The current economic distress has put immense pressure on corporate boards of directors to consider and address the financial and operational challenges faced by their companies. Moreover, directors are often forced to weigh difficult choices among alternatives that are less than optimal, all under tight time constraints and under heightened scrutiny by shareholders and other stakeholders. This high stakes environment has generated a recent series of judicial decisions that focus on directors’ fiduciary obligations and provide guidance on how directors should conduct themselves in these difficult times. Examination of these cases also yields practical pointers on how corporate counsel can advise directors so as to reduce their risk of personal liability.
Duty of Oversight: Monitoring Business Risk vs. Fraudulent or Unlawful Activity
In distressed times, companies are more apt to suffer financial losses and experience other difficulties. When a company experiences significant adversity, it is not unusual for a group of shareholders to bring allegations that the blame should be borne by the directors for having breached one or more of their fiduciary duties.
One such duty, the duty of oversight, was recently discussed by the Delaware Court of Chancery in a derivative suit brought against current and former directors of Citigroup. The suit alleged that the directors breached their fiduciary duty of loyalty for “(1) failing to adequately oversee and manage Citigroup’s exposure to problems in the subprime mortgage market, even in the face of alleged ‘red flags’ and (2) failing to ensure that the Company’s financial reporting and other disclosures were thorough and accurate.”  The “red flags” alleged by the plaintiffs were largely in the public domain (including news articles and credit agency ratings) and reflected worsening economic conditions, a continuing decline in the subprime and credit markets, and the resulting impact on financial institutions.
Typically, boards of directors are protected in exercising their duties by the so-called business judgment rule. The business judgment rule insulates directors from liability relating to their duty of care so long as they act on an informed basis, in good faith, and in the honest belief that their actions are in the company’s best interests.
In bringing their claim, however, the Citigroup plaintiffs relied on Caremark Int’l Inc. Derivative Litigation and its progeny which clarified a director’s “duty of oversight.” While the court in Caremark interpreted the duty of oversight broadly, requiring directors to ensure that an adequate corporate information and reporting system exists, the court also indicated that “where a claim of directorial liability for corporate loss is predicated upon ignorance of liability…only a sustained or systemic failure of the board to exercise oversight…will establish the lack of good faith that is a necessary condition to liability.” The Caremark standard for directors was later affirmed in 2006 in Stone v. Ritter in which the Delaware Supreme Court further clarified that a showing of bad faith is an essential element in proving oversight liability. As the Delaware Supreme Court further explained in Stone: “Where directors fail to act in the face of a known duty to act thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”
In applying the learning of Caremark and Stone, the Delaware Court of Chancery in Citigroup found for the directors and refused to permit the case to proceed. The court labeled the suit as one that “essentially amounts to a claim that the director defendants should be personally liable to the Company because they failed to recognize the risk posed by subprime securities.” The court noted that Citigroup had in fact established procedures and controls to monitor risk, including the establishment of an audit and risk management committee. The court focused on the extremely high burden that the plaintiffs carried in order to rebut the presumption that the directors acted in good faith and cited Chancellor Allen’s observation in Caremark that “director liability based on the duty of oversight is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” The court found that the plaintiffs had failed to plead particularized facts demonstrating that the directors acted in bad faith and consciously disregarded their fiduciary duties. The opinion noted that failing to dismiss the plaintiff’s claim would risk undermining well settled policy of Delaware law by placing courts in the position of essentially second guessing directors’ business decisions.
In finding for the defendants, the Chancery Court essentially ruled that Citigroup was not a Caremark type case. Apart from finding no evidence of bad faith, the court observed that “significant differences exist between failing to oversee employee fraudulent or criminal conduct and failing to recognize the extent of a Company’s business risk.” In fact, the same month as Citigroup, another judge on the Chancery Court allowed a “failure to monitor” claim to survive a motion to dismiss. In that case, the Chancery Court cited well-pled allegations of pervasive, diverse and substantial financial fraud and allowed the suit to proceed.
Board Duties in a Sales Transaction
In these distressed times, boards are more frequently facing the difficult question of whether a distress sale of the business is the only option reasonably available, except for outright liquidation. For example, private equity firms typically lack resources adequate to allow them to support all their troubled portfolio companies. Their principals must decide which companies they will support, which they will sell and which they will abandon. Also, sales in a down market will result in reduced purchase prices which may prompt stockholders and creditors to question whether a particular sale was at fair value. Against this backdrop, several recent cases have addressed the duties of directors in sales transactions.
(a) Fiduciary Duties to the Common vs. the Preferred Holders
The decision by the Delaware Court of Chancery in In re Trados Shareholder Incorporated Litigation makes it clear that, in considering any change in control transaction, directors, particularly private equity-appointed directors, must take care not to favor the interests of the preferred stockholders where they diverge from the interests of the common holders.
In re Trados involved the sale of a company in a transaction where Trados’ preferred stockholders received $57.9 million to satisfy most of their liquidation preference, management received $7.8 million in incentive compensation and the common stockholders received nothing. Certain Trados common stockholders brought an action for breach of fiduciary duty, alleging the directors favored the interests of the preferred stockholders either at the expense of, or without considering, the common stockholders. The plaintiffs asked why the company, which was meeting its financial plan, had to be sold at the point in time chosen by the board.
The Court of Chancery refused to dismiss plaintiff’s fiduciary duty claims. The court cited prior case law holding that directors owe fiduciary duties to preferred where the right claimed by the preferred is a right shared equally with the common. Where this is not the case, the court held it is the board’s duty to favor the interests of the common stock. Because the interests of the preferred and the common stockholders clearly diverged with respect to a sale (most notably since the common would receive zero consideration from the sale), the court held that plaintiffs could avoid dismissal if there were reasonable facts to demonstrate that directors lacked independence. The court then found that appointment of four directors to the board by private equity firms with major holdings of the preferred stock, the employment or ownership relationship between such directors and firms and the fact that another director was the CEO with a bonus tied to the sale price were sufficient to support a reasonable inference that such directors had a personal interest in the sale decision, thereby rebutting the presumption of the business judgment rule. The court did not make a final determination of liability, but it did allow the case to move forward.
(b) Recent Interpretation of Revlon Duties
In sales transactions during distressed times, directors should be especially cognizant of their duties first established by the landmark case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. The Revlon ruling, issued in 1986, requires directors in a change in control transaction to maximize the value of the company and secure the best available price for the stockholders under the circumstances. In March of this year, the Delaware Supreme Court issued its opinion in Ryan v. Lyondell Chemical Co. which provides clarification as to the extent and triggering of such duties.
In Lyondell, stockholders brought an action claiming that the board’s hasty approval of the company’s sale breached the board’s Revlon duties. The Delaware Court of Chancery denied the defendant directors’ motion for summary judgment, noting that the deal had been approved in less than seven days and that the board had performed no market check and also agreed to substantial deal protections for the buyer. Applying the precedent set forth in Stone that the fiduciary duty of loyalty is breached where the board demonstrates “a conscious disregard for their responsibilities” and a failure “to discharge that fiduciary obligation in good faith,” Vice Chancellor Noble was troubled by the above noted aspects of the sales process and refused to grant the directors summary judgment.
In March, however, the Delaware Supreme Court unanimously reversed the lower court’s ruling. The opinion of the Delaware Supreme Court found that although the Delaware Chancery Court had properly stated the principle that bad faith and a breach of loyalty can be based on a conscious disregard of a known duty, the lower court erred in the following respects: (1) finding Revlon duties applied even before the directors had decided to sell the company, (2) requiring a specific process to satisfy Revlon duties, and (3) by “equat[ing] an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of one’s duties that constitutes bad faith.”
The decision of the Delaware Supreme Court is especially helpful to directors in its clarification of two points: (i) that Revlon duties arise only when a company “embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control” and not simply because a potential acquirer has indicated interest in pursuing an acquisition; and (ii) there is “no single blueprint” for how a board must discharge its Revlon duties. The court recognized that each transaction poses a unique set of circumstances that may require different means to satisfy the directors’ fiduciary obligations. The ruling evidences the Delaware Supreme Court’s deference to the business decisions of boards in the context of a Revlon transaction, at least when such decisions are judged under the duty of loyalty and good faith standard.
Practical Implications and Pointers
In addition to clarifying and refining legal principles regarding director liability, these recent Delaware cases, upon further examination, are also a source of some practical pointers on how corporate counsel can help reduce the risk of personal liability for directors through appropriate advice and specific preventative measures, including the following:
1. Establish Appropriate Oversight Policies and Procedures
The board should confirm that appropriate oversight policies and procedures have been established and that active monitoring is taking place. Such policies and procedures should be re-evaluated periodically to ensure that they are responsive not only to external and operational risks, but also to the threat of potential fraud or violations of law by management or employees. For example, the court in Citicorp gave great weight to the fact that the board had established an active audit and risk management committee to help assess the risk related to mortgage-backed securities.
2. Review the Scope of Indemnification Coverage
In both Citigroup and Lyondell, the companies had elective language in their charters pursuant to Section 102(b)(7) of the Delaware General Corporation Law that exculpated the directors from personal liability for breach of their fiduciary duties except for breaches of the duty of loyalty or actions or omissions not in good faith or that involved intentional misconduct or a knowing violations of law. Corporate counsel should confirm the board is fully protected to the full extent allowed under the applicable law. Absent such provisions, director actions would also be judged under the duty of care. Since D&O insurance policies are far from standard, corporate counsel should also have the company’s D&O policy reviewed by an expert to ensure that the coverage for the individual directors and officers is adequate and that the appropriate endorsements have been secured. In particular, it is possible to purchase separately a Side A policy that covers only the directors or non-company directors and helps avoid depletion of coverage resulting from claims against the company and delay of payments in a company bankruptcy.
3. Be Watchful of Situations Involving Director Self-Interest
Even an exculpatory charter provision does not afford protection where the director acts out of self-interest. In such situations, a director’s good faith is called into question and he no longer enjoys the presumption of the business judgment rule. In such situations, a director should recuse himself from deliberations where the matter in question is being discussed or decided so as not to taint the decision-making process and compromise the independence of the other directors. In certain cases it may be appropriate to appoint a special committee of independent directors to address a particular transaction or matter to ensure the business judgment rule still applies.
4. Anticipate Litigation and Avoid Non-Privileged Communications
Directors should be counseled that if suit is brought, all communications among the board members and with management will be subject to discovery. In the In re Trados case, several emails among the private equity-designated board members were quoted in the court’s opinion as possible evidence of self interest in selling the company. Handwritten notes and emails (even “deleted” emails) can come back to haunt their creators. If litigation is anticipated, corporate counsel should issue a document preservation directive. Withholding or destroying materials can result in liability or a claim of spoliation with an adverse inference against the company or the directors.
5. Follow a Deliberative Board Process and Document Its Implementation
While director exculpation provisions have generally been upheld, directors would nonetheless be prudent to fully discharge their duty of care. In that regard, process is key. The board should be well informed and briefed by management. However, the board should also feel free to conduct its own analysis, ask questions and consult with legal and financial advisors on whom it may rely. It is important that directors take the time to make an informed decision. Finally, the board minutes should reflect such deliberations.
6. Be Mindful of Revlon Duties in a Sale Transaction
In a proposed sale transaction, the board should discharge its Revlon duties to secure the best available price under the circumstances. The board should also discuss and consider the impact of the sale on all classes of equity, and if the company is insolvent or in the zone of insolvency, upon the creditors.
7. Counsel the Board Regarding Its Duties
Corporate counsel should, on a regular periodic basis, counsel the board members regarding their fiduciary duties, and provide a refresher briefing when the board is faced with a potential sale or other matter that might attract litigation. Document in the minutes or elsewhere, that the board has been so briefed and is aware of its duties. If suit is then brought, counsel can then demonstrate to the court that the directors understood their duties.