Del. Ch.
Sept. 19, 1989).
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When the corporate existence is
flagrantly disregarded or abused,
it is possible that the parent
corporation or substantial stock-
holders of a corporation may be
found to be liable for the actions of
the corporation under a theory
referred to as “piercing the corpo-
rate veil.”](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-151-2048.jpg)
![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
others have referred to an agency relationship between the two corporations; while still
others have referred to ‘piercing the corporate veil.’”284 This chapter introduces the
primary bases on which courts have relied to disregard the corporate form under Dela-
ware law, including fraud, instrumentality, alter ego, estoppel and agency.
FRAUD
Delaware courts have stated that “[f]raud has traditionally been a sufficient rea-
son to pierce the corporate veil.”285 Other related reasons for piercing the corporate
veil include “contravention of law or contract,” “public wrong,” and similar
injustices.286 In Gadsden v. Home
Preservation Company, Inc.,287 the
plaintiff sued the defendant corpo-
ration for failure to perform home
repairs pursuant to a contract. The
plaintiff obtained a judgment, but
was unable to enforce it because the
corporation had no assets. She
sought to pierce the corporate veil so
that she could enforce the judgment
against the defendant sole stock-
holder, who was also the sole direc-
tor and employee of the corporation.
The court held that the “business
practices of [the defendant] con-
stituted a fraud, contravention of
contract, and a public wrong” and found the sole stockholder liable for the judg-
ment.288 Several factors supported the court’s decision in the Gadsden case, including
the following facts:
• The defendant corporation had no funds in its bank account, and any money
that was placed there was quickly withdrawn by the stockholder;
284 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 839 (D. Del. 1978).
285 Harco Nat’l Ins., 1989 Del. Ch. LEXIS at *10.
286 Id.
287 Gadsden v. Home Preservation Co., Inc., No. 18888, 2004 Del. Ch. LEXIS 14, at *1 (Del. Ch.
Feb. 20, 2004).
288 Id. at *18.
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A court held a stockholder liable under a
fraud theory in a situation where:
• The corporation held no money in its
bank accounts;
• The stockholder withdrew all amounts
placed in the corporation’s bank
accounts;
• All assets used by the corporation
belonged to the stockholder;
• The stockholder always presumed that
he would be liable for the acts of the
corporation; and
• The plaintiff was an individual.](https://image.slidesharecdn.com/90048eff-72a6-4abd-9569-d448d9bb4bbf-161109002116/75/Fiduciary-Duties-and-Other-Responsibilities-Sixth-Edition-2016-152-2048.jpg)
![FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF
CORPORATE DIRECTORS AND OFFICERS
officers, and the parent exerted control over the subsidiary’s finances.309 The court
held that notwithstanding these “close ties,” the two companies had “many of the
indicia of separate corporate existence,” such as separate bank accounts and separate
contractual rights and obligations, and the evidence established that the parent lacked
total control over the subsidiary.310 The Third Circuit later indicated, however, that the
district court in Japan Petroleum Co. may have demanded too much of plaintiffs by
requiring a showing of “total” control, which is “not a prerequisite” to finding an
agency relationship under general principles of agency.311
VEIL PIERCING IN THE CONTEXT OF FIDUCIARY DUTY BREACH
The foregoing discussion focused on the circumstances in which a stockholder,
who may or may not be a director, could be found liable for the actions of a corpo-
ration. The concept of piercing the corporate veil can also surface in director liability
cases. For example, in Grace Brothers, Ltd. v. UniHolding Corp.,312 a court rejected
claims by defendant directors that they could not be liable for breach of fiduciary duty
in their capacity as directors of the parent in connection with acts of a subsidiary. The
court held that “[d]irectors of a parent board can breach their duty of loyalty if they
purposely cause – or knowingly fail to make efforts to stop – action by a wholly-
owned subsidiary that is adverse to the interests of the parent corporation and its
stockholders.”313 In reaching this decision, the court noted that one director was the
chairperson of the subsidiary and that all directors knew about the subsidiary’s chal-
lenged transaction and could have acted to cause the subsidiary to avoid the action.314
While Grace Brothers is not a traditional corporate veil piercing case, it demonstrates
how the doctrine may play a role in director liability cases and sets forth the
responsibilities directors have with regard to their subsidiary corporations.
309 Id. at 840-45.
310 Id.
311 Phoenix Canada Oil Co. v. Texaco, Inc., 842 F.2d 1466, 1477-78 (3d Cir. 1988).
312 No. 17617, 2000 Del. Ch. LEXIS 101, at *1 (Del. Ch. July 12, 2000).
313 Id. at *4.
314 Id at *35-*45.
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Fiduciary Duties and Other Responsibilities Sixth Edition 2016
- 1. Fiduciary Duties and OtherResponsibilities of Corporate Directors and Officers Sixth Edition Christopher M. Forrester Shearman & Sterling LLP Celeste S. Ferber, Esq. Foreword by John Buley Professor of the Practice of Finance Duke University Fuqua School of Business
- 3. FIDUCIARY DUTIES AND OTHERRESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Christopher M. Forrester Shearman & Sterling LLP Celeste S. Ferber, Esq. Foreword by John Buley Professor of the Practice of Finance Duke University Fuqua School of Business Sixth Edition
- 4. Copyright© 2008–2016 ChristopherM. Forrester & Celeste S. Ferber (No claim to original U.S. Government works) All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the authors. This publication reflects the views of its authors only and does not necessarily reflect the views of Shearman & Sterling LLP or any clients of any such firm. Because this pub- lication is intended to convey only general information, it may not be applicable in all sit- uations and should not be relied upon or acted upon as legal advice. It does not constitute legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a professional should be sought. Printed in the United States of America. RR DONNELLEY
- 5. About This Handbook ThisHandbook is designed to assist directors and officers of public and private corpo- rations 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 dis- cussion 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. corpo- rations. Given that a substantial 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 the authors or Shearman & Sterling LLP or any of the attorneys in that firm, and you should not rely on any of the information in this Handbook without consulting with your legal counsel as to your specific circumstances. This handbook was prepared and published as of March 2016 and does not reflect develop- ments or events occurring after that time. RR DONNELLEY
- 6. About the Authors ChristopherM. Forrester As a partner in Shearman & Sterling LLP, Christopher M. Forrester’s practice focuses on the representation of public and private companies and investment banks in general corporate and finance matters, with an emphasis on mergers, acquisitions and strategic transactions, public and private securities offerings and corporate governance and compliance. Celeste S. Ferber Celeste Ferber is former counsel in Shearman & Sterling LLP’s Capital Markets Group and now serves as Associate General Counsel of Aduro Biotech, Inc. Ms. Ferber has extensive experience representing issuers and underwriters in public and private securities offerings and on a broad range of transactional, securities and corporate governance matters. Contributing Authors The following Shearman & Sterling LLP partners provided assistance in the editorial process for this work: Robert Evans, Michael Kennedy, Patrick Robbins and Fredric Sosnick. The following Shearman & Sterling LLP associates provided substantial contributions to the preparation of this Sixth Edition of the Handbook: Antonio Herrera Cuevas, Chen Ye, Jeremy Cleveland, Nathan Mee, Patrick Fischer, Scott Lucas and Yian Huang. RR DONNELLEY
- 7. ABOUT RR DONNELLEYFINANCIAL SERVICES We file 160,000 client submissions annually with the SEC and produce critical documents for regulatory compliance and business transactions. As a Fortune 500 company with a 150-year history, our company’s 65,000 employees deliver solutions to 60,000 clients in 37 countries across all industries and stages of development. RR Donnelley Financial Services provides technology and expertise to help companies create, manage and deliver accurate and timely financial communications to shareholders, regulators, and investors. A single point of contact helps you stay on top of the dynamic regulatory landscape and manage the logistics of your critical financial communications. Of course, RR Donnelley adheres to strict security proto- cols to protect your sensitive data. Our expertise and scale complement our technology platform to deliver a compre- hensive yet flexible solution set. Conferencing Facilities Deal Management Solutions Venue® Virtual Data Rooms Venue® Contract Analytics Venue® Deal Sourcing Venue® Deal Marketing Disclosure Management Services EDGAR Filing Services Integrated Services Creative Design Services Translation Services Global Outsourcing Services Investor Communication Services Proxy Strategy & Design Services Online Enhanced Proxies & Web Hosting Annual Meeting Services Online Compliance Services RRD Active Disclosure™ Print Services XBRL Advisory Services Investment Markets Solutions For more information, visit: financial.rrd.com activedisclosure.com venue.rrd.com RR DONNELLEY
- 8. [THIS PAGE INTENTIONALLYLEFT BLANK]
- 9. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS TABLE OF CONTENTS Page FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv OVERVIEW OF THE HANDBOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi CHAPTER 1 MANAGING THE BUSINESS: THE ROLES OF DIRECTORS AND OFFICERS Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 The Interaction Among the Board, the Chief Executive Officer and the Other Officers . . . . 2 Board Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Appointment to Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Identifying the Constituents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Governing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Mitigating Liability Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 CHAPTER 2 GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OF DIRECTORS AND OFFICERS Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Determining the Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Duty of Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Duties of Loyalty and Good Faith . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Duty to Disclose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Entire Fairness Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Director Liability and Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 CHAPTER 3 FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESS COMBINATION TRANSACTION Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Board Considerations in any Business Combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Precautions in any Business Combination Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Revlon and a Sale of the Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Review of Directors’ Duties in the Context of a Potential Business Combination Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Unocal and Defending Against Hostile Takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Review of Directors’ Duties in the Context of Responding to a Hostile Takeover . . . . . . . . . 53 Special Case: Use of a Poison Pill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Special Case: Director Duties in the Face of Activist Stockholder Demands . . . . . . . . . . . . . 57 Review of Directors’ Duties in the Context of Responding to Activist Stockholder Demands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 CHAPTER 4 FIDUCIARY DUTIES IN THE CONTEXT OF A GOING PRIVATE TRANSACTION Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Standards of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 SEC Requirements and Scrutiny of Going Private Transactions . . . . . . . . . . . . . . . . . . . . . . . 71 i
- 10. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS TABLE OF CONTENTS Page CHAPTER 5 THE USE OF SPECIAL COMMITTEES Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Committee Composition: Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Committee’s Charge: Be Informed and Active . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 The Committee’s Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Legal Duties of Special Committee Members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Overview–When Should a Special Committee be Considered? . . . . . . . . . . . . . . . . . . . . . . . 80 Considerations in Determining Whether an Individual or Firm May be Viewed as Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 CHAPTER 6 FIDUCIARY DUTIES IN THE CONTEXT OF A DISSOLUTION OR INSOLVENCY Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Determining When a Corporation has Become Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Duties to Creditors When the Corporation is Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Duty of Loyalty Considerations in the Context of Insolvency—Delaware’s Rejection of Deepening Insolvency Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Duties During Bankruptcy Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Duties After Dissolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Things to Remember When Managing a Business on the Verge of Insolvency . . . . . . . . . . . 95 CHAPTER 7 ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXT Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Scope of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Invoking and Waiving Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Examples of Waiver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Privilege Versus Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Privilege in Derivative Suits and Class Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Privilege in Corporate Investigations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 CHAPTER 8 INDEMNIFICATION AND INSURANCE Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 Indemnification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 D&O Insurance Terms to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 CHAPTER 9 PERSONAL LIABILITY AND PIERCING THE CORPORATE VEIL Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Instrumentality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Alter Ego Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 Estoppel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 ii
- 11. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS TABLE OF CONTENTS Page Alternative Theory of Stockholder Liability: Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 Veil Piercing in the Context of Fiduciary Duty Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 CHAPTER 10 NONPROFIT ORGANIZATIONS Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 Managing the Business and the Roles of Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . 145 Fiduciary Duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 The Use of Committees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Attorney-Client Privilege in a Nonprofit Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Indemnification and Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Personal Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 iii
- 12. FOREWORD I am honoredto write the Introduction to the Sixth Edition of Fiduciary Duties and Other Responsibilities of Corporate Directors and Officers. I am grateful to my friends Chris Forrester and Celeste Ferber, and their colleagues at Shearman & Ster- ling for providing an accessible resource for managers, directors, investors and other lawyers. While a business practitioner, I often referred to prior editions of this book for its concise, comprehensive, jargon-free, practical guide to the roles of officers and direc- tors. This book’s lessons proved valuable in numerous business combinations, divest- itures, financings and insolvency and bankruptcy proceedings. As an academic, I better appreciate its utility in training current and future business leaders. Understanding the roles and duties of officers and directors to the corporation is critical; and under- standing the relationship between the corporation and its shareholders is increasingly important in the current business climate. It was not always so. Until the late 1980s, corporate governance in general and the role of officers and directors was not of great interest to academics, business pro- fessionals or all but very specialized lawyers. How times have changed. The merger waves of the past three decades, the lever- aged buyout boom, and the advent of poison pills and other defensive tactics have shined a spotlight on the duties and responsibilities of officers and directors to their companies and shareholders. Business practitioners read, “The business and affairs of every corpo- ration…shall be managed by or under the direction of a board of directors” but needed better understanding of that phrase in order to hold their positions and exercise their responsibilities. Directors and officers were well aware that they should “act in the best interests of the corporation,” but what exactly did that term mean? To some, the term meant exactly what it said. A few academics invented the phrase “maximizing share- holder value” in the short term despite long term or potential negative consequences to long-term interests of corporations, other stakeholders or long term shareholders. Scandals at Adelphia, Enron, WorldCom, Global Crossing, Tyco and others high- lighted the need for informed, knowledgeable business professionals who not only understand their businesses but who also understand the governance framework against which they are held accountable. Officers and directors of public and private companies sharpened their understanding of Delaware Corporate Law using prior edi- tions of this book, not to replace the need for legal advice but to understand the context in which legal advice is provided. A new federal law, Sarbanes-Oxley, was enacted to enhance governance and insert specific rules into the corporate governance so that such scandals, and the judicial rulings discussed in this book, would never again occur. iv RR DONNELLEY
- 13. It was notto be. The Global Financial Crisis of the next decade and failures of corporate governance at Bear Stearns, Lehman Brothers and many other financial institutions demonstrated (as if further demonstration was needed) that men and women engaged in business need to have basic legal principles in a single source as a reference tool to understand the context upon which their conduct and decisions would be judged. This book is also helpful in understanding the context of the legal advice provide by in-house and outside counsel. We do not know what the next decade will bring, but we do know that nearly all public company mergers and acquisitions result in litigation claiming officers and directors were not “acting in the best interests of the corporation.” We can expect that shareholders and activist investors will continue to fight “the battle for corporate con- trol” between shareholder democracy and Board of Director independence. We can also expect the next edition of this book to be longer. This book is written with a keen eye towards the needs of business practitioners, senior officers and directors, and persons advising the above. It is an important compi- lation of relevant, highly readable, indexed chapters on each of the issues facing corporate managers and directors and those who advise them. Corporate governance is important and a wealth of academic research demonstrates shareholders will pay a premium for shares of public companies with good corporate governance. To you, the reader, I offer the same advice I have given to hundreds of MBA students who have received this book—When air turbulence hits the plane at 35,000 feet, you know you should have listened to the safety instructions and read the safety card instead of checking email before the fasten seat belt sign came on. Just as you instinctively reach for the printed instructions in the seatback in front of you to figure out where the nearest exit may be, carry this book with you, even if you do not read it cover to cover. You never know when you will have to excuse yourself from a meeting to read the clear, specific, precise and practical guidance contained in this book. John Buley Professor of the Practice of Finance Duke University Fuqua School of Business January 2016 v RR DONNELLEY
- 14. OVERVIEW OF THEHANDBOOK 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 the 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 business judgment 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 busi- ness 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. Chapter 10 discusses fiduciary duties and other responsibilities of officers and directors of non-profit corporations generally. vi RR DONNELLEY
- 15. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS CHAPTER 1 MANAGING THE BUSINESS: THE ROLES OF DIRECTORS AND OFFICERS INTRODUCTION Corporate laws in the United States provide that the board of directors is respon- sible for the management of the corporation’s business and affairs. In managing the business and affairs of corporations, 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 officers who have actual and apparent authority to direct and control the daily activities of the business and the board of directors which has the ultimate responsibility for the corporation and the power and responsibility to supervise the officers. While the officers are 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 directors are not agents and generally can act only as a group. The directors are fiduciaries of the corporation and as a group have the ultimate power and authority over the manage- ment of the business through their ability to hire, supervise and replace the officers.1 In addition to having the responsibility to supervise and, if necessary, replace the officers, the board is charged by law with the power and responsibility to approve major corporate actions, such as issuing securities, entering into a merger, converting the business from a corporation to a limited liability company, partnership or other form, disposing of substantially all of the corporation’s assets or dissolving the corporation. Further, through their super- visory powers, boards frequently require the officers 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 Corpo- 1 8 Del. C. §141(a). The officers are charged with managing the day-to- day operations of the corporation while the board is responsible for the overall management of the corpo- ration and supervision of the officers. 1 RR DONNELLEY
- 16. FIDUCIARY DUTIES ANDOTHER 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, or in addition to, a president pursuant to bylaw provisions. It is important to note that each corporation may approach the roles of, and interaction between, man- agement 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 memo- rialized in the corporation’s charter, bylaws and corporate resolutions, as well as board practices, committee charters and meeting agendas. THE INTERACTION AMONG THE BOARD, THE CHIEF EXECUTIVE OFFICER AND THE OTHER OFFICERS In general, most boards seek to fulfill their obligation to supervise the managers primarily by consulting with the corporation’s most senior officer (usually the chief executive officer) on major decisions affecting the business, and reviewing, guiding 2 See, e.g., 8 Del. C. §§151-52, 251-66, 271-85. 3 8 Del. C. §142. 4 See, e.g., 8 Del. C. §142. Although the board ultimately supervises the activities of all of the officers in managing the business, typically the chief executive officer reports directly to the board, and the other “C-level” officers, including the chief operating and chief financial officers, and vice presidents, report to the chief executive officer. 2 RR DONNELLEY
- 17. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS and ultimately supervising the performance of the chief executive officer. The chief executive officer, in turn, generally is charged with the power and authority to super- vise the other officers, who 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 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 perform- ance of those officers. Beyond the chief executive officer, typical officer positions and their general responsibilities are as follows: • President. The president is responsible for the supervision of the other officers and the day-to-day management of the business. If an organization does not have a separate chief executive officer, then the president is generally the most senior position in the organization. If an organization has both a chief executive officer and a president, those officers generally work very closely to supervise the other officers and manage day-to-day operation of the business. • Secretary. The secretary is the person respon- sible 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 the corpo- ration’s legal counsel is sometimes charged with preparing the initial draft of the minutes. As the official keeper of the books and records, the secretary generally is responsible for certifying the accuracy of corporate documents to third parties, for example, banks or financing sources. In many companies, this position is held by the General Counsel. • Treasurer. The treasurer is generally the most senior financial position in the corporation, although companies often use the title chief financial officer as the most senior level financial position. The treasurer is charged with main- taining the corporation’s finances as well as supervising the accounting functions of the business. In larger companies, it is common not only to have 5 8 Del. C. §142(a). 3 RR DONNELLEY Officer positions and responsibilities are generally established by the corporation’s bylaws and the board is free, to a large degree, to customize those positions under Delaware law.
- 18. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS a chief financial officer who 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. • Vice President. Vice presidents can be appointed to oversee specific busi- ness functions, such as sales, marketing, research and development, human resources, information technology or finance. 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) other offi- cers 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 posi- tions 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 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 non- executive officers, with executive officers being viewed as the primary corporate officers while the non-executive officers are considered a class of junior officers without the same powers or responsibilities. As noted above, 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 non-management directors are not officers and therefore cannot act to bind the corporation, in some states by law, the chairperson of the board also is specifically designated as an officer position.6 Also, many companies specifically create an office of the Executive Chairman in their bylaws, in which case the Executive Chairman typically is designated an officer. Executive Chair positions may be created to separate the CEO and Chairman role, to allow for support of a CEO by a strong Executive Chair, or for other reasons in the discretion of the board. To ascertain whether the chairperson of a particular corporation is or is not an officer, and to understand that officer’s powers and authority, one must consult the bylaws of the corpo- ration and resolutions of the board. 6 See, e.g., Cal. Corp. Code §312. 4 RR DONNELLEY
- 19. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS BOARD DYNAMICS Just as a president or chief executive officer is responsible for the daily manage- ment of the business, the chairperson of the board is generally responsible for manag- ing 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 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). Notice of meet- ings may always be waived by directors at any time either in writing or by their presence at a meeting. The agenda for meetings and support- ing 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 one third of the total number of directors); in the absence of a specific quorum requirement, the DGCL provides a default rule of not less than a majority of the board members.7 Once a board meeting is duly convened and a quorum is present, in the absence of a specific provision in the bylaws otherwise, the vote of a majority of the directors present and voting at the meet- ing will be 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 written consent, which must be signed or electronically consented to by all directors. Unanimous written consents are not effective until all signatures or electronic consents have been obtained.9 7 8 Del. C. §141(b). 8 Id. 9 8 Del. C. §141(f). However, in the case of publicly listed companies, in many cases specific actions must be approved by a majority of the board’s “independent” directors or a committee comprised solely of independent directors. In these cases, the definitions of independence are specified by rules of the U.S. Securities and Exchange Commission or the stock exchange on which such Company’s shares are listed. The chairperson of the board is generally responsible for managing the affairs of the board, including calling meet- ings and setting agendas. 5 RR DONNELLEY
- 20. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Not infrequently board members may speak of having the power to vote by proxy. Unlike stockholders, however, board members cannot vote by proxy.10 The essence of the board’s effectiveness is its ability to engage in meaningful discussions and deliberations where all members of the board can express their views and debate the potential risks and benefits of a particular course of action. 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 contrary to the concept of a robust board deliberation. Extra care should used to 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 meet- ings is underscored by the fact that the rules and regu- lations of the U.S. Securities and Exchange Commission (“SEC”) require that reporting companies under the Secu- rities Exchange Act of 1934 (the “Exchange Act”) dis- close if directors have failed to attend 75% of board and committee meetings.11 In addition to acting as a whole, many boards designate (and in fact, public corpo- ration boards are required to designate) one or more committees or sub-committees. The most notable examples of this are the audit committee and the compensation committee. The rules of the SEC and the listing rules of the national securities exchanges, such as the New York Stock Exchange and The Nasdaq Stock Market, specifically require that reporting companies whose stock is listed on a national secu- rities exchange maintain an audit committee and a compensation committee, each composed entirely of “independent directors.”12 Independent directors are defined as directors who, among other things, do not receive compensation from the company other than in their role as a director, are not part of management and who do not otherwise have a role or relationship with the corporation that has the potential of 10 In re Acadia Dairies, Inc., 15 Del. Ch. 248 (1927). This rule is commonly misunderstood because some jurisdictions, such as the Cayman Islands, do permit directors to vote by proxy. 11 17 C.F.R. 229.407; 17 C.F.R. 240.10A; see Commission Guidance on The Use of Company Web- sites, Release Nos. 34-58288 (Aug. 1, 2008). 12 Nasdaq Listing Rule 5605; NYSE Listing Rules 303A.05 and 303A.06; see also 17 C.F.R. 240.10A- 3 and 17 C.F.R. 240.10C-1. Attendance at board meetings is critically important and board members may not act by proxy. 6 RR DONNELLEY
- 21. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 7 RR DONNELLEY The rules of the SEC and the list- ing rules of the national securities exchanges, require a board to have an audit committee com- posed of independent directors and that includes a designated “audit committee financial expert.” The listing rules of the national securities exchanges require that a board have a nominating committee and compensation committee composed of independent directors. creating any conflict of interest. In addition, members of a public company’s audit committee are expected, through formal education or experience, to have enhanced skills in reading and understanding financial statements and in accounting matters generally. The audit committee is charged with approving the corporation’s auditors, super- vising the chief accounting officer of the corporation in the preparation of the corpo- ration’s financial statements, monitoring complaints by employees regarding financial matters, and other important financial and accounting-related matters.13 The compensation committee is charged with establishing and reviewing the compensation policies and procedures for the senior officers, as well as administer- ing 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 appro- vals under the Internal Revenue Code neces- sary to make certain of the corporation’s compensation payments tax-deductible. In addition, many companies utilize a nominat- ing and/or corporate governance committee to help manage the affairs of the corporation (the national securities exchanges also require independent oversight of director nomi- nations – either through a formal committee, or approval of the independent members of the board). Nominating committees generally evaluate directors’ performance and interview and nominate director candidates for board and stockholder consideration. Boards may also delegate other duties and functions to committees of the board, with certain limitations specified in the DGCL. 13 Id.; see also 15 U.S.C.S. §78j-m.
- 22. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 back to the board on the business of the committee. Though directors who serve on one or more committees or as a chairperson of the board or a committee take on additional responsibilities in those roles, they are subject to the same fiduciary duties 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 pro- hibited 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. Nominees for director can be made by any shareholder or by the board of directors. Public companies generally do not include directors nominated by shareholders in the proxy materials that are prepared and filed with the SEC. Given that many share- holders vote in advance of the meeting by proxy, the fact that the director nominees of shareholders are not included in the proxy materials can effectively preclude such nominees from having a meaningful opportunity to be elected. In an effort to modify this trend, in August 2010, the SEC modified the proxy rules to adopt new Rule 14a-11 to require, among other things, that a company include in its annual proxy statement the names of directors nominated by shareholders who have held shares for at least three years and who hold at least three percent of the company’s outstanding common stock. Rule 14a-11, however, was vacated in 2011 by a federal court that found the SEC had exceeded its authority (although Rule 14a-8 remains and provides 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 is not intended to place additional liability on the individual designated. 17 C.F.R. 229.407(d)(5)(iv)(B). 15 8 Del. C. §211(b). Being designated as the “audit committee finan- cial expert” is not intended to place addi- tional liability on the individual designated. 8 RR DONNELLEY
- 23. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS shareholders some ability to influence matters included in proxy statements).16 The concept has nonetheless been picked up by shareholders and shareholder rights groups, and currently many public companies are being pressured to implement, and some are implementing, policies and procedures that permit shareholder nominees to be included in company proxy materials even though they are not required to do so by law. Even if proxy access rules become operative, a company may still require stock- holders to give advance notice of their intention to propose nominees for director by an appropriate bylaw provision. 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 con- sent of stockholders, if applicable, will be elected to office. Recently, many public companies have modified their charters to require that directors must actually receive a majority of the outstanding votes, or at least a majority of the shares voted at the meet- ing to be elected or, alternatively, if a director receives fewer votes for reelection than withheld votes, the director must submit a resignation for consideration by the board. Although the default rule under Dela- ware law is that directors hold office for one-year terms, the DGCL permits the strat- ification of a board into classes, with each class having a term that expires in succes- sive years.17 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 16 Business Roundtable and Chamber of Commerce of the United States of America v. Securities & Exchange Commission (D.C. July 22, 2011). 17 8 Del. C. §§141(d), 211. Although the default rule under the DGCL is that directors who receive a vote of the plurality of the shares voted (i.e., the most) are elected to office, in response to shareholder pressure, some public corporations have modified their bylaws to specifically require that directors must receive a specified minimum number of shares approving their candidacy before they will be elected. 9 RR DONNELLEY
- 24. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS that 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.18 Many boards feel, and rightly so, that to effectively discharge their duties to manage the business and affairs of the corporation, they should regularly evaluate, counsel and supervise the entire manage- ment team to some degree. For this reason, although a board may delegate the management and performance review of the subordinate 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 oper- ations officer, president and vice presidents. 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, ven- dors, creditors (and bondholders), contract counterparties, customers, communities, society 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 manage- ment 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 ques- tion: a corporation’s board and management owe a fiduciary duty as their primary obliga- tion, above all others, to the stockholders, to maximize the value of the equity of the corpo- ration.19 Fiduciary duty is a core legal concept, perhaps the most fundamental legal concept that underlies the manner in which U.S. corpo- rations are managed. A fiduciary owes an 18 8 Del. C. §142. 19 There is increasing support in the public and various state legislatures for new corporate forms that allow or require directors to consider the interests of constituencies other than shareholders, such as their employees, communities and the natural environment, in making decisions. In a solvent business, directors and officers of a Delaware corporation are bound by a fiduciary duty to manage the business to maximize the inter- ests of the stockholders first and foremost. 10 RR DONNELLEY
- 25. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS utmost duty of care, candor and confidence to its constituent. A fiduciary must act with a high standard of care with respect to its constituent and must avoid conflicts of inter- ests, including taking actions that would advantage the fiduciary to the disadvantage of the constituent. Directors and officers of a solvent corporation are fiduciaries of the common 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, 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 will result in building the business for the stockholders, so that the interests of constituents are aligned. Unfortunately, as business conditions change, boards and officers 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 damag- ing 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 or may otherwise affect the status of employ- ees. 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 stock- holders. 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 interests of the stockholders to protecting the interests of the The duties of the board shift from stockholders to creditors when a business becomes insolvent. 11 RR DONNELLEY
- 26. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS corporation’s creditors. These situations present boards and officers with some of the most difficult decisions they face. The specific and complicated duties and demands placed on boards and officers 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 manag- ing a corporation. Directors and officers 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 complicated contractual obli- gations with third-party insurers and administrators. Some states, such as California, seek to impose their corporate laws on corpo- rations domiciled in other states but that engage in substantial business activities in the concerned state.20 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, antitrust, dis- ability, 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. 20 See, e.g., Cal. Corp. Code §2115. 12 RR DONNELLEY
- 27. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Beyond the realm of statutes, regulations, ordinances and court decisions, there are also industry standards and guidelines that have a substantial impact on a corpo- ration. The books and records of a U.S. corporation typically must comply with Gen- erally Accepted Accounting Principles or GAAP. Further, many corporations doing business outside the United States must also maintain their books and records in accordance with International Financial Reporting Standards or other local require- ments, and transactions between U.S. corporations and foreign investors or entities may be subject to national security scrutiny. 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 that go beyond what is required. MITIGATING LIABILITY CONCERNS Directors and officers face the tough challenge of navigating a path to profit- ability 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. For- tunately, there are several protections that have developed to provide directors and officers with some assurance that their decisions will be respected in the future. 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 deci- sions 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, much of this Handbook is devoted to discussing the applicability of the business judgment rule to various sit- uations. 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 sev- eral further chapters. 13 RR DONNELLEY
- 28. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Additional protections potentially available for directors and officers include cer- tificate 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 protections are also discussed in greater detail in Chapter 8 of this Handbook. 14 RR DONNELLEY
- 29. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 generally are best situated to make difficult decisions that affect the rights of stockholders, and provides strong deference to the integrity of those deci- sions in the face of claims of malfeasance or negligence.21 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 their actions on behalf of the corporation. DETERMINING THE STANDARD OF REVIEW Generally, so long as directors and officers comply with their basic fiduciary duties – the duty of care and the duty of loyalty – they are entitled to the protections of the business judgment rule.22 The business judgment rule provides that directors’ and officers’ decisions are “presumed to have been made on an informed basis, in 21 The business judgment rule historically has protected the actions and decisions of directors and, while Delaware courts and commentators had extended the protections to officers as well by implication, no Delaware court decision had explicitly confirmed the application to officers until recently. In 2009, the Supreme Court of Delaware explicitly extended the scope of the business judgment rule to encompass the actions and decisions of corporate officers. Gantler v. Stephens, 965 A.2d 695, 708-09 (Del. Sup. 2009) (“In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as directors. We now explicitly so hold.”). Although corporate officers will receive the protection of the business judgment rule, if they breach their fiduciary duties, the consequences of the breach will not necessarily be the same as for direc- tors. Under 8 Del. C. § 102(b)(7), a corporation may adopt a provision in its certificate of incorporation exculpating its directors from monetary liability for an adjudicated breach of their duty of care. Although legislatively possible, there currently is no statutory provision authorizing comparable exculpation of corporate officers. 22 Some commentators describe fiduciary duties as three separate duties – the duties of care, loyalty and good faith, although the Delaware courts have now clarified that there are 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). The business judgment rule presumes that direc- tors acted on an informed basis, in good faith and with the best interests of the corporation in mind. 15 RR DONNELLEY
- 30. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS good faith and in the honest belief that the action taken was in the best interests of the corporation.”23 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. Rather, the plaintiff will have the burden of rebutting the presumption and estab- lishing that a fiduciary duty was breached. This requires the plaintiff to produce evi- dence and persuade the court that the evidence demonstrates that the board members or officers 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 the con- stituents to whom a duty was owed. The entire fairness standard is a much more exact- ing standard requiring the directors and officers to demonstrate fair price and fair dealing, as discussed in detail on page 32 under the caption “Entire Fairness Review.”24 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, such as when: • The subject transaction or challenged decision involves interested directors or stockholders;25 • 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 trans- action involving a break-up or sale after receiving a takeover offer; • An unsolicited third-party bid is received after a transaction with respect to the company has been announced; or 23 Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1341 (Del. 1987). 24 Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983). 25 See, e.g., Marciano v. Nakash, 535 A.2d 400, 405 n3 (Del.1987); see also In re Southern Peru Cop- per Corporation Shareholder Derivative Litigation, 30 A.3d 60 (Del. Ch. 2011). 16 RR DONNELLEY
- 31. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • 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. In these instances, courts may impose a more rigorous standard which may require the directors to demonstrate the entire fairness of their actions to the stock- holders, or courts may apply the heightened review standard 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 generally are described as consisting of two separate duties – the duty of care and the duty of loyalty – some commentators also consider the duty of good faith and fair dealing to be a separate duty. However, other commentators and the Delaware courts consider the duty of good faith and fair dealing to be a subset of the duty of loyalty. Nevertheless, courts often 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 extent appropriate: • Obtain and consider all relevant information; • Take time to evaluate corporate actions; • Consider the advice of experts; • 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 con- trols; The duty of care requires directors to fully inform them- selves and deliberate carefully before making corporate decisions. 17 RR DONNELLEY
- 32. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Review and monitor the performance of the chief executive and other senior officers; • Remain informed about the corporation’s operations, performance and chal- lenges; and • Implement and monitor reporting and information systems to check for fail- ures to comply with laws and regulations. Breaches of the duty of care typically are 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, such as failing to review or discuss board materials, act with reckless indifference to stockholder con- cerns or act in a manner that is completely irrational with respect to their decision- making process.26 Consider, for example, several prominent cases: • Breach of Duty of Care Where Directors Take Substantially No Actions to Inform Themselves Regarding a Potential Merger. In Smith v. Van Gor- kom, the court found that the directors breached their duty of care in approv- ing 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 dead- line 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 determi- nation of the purchase price.27 26 Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985). 27 Id. 18 RR DONNELLEY
- 33. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • No Breach of Duty of Care Where Directors Approved a Substantial Sev- erance 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 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 failing to inform themselves of the estimated severance payments for each year of employment and fail- ing to confer with the compensation expert who had assisted in preparing compensation figures for the president. The court determined that the direc- tors 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.28 • 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 Litigation,29 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.30 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.31 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.32 The court determined that, had it been presented with the question, it would not have found the Caremark 28 906 A.2d 27 (Del. 2006). 29 698 A.2d 959 (Del. Ch. 1996). 30 Id. at 961-62. 31 Id. at 971. 32 Id. at 970. 19 RR DONNELLEY
- 34. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS directors liable because they did not and had no reason to know of the viola- tions and had systems in place to check for violations.33 Further, as noted above, courts increasingly are finding that sufficiently egregious breaches of the duty of care may also constitute a breach of the duty of loyalty: • Breach of Duty of Loyalty (as Opposed to Just Duty of Care) Where Direc- tors Fail to Install and Monitor Systems to Police Legal Compliance. In Stone v. Ritter,34 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 oper- ations.35 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 com- pliance system because such failure constituted a failure to act in good faith.36 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. • Potential Breach of Duty of Good Faith When Directors Were Given Sufficient Notice of Safety Violations and Failed to Act. In In re Abbott Labs Derivative Shareholders Litigation, the court found facts sufficient to establish a breach of good faith when the FDA repeatedly served notices of safety violations over a six-year period and the directors took no steps to remedy the violations, resulting in large monetary losses to the company. The court determined that, due to a set of facts indicating their awareness of the problem, the board’s inaction appeared to be intentional and, con- sequently, the directors’ decisions were not made in good faith.37 These find- ings were made in connection with the denial of a motion to dismiss, and this matter was settled prior to a full evaluation of the facts in a trial. 33 Id. at 971-72. 34 911 A.2d 362 (Del. 2006). 35 Id. at 370. 36 Id. at 373. 37 325 F.3d 795 (7th Cir. 2003). 20 RR DONNELLEY
- 35. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Breach of Duty of Loyalty Where Directors Abdicated Responsibilities to Management and Engaged in Rush Sale of Business. In the case In re Bridgeport Holdings, Inc., directors were held to have breached their duty of loy- alty by abdicating crucial decision-making authority in the sale of the company to an officer of the company, fail- ing 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.38 Reliance on Experts In discharging the duty of care, directors and officers often are 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.39 How- ever, 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. Accordingly, 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 38 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008). 39 8 Del. C. §141(e). In considering an expert’s findings, directors should probe and test an expert’s assumptions, analysis and conclusions. 21 RR DONNELLEY The decisions in Caremark, Stone, Abbott Labs and Bridgeport suggest that if directors have failed to act in good faith in adhering to their duty of care obligations, they may also have violated their duty of loyalty and have personal liability for which indemnification is not available.
- 36. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS based on the success of a transaction may not be able to deliver an unbiased opinion.40 Finally, directors must not blindly rely on experts’ findings. Directors should probe and test an expert’s assumptions, analysis and conclusions and should probe any con- flicts the expert may have. DUTIES OF LOYALTY AND GOOD FAITH The Duty of Loyalty Directors owe a fiduciary duty of loyalty to the corporation and to its stock- holders. 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 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 stock- holders. “Essentially the duty of loyalty mandates that the best interest of the corporation and its share- holders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the shareholders generally.”41 Duty of loyalty issues can arise in various contexts, including: • A conflict of interest – where any director or officer has an interest in a trans- action contemplated by the corporation; 40 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 completion of the transaction. Fairness opinion fees generally are bifurcated so that the fee for the opinion is payable regardless of whether a transaction proceeds. Furthermore, if a board is aware that a financial advisor may also benefit from fees related to financing an acquisition, careful con- sideration should be given to any conflict of interest, and thus whether reliance on that financial advisor as an expert is reasonable. See In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL (Del. Ch. March 7, 2014). 41 Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993). 22 RR DONNELLEY The duty of loyalty requires directors to put the corporation’s interests above their personal interests in evaluating opportunities.
- 37. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Misappropriation of corporate opportunities – where a director or officer exploits an opportunity that should have been made available to the corpo- ration; • Competition with the corporation – where the director or officer is compet- ing with the corporation without the express informed consent of the disin- terested directors or stockholders; • Misappropriation of corporate assets – where corporate assets or information are used by an officer or director for non-corporate purposes; and • 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. Unlike the duty of care, liability for breaches of the duty of loyalty cannot be limited by the corporation’s certificate of incorporation, and directors and officers may also not have access to contractual indemnification for breaches of the duty of loyalty that involve bad faith.42 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 “interests” most commonly exist when a director has a material economic interest in a particular transaction or decision, such as when a director has a financial stake in another party with whom the corporation is seeking to do business, when a 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 42 8 Del. C. §102(b)(7). One of the most fertile grounds for breach of fidu- ciary duty claims are instances in which directors have a potential conflict of interest, and thus their duty of loyalty is implicated. 23 RR DONNELLEY
- 38. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 trans- actions are not inherently detrimental to a corporation. As long as a transaction is fair to the corporation, no protected confidences are betrayed, and there is not a mis- appropriation 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 . . . there must be evidence of disloyalty. Examples of such misconduct include, but cer- tainly 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.”43 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 reduces 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 neu- tralize duty of loyalty issues, the independent decision-maker must be fully informed of the conflict of interest as well as the terms of the corporate action and must act in good faith.44 Boards commonly uti- lize disinterested director approval mechanisms or special committees comprised of disinterested and 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 func- tioning 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 demon- strate that a challenged transaction was “entirely fair” to the corporation and its stock- 43 Cede, 634 A.2d at 363. 44 8 Del. C. §144. 24 RR DONNELLEY Duty of loyalty concerns can often be mitigated by obtaining approval of disinterested directors or stockholders of a subject transaction.
- 39. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS holders.45 However, entire fairness can be difficult, time-consuming and costly to establish, as discussed in detail later 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 oppor- tunities 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 com- pete 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 opportunity issues also arise where an officer or director has personal business inter- ests that compete with the corporation’s 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? In general, a corporate opportunity exists, and a corporate officer or director is prohibited from taking such business opportunity for his or her own without first offer- ing it to the corporation, if: • The corporation has an interest or expectancy in the opportunity; • The corporation is financially able to exploit the opportunity; • The opportunity is within the corporation’s line of business; and • By taking the opportunity for his or her own, the corporate fiduciary will thereby be placed in a position contrary to his or her duties to the corpo- ration. 45 Id. 25 RR DONNELLEY
- 40. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS The corollary to this rule is that a director or officer may generally take a corpo- rate 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.46 Of course, the safest course of action with respect to a transaction involving a potential conflict over a corporate opportunity is approval of the subject transaction by the disinterested directors or stockholders after the full disclosure of its terms. Mitigating Corporate Opportunity Issues Corporations employ a wide range of practices to mitigate the risk of corporate opportunity issues. Some alternatives include: • 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 mem- bers of the board of directors of each entity from bringing to the other oppor- tunities 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 46 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). 26 RR DONNELLEY Many corporations build extensive guidelines into their employee conduct codes in an effort to avoid potential conflicts of interest and corporate opportunity issues with their executives and directors.
- 41. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 busi- nesses; 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 offi- cer, 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 con- flicts to the boards of directors of the corporation and the competing entity. 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.47 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 oper- ating 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;48 • A transaction was authorized for pur- poses other than to advance corporate welfare and in violation of applicable laws;49 47 Guth, 5 A.2d at 509; Stone v. Ritter, 911 A.2d 362 (Del. 2006). 48 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). 49 Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 n.2 (Del. Ch. 1996). 27 RR DONNELLEY The duty of good faith is a subset of the duty of loyalty. Duty of good faith violations may occur when directors blatantly disregard their duty to act in the best interests of the corporation and its stockholders.
- 42. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • A director’s decision was primarily motivated by personal interest and not the best interests of the corporation;50 • Actions were consciously taken with a dishonest purpose or moral obliq- uity;51 and • Directors failed to prevent waste or self-dealing by another director or corpo- rate officer.52 There was some ambiguity surrounding the duty of good faith, including some confusion regarding whether the duty of good faith is an independent duty or an ele- ment of the duty of loyalty. Two Delaware Supreme Court cases settled the issue. In In re Walt Disney Co. Derivative Litigation,53 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).54 • Category 2 – Grossly negligent conduct, without more.55 • Category 3 – The fiduciary intentionally acts with bad faith dereliction of duty, a conscious disregard for one’s responsibilities.56 For example, the fiduciary acts with a purpose other than 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.57 50 Washington Bancorp. v. Said, 812 F. Supp. 1256, 1269 (D.D.C. 1993). 51 Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1208 n.16 (Del. 1993). 52 In re Nat’l Century Fin. Enter. Inv. Litig., 504 F. Supp. 2d 287, 313 (S.D. Ohio 2007). 53 906 A.2d 27 (Del. 2006). 54 Id. at 64. 55 Id. 56 Id. at 66. 57 Id. at 67. 28 RR DONNELLEY
- 43. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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.58 Following the 2006 Disney decision, the Delaware Supreme Court again addressed the duty of good faith in Stone v. Ritter.59 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.”60 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.61 • No Breach of Fiduciary Duty for Losses Due Solely to Errors in Judg- ment. 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. 58 Id. at 64. 59 911 A.2d 362 (Del. 2006). 60 Id. at 370. 61 683 A.2d 1049 (Del. Ch. 1996). 29 RR DONNELLEY
- 44. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Errors in judgment, without more, were not sufficient grounds for judicial interference.62 • 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 made an illegal campaign contribution in violation of federal law. The business judgment rule does not insulate directors from liability after they knowingly commit illegal activities.63 • Breach of Duty of Loyalty Where Directors Abdicated Responsibilities to Management and Engaged in Rush Sale of Business. In the case In re Bridgeport Holdings, Inc., the 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.64 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 viewed as a subset of the duty of care and does not stand 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.”65 Today, if considering an action or decision that might raise duty of loyalty considerations, directors are advised to demonstrate their good faith 62 383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976). 63 507 F.2d 759 (3d Cir. 1974). 64 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008). 65 In re ML/EQ Real Estate Partnership Litigation, No. 15741, 1999 Del. Ch. LEXIS 238 (Del. Ch. Dec. 20, 1999). 30 RR DONNELLEY
- 45. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS (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 and loyalty, corporate directors also have a duty of disclosure, sometimes referred to as the duty of candor.66 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 or failing to make a disclosure, the violation also implicates the duty of loyalty.67 When directors do seek to make a disclosure, such as in seeking stockholder approval, Delaware courts have held that they need to “disclose fully and fairly all material information within the board’s control.”68 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.”69 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 reason- able 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.70 66 Malone v. Brincat, 722 A.2d 5, 11 (Del. 1998). 67 In re Tyson Foods, Inc. Consol. Shareholder Litigation, 919 A.2d 563, 597-98 (Del. Ch. 2007). 68 Malone, 722 A.2d at 10 (Del. 1998). 69 Id. 70 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). 31 RR DONNELLEY
- 46. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS ENTIRE FAIRNESS REVIEW Overview In situations where the presumption of the business judgment rule is not avail- able, directors will be required to establish the entire fairness of the transaction or decision in question. When engaging in an entire fairness review, a court will determine whether the transaction or decision is entirely fair to stockholders and should therefore be upheld, notwithstanding any deficiencies on the part of the board.71 This standard of review is rigorous and the board bears the burden of not only provid- ing the evidence to the court but also persuading the court that the evidence demon- strates that the directors have met their burden. The practical implication of a rebuttal of the business judgment rule is that the chances that a transaction may be set aside are greatly increased. As a result, it is of the utmost importance that boards 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 disin- terested directors through a properly formed, empowered and functioning committee and disinterested stockholders.72 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 would 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 71 See, e.g., Citron v. E.I. Du Pont de Nemours & Company, et al., 584 A.2d 490 (1990). 72 See, e.g., In re S. Peru Copper Corp. S’holder Derivative Litig., 30 A.3d 60 (Del. Ch. 2011). 32 RR DONNELLEY The entire fairness test requires directors to produce evidence that demonstrates that the subject transaction was the product of fair dealing and produced a fair price for the stockholders.
- 47. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS (who would then be required to demonstrate that the transaction was not entirely fair).73 A shift in who bears the burden of proof has a significant impact on both the cost and difficulty of litigation, as well as the probability of success. Additionally, in certain circumstances, approval by an independent committee of the board and disin- terested stockholders may result in the application of the business judgment rule as discussed in greater detail in Chapter 4 below. Fair Dealing and Fair Price 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.74 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. 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, Dela- ware courts will consider, in particular: • 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? 73 See Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983); Kahn v. Lynch Comm. Sys., Inc., 638 A.2d 1110 (Del. 1994). 74 Id. at 711. 33 RR DONNELLEY
- 48. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • The quality of the result the board achieved – for example: O On balance was the end result fair 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.75 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 buyer 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.76 In considering that price, directors may consider the eco- nomic and financial considerations of the proposed merger, including all relevant fac- tors: assets, market value, earnings, future prospects and any other elements that affect the intrinsic or inherent value of a company’s stock. 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 corpo- ration 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 mis- conduct or a knowing violation of law; 75 See Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1140 (Del. Ch. 1994), aff’d, 663 A.2d 1156 (Del. 1995). 76 Id. at 1143. 34 RR DONNELLEY
- 49. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Unlawful dividends, stock purchases and redemptions by the corporation; or • Any transaction from which the director derived an improper personal bene- fit.77 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 both publicly and privately held corporations commonly include such provisions in their certificates of incorporation. 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. 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.78 If the breach that triggered application of the entire fairness standard was a breach of the duty of care, provisions in a corporation’s certificate of incorporation eliminating or limiting the personal liability of directors for breaches of this fiduciary duty likely would shield directors from personal liability.79 However, as noted above, a breach of the duty of loyalty or the related duty of good faith may not be eligible for these protections.80 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 77 8 Del. C. §102(b)(7). 78 Cinerama, 663 A.2d at 1164. 79 See 8 Del. C. §102(b)(7). 80 See id. 35 RR DONNELLEY A director who has been found to have breached his duty of loyalty or good faith may not be entitled to exculpation or indemnification from the corporation under Delaware law.
- 50. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS favor of directors may be limited when they breach their duties of good faith and loy- alty. 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. 36 RR DONNELLEY
- 51. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS CHAPTER 3 FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESS COMBINATION TRANSACTION INTRODUCTION Generally, when a board of directors is presented with a potential business combi- nation, 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, in such a situation, directors are advised to take a number of steps to best posi- tion themselves to receive the benefit of the business judgment rule. • First, directors should diligently inquire with all parties as to any relation- ships with potential counterparties so as to ensure that any facts that give rise to potential duty of loyalty considerations are identified and mitigated or eliminated. • Second, directors should collect as much relevant information regarding the poten- tial transaction as reasonably possible, review the information carefully, and seek the advice of experts, including lawyers, bankers and accountants, as appropriate, to ensure that the directors have a com- plete understanding of the transaction. • Third, directors should investigate, to a reasonable extent, the information provided to the directors and any related underlying assumptions. Although directors are permitted to rely on information provided to them by management and out- side advisors, they cannot do so blindly and will be expected to have, at a minimum, probed and tested such information to give themselves a level of comfort and assurance as to its accuracy, veracity and completeness. • Fourth, directors should consider carefully the options available to the corpo- ration and openly deliberate among themselves the merits of the potential When faced with a poten- tial 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. 37 RR DONNELLEY
- 52. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS transaction. 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 directors 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 subject transaction, including the directors’ decision-making process with respect thereto. Specifically: • Under certain circumstances directors may be required to demonstrate the entire fairness of the transaction to the stockholders; • When a board of directors determines to sell or break-up a corporation, the decision of the directors will be evaluated under the Revlon standard;81 and • When defending against a threatened or proposed change in control of the corporation, directors’ actions may be reviewed against the standard set forth in the Unocal decision and its progeny.82 BOARD CONSIDERATIONS IN ANY BUSINESS COMBINATION In general, in reviewing a potential business combination, directors should consider multiple factors, including the following: • The price or merger consideration in the transaction; • The opinion of a financial advisor as to the fairness of the transaction consid- eration from a financial point of view; • The advice of advisors concerning the terms of the transaction; • Alternative proposals and the prospects for the continuing business without undertaking a transaction; • In the case of a stock-for-stock transaction: (a) an assessment of the potential counterparty and the prospects of the combined corporation following the closing (including synergies from the combination, perceived strengths and weaknesses of the management team and the directors and factors affecting 81 Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). 82 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985). 38 RR DONNELLEY
- 53. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS stock price and performance), (b) the impact of the transaction on the corpo- ration’s long-term strategic plans and (c) integration risks of the transaction; • The legal terms of the potential business transaction, including pricing, con- ditions to closing, restrictions prior to closing and any other key terms of the transaction; • Deal protection terms including “no shop” provisions, “break up” or termi- nation fees and similar devices; • The accounting and tax treatment of the transaction; • The right of the corporation’s stockholders to vote on the transaction, if appli- cable; • The risk that proposed conditions to the transaction, such as receipt of financ- ing and regulatory approvals, may not be satisfied; • The outlook for the corporation’s business and industry; • The results of due diligence review for the potential transaction; and • The legal or other approval requirements needed to complete the potential 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. When a transaction is challenged, cer- tain factors may have much greater weight assigned to them depending on the circum- stances of the particular matter. 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 a share-for-share business combination transaction. PRECAUTIONS 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 process for considering one or more possible business combination trans- actions is highly confidential; all aspects of information flow and disclosure need to be tightly coordinated; 39 RR DONNELLEY
- 54. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Care should be taken to avoid trading by any insiders in the securities of the corporation or any counterparty, to avoid both signaling the market and potential violations of law; • Discussions with investors, the press and securities market professionals should not be undertaken except where approved as part of the overall trans- action process; • Communications with directors, management and the corporation’s advisors should be coordinated to assure an informed decision-making process; and • Notes and other records that directors choose to keep, if any, should be pre- pared carefully, 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 OF THE CORPORATION Introduction Once a board makes the decision to sell a corporation, Revlon duties arise and 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 in a sale for the stock- holders’ benefit.83 While Delaware courts have emphasized that there is no “single blueprint” that directors can follow to satisfy their Revlon duties, the duties can be described as the board’s responsibility to maximize the short-term value to be received by stockholders.84 Once Revlon duties apply, even in the context of a transaction in which the business judgment rule otherwise applies, courts are more likely to scruti- nize the board’s process and actions in order to ensure that the directors took the steps necessary to maximize stockholder value.85 83 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). 84 Barker v. Amsted Industries, Inc., 567 A.2d 1279, 1286 (Del. 1989). 85 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). 40 RR DONNELLEY
- 55. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Applicability of the Revlon Duties Whenever a sale of control is implicated, Revlon duties likely will apply. Gen- erally, sale of control is implicated in any transaction in which corporate control passes to a third party, including: • A transaction involving a sale or merger for cash or debt securities; • A merger involving stock-for-stock consideration (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 result in a break-up of the corporation; or • A sale of equity securities that results in a change of control. In contrast, Revlon duties generally do not apply in the following situations: • Where a board (or a controlling stockholder) rejects a third-party offer (whether solicited or unsolicited) as not in the best interest of its stock- holders;86 • In a merger or other business combina- tion transaction in which sale of control of the corporation is not implicated; • In a merger or other business combina- tion transaction in which sale of control of the corporation is implicated if the transaction is a “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; or • Unless a board’s actions have otherwise subjected it to Revlon duties, it has no legal duty to engage in discussions or to negotiate with respect to a hos- tile or otherwise unsolicited takeover offer. 86 Frank v. Elgamol, 2014 WL 957550, at *21 (Del. Ch. Mar. 10, 2014). Unless a board’s actions have otherwise subjected it to Revlon duties, it has no legal duty to engage in discussions or to negotiate with respect to a hostile or otherwise unsolicited takeover offer. 41 RR DONNELLEY
- 56. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Notwithstanding the historical notion that Revlon does not apply to a “merger of equals” transaction87, the Delaware Chancery Court has held that Revlon may apply when the transaction is mixed cash and stock consideration, depending on the circum- stances. In In re Smurfit-Stone Container, the court held that Revlon would likely apply even though target stockholders would own approximately 45% of post-closing buyer stock with the balance of the stock held by a diverse stockholder base. The court reasoned that enhanced judicial scrutiny was in order because a significant portion “of the stockholders’ investment . . . will be converted to cash and thereby deprived of its long-run potential,” and that the transaction “constitutes an end-game for all or a sub- stantial part of a stockholder’s investment.” The court twice noted, however, that the issue remains unresolved by the Delaware Supreme Court, and that the “conclusion that Revlon applies [to a mixed-consideration merger] is not free from doubt.”88 Revlon duties arise at the time that the directors have or are deemed to have decided to sell control of the corporation.89 Generally, Revlon duties do not arise when the directors merely have authorized corporate officers or a board committee to nego- tiate a sale, but may arise when the directors have formally resolved to conduct a sale. Thus, Revlon duties typically will not apply if the directors never authorize the sale of the corporation or indicate any inevitable commitment to sell the corporation to a par- ticular buyer, or if they merely authorize the exploration of a variety of alternatives intended to enhance profitability, including a possible sale. As most sales are preceded by such informal investigations of alternatives, directors should be aware of Revlon duties when such a process commences and avoid commitments that might make it difficult to meet their Revlon duties if they should arise later. The Delaware Supreme Court clarified in Lyondell Chem. Co. v. Ryan that the Revlon duties apply only when a corporation embarks upon a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control.”90 Until the board decides 87 The Delaware Court of Chancery recently reinforced this notion by noting that Revlon did not apply to a stock-for-stock merger of equals transaction in which ownership of [the corporation] would remain “in a large, fluid, changeable and changing market” following the merger. See In re TriQuint Semi- conductor, Inc. Stockholders Litigation, C.A. No. 9415-VCN (Del. Ch. June 13, 2014). 88 In re Smurfit-Stone Container Corp. S’holder Litig., C.A. 6164-VCP (May 20, 2011). 89 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). 90 Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242 & n.23 (Del. 2009). 42 RR DONNELLEY
- 57. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS actively to pursue a change-of-control transaction, directors can assume a “wait and see” approach with respect to activities of third parties or reject an unsolicited offer without triggering obligations under Revlon.91 Revlon Duties and Guidelines Once Revlon duties arise, the board should adhere to the following guidelines: • Obtain the Highest Value. Directors have a responsibility to conduct a proc- ess reasonably designed to obtain the highest value reasonably attainable for the stockholders. There is “no single blueprint” that directors must follow in seeking the highest value.92 In evaluat- ing competing offers where differing amounts or types of consideration are offered and one or more of the bidding parties offers its own securities as part of the merger consideration, 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 may consider the aggregate value of each of the proposed trans- actions, including in the case of acquirer B the perceived value of the stock consideration. In addition, in a Revlon transaction (just as in any business combination), 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 under the Revlon standard should analyze the entire situation and evaluate the consid- eration being offered from each transaction in a disciplined manner with the objective of maximizing short-term value for the stockholders. 91 Id. at 237; Gantler, 965 A.2d at 706 & n.29. 92 Paramount Communications Inc. v. QVC Network Inc., 637 A.2d at 44; see also Lyondale Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). 43 RR DONNELLEY Once implicated, Revlon duties require directors to: • Obtain the highest value; • Act with neutrality; • Establish appropriate exceptions to deal pro- tection measures; and • Consider a market check
- 58. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Act with Neutrality. The board must act in a neutral manner with bidders to encourage the highest possible price for the stockholders. Moreover, where one or more directors have or may have a conflict of interest with respect to one or more of the bidding parties, courts have ruled that the active involvement of a corporation’s independent directors is critical to satisfying a board’s Revlon duties. • Establish Appropriate Exceptions to Deal Protection Measures. Although deal protection measures (generally scrutinized under the Unocal standard described below) are common in business combination transactions, and their validity can be attacked in any transaction, these measures frequently are subjected to heightened scrutiny in Revlon transactions. Common meas- ures include lock-ups, no-talk provisions, force-the-vote provisions and no-shop provisions, commitments to recommend the transaction, stock option grants, break-up and termination fees, voting agreements and similar arrangements. In a number of transactions in recent years involving Revlon duties, target corporations have insisted upon “go-shop” provisions in an effort to maximize the likelihood that the stockholders are receiving the greatest short-term value for their shares. These provisions permit the target, after executing the acquisition agreement, affirmatively to seek a potential alternative acquirer for a specific period of time (in other words, the “no-shop” provision does not apply during such “go-shop” period). But even in the absence of a go-shop provision, directors should consider including in the acquisition agreement other exceptions to deal protection measures, such as permitting the target corporation’s board (or if applicable, a committee of the board) to change its recommendation in favor of the transaction, or even terminate the acquisition agreement in order to permit the company to enter into an alternative transaction with a third party that constitutes a “superior proposal” when compared to the transaction contemplated by the acquisition agreement. Deal protection provisions and other defensive tactics that might impair the sales process, unfairly favor one bidder over another, or otherwise preclude stockholders from having a meaningful opportunity to determine whether to approve a transaction, will be carefully scrutinized in considering whether the board met its Revlon duties. 44 RR DONNELLEY
- 59. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Consider a 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 strongly advisable where the board is considering a single offer and no bidding contest is present. A “market check” may assist the board in determining whether a proposed change of control transaction maximizes stockholder value. However, there is no particular obligation to conduct a market check, and a board may, depending on the circumstances, fulfill its duty of care by including appropriate provisions in the acquisition agreement (such as a go-shop provision, or the right to terminate the transaction in favor of a superior offer) that help enhance the likelihood that the highest short-term value will be achieved for the stockholders.93 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 corpo- ration, 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 remain independent or otherwise 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 to ensure that the directors have engaged in a thoughtful analysis of why they believe stockholder value can be enhanced by not selling the corporation, and that thought process should be appropri- ately documented. 93 C&J Energy Series, Inc. v. City of Miami General Employees and Sanitation Employees’ Retirement Trust, 2014 WL 7243153 (Del. Dec. 19, 2014). 45 RR DONNELLEY
- 60. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF A POTENTIAL BUSINESS COMBINATION TRANSACTION In light of the foregoing discussion, directors should undertake the following in connection with a potential 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 to each other; O Make 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 identify and consider issues and perspectives; O Create a record of the decision-making process, including correspondence with third parties discussing the transaction; • Act in Good Faith: O Always act in the best interests of the stockholders; O Avoid taking any actions (including adopting deal protection devices) that improperly limit the board’s ability to exercise its fiduciary duties; O Avoid making any decisions that would favor one bidder over another without appropriate business justification; and O Avoid taking any action that might have the effect of favoring a related party over a competing bidder or the stockholders. 46 RR DONNELLEY
- 61. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS UNOCAL AND DEFENDING AGAINST HOSTILE TAKEOVERS Introduction In contrast to situations where a board’s actions contemplate the sale of a corpo- ration, in circumstances where a corporation receives a hostile or unsolicited acquis- ition proposal, and its board of directors determines that the proposal is not in the best interests of the corporation and its stockholders and adopts one or more defensive takeover measures, the Unocal standard will apply. Generally, Unocal requires, in the context of a hostile or unsolicited acquisition proposal, that the board demonstrate that (a) it had reasonable grounds for believing that a danger or threat to corporate policy and effectiveness existed and (b) its response was reasonable in relation to the danger or threat to corporate policies posed by such proposal. Defensive takeover measures are myriad and include stock- holder rights plans (or “poison pills”), pro- tective provisions in the corporation’s charter and bylaws, such as a classified board, limitations on stockholders’ rights to act by written consent, call special meetings and remove directors and supermajority vot- ing requirements. Boards may also seek to prevent a hostile or unsolicited takeover by implementing an alternative transaction with a friendly acquirer or a separate transaction (including recapitalizations) to make the corporation undesirable to the hostile party. 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 an actual threat, the heightened standard of Unocal will be applied by a court reviewing challenged actions of the board.94 Further, defensive measures adopted in the absence of an actual threat may be tested under Unocal when and if they are later utilized to attempt to thwart a particular hostile or unsolicited action by a third party. 94 As discussed in greater detail below, in the section “Special Case: Use of a Poison Pill,” institutional shareholders frequently oppose defensive measures. 47 RR DONNELLEY Defensive measures adopted by a board in the face of a hostile bid must be reasonable and proportionate to the threat posed, and the board must have reasonable grounds to believe the threat to corporate policy and effectiveness actually exists.
- 62. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Delaware courts typically analyze the reasonableness of the deal protection provi- sions in a particular transaction holistically, in the aggregate, and not on a one-by-one basis. Each case is decided based on the particular facts and circumstances involved in the transaction. Thus, while general guidance is given below, it is often difficult to make generalizations about the overall permissibility of particular provisions. For example, a particular deal protection device might be permissible if it were the only deal protection mechanism, but could be found to be in violation of the Unocal stan- dard, as an unreasonable or disproportionate response to the threat perceived, when included in combination with other deal protection devices. This area of Delaware law is sophisticated, complex, fact-intensive and ever-evolving as boards and committees, and their counsel, struggle to devise deal structures with effective protections that will withstand judicial scrutiny. Overview of Common Defensive Takeover Measures As noted above, there are several anti-takeover measures and variants of these measures. A summary of some of the more common measures includes: • Staggered Board. Perhaps one of the most common devices, a staggered board divides the corporation’s board of directors into several classes, with each class serving a fixed term but elected in different years. For example, class I directors serving three-year terms beginning in 2017 would expire in 2020, while class II directors’ terms would expire in 2021 and class III directors’ terms would expire in 2022. Thus, even if a substantial amount of the corporation’s stock were acquired by a single or group of related stockholders, the entire board could not be replaced at a single election. A staggered board is implemented through an amendment to the corporation’s charter, typically requiring that a majority of the outstanding shares approve the staggered board. A board may also be de-staggered with an amendment to the charter (again requiring approval of not less than a majority of the outstanding shares). Frequently, staggered boards are implemented in connection with a corporation’s initial public offering (when the group of stockholders is generally much smaller and less disparate) and the structure is protected by requiring that changes require a supermajority share- holder vote. Consequently, it is sometimes difficult to eliminate a staggered board. On the other hand, stockholder rights organizations generally disfavor defensive takeover measures, including staggered boards in particular, so any proposal to eliminate a staggered board is likely to meet with the approval of 48 RR DONNELLEY
- 63. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS such organizations and in fact, over the past few years, a substantial number of companies have eliminated their staggered boards in response to shareholder initiatives. The elimination of a staggered board does not de facto remove direc- tors from office or shorten the terms of directors who are serving terms that do not expire in the year in which the board is de-staggered. Such directors should continue to serve until their original term is complete, or their earlier death, removal or resignation. Proponents of staggered boards argue that board con- tinuity is beneficial to the company and a staggered board prevents a hostile acquirer from replacing the board in one single election. Opponents argue that a staggered board promotes entrenchment among directors, and at times, their favored management. • Restrictions on Stockholder Action by Written Consent. DGCL Section 228 provides that unless prohibited by the corporation’s charter, stockholders may act by written consent to approve any action that could otherwise be approved at a properly convened meeting of stockholders. Many corpo- rations, in implementing anti-takeover strategies, adopt charter provisions that restrict stockholders’ ability to act by written consent. This prevents a single stockholder or group of stockholders acting together from pursuing approval of action at the stockholder level without a properly convened meeting of stockholders. Proponents of restrictions on stockholders’ rights to act by written consent argue that these restrictions, together with other anti-takeover devices, have the effect of encouraging a potential acquirer to interface directly with the corporation’s board of directors rather than going “over its head” directly to the stockholders, thus enabling the board to seek the best value for all the stockholders. Opponents of these restrictions argue that they deny a majority stockholder its right to exercise one of the basic tenets of ownership – the ability to vote shares and by doing so, control major corporate actions. • Limitations on Stockholders’ Rights to Call a Special Meeting. Many corporations, through their charter or bylaws, also limit who may call a spe- cial stockholders meeting. Specifically, rather than granting stockholders the right to call a special meeting, such corporations vest the right to call a spe- cial meeting only in the board of directors, chief executive officer, chairman or president of the corporation. As many corporate actions require stock- 49 RR DONNELLEY
- 64. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS holder approval, shareholder rights organizations argue that restrictions on stockholders’ rights to act by written consent or call a special meeting have the practical effect of depriving stockholders of the ability to have a mean- ingful voice as to management of the corporation’s affairs except through the election of directors at an annual meeting. Proponents of this mechanism argue that it forces a potential hostile acquirer to interface directly with the board in any potential takeover attempt. • Rights Plans (aka Poison Pills). Perhaps the most well-known anti-takeover device, rights plans (also called “poison pills”) are a mechanism that seeks to prevent a stockholder from increasing its ownership of the corporation beyond a certain percentage (usually 15-20%) without the approval of the corporation’s board of directors. Rights plans are discussed in detail at the end of this Chapter 3 in the section entitled “Special Case: Use of a Poison Pill.” The Unocal Test: Reasonable Basis and Proportionate Response As discussed above, anti-takeover measures generally are reviewed under the Unocal standard. The Unocal standard is 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.”95 Second, the board must demonstrate that its response was reasonable and proportionate to the threat.96 Reasonableness Test With respect to the first prong of the Unocal test, a threat to corporate policy can exist from, among other things, the risk that a hostile or unsolicited acquisition pro- posal is inadequate or constitutes a coercive tender offer, or is timed so as to disrupt strategic goals.97 Attempts to satisfy this prong of the test should be supported by a reasonable investigation of the facts surrounding the takeover offer by an independent and disinterested majority of the board.98 95 Unocal, 493 A.2d at 946. 96 See id. 97 Id. 98 Id.; see also Unitrin Inc. v. American General Corp., 651 A.2d 1361, 1375 (Del. 1995). 50 RR DONNELLEY
- 65. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS In examining the threat posed in connection with a hostile takeover bid, directors should take into account, among other considerations: • The adequacy of the price offered; • The nature and timing of the offer; • Regulatory considerations; • The risk of non-consummation of the offer; • 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 if the bid were to succeed; and • The risk that stockholders will mistakenly accept an underpriced offer because they disbelieve management’s representation of intrinsic value.99 Proportionality Test Proportionality requires that the board’s actions in implementing an anti-takeover measure 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.”100 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 contests or otherwise.101 A response will be “coercive” if, among other things, it forces a management-sponsored alternative upon stockholders.102 Second, assuming the response was not preclusive or coercive, the board must show that the response was within a “range of reasonableness.”103 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 busi- ness decision which a board may routinely make in a non-takeover context, (ii) limited 99 See Unocal, 493 A.2d 946; Unitrin, 651 A.2d 1361. 100 Unitrin, 651 A.2d at 1367. 101 Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 935 (Del. 2003). 102 Id. 103 Id. 51 RR DONNELLEY
- 66. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS and corresponded in degree or magnitude to the degree or magnitude of the threat, and (iii) responded to the needs of stockholders.104 Under Delaware law, boards should be given some level of deference in showing proportionality.105 Consider the following court decisions regarding reasonableness and proportion- ality 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 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 pre-existing transaction in an altered form.106 • Defensive measures may be both preclusive and coercive if the measures constitute a fait accompli. In Omnicare, Inc. v. NCS Healthcare, Inc., the combination of a “force-the-vote provision” and stockholder voting agree- ments from a majority of the outstanding shares were found, acting in con- cert, to have a preclusive and coercive effect because the defensive measures made it mathematically impossible for any alternative proposal to succeed, no matter how superior the proposal.107 • 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 union contract providing the union rights to renegotiate the contract in the event of a takeover – was found to be unreasonable and there- fore disproportionate because the takeover defense could not be rescinded by the company.108 104 Unitrin, 651 A.2d at 1389. 105 See id. at 1388. 106 See Paramount Communications, Inc. v. Time, Inc., 571 A.2d at 1154-1155. 107 See Omnicare, 818 A.2d 914. 108 See Air Line Pilots Assoc., Int’l. v. UAL Corp., 897 F.2d 1394 (7th Cir. 1990). 52 RR DONNELLEY
- 67. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 responding to a hostile takeover attempt: • 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 anti-takeover measures from a majority of independent directors; and • Avoid deal protection measures or actions that limit a board’s ability to exercise its fiduciary duties. 53 RR DONNELLEY
- 68. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS SPECIAL CASE: USE OF A POISON PILL Overview and Mechanics As discussed above, there are several anti-takeover measures available to a corpo- ration that is seeking to reduce the threat of abusive takeover attempts. One of the most common of these options is a stockholder rights plan, also known as a “poison pill.” Since the 1970s, stockholder rights plans have been a commonly used device 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 their shares. Poison pills generally are designed to deter certain abusive takeover devices and tactics, including acquisitions of a controlling interest without paying a premium or at a market price which may not reflect actual value. Proponents of stockholder rights plans argue that a stockholder rights plan can be very useful because it may afford the board adequate 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 alternatives to such an offer, including a superior proposal from a “white knight” bidder, thereby enhancing the board’s negotiating power and its corresponding ability to promote the best interests of the stockholders. A stockholder rights plan can be adopted by a corporation’s board without stock- holder approval (although doing so may under certain circumstances result in stock- holder rights organizations recommending against the re-election of directors approving the plan). 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, which, when “triggered,” entitle such hold- ers to purchase a significant amount of the corporation’s securities at a 50% discount to then-market value, resulting in a significant dilutive effect on the “acquiring person” (the hostile or unsolicited bidder who has triggered the rights by acquiring more than 54 RR DONNELLEY Stockholder rights plans, or so-called “poison pills,” have been used by boards for many years to increase their leverage in negotiating potentially hostile acquisitions.
- 69. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS the designated ownership limit (typically 15% to 20%) of the then-outstanding shares of the corporation’s common stock. Because the rights held by the acquiring person do not become exercisable, the effect of a triggering event is to substantially dilute the acquiring person’s interest in the target and make any acquisition prohibitively expensive. 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 third party (or group of affiliated or associated persons) actually becomes an acquiring person. The term of stockholder rights plans generally is from three to ten years, and the exercise price of a right is typically anywhere from six to ten times the market value of the corporation’s common stock at the time the stockholder rights plan is adopted. The rights, therefore, are significantly “out of the money” at the time of issuance. Rights plans typically also have “exchange” features that permit a board of directors, instead of declaring the rights exercisable for cash, simply to issue to all stockholders (other than the acquiring person) a share of common stock in exchange for each right. While the dilutive effect of such an exchange is not as great as the dilution that would be caused by a full exercise of the rights, such a procedure is simpler and promotes equal- ity among stockholders, not all of whom will have the financial resources to fully exercise their rights. In the one reported instance of a third party consciously triggering a stockholder rights plan by acquiring more than the designated percentage of the corporation’s outstanding shares, the board of the target company elected to effect such an exchange.109 Fiduciary Duties Given the recent rise in activist stockholder activity regarding stockholder rights plans, directors should proceed cautiously when considering 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 auc- 109 Versata Enterprises, Inc. and Trilogy, Inc. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010). 55 RR DONNELLEY
- 70. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS tion110 or where use of the plan violates another principle of takeover law (e.g., utiliz- ing a rights plan in a discriminatory manner favoring one change-in-control transaction over another).111 Delaware courts believe that, while a board’s actions in the face of a hostile take- over attempt should be scrutinized carefully due to the possibility that “entrenched” directors will act in their own self-interest, a board’s planning for a hostile takeover defense in advance, in the context of a corporate environment in which hostile or unsolicited takeover attempts are not uncommon (but prior to the actual commence- ment of such an attempt), will generally be evaluated under the business judgment rule. On the other hand, if a stockholder rights plan is enacted in response to a partic- ular hostile takeover bid, or if a board refuses to terminate the plan (including by redeeming the rights) in the face of such a bid, the heightened Unocal standard likely will apply. Because the judicial standard applicable to the adoption of a rights plan in the face of a hostile bid is identical to the standard applicable to the refusal of a board to terminate an existing plan at such time, many boards in recent years, rather than actually adopting rights plans when no threat to corporate independence exists, have adopted the alternative strategy of putting all of the documents together for a stock- holder rights plan but then placing the plan “on the shelf,” keeping it ready for quick adoption in the future as needed. The benefit of this course of action is that an “on the shelf” plan does not invoke the ire of shareholder rights organizations that are gen- erally opposed to these types of defensive measures. 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” stock- holder rights plan will, by its terms, prevent directors appointed by a hostile acquirer 110 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. 1988), 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”). 111 Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994). However, in Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182 (Del. 2010), the Delaware Supreme Court upheld a board’s refusal to redeem a rights plan, thus successfully blocking a hostile takeover attempt at a price that was a significant premium to market price. A key factor behind the decision was an independent and knowledgeable board with a long-term business plan. 56 RR DONNELLEY
- 71. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 been struck down by Delaware courts on several occasions for a variety of reasons, including under the Unocal standards.112 SPECIAL CASE: DIRECTOR DUTIES IN THE FACE OF ACTIVIST STOCKHOLDER DEMANDS Since the early 2000s, 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, stockholder rights organizations, state pension funds and corporate raiders. Sometimes activist share- holders own a substantial block of stock of the corporation; however, many times acti- vist shareholders have only a small percentage of the corporation’s outstanding stock, but nevertheless make demands for significant control over the corporation. When attempting to effect change at a corporation, activist stockholders are more likely to focus on specific key issues and exert pressure to influence corporate policies, rather than seek outright control of the corporation. Common demands include: • Change the composition and membership of the board of directors; • Change the strategy or management of the corporation; • Make dividend payments, repurchase stock or divest assets; • Effect corporate governance changes; • Sell the corporation; or • Initiate or stop a strategic transaction. 112 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). 57 RR DONNELLEY
- 72. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS A common goal of activist stockholders is to force an event to trigger “value crea- tion” for the stockholders, which generally means a transaction that creates full or partial liquidity. 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 current stock price, that emphasize results in the short term and prevent the board from focusing on and direct- ing the long-term success of the corporation. In addition, critics argue that stockholder activism does not usually create value for the other stockholders unless the corporation is put up for sale, and even then there is little change in the stock performance of a corporation 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 share- holder rights organizations; • Development of “wolf packs”113; 113 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 in a stealthy manner. 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 require- ments of the Exchange Act by utilizing equity swaps instead of acquiring the securities of a company. Notably, a 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 posi- tions was fraudulent. CSX Corp. v. The Children’s Investment Fund Management, 562 F. Supp. 2d 511 (S.D.N.Y. 2008), aff’d in part and rev’d in part, 654 F.3d 276 (2d Cir. N.Y. 2011). 58 RR DONNELLEY
- 73. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Stockholder proposals; • 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 stock- holders 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 properly exercise their fiduciary duties. For example, the Delaware Supreme Court has considered whether stock- holders 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 corpo- ration 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 success- fully nominated a slate of directors. The court held that the process for electing direc- tors 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.114 114 CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227 (Del. 2008). This decision arose out of a request from the SEC under a new certification procedure. 59 RR DONNELLEY
- 74. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS What Should Directors and Officers Do When Confronted with an Activist Stockholder Demand? It is imperative that boards react quickly and thoughtfully to activist stockholder demands. To help demonstrate that they are fulfilling their fiduciary duties to the corporation, members of the board should consider carefully 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 conflicts of interest are implicated. Further, many activist stockholders 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. Sometimes activist stockholders seek to install advisors or management that will be sympathetic to their agenda. 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 may help the board to more effectively articulate its long-term strategy for value creation and defend itself against 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 solic- itation 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 60 RR DONNELLEY
- 75. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS pursuing that proposal. If there are competing proposals by the officers of the corpo- ration or others, the directors should carefully consider those proposals. The directors should consider whether there are any alternative courses of action, and how the pro- posal 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 manage- ment 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 Notify 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. The board also should consider that, although an activist stockholder may not hold a significant amount of the outstanding stock, its views or its demand may be shared by a majority of the stockholders. If the board decides not to comply with the demand, public dis- closure of the reasons why the board has determined not to comply with the demand should be considered, including explaining why the demand is not, in the view of the board, in the best long term interests of the corporation or its stockholders. Ultimately, activist stockholder demands may prove to be expensive and time-consuming 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. 61 RR DONNELLEY
- 76. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 special committee (or where appropriate a disinterested and independent majority of the board) 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 the proposal’s proponents to discuss available options; • Recommend a concrete response plan for full board consideration; and • Consider disclosing the rationale for the recommended action to stock- holders at large. 62 RR DONNELLEY
- 77. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 affili- ated with a public corporation (often a large or controlling stockholder or an outside investor, such as a private equity firm and the corpo- ration’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- ration can deregister under the Exchange Act. Going private transactions frequently implicate complicated fiduciary and disclosure issues for the board, the management team and the acquirer. In addition to state law fiduciary duty concerns, going private transactions are also subject to extensive regu- lation by the SEC pursuant to Rule 13e-3 under the Exchange Act. As discussed in detail in Chapter 2 above, transactions with controlling share- holders are typically subject to greater scrutiny absent certain procedural protections designed to protect minority stockholders. However, the question of what standard of review applies under various circumstances has been the subject of debate in Delaware courts and varies depending on the facts and circumstances surrounding the transaction and, in some circumstances, the structure of the transaction itself. STANDARDS OF REVIEW Going private transactions are typically structured as either (i) a cash-out merger or (ii) a tender offer followed by a back-end merger. Another, less popular option, is to effect a going private transaction through a reverse stock split. Each of these approaches has its own risks and perceived benefits. Cash-Out Merger In a going private transaction effectuated through a cash-out merger, a majority stockholder or other insider typically seeks to acquire the minority interest in the target Going private transactions present complex fiduciary duty and disclosure issues for the board, management and the buying group. 63 RR DONNELLEY
- 78. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS through a merger of a newly formed corporation wholly owned by the acquirer with the target corporation. The acquirer engages in direct negotiations regarding the trans- action with the target’s board (or a special committee thereof) and enters into a merger agreement with the target after the target board approves the merger agreement. Shares are typically acquired for cash, but the consideration also can be shares of the acquirer. As a statutory matter, the merger requires the approval of a majority of the outstanding shares of the target. Historically, going private transactions struc- tured as mergers requiring stockholder approval were reviewed under the entire fairness stan- dard.115 However, Delaware courts have held that two procedural protections are available to allow the target and acquirer to try to shift the burden of showing that the transaction was unfair back to the plaintiffs (usually the minority stockholders). Either the transaction could be eval- uated and approved by a properly functioning independent committee of the board with the power to negotiate and approve the transaction and with the resources and ability to hire its own independent legal and financial advisors, or the transaction could be approved by the majority of the minority stockholders.116 Prior to 2013, however, Delaware courts had not opined on the standard of review for cash-out mergers where acquirers had used both procedural protections. M & F Worldwide changed that, attempting to unify the standard of review for controlling stockholder acquisitions via tender offers and those via mergers. The Delaware Supreme Court held that the business judgment rule applies to going-private trans- actions where a controlling stockholder conditions the transaction on the approval of both an independent special committee and a vote of a majority of the stockholders unaffiliated with the controlling stockholder.117 115 Kahn v. Lynch Communication Systems, 638 A.2d 1110 (Del. 1994). 116 Id. at 1117. 117 Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014); In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. May 29, 2013). The use of special committees composed of independent and disinterested directors can substantially benefit a going private process. In cash-out mergers, boards should consider utilizing pro- tective measures, such as independent committees and a majority of the minority approval requirement. 64 RR DONNELLEY
- 79. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Under this unified standard, the Delaware Supreme Court clarified that the busi- ness judgment standard of review is applicable if and only if: • The controlling stockholder conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders; • The special committee is independent; • The special committee is empowered to freely select its own advisors and to say “no” definitively; • The special committee meets its duty of care in negotiating a fair price; • The vote of the minority is informed; and • There is no coercion of the minority stockholders. The Delaware Court of Chancery’s decision in In re Lear Corporation Share- holder Litigation illustrates the point that material conflicts of interest involving a director, an officer or a board advisor should be disclosed to stockholders.118 There, the court granted a preliminary injunction based, in part, on inadequate disclosures regarding the role of the target’s CEO in negotiating the transaction and the benefits that he stood to gain from it. One such benefit potentially was to increase the financial security with respect to the ultimate payment of the CEO’s retirement benefits. The CEO was concerned over the company’s continued financial viability, which could be affected by a transaction with a stronger buyer regardless of the price paid for shares in the transaction. The CEO, who also was an inside director, was a principal negotiator in the transaction. Although the court recognized that the CEO did not act inappropriately, it held that his interests and role should have been disclosed more completely to investors. Tender Offer Contrary to cash-out mergers, going private transactions structured as a tender offer by a controlling stockholder, followed by a back-end merger, have not histor- ically been subject to the entire fairness standard. Under this structure, an acquirer must obtain at least a majority of the outstanding shares in a tender offer (subject to 118 In re Lear Corp. S’holder Litig., 926 A.2d 94 (Del. Ch. 2007) 65 RR DONNELLEY
- 80. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS certain additional conditions),119 and can then complete a back-end merger via a short- form merger to squeeze out any remaining stockholders who did not originally tender their shares.120 Historically, two-step tender offers have been perceived to be more popular than cash-out mergers because they were subject to less scrutiny by courts if challenged and could be completed more quickly. Until 2010, courts relied on the Pure Resources three-factor plus test to determine whether a tender offer was coercive.121 Under Pure Resources, a tender offer by a controlling stockholder was 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 a majority of the shares; and • The controlling stockholder has not made any retributive threats.122 In addition, the target and controlling stockholder had to give the target’s independent directors “free reign and adequate time” to react to the offer, such as by hiring their own advisors to help them evaluate the offer, and had to provide full dis- closure of information that a reasonable investor would consider important in tender- ing his or her stock. This would include, for example, disclosing the content and 119 Prior to the August 2013 amendments to Delaware General Corporation Law Section 251 (“DGCL §251”), acquirers needed to hold at least 90% of outstanding shares following a tender offer to take advantage of a short-form merger. Following another round of amendments to DGCL §251 in August 2014, controlling stockholders were also allowed to rely on this lower majority threshold for back-end mergers. 120 Under Delaware law, tender offers also can be used by private equity investors working with man- agement to acquire the corporation. However, due primarily to complications with obtaining the financing typically utilized by private equity firms, such firms generally have avoided tender offers in favor of one- step mergers (with some recent exceptions utilizing top-up options and other structures). 121 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). 122 Id. at 445. 66 RR DONNELLEY
- 81. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS background of any fairness opinion that may have been delivered to the parties in connection with negotiating the particular transaction.123 Recent cases, however, have resulted in uncertainty regarding how Delaware courts will review two-step tender offers.124 Under CNX Gas, the Delaware Court of Chancery held that a tender offer by a controlling stockholder followed by a short- form merger would presumptively be subject to the business judgment standard of review if the transaction is conditioned on both: • the negotiation and approval of an independent special committee; and • a vote of a majority of the stockholders unaffiliated with the controlling stockholder. Unlike under Pure Resources where a special committee needed only to evaluate an offer and make a recommendation (or stay neutral) to stockholders as part of an effort to avoid the burden of proving entire fairness, a special committee under CNX Gas had to have the board’s full power and authority with respect to the tender offer and approve the transaction to be eligible for the business judgment standard of review. Thus, under CNX Gas, if the target’s independent directors did not approve the tender offer, contrary to the Pure Resources standard, the entire fairness standard would be imposed. After CNX Gas, though, the controlling stock- holder, however, could still gain the benefit of shifting the burden of disproving entire fairness to prospective plaintiffs if it obtained an affirmative vote by a majority of minority shareholders. In any case, under Delaware law, these varying standards give controlling stock- holders options in structuring going private transactions. They can now rely on either procedural safeguard available to shift the burden of disproving entire fairness to the plaintiffs, or they can use both safeguards to invoke the presumptions of business judgment rule. 123 Id. at 449. 124 See In re CNX Gas Corporation Shareholders Litigation, 4 A.3d 397 (Del. Ch. 2010); In re Cox Communications, 879 A.2d 604 (Del. Ch. 2005). Delaware courts have recently transitioned to a unified standard of review for mergers and two-step tender offers. 67 RR DONNELLEY
- 82. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Putting aside burdens of review, tender offers by controlling stockholders may be pursued either with or without prior approval of the board (or a committee of the board of directors – see Chapter 5) of the target. Although a tender offer does not necessarily need to be negotiated or approved by the board in all circumstances,125 the target must make full disclosure of all relevant information regarding the transaction to its stock- holders, including whether the tender offer was considered by the board (or a commit- tee thereof) and whether or not the target’s board recommends that its stockholders tender their shares into the offer. The rules and regulations of the SEC specifically require that the target corporation’s board prepare a written recommendation to the stockholders in response to a tender offer and file the recommendation with the SEC. Reverse Stock Split A corporation may also use a reverse stock split to reduce the number of stock- holders of record to a number below the applicable deregistration threshold, suspend- ing the corporation’s SEC reporting requirements. A prospective acquirer holding an interest in the corporation that is larger than any other unaffiliated holder may attempt to effectively acquire the corporation through a reverse stock split, in which the corpo- ration 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 to 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, but as with everything under Delaware law, the mere power to take an action does not guarantee that the taking of such action, under the circumstances, will not be found to have violated the target board’s fiduciary duties.126 The compensa- tion of cashed-out stockholders must be at a fair price and the reverse stock split must 125 Unlike in a merger, the Delaware corporate statute does not require the target board to approve a tender offer. However, in many cases the target board may be required to take some action pursuant to other circumstances, such as to provide a waiver under an existing rights agreement or other contract or to provide an approval pursuant to state statutes governing transactions with significant stockholders such as Section 203 of the DGCL. 126 8 Del. C. §155. 68 RR DONNELLEY
- 83. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS be designed in good faith and have a legitimate business purpose.127 Delaware courts have held that the business judgment rule applies with respect to board recom- mendations for a charter amendment, in the absence of a violation of fiduciary duty.128 Although there is little case law addressing how a challenge to a going private trans- action effected through a reverse stock split would be treated by Delaware courts, it would be advisable to assume that the standards applied would be similar to those applicable to other forms of going private transactions, and utilize any procedural protections reasonably available in implementing such a transaction, such as requiring approval by independent special committee composed of disinterested and independent directors.129 Procedural Safeguards When a going private transaction is challenged in court, and it is alleged that the target corporation’s board of directors breached its fiduciary duties, the manner in which the transaction was negotiated among the interested parties will be scrutinized. For this reason, the parties to a going private transaction are well advised to implement procedural safeguards, including, among others, those described above during the negotiation process. As discussed above, properly established procedural safeguards are capable of changing the standard of review from entire fairness to that of business judgment or shifting the burden of proof under the entire fairness standard. To avoid costly litigation, boards should consider 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. In addition to helping directors satisfy their fiduciary duties, the use of a disinterested and independent subset of the board or special committee may also result in a higher negotiated purchase price for the minority stockholders. For maximum effect, 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 buyer or subset of buyers is made or the deal is heav- 127 Id.; Applebaum v. Avaya, Inc., 812 A.2d 880, 886-87 (Del. 2002). 128 Williams v. Geier, 671 A.2d 1368 (Del. 1996). 129 See, e.g., Applebaum, 812 A.2d 880; Williams, 671 A.2d 1368. 69 RR DONNELLEY
- 84. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS ily negotiated.130 Extra care should be taken to ensure that interested directors and interested members of the management team are isolated as much as possible from the negotiation, deliberation and decision-making process of the special committee. The special committee should be empowered with real bargaining power in the process and access to the resources it needs, including access to management, information about the business and the proposed acquirer, the authority to pursue alternative transactions, the ability to simply say “no” to any proposed going private transaction, and the ability to choose and utilize independent legal counsel, finan- cial advisers, accountants and other experts. Among other things, the disinterested and independent direc- tors likely will seek to obtain a fairness opinion from an independent investment bank as to the consideration to be paid in the transaction (or in the case of a transaction opposed by the independent and disinterested directors, consider obtaining an inadequacy opinion supporting its refusal to approve the deal). So as to qualify for the business judgment standard of review, the board should also strongly consider seeking approval of a going private transaction by a vote of a majority of the shares held by the minority stockholders (stockholders other than the acquirer and its affiliates and related persons). However, while this may help to address any charges of unfairness to the minority stockholders (by shifting the burden of proof or altering the standard by which the transaction is evaluated), it also introduces an element of risk to the proposed transaction, since if the transaction is not approved by a majority of the minority, a closing condition will not be satisfied and the acquisition will be terminated. In all cases, 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. 130 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). Boards should consider obtaining a fairness opin- ion from an investment bank before approving any business combination transaction, but going private transactions in particular. 70 RR DONNELLEY
- 85. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS SEC REQUIREMENTS AND SCRUTINY OF GOING PRIVATE TRANSACTIONS Acquirers in going private transactions must sat- isfy 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 that helps stockholders eval- uate the fairness of the transaction and other material information. In addition to the acquirer’s tender offer or proxy filing obligations, the target corporation is required to file a Schedule 14d-9 setting forth its recommendation with respect to the tender offer or merger, any material factors supporting that recommendation and any reports, opinions and appraisals by financial advisers, as well as a Schedule 13e-3. The SEC staff carefully reviews filings made in connection with going private transactions, and companies should consider allocating appropriate time to provide for responses to any SEC review. Among other things, the SEC will review disclosures relating to valuation, fairness of the transaction price, transaction background and his- tory, and the independence of the directors (or members of the special committee) recommending or approving the transaction. Boards should be mindful that SEC requirements mandate extensive dis- closure of the entire process involved in negotiating and approv- ing a going private trans- action. 71 RR DONNELLEY
- 86. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS CHAPTER 5 THE USE OF SPECIAL COMMITTEES INTRODUCTION Transactions between a controlling party and the controlled corporation are sub- ject 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 statutory requirement under Delaware law that a board of directors utilize a special committee composed of independent131 and disinterested132 directors when considering a related-party transaction, Delaware courts have indicated that in the absence of such a committee (or a majority of the board being comprised of disinterested and independent directors functioning in an equivalent manner), a going private transaction may be more likely, under the entire fairness standard, to be unfair to the minority stock- holders. Technically, a special committee is only required where, in the absence of the committee, a majority of the board would not otherwise be disinterested and independent. However, even in circumstances where a majority meets that criteria, the use of a special committee should be considered to more effectively insulate the proc- ess of the proposed transaction from the directors who are conflicted. 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). 131 In the context of approval of a related-party transaction, “independence” means that 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. 132 In the context of approval of a related-party transaction, “disinterested” means the director would not derive any personal benefit from the subject transaction that is not shared by all stockholders. Transactions involving a corpo- ration and a related party are subject to careful scrutiny by Delaware courts – boards are well advised to consider utilizing a special committee comprised of independent and disinterested directors when considering such transactions. 72 RR DONNELLEY
- 87. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 arms-length basis.133 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 members and the committee’s representatives were informed and actively engaged in a negotiation process; and • The extent of the powers granted to the committee. Further, as discussed in Chapter 4 above, the use of a properly functioning special committee together with a requirement that a transaction be approved by a majority of the minority stockholders can, in certain circumstances, reduce the standard of review from the entire fairness standard to the business judgment standard. COMMITTEE COMPOSITION: DISINTERESTED AND INDEPENDENT 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 inter- ested 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 deal- ings with the other party that would not be available but for the challenged transaction. 133 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, e.g., Citron v. E.I. Du Pont de Nemours & Company, et al., 584 A.2d 490 (1990). 73 RR DONNELLEY
- 88. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Independent Even if a director is disinterested, he or she may still be deemed to be incapable of making an independent decision if the decision would be based on extraneous considerations or influences rather than the merits of the transaction being considered by the board. In this regard, courts often look to whether the director is controlled by or beholden to another person or entity, or whether other outside influences affect his or her business judgment. For example, in In re Maxxam, Inc./Federated Development Shareholders Litigation,134 special committee members were found to lack independence where they received significant compensation from employment by entities controlled by the individual who controlled the corporation’s major stockholder. In In re Oracle Corp. Derivative Litigation,135 two special litigation committee mem- bers who were both Stanford University professors were found to lack independence where they had been tasked with deciding whether to pursue insider trading litigation against directors including a fellow Stanford professor and two benefactors of the university. In contrast, Delaware courts have found that a personal friendship between a special committee member and an interested party, without more, will not necessa- rily result in such special committee member lacking independence.136 In addition to ensuring that the members of the special committee are independent and disinterested, the committee should consider carefully whether any of the financial or legal 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, including through the prior provision of professional services to the target corporation.137 Although such financial ties are only one of a number of factors consid- 134 In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760 (Del. Ch. 1995). 135 In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003). 136 Beam v. Stewart, 845 A.2d 1040 (Del. 2004). 137 See, e.g., In re Tele-Communications, Inc. Shareholders Litigation, No. 16470, 2005 Del. Ch. LEXIS 206 (Del. Ch. Dec. 21, 2005). To be effective, special committees should: • Be composed of independent and disin- terested directors; • Be informed as to the process and terms of the transaction; and • Be active in the negotia- tions process. 74 RR DONNELLEY
- 89. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS ered by the courts, they are likely to cause greater scrutiny of the adequacy of the committee’s process. A special committee’s use of 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 it retains advisors with no prior relationship with the corporation.138 Use of the corporation’s existing advisors may be viewed by a court as detracting from the committee’s independence.139 Although the DGCL permits a committee to be composed of one member, it is advis- able that boards appoint more than one member to a special committee.140 And finally, it is important that the members of the committee be chosen solely by independent and disinterested directors – the participation by one or more interested or conflicted direc- tors in the selection of the committee can itself taint the process. In making determinations as to whether an individual or firm is disinterested and independent, directors likely will want to carefully examine historical financial rela- tionships and other connections. A list of factors and questions to consider is set forth on page 81 under the caption “Considerations in Determining Whether An Individual or Firm May be Viewed as Disinterested and Independent.” COMMITTEE’S CHARGE: BE INFORMED AND ACTIVE To be informed, the special committee must be knowledgeable concerning the corporation’s business and must be involved in or kept abreast of the ongoing negotia- tions. To be active, the members should either be involved in the negotiations or fre- quently 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.141 Situations where Delaware courts have held that special committees were not informed and active include where: • The committee never negotiated for a better price;142 • The committee failed to choose its own independent advisors;143 138 Citron v. E.I. Du Pont de Nemours & Company, 584 A.2d 490 (Del. Ch. 1990). 139 See, e.g., Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997). 140 The laws of some states, for example, California, prohibit committees of only one member. See, e.g., Cal. Corp. Code § 311. 141 Kahn v. Tremont, 694 A.2d 422, 430 (Del. 1997). 142 In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760, 768-70. 143 Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261 (Del. 1989). 75 RR DONNELLEY
- 90. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • The committee members failed to attend the informational meetings with the committee’s special advisors;144 • 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;145 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.146 In contrast, the 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;147 and • The committee was advised by competent and independent legal and finan- cial 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.148 144 Kahn v. Tremont Corp., 694 A.2d 422, 429-30 (Del. 1997). 145 In re Tele-Communications, Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS at *49. 146 In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011). 147 In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 546 (Del. Ch. 2003). 148 Kohls v. Duthie, 765 A.2d 1274, 1285 (Del. Ch. 2000). 76 RR DONNELLEY
- 91. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 independence.149 In Airgas, Inc. v. Air Products and Chemicals, Inc.,150 the Delaware Supreme Court reaffirmed the principle that an independent and knowledgeable board, confident in the corpo- ration’s long-term business plan, can block a bid that the board determines to be inadequate. After the board of Airgas rejected a fully financed hostile offer made by Air Products at a price significantly greater than Airgas’ trading price, Air Products launched a proxy contest to replace the members of Airgas’s staggered board and sought to force the Airgas board to redeem its shareholder rights plan. After the board’s action in refusing to redeem the rights plan was upheld in court, both at the Court of Chancery and then at the Delaware Supreme Court, Air Products terminated its pursuit of Airgas. However, the power to say “no” alone may not be sufficient to shift the burden in the context of a transaction subject to the entire fairness standard. The committee should be empowered to actively negotiate with the related party in a manner that approximates an arms’ length transaction.151 For example, in In re Republic American Corporation Litigation,152 the Delaware Court of Chancery held that a special commit- tee 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. Similarly, the court In re Southern Peru, held that a committee’s failure to actively seek other potential trans- actions as an alternative to a transaction proposed by the company’s majority stock- holder was a factor in concluding that the committee did not have negotiating leverage 149 In re First Boston, Inc. Shareholders Litigation, No. 10338, 1990 Del. Ch. LEXIS 74 (June 7, 1990). 150 Airgas, Inc. v. Air Products and Chemicals, Inc., No. 649, 2010 (Del. Nov. 23, 2010) 151 Rabkin v. Olin Corp., 1990 Del. Ch. LEXIS 50 (Del. Ch. Apr. 17, 1990). 152 In re Republic American Corporation Litigation, No. 10112, 1989 Del. Ch. LEXIS 31 (Del. Ch. Apr. 4, 1989). 77 RR DONNELLEY Special committees should: • Have access to independent financial, legal and accounting advisors; • Have access to management and other experts; and • Have real bargaining power, including the ability to say “no.”
- 92. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS and was not properly functioning.153 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; • 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.154 While it is clear that a special committee must have power to negotiate as if nego- tiating an arms-length transaction, uncertainty regarding how aggressively a committee must exercise that power remains.155 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.156 Also, in empowering a committee, care should be taken not to undermine other procedural protections. For example, the court in In re John 153 In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011). 154 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. §141(c)(2); Krasner v. Moffett, 826 A.2d 277 (Del. 2003). 155 Although, the court suggests in In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011) that a special committee should critically review and continuously evaluate, instead of merely rationalize, a proposed transaction and avoid falling into a “controlled mindset.” 156 In re Pure Resources, Inc. Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002). 78 RR DONNELLEY
- 93. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Q. Hammons Shareholder Litigation157 declined to apply the business judgment rule in the context of a challenged transaction in part because a special committee had the ability to waive a requirement that the subject transaction be approved by a majority of minority vote. As the court explained, “an effective special committee, unlike dis- aggregate stockholders who face a collective action problem, has bargaining power to extract the highest price available for the minority stockholders. The majority-of- minority vote, however, provides minority stockholders an important opportunity to approve or disapprove of the work of the special committee and to stop a transaction they believe is not in their best interests. Thus, to provide sufficient protection to the minority stockholders, the majority-of-minority vote must not be waivable even by the special committee.”158 LEGAL DUTIES OF SPECIAL COMMITTEE MEMBERS The legal obligations of directors serving on the special committee are not differ- ent than their duties as directors generally. They are under a duty of care, which obli- gates 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. 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 dis- cussed in detail in Chapter 2 of this Handbook. SUMMARY In essence, the role of a special committee is to assist the target corporation in replicating as much as possible the process that would occur in a negotiated trans- action between the corporation and an unrelated third party. The utilization of a prop- erly functioning special committee provides “powerful evidence of fairness.”159 The legal benefits resulting from special committee approval of a transaction will accrue, however, only if the special committee is independent and disinterested, active, informed and has real bargaining power. 157 In re John Q. Hammons Shareholder Litigation, 2009 Del. Ch. LEXIS 174. 158 Id. at *42. 159 In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 550 (Del. Ch. 2003). 79 RR DONNELLEY
- 94. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 or other conflict, the board should consider whether use of a special committee might enhance the process of evaluating the transaction. If a special committee is 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 and the power to consider alternative transactions. 80 RR DONNELLEY
- 95. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Considerations in Determining Whether an Individual or Firm May be Viewed as Disinterested and Independent To ascertain potential conflicts in selecting advisors, directors should consider questioning potential advisors regarding any existing, past or con- templated relationships with the company, potential buyer or any of their respective affiliates as to the following, among other things: 1. Tell us about any economic or other material relationships you may have or contemplate with the prospective buyer or any of its affiliates, including whether you or any of your officers, directors or principals are investors in, or have done any material work for, or are seeking to do any material work for, the buyer or any of its affiliates. 2. Tell us about your historical relationship with the company, including whether your firm or any of your officers, directors or principals have been engaged by the company for any work. 3. Tell us whether your firm, your officers or directors have in the past worked for any person affiliated with the company or the potential buyer in connection with any other matter, whether related to the company or not. 4. Have you discussed the contemplated transaction, or any similar trans- action involving the company, with any other person? 5. Please describe any business, family or other non-business relationships you or any member of your firm has with any member of the company, the buyer or any of their respective members or affiliates. It is important to note that an existing or previous relationship between a potential advisor for a particular situation and the company, the buyer or either of their respective affiliates or members, does not necessarily preclude the potential advisor from being viewed as disinterested or independent. The board must eval- uate the extent of the relationship, including the size, timing, hiring party, materiality of the investment or fees and any other relevant details and determine whether any of the facts could lead to a perceived bias for such advisor. 81 RR DONNELLEY
- 96. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS It is also important to note that it is not always possible, or even advisable, to avoid all conflicts, and in fact the best advisor may be one who has some rela- tionships or other potential conflicts. However, the board should take steps to ensure that it understands the potential conflicts and their implications, and con- sider steps to avoid or mitigate the impact of any potential or actual conflict, so that the board ultimately can decide whether the benefits of a particular advisor (with any mitigating measures) outweigh the detriments of the potential conflicts. The board also should be prepared to disclose the potential conflicts to the company’s shareholders. 82 RR DONNELLEY
- 97. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 corpo- ration’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 insolvency, and directors can still be held liable for actions or omissions that breach those duties or are otherwise tortious or illegal. However, when the corporation becomes insolvent, the beneficiaries of those duties expands from the stockholders of the corporation to include the creditors of the corporation. 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.160 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, direc- tors generally can decide to preserve for sale the going concern value of the business 160 Not all states extend such fiduciary duties to creditors during insolvency. See, e.g., In re Bostic Construction, Inc., 435 B.R. 46 (Bankr. M.D.N.C. June 25, 2010) (“In North Carolina, directors of a corporation do not owe a fiduciary duty to the creditors of the corporation.”). 83 RR DONNELLEY Directors’ fiduciary duties do not change when the corpo- ration approaches or enters insolvency, but when the corporation enters insolvency, the beneficiaries of the duties do expand to include creditors.
- 98. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 “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 impre- cise. 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 often is 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-by- minute 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 state- ments are sent by vendors after the close of a particular billing cycle. Similarly, cus- tomers 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 solvent to insolvent 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 value of its total assets; and • Equitable Insolvency Test – A corporation is insolvent when it is generally unable to pay its debts as they become due. 84 RR DONNELLEY
- 99. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 cir- cumstances of the case.161 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 liti- gation. 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 partic- ularity 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). In many bankruptcy cases, the aggregate proofs of claim filed by creditors far exceed the balance sheet liabilities, and many assets realize disappoint- ing recoveries, such as receivables that are collected less offsets and defenses by coun- terparties. Moreover, the Bankruptcy Code test for solvency is nearly identical to the Delaware test. With that reality having been determined, it can be challenging to per- suade that same court (or even another court) of different facts for the solvency calcu- lation as to litigation against the directors and officers, even as to some pre-bankruptcy time. 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 com- pany advisers are also helpful in supporting directors regarding many other business judgment questions, although directors cannot delegate their duties to such pro- fessionals. 161 See, e.g., 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 92 (Del. 2007), and Quadrant Struc- tured Products Company, Ltd. v. Vertin, 115 A.3d 535, 539 (Del. Ch. 2015). 85 RR DONNELLEY
- 100. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS DUTIES TO CREDITORS WHEN THE CORPORATION IS INSOLVENT The Introduction of the Zone of Insolvency Concept Although the question of when directors’ fiduciary duties shift from stockholders to creditors is now settled in favor of insolvency as the test, Delaware and bankruptcy courts introduced significant uncertainty into this question in the early 1990s in a ser- ies of decisions that focused on the so-called “zone of insolvency” test creating an ear- lier trigger. The Delaware Court of Chancery first introduced the “zone of insolvency” con- cept in its 1991 decision in Credit Lyonnaise Bank Nederland, N.V. v. Pathe Communications Corp.162 In addressing the question of to whom directors of finan- cially 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 to the corporate enterprise,” which includes both stockholders and creditors.163 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.”164 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.165 Unfortunately, the courts did not provide clarity as to when exactly a corporation would be deemed to have entered into the zone 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 stock- holders 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 162 No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991). 163 Id. at *108 and n.55. 164 Id. n.55. 165 Id . 86 RR DONNELLEY
- 101. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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. The relevance of this history now is to caution directors of a distressed corpo- ration to begin thinking defensively when the corporation is nearing insolvency. This is especially wise because in hindsight most corporations are demonstrated to have become insolvent sooner than they realized. 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 zone of insolvency. In 2006, the Delaware Court of Chancery decided North American Catholic Educational Programming Foundation, Inc. v. Gheewalla,166 holding that “no direct claim for breach of fiduciary duties may be asserted by creditors of a solvent corporation operat- ing in the zone of insolvency.”167 In its analysis, the court noted that “the notion that creditors of an insolvent corpo- ration are permitted standing to maintain derivative claims for breach of existing fidu- ciary 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.”168 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 brought on behalf of the corporation by the creditors). 166 2006 Del. Ch. LEXIS 164. 167 Id . at *65. 168 Id. at *55-56. 87 RR DONNELLEY
- 102. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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.”169 The court noted that because creditors have existing protections afforded by other sources, such as the credit documents, additional protection through direct claims of breaches of fiduciary duty is inefficient. 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.”170 169 Id. at *62. 170 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). An intermediate appellate court in California also held that there is not a duty to creditors when a corporation is in the “zone of insolvency,” but after insolvency, creditors are entitled to protection under the “trust fund doctrine” to prevent dissipation, diversion or undue risk to assets that might other- wise be used to pay creditors. Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020, 1041 (2009). Similarly, the United States District Court for the Southern District of New York has held that “New York State’s corporate directors do not owe a duty of care to a corporation’s creditors when the corporation is arguably operating within the ‘zone of insolvency.’” RSL Commc’ns PLC v. Bildirici, 649 F. Supp. 2d 184, 203 (S.D.N.Y. 2009), aff’d sub nom. RSL Commc’ns PLC, ex rel. Jervis v. Fisher, 412 F. App. 337 (2d Cir. 2011). However, the United States Bankruptcy Court for the Eastern District of Virginia has held that “once a [Virginia] corporation enters the zone of insolvency, the fiduciary duties owed by the Directors extend also to the corporation’s creditors.” In re James River Coal Co., 360 B.R. 139, 170 (Bankr. E.D. Va. 2007). 88 RR DONNELLEY Operating in the zone of insolvency does not change directors’ fiduciary duties.
- 103. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 bring derivative actions on behalf of the corporation because they are the ultimate benefi- ciaries of the corporation’s growth and increased value. When a corpo- ration is insolvent, however, its cred- itors take the place of the stockholders as the residual 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 fidu- ciary duties.” The Supreme Court held that “individual creditors of an insolvent corpo- ration 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 non- fiduciary claim that may be available for individual creditors.”171 The Gheewalla decisions have greatly clarified directors’ duties when their corpo- ration 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 corpo- ration 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 gen- erally (stockholders when it is solvent, and creditors when it is insolvent). As a prac- tical matter, outside of bankruptcy, 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 171 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 the corporation’s estate, including creditors. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1985). 89 RR DONNELLEY When a corporation becomes insolvent, creditors take the place of stockholders as the residual beneficiaries of any increase in value. Consequently, creditors of an insolvent corporation have standing to bring derivative claims against directors for breaches of fiduciary duty.
- 104. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS creditor, in a fairly unique set of circumstances, such as where the plaintiff creditor had a relatively large stake in the outcome vis-a-vis other creditors.172 In a Chapter 11 case, however, such claims may be pursued by an unsecured creditors committee in order enhance the recoveries of all creditors. It may also be worth noting 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. Whether direc- tors owe duties to shareholders, creditors, or both, the business judgment rule applies, and it does not necessarily require that the subject become more conservative and favor cred- itors prophylactically over shareholders once the creditors have become beneficiaries of the duty.173 Of course, in light of the same hindsight risk discussed above in connection with solvency determinations, as a practical matter officers and directors probably will want to be more conservative in their decisions. In addition, there are other potential pit- falls for directors to consider as the business approaches insolvency. For example, direc- tors 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 compa- nies often are torn between attempts to turn around the corporation’s fortunes and termi- nate the corporation’s existence through a sale of the corporation or, in partic- ularly dire situations, liquidation and dissolution or bankruptcy. The threat of deepening insolvency claims would influence directors to 172 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 Del. Ch. LEXIS 164, at *47 (Del. Ch. Sept. 1, 2006). 173 Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772, 787-88, 790 n.57 (Del. Ch. 2004) 90 RR DONNELLEY Deepening insolvency is no longer recognized by Delaware courts as an independent cause of action, but it may be permitted as a measure of damages on other claims.
- 105. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS terminate their corporation’s existence, rather than prolong its life with the hope of providing a greater benefit to stockholders in the long run. In 2001, the Third U.S. Circuit Court of Appeals recognized174 for the first time a 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 ill- considered attempt to salvage the company, resulting in further decline in the corpo- ration’s net worth and the creditors’ ability to recover from the corporation. In 2006, the Delaware Court of Chancery flatly rejected deepening insolvency claims and consequently clarified the state of fiduciary duties of directors of finan- cially 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 direc- tors 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.”175 Strategies that result in continued or even deepening insolvency do not in them- selves give rise to a cause of action. “Rather, in such a scenario the directors are pro- tected by the business judgment rule.”176 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 tradi- tional toolkit, which contains, among other things, causes of action for breach of fidu- ciary duty and for fraud.”177 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 bank- 174 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001). 175 906 A.2d 168, 174 (Del. Ch. 2006), aff’d, 931 A.2d 438 (Del. 2007); see also Berg & Berg Enter- prises, LLC v. Boyle, 178 Cal. App. 4th at 1041 (duty is to avoid “actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditor claims”) (emphasis in original). 176 Id. at 205. 177 Id. 91 RR DONNELLEY
- 106. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS ruptcy 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).178 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. 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 pre- scribed 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 appointed in a Chapter 11 case, the existing corporate gover- nance remains in place and the directors assume the fiduciary duties of a debtor-in-possession.179 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.180 Thus, the various statutory provisions and legal doc- trines defining the fiduciary duties of a Chapter 11 trustee are equally applicable to a debtor-in-possession.181 It should be noted, however, that some courts have indicated 178 See, e.g., In re Brown Schools, 2008 Bankr. LEXIS 1226 (Bankr. D. Del. Apr. 24 2008). 179 In re FSC Corp., 38 B.R. 346, 349 (Bankr. W.D. Pa. 1983). 180 11 U.S.C.S. §1107(a) (1984). 181 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-in- possession 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). 92 RR DONNELLEY Debtors-in-possession owe fiduciary duties under state and federal bankruptcy law to both creditors and stock- holders.
- 107. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS that a Chapter 11 trustee running the business of a debtor may be subject to less court oversight than a debtor-in-possession.182 A debtor-in-possession owes a fiduciary duty to all interested parties, creditors and stockholders alike.183 The substance of these federal bankruptcy law fiduciary 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.184 The debtor-in-possession has a duty of loyalty to “maximize the value of the estate,”185 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.”186 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 offi- cers would 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. 182 See In re Lifeguard Industries, Inc., 37 B.R. 3, 17 (Bankr. S.D. Ohio 1983); In re Airlift Interna- tional, 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). 183 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). 184 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). 185 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 352 (1985). 186 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). 93 RR DONNELLEY
- 108. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 and creditors.187 Directors that serve after the dissolution of a corporation will thus 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 viola- tion of their statutory duty as trustees to liquidate and distribute the corporation’s 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 pend- ing 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.188 This allows the appointed trust- ees to reduce their risk of personal liability by seeking express court approval of actions during the dissolution and winding up of the corporation. 187 8 Del. C. §§278, 279. 188 8 Del. C. §§279, 291. 94 RR DONNELLEY Directors of a corporation can mini- mize their personal liability exposure by relying on statutory procedural safeguards in the dissolution process.
- 109. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 busi- ness advisers of various options. • Remember that fiduciary duties continue to apply to stockholders. Cred- itors may also bring direct claims for breach of contract against the corpo- ration, 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 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 respon- sible resolution. 95 RR DONNELLEY
- 110. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 made for the purpose of obtaining legal advice.189 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.”190 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 [or her] to give sound informed advice.”191 Attorney-client privilege applies to both oral and written confidential communications provided for the purpose of legal advice, either originating from the client or from the lawyer in response to a client’s inquiries.192 However, privilege protects only communications, not the underlying facts communicated.193 In addition, attorney-client privilege is generally inapplicable to the information the attorney receives from independent non-client sources. There are exceptions to the attorney-client privilege that result in otherwise priv- ileged communications losing their privileged status. For example, in the context of a derivative stockholder action, a claim of attorney-client privilege can also be defeated upon a showing of “good cause,” as described below.194 The attorney-client privilege 189 8 JOHN H. WIGMORE, EVIDENCE §2290 (John T. McNaughton rev. ed., 1961). 190 Upjohn v. United States, 449 U.S. 383, 389 (1981). 191 Id. at 390. 192 Id. at 389. 193 Id. at 395. 194 Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970). The privilege protects only the communications between the client and the lawyer, and not the under- lying facts. 96 RR DONNELLEY
- 111. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS can be waived either intentionally or by inadvertent disclosure of privileged information. Further, in certain limited situations, the attorney-client privilege cannot be asserted, such as to protect communications that further an ongoing crime or fraud, known as the crime-fraud exception. 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; • 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 pro- tected from disclosure by the client or by the legal advisor; and • When the protection is not waived.195 195 8 JOHN H. WIGMORE, EVIDENCE §2292 (John T. McNaughton rev. ed., 1961). 97 RR DONNELLEY The attorney-client privilege is designed to protect the relationship between the lawyer and the client by providing that communica- tions between the lawyer and client are not subject to dis- covery, with certain exceptions.
- 112. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Attorney-client privilege in the corporate context exists but can be 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 or other constituent of the corporation. A lawyer representing a corporation must communicate with, and receive direction from, the client through its officers, directors and employees.196 Accordingly, “[a]n otherwise priv- ileged communication by a lawyer to a corporate agent does not lose its protected status simply because the agent then conveys the attorney’s opinion to a corporate committee charged with acting on such issues.”197 Over time, the state and federal courts have developed the following three different methods to determine whether certain communications are considered privileged in the corporate context: • Control Group Test. This test supports the idea that privilege in the corpo- rate 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.198 As noted in the discussion of the Upjohn test below, this test has been criticized by Federal courts as too nar- row199 and inadequate.200 • Subject Matter Test. The subject matter test extends privilege to communications with lower-level employees or corporate agents, so long as the communication with legal counsel is related to the subject matter of representation.201 196 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A Jeremiad for Upjohn, 61 BUS. LAW. 95, 97 (2005). 197 Shriver v. Baskin-Robbins Ice Cream Co., 145 F.R.D. 112, 114 (D. Colo. 1992). 198 Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D. Pa. 1962). 199 Upjohn, 449 U.S. at 392. 200 Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 491 (7th Cir. 1970). 201 Id.; Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977). 98 RR DONNELLEY In general, when dealing with a corporation, the privilege belongs to the corpo- ration. It cannot be asserted by officers or direc- tors for their personal benefit. In the context of a corpo- ration, the scope of the attorney-client privilege may be limited and may not extend to all employees.
- 113. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • 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 factors202: 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 whether the information was available from upper-echelon management.203 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 inter- viewed corporate personnel. The corporation then shared some of the information with the SEC. The Internal Revenue Service later commenced its own investigation and issued a sum- mons requiring production of all files relating to the corporation’s internal inves- tigation, specifically including the questionnaires. The corporation claimed that the attorney-client privilege applied to the files from the internal investigation. The Appel- late Court applied the control-group test and held that privilege did not apply to 202 Upjohn, 449 U.S. at 396-9. 203 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 the 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. 99 RR DONNELLEY Directors and officers should take extra pre- cautions when dealing with sensitive legal communications to preserve the maximum scope of the attorney- client privilege.
- 114. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS communications with middle management employees who could not direct the corpo- ration’s response to the legal advice received. However, the 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.204 Although the Upjohn test is now the prevailing test used to evaluate when the attorney-client privilege applies in the corporate context in federal courts and many state courts, some state courts still use variations of both the control-group and subject matter tests. INVOKING AND WAIVING PRIVILEGE The corporation’s attorney-client priv- ilege belongs to the corporation, thus the power to invoke or waive the privilege lies with the corporation’s management or authorized agents. An individual cannot pre- vent disclosure of communications between himself and the corporation’s counsel if the corporation has waived privilege.205 Further, communications involving personal or individual concerns of a corporate agent often are not entitled to the privilege.206 In certain 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.207 However, as illustrated by the Ninth Circuit’s decision in United States v. Ruehle, employees must be made aware that the corporation controls the attorney-client priv- ilege and the privilege may not protect employee communications made in the course of an investigation from disclosure to third parties, including the government. The corporation has discretion to waive the privilege or otherwise disclose information without input from individual employees, unless the individual employees retain 204 Id. at 383-384. 205 Diversified Indus., Inc. v. Meredith, 572 F.2d at 611 n.5. 206 Horton, 61 BUS. LAW. at 112. 207 Id. 100 RR DONNELLEY Disclosing confidential and priv- ileged communications to individuals outside the corpo- ration, such as the corporation’s accountants, may result in loss of the privilege.
- 115. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS independent legal counsel at the outset of the investigation to protect their individual interests, or clearly seek dual representation by the corporation’s attorneys in a way that maintains their individual privilege.208 An officer or agent acting within the scope of his or her authority also has the power, advertently or inadvertently, to waive the attorney-client privilege. Usually, if communications are disclosed to third parties, not for the purpose of assisting the attorney in rendering legal advice, the privilege is lost.209 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 does not result in the loss of the confidentiality pro- tections of the attorney-client privilege.210 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 a common interest in liti- gation, actual or prospective.”211 Additionally, the Delaware Court of Chancery has held that Delaware law approves the privilege’s application to attorney-client communications where an investment banker is present, especially in the context of a corporate transaction.212 The common interest privilege also can be extended to communications with auditors.213 When control of a corporation passes to new management – through a sale, fore- closure on stock, or bankruptcy – the authority to assert and waive the corporation’s attorney-client privilege passes as well.214 The new managers or trustees may assert or waive the privilege, even as to communications made by former directors and officers.215 208 United States v. Ruehle, 583 F.3d 600 (9th Cir. 2009). 209 Thomas R. Mulroy & Eric J. Muñoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM. L.J. 49, 61-62 (2002); but see 3Com Corporation v. Diamond Holdings, Inc., C.A. No 3933 (Del. Ct. Ch. May 31, 2010). 210 Id. 211 Id. at 62. See also Transmirra Prods. Corp. v. Monsanto Chem. Co., 26 F.R.D. 572, 579 (S.D.N.Y. 1960). 212 3Com Corporation, C.A. No 3933. 213 See, e.g., Sherman v. Ryan, 911 N.E.2d 378, 400-02 (Ill. App. Ct. 2009). 214 Commodity Futures Trading Comm’n, 471 U.S. at 349. 215 Id. 101 RR DONNELLEY Although the attorney-client privilege belongs to the corpo- ration, it can be waived, even inadvertently, by an officer or director acting within the scope of his or her duties.
- 116. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Similarly, the power to assert and waive a subsidiary’s privilege passes to new owners; once control of the subsidiary passes, the former parent corporation can no longer prevent the subsidiary from waiving privilege.216 In-House Counsel 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 covered by attorney- client privilege if the communications concern matters within the scope of the employee’s corporate duties and the employees are sufficiently aware that questions posed to them by in-house counsel are for the purpose of the corporation obtaining legal advice.217 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 more likely to be aware of issues and problems that may arise than upper-level management. Attorney-client privilege works to promote free communica- tion between employees and in-house counsel in the corporate context; without such protection, internal counsel could face difficulty in assisting the corporation with resolving and remedying legal matters.218 EXAMPLES OF WAIVER Inadvertent Waiver An inadvertent waiver often occurs during litigation, when a corporation fails to assert the privilege when a question is asked about a written communication or mis- takenly includes a privileged document in response to a request.219 However, most courts conclude that such inadvertent and mistaken disclosure of information does not result in waiver if the company took reasonable precautions to prevent disclosure and promptly took reasonable steps to rectify such error.220 Other courts hold that because a client is the only one who can waive the privilege, the accidental and inadvertent 216 Id. 217 Upjohn, 449 U.S. at 403. 218 Horton, 61 BUS. LAW. at 128-29. 219 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:23 (2007). 220 Id.; Fed. R. Evid. 502(b). 102 RR DONNELLEY In-house counsel should exercise extra care to ensure that their con- fidential communica- tions are entitled to the privilege.
- 117. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS disclosure of confidential information alone is insufficient to constitute a waiver.221 Federal rules of evidence 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 per- son should promptly notify the other party of such disclosure so he or she can take protective action.222 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.223 Federal Rule of Civil Procedure 26(b)(5)(B) further allows a producing party to notify the receiving party of information produced in discovery that is subject to a claim of privilege or of protection as trial-preparation material.224 On receipt of the notice, the receiving party “must promptly return, sequester, or destroy the specified information and any copies it has; must not use or disclose the information until the claim is resolved; must take reasonable steps to retrieve the information if the party disclosed it before being notified; and may promptly present the information to the court under seal for a determination of the claim.”225 Deliberate Waiver Occasionally, a corporation may decide deliberately to disclose a confidential 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 SEC.226 In these circumstances, most courts will find that the disclosure waives privilege.227 Selective Waiver Some courts hold that the doctrine of selective waiver works to preserve attorney- client privilege and work product protection against third parties on certain privileged 221 Id. 222 Id. 223 Id. 226 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 73-74 (D. Md. 1998). 227 United States v. Billmyer, 57 F.3d 31, 36-37 (1st Cir. 1995). 103 RR DONNELLEY
- 118. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS documents or materials that have been previously disclosed to a government agency.228 Selective waiver was recognized in Diversified v. Meredith when the court asserted that the right to disclose investigative material to a federal agency should result in the limited waiver of the attorney-client privilege for that purpose.229 However, selective waiver is reviewed by courts on a case-by-case basis. Unlike in Diversified, many courts have refused to recognize selective waiver of attorney-client privilege. For example, in 2006 the court in In re Qwest Communications International Inc. Secu- rities Litigation230 rejected Qwest’s assertion that thousands of documents in a class action litigation were protected by the attorney-client privilege where it had previously produced such documents to the SEC and the Department of Justice under con- fidentiality agreements that provided for selective waiver during an investigation. Crime-Fraud Exception Attorney-client privilege does not apply to communications by a client with his or her lawyer that further ongoing criminal activities. This is known as the crime-fraud exception. The crime-fraud exception attempts to protect legitimate inquiries for legal advice, without permitting clients to use their attorneys as knowing or unknowing participants in ongoing criminal activity. Most courts follow a two-pronged test to over- come 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 or 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.231 228 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., 572 F.2d at 611. 229 Diversified Indus., Inc., 572 F.2d at 611. 230 450 F.3d 1179 (10th Cir. 2006). 231 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §82. 104 RR DONNELLEY The attorney-client privilege may not be used to shield dis- closure of information that is provided to counsel as part of a plan or scheme to engage in wrongful or illegal conduct.
- 119. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS PRIVILEGE VERSUS CONFIDENTIALITY General The attorney-client relationship alone does not create a presumption of con- fidentiality. The client must intend that the communication with the attorney remain confidential. If the client intended that the information be published or distributed to others, the privilege will not apply.232 Maintaining Confidentiality Most commonly, concerns regarding the confidentiality of corporate attorney-client 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.233 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.”234 232 In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984). 233 Scott Paper Co. v. United States, 943 F. Supp. 489, 499 (1996); see also 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:12 (2007). 234 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §70(f) (2000). See also United States v. Kovel, 296 F.2d 918 (1961). 105 RR DONNELLEY The attorney-client privilege is only intended to protect dis- closure of confidential information. If the information is not maintained in confidence, the privilege will be lost as to that information.
- 120. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Differences Between a Lawyer’s Duty of Confidentiality and Attorney-Client Privilege There are important differences between evidentiary privilege given to attorney- client communications and the broader duty of confidentiality that lawyers owe to their clients. The chief difference between the professional duty of confidentiality and the evidentiary attorney-client privilege is that the duty of confidentiality applies to virtually all information provided to a lawyer concerning a client, and prohibits virtually all disclosures, whereas the attorney-client privilege only applies the question of whether communications between a lawyer and his or her cli- ent are subject to compelled disclosure in litigation or a regulatory proceeding discovery in litigation.235 Privilege exists to protect specific types of communications between a client seeking legal advice and the lawyer from whom such advice is sought.236 A lawyer’s ethical obligation pertains to the information relating to the representa- tion, whether disclosed by the client or brought to the lawyer’s attention from another source.237 Disclosures contrary to the ethical obligation of confidentiality may be made only in those limited circumstances permitted under relevant ethical rules (or in com- pliance with other laws) or with the informed consent of the client.238 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.239 235 Horton, 61 BUS. LAW. at 101. 236 Id. 237 Id. 238 Id. 239 Id. at 102. 106 RR DONNELLEY As a fiduciary, a lawyer’s obligation to maintain the confidentiality of a client’s information is much broader than the attorney-client privilege.
- 121. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Work Product Doctrine Similar to the doctrine of attorney-client privilege, the work product doctrine protects the confidentiality of certain materials related to the legal representation of a client. 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.”240 Federal Rule of Civil Procedure 26(b)(3), codifying the work product doctrine as it was set forth in Hickman v. Taylor,241 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 antici- pation 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 party seeking discovery has substantial need of the materials in the preparation of the par- ty’s case and that the party is unable without undue hardship to obtain the substantial equivalent of the materials by other means. In 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.”242 Recently, the Court of Appeals for the District of Columbia expanded the pro- tections afforded by the work product doctrine, holding that (i) a document prepared by an outside auditor “because of” the prospect of litigation was protected by the work product doctrine, and (ii) there was no waiver of those protections when the company shared certain work product with the outside auditor.243 The court reasoned that the company had not disclosed the work-product to an adversary or a conduit to an adver- sary since the outside auditor was not a potential adversary in the dispute at question and the outside auditor had a duty of confidentiality to the company. 240 United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998). 241 329 U.S. 495 (1947). 242 Fed. R. Civ. P. 26(b)(3). 243 United States v. Deloitte LLP, 610 F.3d 129 (D.C. Cir. 2010) (Although the court found that the work product doctrine had not been waived, the court noted that such voluntary disclosure did waive the attorney-client privilege). The work product doctrine is designed to protect the attorney’s drafts and notes that reflect the attorney’s considerations and strategies. It cannot be used to shield facts from discovery. 107 RR DONNELLEY
- 122. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS PRIVILEGE IN DERIVATIVE SUITS AND CLASS ACTIONS A derivative suit is a legal action brought by a stockholder or former stockholder purportedly in the name of the corporation and against one or more of its officers or directors seeking a recovery on behalf of the injured corporation for wrongful conduct. The purpose of the derivative action is to enforce a corporate right that the corporation has failed or refused to assert.244 By contrast, a class action suit may be brought against the corporation on behalf of current or former shareholders (as well as current or former officers or directors) to remedy harm inflicted directly upon shareholders. 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.245 When stockholders sought discovery of communications between management and the corporation’s attorneys, the corporation asserted the attorney-client privilege. The court noted tensions between protecting the integrity of management’s decision-making process and the stockholders’ interest. The court articulated 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.”246 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, including: • The number of stockholders and the percentage of stock they represent; 244 1 R. FRANKLIN BALOTTI & JESSE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND BUSINESS ORGANIZATIONS §13.10 P. 13-20. 245 Garner, 430 F.2d at 1103. 246 Id. at 1100. 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 injured corpo- ration for wrongful conduct by such officers or directors. In derivative actions, directors and officers who have been charged with wrongdoing are unlikely to be able to use the priv- ilege to avoid disclosure of communications with the corporation’s counsel. 108 RR DONNELLEY
- 123. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • 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 its availability 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 composed 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 con- fidentiality the corporation has an interest for independent reasons.247 In general, Garner holds that, in a derivative action, shareholders can access priv- ileged corporate communications, so long as there is “good cause” to waive the attorney-client privilege and disclose the information.248 Even though the Garner test is flexible, there are generally accepted limitations to the rule, including, among other things, privileged communications that result in remedial measures or those made during the course of the derivative suit.249 Garner also does not apply to claims of work product because Garner is premised on the idea of mutuality of interest between management and stockholders, “once there is sufficient anticipation of litigation to trigger the work product immunity,” this mutuality is destroyed.250 247 Id. at 1104. 248 Ward v. Succession of Freeman, 854 F.2d 780, 784 (5th Cir. 1988). 249 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1.27 (2007). 250 Sherman v. Ryan, 392 Ill. App. 3d 712 (Ill. App. Ct. 2009). 109 RR DONNELLEY
- 124. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS PRIVILEGE IN CORPORATE INVESTIGATIONS Government Investigations When a corporation is being investigated for alleged criminal or fraudulent activ- ity, a board often will announce an intention to cooperate fully with the inves- tigation.251 In past years, the Department of Justice evaluated cooperation based on the corporation’s willingness to waive attorney-client privilege and work product pro- tections. These positions were embodied in Department of Justice guidance to prose- cutors, 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 had significantly changed its policies. 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 memo- randums (each named after the Deputy Attorney General who issued them) as well as Department of Justice announced guidelines and the Congressional response. 251 Id. In internal investigations, corpo- rations may voluntarily elect to waive the privilege in order to better situate themselves with government investigators. 110 RR DONNELLEY
- 125. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Holder Memorandum252 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 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.”253 Adhering to the suggestions of the Holder Memorandum results in the corporation’s effective waiver of privileges that may otherwise be available in a potential action, leaving the corporation vulner- able. Thompson Memorandum254 In January 2003, Deputy Attorney General Larry D. Thompson issued a revised statement emphasizing changes to the ways in which the Department of Justice would assess the authenticity of a corporation’s cooperation.255 “Too often business orga- nizations, 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.”256 Like the Holder Memorandum, the Thompson Memorandum urged voluntary disclosure, identification of culpable corporate agents, and waiver of applicable privileges.257 252 Memorandum from Eric H. Holder, Deputy Attorney General, to Heads of Department Component Heads and United States Attorneys (June 16, 1999), http://www.abanet.org/poladv/priorities/ privilegewaiver/ 1999jun16_privwaiv_dojholder.pdf. 253 Id. 254 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. 255 Horton, 61 BUS. LAW. at 116. 256 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. 257 Id. 111 RR DONNELLEY
- 126. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS McNulty Memorandum258 In December 2006, Deputy Attorney General Paul J. McNulty announced a for- mal 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 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.259 If a “legitimate need” existed for disclosure of protected information, the prose- cutor was required to seek the least intrusive waiver necessary to conduct a complete and thorough investigation. Also, before requesting a privilege waiver from the corpo- ration, the prosecutor was required to obtain formal written approval from the Department of Justice, though this was unnecessary if the corporation voluntarily offered privileged documents. The McNulty Memorandum was 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.”260 Further, the “slippery slope toward diminution or even elimination of the corporate attorney-client privilege insofar as it relates to governmental inves- tigations and prosecutions may well have a chilling effect on 258 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. 259 Id. 260 Horton, 61 BUS. LAW. at 119. 112 RR DONNELLEY
- 127. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS communications between corporate client representatives and corporate lawyers, which is likely to lead in turn to less effective lawyering in the corporate and transac- tional context and diminished legal compliance by corporations.”261 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.262 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. 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 would no longer be measured on whether a corporation chooses to waive attorney-client priv- ilege – rather, it would depend on whether the corporation has timely dis- closed relevant facts; • Second, federal prosecutors would no longer demand privileged attorney- client communication or attorney work product; • Third, the Department of Justice would no longer consider whether a corpo- ration has advanced attorneys’ fees to its employees in evaluating coopera- tion; • Fourth, the Department of Justice would not penalize corporations that have entered into joint defense agreements, provided they refrain from sharing information the Department of Justice disclosed in confidence; and 261 Id. at 126. 262 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. 113 RR DONNELLEY
- 128. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Fifth, the Department of Justice would not evaluate cooperation based on a company’s disciplinary action against its employees.263 The Seaboard Report264 In October 2001, in response to an enforcement action against an employee of a subsidiary of the Seaboard Corporation, the SEC provided criteria to evaluate the independent efforts and level of cooperation exhibited by companies charged with securities law violations (the “Seaboard Report”).265 Specifically, the SEC emphasized that it would consider whether public companies hired outside counsel to conduct internal investigations and whether the company had ever previously engaged such outside counsel.266 Further, in the Seaboard Report, the SEC clarified its position that disclosure of privileged information, pursuant to a confidentiality agreement, to the SEC in the course of an investigation should not necessarily waive the attorney-client privilege as to third parties although some courts have not agreed with this view.267 Congressional Investigations The Constitution grants Congress an implied power of inquiry to inform itself as it makes laws and oversees their execution, and Congress may enforce its power through subpoenas and contempt proceedings.268 A congressional investigation is usually initiated by the U.S. Senate or House of Representatives through standing committees and sub- committees or through committees authorized to investigate specific matters.269 A congressional investigation resembles a trial more than a routine oversight hearing.270 Although corporations subject to congressional investigations have the right to invoke constitutional privileges during such an investigation, attorney-client privilege and the work product doctrine are not guaranteed by the Constitution and are not required to be recognized by Congress.271 However, in practice, Congress some- times accommodates a corporation’s legitimate assertion of attorney-client privilege.272 As a result, corporations and attorneys must decide whether to disclose privileged communications and documents in response to committee requests or instead invoke privilege at the risk of having it rejected. 263 Id. 264 Securities Exchange Act Release No. 44969, October 23, 2001. 265 Id. 266 Id. 267 Id.; Brief of SEC as Amicus Curiae, McKesson HBOC, Inc., No. 99-C-7980-3 (Ga. Ct. App. Filed May 13, 2001); see also 450 F.3d 1179 (10th Cir. 2006). 114 RR DONNELLEY
- 129. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Internal Investigations A corporation may initiate an internal investigation in response to a stockholder demand or lawsuit, government agency investigation or subpoena; or as a result of either a complaint or grievance from an employee or group of employees.273 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 analysis in the inves- tigation.274 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.275 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.276 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.277 CONCLUSION To a surprising degree, whether a corporation’s communications with its lawyers are protected from disclosure remains subject to a shifting amalgam of state and federal statutes, legal theories, and rules. For example, Section 307 of the Sarbanes-Oxley Act of 2002 requires the SEC to issue rules setting forth minimum standards for professional conduct of attorneys appearing and practicing before the SEC, including such rules requiring attorneys to “report-up” within the organization any evidence of a material violation of securities law or fiduciary duty (or similar duty) by an issuer or any agent thereof.278 This type of rule- making demonstrates the increased pressures placed on the corporate attorney-client priv- ilege.279 It is important for corporate counsel, directors, officers and other employees to be informed of these types of considerations so that the corporation’s counselors can protect its confidences in a manner that is compliant with all pertinent rules and regulations. 273 Thomas R. Mulroy & Eric J. Munoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM. L.J. 49 (2002). 274 Id. at 49. 275 Id. at 58. 276 Id. 277 Id. 278 15 U.S.C.S. §7245 (2002). 279 Horton, 61 BUS. LAW. at 115. 115 RR DONNELLEY
- 130. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 or available in all circumstances (e.g., for breaches of the fiduciary duty of loyalty where the director or officer acted in bad faith or insolvency of the company), it is permitted in a wide variety of circumstances and generally provides officers and directors with the most financial protection. In addi- tion, in certain instances, indemnification is mandatory under the DGCL. For those situations in which indemnification is not available, D&O insurance can provide another line of financial protection. 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, the law, 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 most capable and responsible persons to serve in corporate management.280 A corpo- ration generally has statutory authority to indemnify any person who was or is a party to any direct legal proceeding (an action brought against the person by a third party) by reason of the fact that the person is or was a director, officer, employee or agent of the corporation. The corporation can indemnify a person for reasonably incurred 280 Merritt-Chapman & Scott Corp. v. Wolfson, 264 A.2d 358, 360 (Del. Super. Ct. 1970). Indemnification and D&O insurance protect directors and officers against incurring personal liability for their actions on behalf of the corporation. 116 RR DONNELLEY
- 131. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS expenses, judgments, fines and amounts paid in settlement. The corporation can only do so, however, as long as the person acted in good faith and in a manner the person reasonably believed to be in the best interest of the corporation. If a derivative action (an action on behalf of the company by a stockholder or creditor) is brought against a director or officer, the company may only indemnify that person for expenses, such as attorney’s fees, in connection with defense of such action and only if that person acted in good faith and in a manner that person believed to be in the company’s best interest. Unlike for a direct action, the company is not permitted to indemnify the director or officer for any judgment or settlement in a derivative action. (This is because, in a derivative action, the alleged harm is to the company, so any judgment or settlement would go to the company. If the company were then to indemnify the director or officer for the judgment or settlement, there would be no net recovery to the company.) Section 145 provides that in either a direct or derivative action, the corporation must indemnify any person who successfully defends such action for expenses, such as attorney’s fees, reasonably incurred. If the person is not successful on the merits or settles the action, the corporation may only indemnify him for those expenses upon a determination by a neutral body that the person acted in good faith and in a manner he reasonably believed to be in the best interests of the company. Depending on whether it is a direct or derivative case, the neutral body can be the court, the board of direc- tors, an independent legal counsel or the stockholders. The corporation may also indemnify a person for judgments, fines, or settlements in a direct case as long as approved by the neutral body. 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. In addition, Section 145 allows corporations to advance such expenses (including attor- neys’ fees) to persons serving at the request of the corporation as directors, officers, employees or agents of another entity on such terms and conditions, if any, as the corporation deems appropriate. 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. 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 117 RR DONNELLEY
- 132. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS determine a corporation’s obligation to advance expenses (including attorneys’ fees), thus providing 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. Moreover, the right to indemnification or advancement of expenses under a provision in the certificate of incorporation or the bylaws cannot be eliminated or impaired by an amendment to such provision after the occurrence of the act or omission that is the subject of the action for which expense reimbursement is sought, unless the provision in effect at the time of the act or omission explicitly authorizes such elimination or impairment.281 Additional Sources of Indemnification Rights In addition to the mandatory indemnification provided by the DGCL, most corpo- rations provide for indemnification in their charters and bylaws to the maximum extent allowed by Delaware law. In addition, many corpo- rations enter into specific indemnification agreements with their directors and officers. Due to the significant risks of stockholder lawsuits and other potential liabilities that directors and officers face as a result of their roles within their corporations, the vast majority of qualified director and officer candidates expect, and oftentimes will not serve without, robust indemnification and related rights. Directors and officers should be familiar with the various provisions of the corpo- ration’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 its directors and officers (as well as legal counsel or other appropriate advisors) from time to time as circumstances merit to evaluate 281 See 8 Del. C. § 145(f) (reversing the rule announced in Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. 2008), which permitted a corporation to eliminate the right to indemnification or advancement of expenses 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). 118 RR DONNELLEY Given the proliferation of suits against corporations, the vast majority of qualified director and officer candidates expect that a corporation will provide for robust indemnification rights.
- 133. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS whether the indemnification rights and obligations they contain continue to be appro- priate 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 indemnify its directors and officers in situations where Section 145 provides for per- missive 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 the certificate of incorporation. Without such a provision or other contractual right to indemnification, the availability of indemnification for directors and officers would be at the discretion of the board. Whether a board would grant indemnification under particular 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 directors and officers to the full extent provided by Section 145. 119 RR DONNELLEY Indemnity provisions contained in a corporation’s charter can- not be modified without a stockholder vote, and therefore provide greater protection for directors and officers than provisions contained in the corporation’s bylaws.
- 134. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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. Unless expressly permitted by the charter or bylaws, the right to indemnification or advancement of expenses provided in the bylaws cannot be eliminated or impaired by a subsequent amendment to the bylaws after the act or omission relating to the indemnification or expense advancement has occurred; how- ever, the board of directors may amend or repeal such protections at any time before the occurrence of such act or omission.282 Contractual Indemnification Rights Many corporations enter into indemnification agreements with directors and offi- cers that provide an additional layer of comfort beyond the statutory provisions and provisions contained in the charter and bylaws. These agreements typically provide for indemnification and advancement of expenses to the fullest extent permitted by Dela- ware 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 into indemnification agreements with its directors and executive officers, it should consider seeking stockholder approval of those agreements in accordance with the interested director transaction provi- sions 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, 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. In the case of adoption of an indemnification agreement for the benefit of all the directors, none of the directors 282 8 Del. C. § 145(f). 120 RR DONNELLEY Corporations should consider obtain- ing stockholder ratification of indemnification agreements with offi- cers and directors so as to reduce chal- lenges to the enforceability of such related-party agreements.
- 135. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS may be considered disinterested and thus securing the ratification of stockholders of such arrangements is desirable. Well-crafted indemnification agreements directly between the corporation and the affected individual provide the individual with the greatest level of comfort and cer- tainty as to his or her indemnification rights. Assuming the corporation does not enter bankruptcy (in which case appropriate D&O insurance, as discussed below, takes on an added measure of significance), if the director or officer has an indemnification agreement directly with the corporation, the corporation will generally be obligated to fulfill its indemnification obligations to that individual as set forth in the contract. This is so even if 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 very specific procedural mechanisms (regarding advancement of defense costs, burden of proof, 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. SEC Position on Indemnification for Securities Law Violations The SEC 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, some courts have affirmed the SEC’s view. As a result, directors and officers should not assume that their indemnification rights for claims brought under the Securities Act will be upheld if challenged by the SEC, even if Delaware law would otherwise permit indemnification. 121 RR DONNELLEY Contractual agreements with directors and officers providing for indemnification rights gen- erally provide the highest level of comfort for the directors and officers because they cannot be modified without their consent.
- 136. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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, was or will be a director, officer, employee or agent of the corporation or who serves in certain capacities with another entity at the request of the corporation. The underlying public policy stems from the fact that, as discussed above, a corporation is not legally permitted to indemnify its directors and officers in certain circum- 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 corpo- ration. 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. 122 RR DONNELLEY D&O insurance is an essential part of managing the risk that directors and officers expose themselves to through their service to the corporation.
- 137. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS D&O insurance policies are complex documents and the market for D&O insurance, including the products offered and their related costs, is constantly evolv- ing. A corporation seeking to implement or renew a D&O insurance policy should plan to invest a significant amount of time (at least 30 to 60 days generally is necessary) and effort in seeking competing proposals from reputable insurers and carefully review- ing and negotiating the terms and conditions of the policy that they ultimately purchase. Like all forms of insurance, the real value of 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 covered. It is important to remember that employees of an insurance company’s claims department are trained to read the policy as nar- rowly as reasonably possible. 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 nego- tiate 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 should consider the policy’s bankruptcy exclusions despite the fact that bankruptcy is unlikely at the time. A corpo- ration 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. Furthermore, a D&O policy should be reviewed by the corporation at least annu- ally 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. 123 RR DONNELLEY Careful upfront negotiation of a D&O policy may pay substantial dividends when a claim is pre- sented by reducing the risk that the claim is denied by the carrier.
- 138. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS While public companies should consider D&O insurance to be indispensable, private companies should consider purchasing D&O insurance as well, particularly if 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 secu- rities 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 corpo- ration’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 type of claims covered by the policy, 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 between the corporation and all insured directors and officers, 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 124 RR DONNELLEY Although virtually essential to a public company, private compa- nies are increasingly considering purchasing D&O policies as well.
- 139. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 or the corporation is unable to indemnify 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 when it actually indemnifies 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 insurer to insurer, they generally provide cover- age in situations where other coverage would not be available to the individual insured direc- tor or officer (e.g., when the primary D&O insurer improperly refuses to provide coverage or where the primary D&O policy has been exhausted or rescinded). Side A DIC poli- cies contain their own exceptions and exclusions, so these policies should be carefully scrutinized as well. Because stand-alone Side A DIC 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, some companies may determine that it is 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. 125 RR DONNELLEY Directors and officers should carefully review the D&O policy to educate and familiar- ize themselves as to the scope and amount of coverage.
- 140. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Employment Practices Liability Insurance In addition to and in connection with a D&O policy, many corporations are pur- chasing 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 eval- uate 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 set- tles or is adjudicated for a larger amount, the company must cover the difference. Other “hammer clauses” permit a carrier to recommend alternative dispute resolution for the claim. 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 applicable to the policy is negotiable, but the corporation should typically negotiate its 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 126 RR DONNELLEY Companies should regularly review their D&O policies to analyze the scope of coverage, retention and exclusions.
- 141. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS condition 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 offi- cers 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. 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 when 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 con- stitutes 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 127 RR DONNELLEY
- 142. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 fail- ures 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 claims. Companies are sometimes successful in negotiating language providing that claims can be submitted any time up to the policy expiration date (or in some cases, after the expiration date.) Tail Policies Under certain circumstances, a corporation may purchase a “tail” insurance policy to extend the coverage time period 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 after- wards. 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. 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 therefore have coverage under the acquiring corporation’s D&O policy. Directors and officers of a target corporation engaged in acquisition nego- tiations should consider who will bear the cost of a necessary tail policy, and should consult their D&O carrier well in advance of the transaction closing to 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 128 RR DONNELLEY Many D&O policies do not survive significant corporate events such as a merger or bankruptcy filing. When contemplating such an event, the policy should be carefully reviewed to determine whether a “tail” policy will be needed, and the company should allot sufficient time and funds to timely acquire such a policy.
- 143. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 reevaluate carefully their changing D&O insurance needs and cir- cumstances at least a couple of months before the expiration of their current policy so that they have sufficient time to negotiate new or revised terms with their current car- rier, or to 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 sev- eral 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 generally are not 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 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 offi- cers) are paid before the corporation receives any coverage under Side B 129 RR DONNELLEY
- 144. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS (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 could not be exhausted by the corporation. 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 generally are 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 mem- bers of its board and management team, applications by public companies generally require the corporation to attach its financial statements and certain SEC 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). As with other forms of insurance, misstatements or omissions in the corporation’s application, including in any SEC 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 SEC 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 plum- meted after a recent release of negative financial results. If the financial statements and SEC 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 circum- stances 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 130 RR DONNELLEY
- 145. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 fraudu- lent 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. 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 appli- cable to the misconduct exclusion can have the same prophylactic effect. Good sever- ability 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 is also sometimes possible to avoid an application altogether, or to submit an abbreviated application, if the corporation simply is renewing its D&O policy with its current carrier. Companies generally should 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. 131 RR DONNELLEY
- 146. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 omis- sions 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 insured persons (i.e., one of the corporation’s current or former officers or directors) 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 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. Furthermore, a broad definition of who constitutes an “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, if employees are insureds under the policy and if an employee provides assistance to the named plaintiffs by supplying information or otherwise, the insurer may invoke the insured vs. insured exclusion to deny coverage. Issues can also arise in connection with claims in merger and acquis- ition, 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 132 RR DONNELLEY
- 147. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 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 hun- dreds of thousands of dollars or more to defend and can take years before a final reso- lution is reached. Essentially, in addition to paying its own defense costs, the corporation would be required to advance all defense costs to its officers and directors, and may have to wait 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 sig- nificance 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. For example, 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. To preserve the bankrupt corpo- ration’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 corpo- ration’s rights in the D&O policy are subordinate to the rights of the directors and offi- cers, and that the policy is therefore not an asset that must be used to satisfy the claims of the corporation’s creditors in bankruptcy. An alternative is to negotiate a provision providing that the company (i) waive any automatic stay or injunction that may apply and (ii) agree not to oppose any efforts by the insurer to pay an insured person. In addition, 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 133 RR DONNELLEY
- 148. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 sit- uation, but the particular language should be scrutinized closely to ensure that it is sufficiently broad. Directors and officers of a corporation that is contemplating bankruptcy should review carefully 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, and may not be available. 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 scrutinized carefully, and negotiated if necessary, before purchasing the D&O policy. For example, there are generally provisions specifying the applicable venue and forum in the event of a dispute under the policy. If resolving a dis- pute 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 arbi- tration 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 be, as with any other provisions, significantly dependent on the market for D&O insurance at the time of purchase. 134 RR DONNELLEY Boilerplate provisions in D&O policies should be carefully reviewed as they may contain important substantive provisions.
- 149. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 and Coverage Limits: A company should be aware that gen- erally, 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 time by which notice must be given of 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 mis- conduct or fraud of one or more individuals. If the severability defi- nition 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 vs. 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. 135 RR DONNELLEY
- 150. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • 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 the proceeds of D&O insurance are an asset of the estate the company should 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 and 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. 136 RR DONNELLEY
- 151. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 con- ducted 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 in part 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 fla- grant disregard and disrespect for the corporate entity and its formalities, or the pres- ence 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 sub- sidiaries, individual stockholders (such as sole or majority stockholders) are also sometimes sued under this theory. By asserting that a court should pierce the corporate veil, a plaintiff is requesting the court to ignore the separate existence of a corporation, because of fraud or other similar injustice, and hold the stockholders personally liable for any damages sustained by the plaintiff. A Delaware court will uphold this request if it would be inequitable or unfair not to do so. “[P]ersuading a Delaware court to disregard the corporate entity is a difficult task,”283 and therefore corporate veil piercing is rarely successful. Interpretations of the theory of piercing the corporate veil vary among the 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; 283 Harco Nat’l Ins. Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *10 (Del. Ch. Sept. 19, 1989). 137 RR DONNELLEY When the corporate existence is flagrantly disregarded or abused, it is possible that the parent corporation or substantial stock- holders of a corporation may be found to be liable for the actions of the corporation under a theory referred to as “piercing the corpo- rate veil.”
- 152. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS others have referred to an agency relationship between the two corporations; while still others have referred to ‘piercing the corporate veil.’”284 This chapter introduces the primary bases on which courts have relied to disregard the corporate form under Dela- ware law, including fraud, instrumentality, alter ego, estoppel and agency. FRAUD Delaware courts have stated that “[f]raud has traditionally been a sufficient rea- son to pierce the corporate veil.”285 Other related reasons for piercing the corporate veil include “contravention of law or contract,” “public wrong,” and similar injustices.286 In Gadsden v. Home Preservation Company, Inc.,287 the plaintiff sued the defendant corpo- ration for failure to perform home repairs pursuant to a contract. The plaintiff obtained a judgment, but was unable to enforce it because the corporation had no assets. She sought to pierce the corporate veil so that she could enforce the judgment against the defendant sole stock- holder, who was also the sole direc- tor and employee of the corporation. The court held that the “business practices of [the defendant] con- stituted a fraud, contravention of contract, and a public wrong” and found the sole stockholder liable for the judg- ment.288 Several factors supported the court’s decision in the Gadsden case, including the following facts: • The defendant corporation had no funds in its bank account, and any money that was placed there was quickly withdrawn by the stockholder; 284 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 839 (D. Del. 1978). 285 Harco Nat’l Ins., 1989 Del. Ch. LEXIS at *10. 286 Id. 287 Gadsden v. Home Preservation Co., Inc., No. 18888, 2004 Del. Ch. LEXIS 14, at *1 (Del. Ch. Feb. 20, 2004). 288 Id. at *18. 138 RR DONNELLEY A court held a stockholder liable under a fraud theory in a situation where: • The corporation held no money in its bank accounts; • The stockholder withdrew all amounts placed in the corporation’s bank accounts; • All assets used by the corporation belonged to the stockholder; • The stockholder always presumed that he would be liable for the acts of the corporation; and • The plaintiff was an individual.
- 153. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • The corporation had no assets – all tools and equipment used to perform home repairs by the defendant corporation were owned by the stockholder. Nonetheless, the corporation continued to fraudulently guarantee its repairs for 10- and 20-year periods; and • The plaintiff was a homeowner rather than a more sophisticated and knowl- edgeable creditor.289 After considering these factors, the court held the defendant stockholder personally liable because “to uphold the corporate status of Home Preservation in these circum- stances would be tantamount to blessing a scheme for business owners to defraud creditors routinely.”290 INSTRUMENTALITY Alleging that a corporation is a “mere instrumentality” of an individual stockholder or a parent corporation is another way plain- tiffs may attempt to hold stockholders liable for a corporation’s wrongs. This theory applies where the controlling stockholder or parent company has ignored the separate identity of its subsidiary.291 Although it does not require a showing of fraud, some courts have required a showing of unfairness or injustice.292 Two cases illustrate this theory of liability. • In Equitable Trust Co. v. Gallagher, the defendant president and predom- inant stockholder of the corporation set up a trust consisting of shares of the corporation’s stock for an employee, with the corporation serving as trustee.293 In an attempt to replace the trust, the defendant, rather than the trustee corporation, entered into an agreement with the employee to make an outright gift of the shares. 289 Id. at *16. 290 Id. at *18. 291 Walsh v. Hotel Corp. of Am., 231 A.2d 458, 461 (Del. 1967). 292 Harper v. Del. Valley Broadcasters, Inc., 743 F. Supp. 1076, 1086 (D. Del. 1990) (citing Harco Nat’l Ins., 1989 Del. Ch. holding that an “overall element of injustice or unfairness must always be pres- ent” before Delaware courts will disregard separate legal entities in equity). 293 Equitable Trust Co. v. Gallagher, 99 A.2d 490 (Del. 1953), modified, 102 A.2d 538 (Del. 1954). 139 RR DONNELLEY Where a stockholder uses a corporation solely as an instrumentality or an alter ego and does not respect its existence, courts have found the stockholder to be liable for the acts of the corporation.
- 154. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS The actual shares were never transferred, and after the employee’s death the defendant refused to give the shares to the trust’s executor, arguing that the gift was not an enforceable promise. The court disregarded the existence of the trustee corporation, on the grounds that: (i) the defendant or his immediate relatives owned virtually all of the stock of the corporation, (ii) the defendant “personally dominated the corporation in all its operations,” and (iii) the defendant admitted that he “regarded himself as the corporation.”294 In evaluating the enforceability of the promise, the court found that it did not matter that the offer was made by the defendant rather than the trustee corporation because the corporation was a mere instrumentality of the defendant. • In Walsh v. Hotel Corp. of America, the plaintiff was injured while staying at a motel operated by the subsidiary and sued the defendant parent corpo- ration. The court allowed the plaintiff to amend her complaint to assert that the defendant was liable for the acts of its wholly owned subsidiary.295 Given that the defendant’s name was the only one displayed in the lobby and on the motel’s stationery, and that the defendant was listed as the operator of the motel in a reputable financial handbook, the court held that these facts “furnished reasonable grounds to suggest that the defendant, as the sole stockholder of its subsidiary, may have disregarded the separate existence of that subsidiary.”296 The court permitted the amendment and allowed addi- tional discovery in support of the instrumentality theory of liability. ALTER EGO THEORY The alter ego theory of liability is sometimes treated as synonymous with the instrumentality theory,297 and has been described as a close relative of the veil-piercing theory.298 Under the alter ego theory, where a corporation is merely a shell or façade for its dominant stockholders, the stockholders may be liable for the corporation’s wrongs. 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; 294 Id. at 493-94. 295 Walsh, 231 A.2d at 461. 296 Id. 297 Id. 298 Harper v. Del. Valley Broadcasters, Inc., 743 F. Supp. 1076, 1085 (D. Del. 1990). 140 RR DONNELLEY
- 155. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS • Whether the corporation was solvent; • Whether dividends were paid; • Whether corporate records were kept; • Whether directors and officers functioned properly; • 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.299 The above list is not exhaustive. “No single factor could justify a decision to dis- regard the corporate entity, but. . . an overall element of injustice or unfairness must always be present as well.”300 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 under the alter ego theory.301 In Harper, an independent con- tractor 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 discus- sing 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 Harper court focused its 299 Harco Nat’l Ins. Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *11-12 (Del. Ch. Sept. 19, 1989) (quoting U.S. v. Golden Acres, Inc., 702 F. Supp. 1097, 1104 (D. Del. 1988)). 300 Harper v. Del. Valley Broadcasters, 743 F. Supp. at 1086 (citing Harco Nat’l Ins., 1989 Del. Ch. LEXIS 114, at *11-12). 301 Harper v. Del. Valley Broadcasters, 743 F. Supp. 1076 (D. Del. 1990). 141 RR DONNELLEY 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 appro- priate under the alter ego or fraud theories of liability.
- 156. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 injustice had been alleged, and the court refused to ignore the separate legal existence of the defendant.302 ESTOPPEL Equitable estoppel is another theory that courts have relied upon in finding a stockholder liable for the acts of a corporation. Under this theory, a parent company or controlling stockholder may be liable when: (i) it has by its conduct led a third party to believe that the parent or controlling stockholder would be responsible for the obliga- tions of the subsidiary or controlled company, and (ii) the third party has changed its position in detrimental reliance on that belief. For example, in Mabon, Nugent & Co. v. Texas American Energy Corp.,303 the court held the plaintiff debenture holders had alleged facts sufficient to support a claim that the parent company of the debenture issuer could be held liable for payment of the debentures on a theory of equitable estoppel.304 The court held the plaintiffs had estab- lished detrimental reliance by alleging that they had purchased and held the debentures of the subsidiary company in reliance on the belief that the parent had assumed the subsidiary’s obligations under the debenture, based on the following alleged facts: • Following a reorganization of the subsidiary, the consolidated financial statements of 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; and • 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.305 302 Id. at 1086. 303 Mabon, Nugent & Co. v. Texas American Energy Corp., No. 8578, 1988 Del. Ch. LEXIS 11, at *1 (Del. Ch. Jan. 27, 1988). 304 Id. at *11 (quoting Wilson v. Am. Ins. Co., 209 A.2d 902, 904 (Del. 1965)). 305 Id. at *10-11. 142 RR DONNELLEY
- 157. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS 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 for the parent’s benefit, such that the subsidiary is acting as an agent of the parent, then the parent may be found liable for the acts of the subsidiary. A showing that the parent and subsidiary share the following may support a finding that the parent controls the subsidiary as an agent: • Stock ownership; • Directors and officers; • Financing arrangements; • Responsibility for day-to-day operations; • Arrangements for payment of salaries and expenses; or • Origin of the subsidiary’s business and assets.306 All of these factors (and others) may be considered; no one factor alone is suffi- cient to prove that an agency relationship exists. 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 the subsidiary’s acts.307 Importantly, some courts have held that holding a parent company liable for the acts of the subsidiary under an agency theory does not require a showing of fraud or other inequity, as would be required for a showing of liability under a theory of corporate veil piercing.308 However, demonstrating that a subsidiary is an agent of a parent is a diffi- cult burden for a plaintiff. For example, in Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., the court held that a subsidiary was not the agent of a parent com- pany even though the companies had joint operations, shared common directors and 306 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 841 (D. Del. 1978). 307 Id. 308 Id. at 840. Agency is an alternative theory of parent liability for a subsidiary corpo- ration that does not generally require a showing of fraud or inequity. 143 RR DONNELLEY
- 158. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS officers, and the parent exerted control over the subsidiary’s finances.309 The court held that notwithstanding these “close ties,” the two companies had “many of the indicia of separate corporate existence,” such as separate bank accounts and separate contractual rights and obligations, and the evidence established that the parent lacked total control over the subsidiary.310 The Third Circuit later indicated, however, that the district court in Japan Petroleum Co. may have demanded too much of plaintiffs by requiring a showing of “total” control, which is “not a prerequisite” to finding an agency relationship under general principles of agency.311 VEIL PIERCING IN THE CONTEXT OF FIDUCIARY DUTY BREACH The foregoing discussion focused on the circumstances in which a stockholder, who may or may not be a director, could be found liable for the actions of a corpo- ration. The concept of piercing the corporate veil can also surface in director liability cases. For example, in Grace Brothers, Ltd. v. UniHolding Corp.,312 a court rejected claims by defendant directors that they could not be liable for breach of fiduciary duty in their capacity as directors of the parent in connection with acts of a subsidiary. The court held that “[d]irectors of a parent board can breach their duty of loyalty if they purposely cause – or knowingly fail to make efforts to stop – action by a wholly- owned subsidiary that is adverse to the interests of the parent corporation and its stockholders.”313 In reaching this decision, the court noted that one director was the chairperson of the subsidiary and that all directors knew about the subsidiary’s chal- lenged transaction and could have acted to cause the subsidiary to avoid the action.314 While Grace Brothers is not a traditional corporate veil piercing case, it demonstrates how the doctrine may play a role in director liability cases and sets forth the responsibilities directors have with regard to their subsidiary corporations. 309 Id. at 840-45. 310 Id. 311 Phoenix Canada Oil Co. v. Texaco, Inc., 842 F.2d 1466, 1477-78 (3d Cir. 1988). 312 No. 17617, 2000 Del. Ch. LEXIS 101, at *1 (Del. Ch. July 12, 2000). 313 Id. at *4. 314 Id at *35-*45. 144 RR DONNELLEY
- 159. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS CHAPTER 10 NONPROFIT ORGANIZATIONS INTRODUCTION This chapter highlights the major differences between the fiduciary duties and other responsibilities of corporate directors and officers of nonprofit organizations and their counterparts in for-profit corporations. This chapter is not a comprehensive guide for directors and officers of nonprofit organizations. It is incumbent on the directors and officers of nonprofit organizations to familiarize themselves with the nuances of the nonprofit sections of the corporations code of their particular state of incorporation, particularly because state laws governing nonprofit organizations are not uniformly subject to influence by Delaware law to the same extent as the laws governing for- profit corporations. MANAGING THE BUSINESS AND THE ROLES OF DIRECTORS AND OFFICERS Generally, directors and officers of a nonprofit organization are responsible for directing the corporation’s activities in a manner that is consistent with its purpose, by contrast to the responsibility of a board of a for-profit corporation to maximize share- holder value. The organizational structure of a non-profit organization is typically the same as a for-profit entity; the board of directors, which may also be called the board of trustees, is responsible for the management of the organization’s business and affairs, but acts in a supervisory role and delegates the details of the day-to-day man- agement of the organization to the officers of the corporation. Similar to a for-profit organization, a nonprofit organization may have a chief executive officer or president (who may also be referred to as an executive director), secretary, treasurer and such other officers as may be determined by the board of directors or as may be required by the laws of the state in which the nonprofit is organized. Typically, the officers are agents of the corporation in the strict legal sense and as such have the power individually to bind the corporation, while the directors can only act as a group. Nevertheless, directors are clearly fiduciaries of the corporation and have ultimate power and authority over the corporation through their ability to hire, supervise and replace the officers. 145 RR DONNELLEY
- 160. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS FIDUCIARY DUTIES The fiduciary duties of corporate directors and officers of nonprofit organizations generally are similar to those of their counterparts in for-profit corporations, but vary by state and also depending on the type of non-profit entity. For centuries, trustees of charitable trusts have been deemed to have the same obligation toward the assets of the trust as towards their own, personal resources. This responsibility, the duty of care, is to act prudently when managing the nonprofit organization’s income and assets. Most states impose the standards of fiduciary responsibility (including the duty of care, duty of loyalty and other duties summarized in Chapter 2) on directors of nonprofit orga- nizations, whether or not the organizations are trusts and whether or not they are chari- table. Similarities between the fiduciary duties of directors and officers of nonprofit and for-profit corporations notwithstanding, fiduciary law does not assure accountability in nonprofit organizations because of the absence of rigorous enforcement by regulators (e.g., state attorneys general) and constituents. For example, in the for-profit context, shareholders enforce director accountability by bringing derivative lawsuits against the corporation in the event of a breach of fiduciary duty in order to protect their economic investment. Because nonprofit organizations do not have shareholders, this account- ability mechanism is less likely to have the same force. However, the IRS and state attorneys general have authority to supervise activities of non-profits. The IRS can impose penalties on directors or officers of non-profits that receive excess compensa- tion and can revoke a non-profit’s tax-exempt status if it engages in unreasonable activities. Further, state attorneys general also may investigate non-profits and bring actions against non-profits and their directors and officers on behalf of the public. 146 RR DONNELLEY
- 161. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Because of a lack of enforcement, watchdog agencies have assumed a role in monitoring and publicizing the activities of nonprofit entities. Generally, these watch- dog agencies (i) write standards to which charitable organizations are expected to adhere; (ii) enforce standards by rating entities in adherence to standards; and (iii) distribute ratings and other reports to the general public. The Standards for Charity Accountability issued by the Better Business Bureau Wise Giving Alliance serve as a leading example of watchdog agency standards.315 The Standards for Charity Accountability enumerate twenty standards across four categories of accountability: (i) governance and oversight; (ii) measurement of effec- tiveness; (iii) finances; and (iv) fundraising and informational materials. While volun- tary standards such as those put forth by the Better Business Bureau Wise Giving Alliance go beyond the requirements of local, state and federal laws and regulations, some of these rules may take on the force of law as federal and state governments evolve best practices guidelines for nonprofit organizations in the future. THE USE OF COMMITTEES As in the for-profit context, the bylaws of a nonprofit organization may authorize, or the board may establish by resolution, committees that are given the authority to act on behalf of the board. For many nonprofit organizations, the only committee possess- ing the authority to take action that will bind the corporation when the board of direc- tors is not in session is the executive committee. The bylaws may also provide for committees that do not exercise the authority of the board, whose members are not voting directors. Because of the typical nonprofit organization’s dependency on volun- teer time and services to accomplish essential tasks, the use of committees is essential. Certain states, such as California, require that nonprofit organizations organized for charitable purposes that receive or accrue gross revenue of at least $2 million in any fiscal year have an audit committee, which may not include any officers or other members of the organization’s staff. The audit committee must be separate from any finance committee also established by the board. Audit committee members must not 315 Better BUSINESS BUREAU WISE GIVING ALLIANCE, STANDARDS FOR CHARITY ACCOUNTABILITY (2003), http://give.org/for-charities/How-We-Accredit-Charities/. These standards are intended to apply to publicly soliciting organizations that are tax exempt under section 501(c)(3) of the Internal Revenue Code and to other organizations soliciting charitable donations. These standards are not intended to apply to private foundations that do not solicit contributions from the public. 147 RR DONNELLEY
- 162. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS be compensated for service on the committee and may not have a material financial interest in any entity doing business with the corporation.316 ATTORNEY-CLIENT PRIVILEGE IN A NONPROFIT CONTEXT For communications to be protected under attorney-client privilege, the communication must be made in confidence between a lawyer and a client, both acting in their respective capacities. There is no difference in the applicability of the attorney- client privilege in a for-profit or nonprofit context. For more detailed information regarding attorney-client privilege, please refer to Chapter 7. INDEMNIFICATION AND INSURANCE To protect directors and officers from personal liability for acts or omissions made while serving in their official capacities, a nonprofit organization may indemnify or provide insurance for directors and officers, as described below. Many states have statutes permitting and in some instances requiring a non-profit entity to indemnify its officers and directors.317 However, to provide clear and comprehensive indemnification rights, a nonprofit organization should provide in its articles or bylaws that it will pay the judgments and related expenses incurred by directors and officers when those expenses are the result of an act or omission by the director or officer while acting in the service of the organization. Indemnification cannot extend to criminal acts and may not cover certain willful acts that violate civil law. To protect directors and officers, a nonprofit organization should consider pur- chasing directors’ and officers’ liability insurance (“D&O Insurance”), so that the resources of the insurer will be available to provide protection to the directors and officers if the insured does not have sufficient resources. It is worth noting that D&O Insurance will not cover violations of criminal law. Further, D&O Insurance typically excludes an extensive list of civil law transgressions that may include offenses such as libel and slander, employee discrimination, and antitrust activities – the most prevalent types of liability in the nonprofit context. The exclusions to D&O Insurance coverage should be carefully reviewed before concluding that the policy offers the necessary coverage to directors and officers of a nonprofit organization. 316 Cal. Gov’t Code §12586(e)(2). 317 See 8 Del. C. §102 and §145; see also Cal. Corps. Code §§5238(d), 72376 and 9246(d). 148 RR DONNELLEY
- 163. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS Please refer to Chapter 8 for a more detailed discussion of indemnification and insurance of directors and officers. PERSONAL LIABILITY Because the law recognizes corporations as separate legal entities, the corporate form often serves as a shield against a director’s or officer’s liability. It is unusual for directors or officers to be found personally liable for an act or omission done while serving a nonprofit corporation, particularly where the transaction or other behavior is outside the realm of investment decisions. Of course, directors or officers of a non- profit corporation are not completely immune. Personal liability may result when a director or officer of a nonprofit corporation (i) breaches standards of fiduciary responsibility; (ii) violates civil rights law; or (iii) breaches defamation, antitrust or fundraising regulation law. Further, personal liability may attach where a director’s or officer’s conduct is wrongful and willful, continuous, or not based on reasonable care. In limited circumstances, certain volunteer directors and officers of nonprofit organizations may be protected from liability under the federal Volunteer Protection Act if the volunteer (i) performs services; (ii) volunteers for a nonprofit organization or governmental entity; and (iii) either (a) receives no compensation (reasonable reimbursement for expenses is allowed) or (b) does not receive anything of value in lieu of compensation in excess of $500 per year.318 Under the Act, a volunteer of a nonprofit organization or governmental entity is not liable for economic harm caused by an act or omission made while carrying out responsibilities on behalf of the orga- nization, so long as the volunteer is properly authorized and licensed, if such author- ization is needed.319 However, if the harm was caused by willful or criminal misconduct, gross negligence, reckless misconduct or a conscious, flagrant indif- ference to the rights or safety of the harmed individual, or if the harm was caused by the volunteer operating a motor vehicle, vessel, aircraft or any vehicle for which a license or insurance is required, the Act will not shield the volunteer from liability.320 318 42 U.S.C.S. §14505(6). 319 42 U.S.C.S. §14503-4. 320 42 U.S.C.S. §14503(a)(3) and (4). 149 RR DONNELLEY
- 164. FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS A major benefit of federal volunteer protections, such as those available under the Volunteer Protection Act, is the encouragement of a comprehensive and consistent approach to volunteer immunity, resulting in similar treatment of volunteers serving in different states. While the Volunteer Protection Act fills in gaps created by divergent and wide-ranging differences in current state volunteer immunity laws, volunteer directors and officers of nonprofit organizations are already protected in many states. Several states have enacted immunity laws that protect volunteer directors and officers of nonprofit organizations from assertion of civil law violations. For example, Cal- ifornia state law provides that a volunteer director or executive officer of a nonprofit corporation is not liable for monetary damages to a third party if the act or omission was done in good faith and within the scope of duty.321 321 Cal. Gov’t Code §5239 (with exceptions for reckless, wanton, gross, or intentional negligence and with a requirement of liability insurance policy coverage). 150 RR DONNELLEY
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