In the opening weeks of 2010, Parliament in London took up a bill to consider whether company directors might be held personally liable in certain areas implicating health and safety of workers. This bill, scheduled for further consideration later this spring, does not address intellectual property. However, it reminds us to stay aware of a doctrine that already exists in U.S. law under which directors can be held accountable for corporate trade secret misappropriation. A plaintiff seeking to establish a director’s tort liability typically faces a very high hurdle in the Business Judgment Rule (BJR). Directors are not personally liable in tort unless their action, including any claimed reliance on expert advice, was clearly unreasonable under the circumstances known to them at that time. Frances T. v. Village Green Owners Ass’n, 42 Cal. 3d 490 (1986). Even where the underlying facts raise suspicions about the reasonableness of the board’s action, a prima facie showing of good faith and reasonable investigation, supporting application of the BJR, is established provided only that a majority of the board is comprised of outside directors and has received advice of independent consultants on the issue. Katz v. Chevron Corp., 22 Cal. App. 4th 1352 (1994); see also FDIC v. Castetter, 184 F.3d 1040 (9th Cir. 1999) (applying BJR in non-tort context after finding the two factors above, without further inquiry). However, one line of decisions applying the rule continues to present a potential danger for investors seeking an active role in the management of their investment.

In PMC, Inc. v. Kadisha, 78 Cal. App. 4th 1368 (2000), the California Court of Appeal for the Second District articulated a new theory of officer and director liability that corporate officers or directors may be liable for the trade secret misappropriation of the company in which they are investing if:

  1. the officer or director purchased or invested in a corporation whose principal assets were the result of unlawful conduct;
  2. the officer or director took control of the corporation and appointed personnel to run the corporation; and
  3. the officer or director did so with knowledge of or, with respect to trade secret misappropriation, had reason to know of the unlawful conduct.

Kadisha thus created potential liability for investors taking a controlling interest in the management of the business, as their involvement may subject them to liability for past corporate wrongdoing. However, the key takeaway is that this rule only applies where there are facts suggesting the wrongdoing was a core part of the corporate strategy prior to the investment.

Kadisha involved a suit for misappropriation of trade secrets brought by majority shareholders of a corporation against former managers who had gone on to found a new company. The Kadisha plaintiffs, however, also sued previously unaffiliated investors in the new entity who had assumed roles as its officers and directors.

The appellate court rejected defendants’ argument that they could not be liable for trade secret violations that predated their investment, finding that “misappropriation is not limited to the initial act of improperly acquiring trade secrets; the use and continuing use of trade secrets is also misappropriation.” The court further explained that officer and director liability in tort generally requires a finding of actual participation by the officer or director in the tortious conduct, but also extends to knowing approval and consent to unlawful acts. The court went on to announce the three factors identified above, and found:

[P]laintiffs presented sufficient evidence to raise a triable issue whether, when defendants invested in [the new entity], became majority shareholders, officers and directors, effectively took control of the corporation, hired personnel to run it, and continued its operations, they knew or, with respect to trade secret misappropriation, had reason to know, that their codefendants had engaged in tortious conduct harmful to [the former corporation]. In a nutshell, there was evidence from which a trier of fact could reasonably infer defendants, in anticipation of enormous corporate and personal profit, knowingly invested at a bargain price in a corporation whose sole business assets consisted of stolen confidential information and processes, and subsequently controlled the entity which was engaging in unlawful conduct. (emphasis added). In reaching this conclusion, the Court relied upon evidence that the defendant corporation was an “exact replica” of the plaintiff corporation and was founded in order to capitalize on the plaintiffs’ manufacturing processes and contracts.

In addition, there may be a further limitation available to a passive director. Kadisha was unclear regarding whether the fact of the investors’ resulting positions at the corporation (as various officers and directors) is sufficient to impose liability on its own, or whether liability was based on actual exercise of control over management of the business. Courts interpreting Kadisha, however, have required that plaintiffs demonstrate the investors have actual resulting control over the management of the business. See, e.g., Verigy US, Inc. v. Mayder, No. C-07-04330, 2008 U.S. Dist. LEXIS 89271 (N.D. Cal. Nov. 4, 2008); M-Cam Inc. v. D’Agostino, No. 3:05-CV-00006, 2005 U.S. Dist. LEXIS 45288 (W.D. Va. Aug. 22, 2005); but see Moser v. Triarc Co., No. 05-cv-1742, 2007 U.S. Dist. LEXIS 22983 (S.D. Cal. Mar. 29, 2007) (that the defendant was only a shareholder in the corporation was insufficient to support dismissal of claim; plaintiff could still show direct participation in the alleged tort).

For example, in Verigy US, Inc. v. Mayder, Plaintiff contended that defendant W. Mayder, as a director of defendant STS, Inc. and member of defendant STS LLC, was liable based on his investment in and control of the companies and his knowledge or constructive knowledge of the misappropriation of plaintiff’s trade secrets. Plaintiff argued that W. Mayder had control over the companies based on: (1) his investments of $250,000 in each corporation; (2) the referral of a new investor to STS, Inc.; (3) the use of his driver’s license to obtain a seller’s permit for the company; (4) the operation of a website for STS, Inc.; (5) the recommendation of someone to help date R. Mayder’s (W. Mayder’s brother) lab notebook. Plaintiff argued W. Mayder knew or had reason to know of his brother’s misappropriation of trade secrets prior to the lawsuit based on a pair of letters sent by plaintiff to R. Mayder raising the same allegations made in the lawsuit, which were forwarded to W. Mayder, who allegedly failed to perform any investigation other than asking his brother’s opinion of the letters. The court rejected plaintiff’s argument for liability under Kadisha, finding that there was insufficient evidence to show an active role in either the misappropriation itself, or control of the corporation.

Similarly, in M-Cam Inc. v. D’Agostino, the court addressed the control point in the context of analyzing entity liability based on investor/director status. Defendant Principal Financial Group (Principal) was an investor in Defendant IPI. Plaintiff alleged that Principal continued to invest in IPI even after plaintiff informed the company of IPI’s illegal behavior, including misappropriation of its trade secrets. The district court distinguished Kadisha on the basis that Principal did not gain substantial control over the company through its investments:

[I]n that case [Kadisha], the defendants “became majority shareholders, officers, and directors[,] effectively took control of the corporation, hired personnel to run it, and continued its operations.” The California court based its holding both on the defendant company’s investment in and substantial control over the offending corporation. M-CAM has not alleged that Principal had any control whatsoever over IPI’s activities, aside from providing funding. Nor can the court infer from the Complaint that Defendant had sufficient control over IPI to be held vicariously liable for IPI’s misappropriation of trade secrets.

(internal citations omitted).

In Kadisha, the directors sought protection under the BJR, but the rule did not provide protection from the claims because, given the nature of the misappropriation allegations, an adequate investigation was required to invoke the rule. Under established law, an investigation prior to officer/director action is necessary to invoke the BJR where there are: “(1) allegations of facts which would reasonably call for such an investigation, or (2) allegations of facts which would have been discovered by a reasonable investigation and would have been material to the questioned exercise of business judgment.” Lee v. Interinsurance Exchange, 50 Cal. App. 4th 694 (1996). Kadisha shed more light on the nature of an adequate investigation, counseling that:

  1. The person responsible for the investigation should be given direction regarding its scope;
  2. The investigation should cover any alleged past acts of misappropriation;
  3. The investigation should include interviews of the person(s) alleged to have actually conducted the misappropriation, and examination of relevant evidence to determine how the corporation had produced its products; and
  4. The expert hired to opine on the investigation should express an opinion regarding whether the company’s products were produced using plaintiffs’ trade secrets. However, Kadisha and subsequent cases provide little guidance as to precisely what parameters an investigation must have to support summary judgment of no liability for trade secret misappropriation or other torts. One potential analogy comes from cases analyzing the adequacy of an investigation in the context of assertions of a special litigation committee defense to a derivative action, since that defense is essentially an application of the BJR. See, e.g., Desaigoudar v. Meyercord, 108 Cal. App. 4th 173 (2003); Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. Super. Ct. 1981); Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979).

Conclusion

Despite the potential “control” limitation and the ability to insulate directors from liability with a more thorough investigation, Kadisha represents a rather aggressive departure from traditional applications of the BJR that investors should consider when facing facts indicating potential wrongdoing at the subject investment. As the issue of directors’ personal liability gains headlines in other areas, it is likely that the Kadisha doctrine will receive renewed attention by potential plaintiffs as well.