Posts from 2011

Are Directors Vulnerable for Lack of Oversight When a Natural Disaster Strikes?

Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 06, 2011
 
The recent events in Japan prompt the question of whether the members of a corporation’s board of directors have any exposure to liability when a natural disaster strikes their company. The potential claim would be that as part of their duty to oversee the company’s risk management, they should have better protected their company from the losses resulting from a natural disaster.

Of course, most people view such national disasters as "black swans," or events no one anticipates will happen.

Surely directors are not responsible for future events no one anticipates.

Or are they?

The analysis of this issue begins with a review of the directors’ duty to oversee their corporation’s activities to proactively prevent losses. In Delaware, this duty is often referred to as a "Caremark" duty, after the decision that proposed such a duty exists. Delaware courts have repeatedly described a Caremark claim as possibly the most difficult claim to win under Delaware corporate law. Yet, Caremark claims continue to be filed, albeit less frequently than other types of claims against directors.

A Caremark claim is particularly dangerous to directors. The Delaware Supreme Court has characterized some Caremark claims as breaches of the duty of loyalty that all directors and officers owe to their corporations. While that may not seem too different from a claim based on lack of care, the difference is significant.

The Delaware statute permitting a corporation to immunize directors from damages does not apply to breach of loyalty claims. Thus, director liability under a Caremark claim may have serious consequences if D&O coverage is not sufficient.

Regardless of whether the plaintiff characterizes the claims as a breach of the duty of loyalty or care, the claims will have one common characteristic. Typically, Caremark plaintiffs allege that the directors failed to take affirmative steps in some way that would have prevented damage to the corporation. That failure cannot be just simple negligence because under Delaware law, simple negligence is insufficient to constitute a breach of a director’s duty. Rather, at least gross negligence must be alleged to state a claim.

Thus, to state a Caremark claim the complaint usually alleges that the directors were aware of their duty to take action and that their failure to do so was grossly negligent. That awareness usually depends on "red flags" -- warnings the directors received before they failed to act. If the directors receive enough red flags and ignore them, then it may be said they were grossly negligent, and a Caremark claim exists.

However, the courts have also permitted a Caremark claim even without any red flags. When directors have utterly failed to do any monitoring of corporate affairs or put in place some system of supervision over corporate activities, a Caremark claim may be brought when damages occur because of bad conduct by employees. Directors just cannot simply sit back and do nothing, even in the absence of a warning that things are amiss.

Does it not follow that almost by definition a natural disaster is not anticipated because it is out of the ordinary and no red flags went up? That does not necessarily follow when you think about it. For example, it is reported that Japan had at least one prior earthquake that seriously affected a nuclear power plant. Japan has building codes that require earthquake protection. Does it follow that the past damage to a nuclear plant and the building codes generally together constituted red flags that directors of Japanese companies in the nuclear power business could not safely ignore? What do directors need to do to avoid liability for natural disasters?

In the final analysis, the answer to this question will depend upon what was reasonable under the circumstances. A large corporation may receive literally thousands of complaints each year from customers, employees or regulators. It is not reasonable to ask a board of directors to consider each of those complaints as red flags requiring their inquiry. The board would do nothing else if it had to look into a thousand complaints. Instead, what the board should do is have in place some process that is designed to catch wrongdoing, filter complaints and send to the board only those few that warrant further action by the board of directors.

That same analysis applies to the board’s duties concerning potential natural disasters. It is to be expected that some level of natural events may occur and lead to damages to a corporation’s infrastructure. Storms are even classified by how often they are expected to occur, with a "10 years storm" expected at least once a decade. The board should have in place insurance and other measures that it has been advised by experts are sufficient to protect their corporation from natural disasters that are reasonably likely to occur.

The board should periodically review the company’s insurance and disaster avoidance plans, at least to be satisfied that appropriate steps have been taken by management to address that threat to the company.

Not every potential disaster needs to be planned for, just those that are actual threats. If these basic steps are taken, directors should not be held liable if a natural disaster causes an anticipated harm to their company. We have not yet reached the point where the courts will expect directors to foresee black swans. Some risk is necessary for success. A properly functioning board is entitled -- and indeed expected -- by its investors to take such risks.

Edward M. McNally (emcnally@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.

 

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Delaware Superior Court CCLD Interprets Complex Contract

Textron Inc. v. Acument Global Technology Inc., C.A. 10C-07-103-JRJ CCLD (April 6, 2011)

The new Complex Civil Litigation Division of the Delaware Superior Court has attracted over 40 new cases because of its special  treatment of business disputes.  This opinion illustrates that Court will provide the careful treatment of contract disputes that is needed by the parties. Applying settled Delaware law to the issues presented, the Court denied a motion for judgment on the pleadings while providing the litigants guidance that may lead them to resolve their dispute. 

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Delaware Superior Court Recognizes New Tort Theory

Allen Family Foods Inc. v. Capital Carbonic Corporation , C.A. N10C-10-313 JRS CCLD (March 31, 2011)

In this decision the Delaware Superior Court declined to follow federal precedent and adopted the liability theory of the Restatement (Second) of Torts Section 766A. Under that Section, a claim is permitted for interfering with a plaintiff's contract rights with a third party even when the contract is not broken.  This is different from a more typical interference claim where the third party refuses to perform because of some wrongful act.

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Court Of Chancery Explains How To Divide Fees

In Re Allion Heathcare Inc. Shareholders Litigation, C.A. 5022-CC (March 29, 2011)

How to divide the fees awarded in a multi-jurisdiction case is a recurring problem.  As the Chancellor explains in this opinion, it is preferable if the various courts are notified of a settlement and asked to decide which court should resolve any problems.  That has worked well.

However, when the lawyers are too stubborn to do so, then the Court will apply the principle established long ago in the fabled story, The Little Red Hen.  She who bakes the bread is she who eats the bread.

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Court Of Chancery Again Explains Preferred Stock Rights

Fletcher International LTD v. Ion Geophysical Corp., C.A. 5109-VCS (March 29, 2011)

This is another in the line of decisions that stress that preferred stockholder rights are what is set out in the certificate of incorporation and nothing more.  Thus, if the preferred stockholders bargain for the right to consent to the sale of stock by any subsidiary, then they do not also have the right to vote on the sale of subsidiary stock by the parent.

To be fair, this brief description does not do justice to the Court's careful reasoning and simplifies the charter provisions at issue.  However, best to state the principle starkly to avoid any misunderstanding.

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Court Of Chancery Summarizes Past Fee Awards

In Re Emerson Radio Shareholder Derivative Litigation, C.A. 3392-VCL (March 28, 2011)

Delaware lawyers are often asked to estimate what the Court of Chancery will award in fees following settlement or trial of a derivative action. Well this decision summarizes those fee awards:

10 - 15% for a fast settlement

15 - 25% for contesting motions and other pretrial work that leads to a settlement

25 - 33% for winning after trial

All these percentages apply to monetary settlements, but the Court also explains how to determine fees in cases invovling non-monetary settlements.

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Directors Designated By Investors Owe Fiduciary Duties to the Company as a Whole and Not to the Designating Investor

This article was originally published in The Delaware Business Court Insider | 2011-03-23

Investors who make substantial investments often demand a seat on their company’s board of directors.  That is a reasonable request as it permits the investor to have a representative on the board of directors with a voice in management of the company.  It is well-settled that directors elected by stockholders of a Delaware corporation owe fiduciary duties to the company and all its stockholders once they serve on the board.  Thus, they may make decisions in the exercise of their fiduciary duty that are different than what is in the best interest of designating investor. The Court of Chancery’s recent decision in Air Products and Chemicals, Inc. v. Airgas, Inc., 2011 WL 519735 (Del. Ch. Feb. 15, 2011) reflects this issue.

Air Products had sought to acquire control of Airgas since October, 2009.  When Airgas rebuffed its inquiries, Air Products launched a hostile tender offer.  One of the conditions of its tender offer was that Airgas lift its poison pill.  The poison pill made it prohibitively expensive for Air Products to proceed.  Airgas refused to lift the pill on the ground that the Air Products offer was inadequate.

Frustrated by its inability to proceed with a tender offer, Air Products nominated three directors to the Airgas board.  It stated that its nominees would be impartial in their evaluation of the Air Products tender offer, although they would be replacing Airgas directors who had voted to maintain the Airgas poison pill. Air Products succeeded and its three nominees were elected by the Airgas stockholders to the Airgas board.  Once they were on the board of Airgas, the Air Products designees obtained their own legal and financial advisors. Based in part on the advice of their advisors and on their own assessment of the business plans of Airgas, these Air Products nominated directors determined that the Air Products offer was inadequate and voted with their colleagues to maintain the Airgas poison pill.

In so acting, these directors acted consistently with Delaware law.  As stated in Phillips v. Insituform of N. Am., Inc., 1987 WL 16285, at *10 (Del. Ch. Aug. 27, 1987) the “law demands of directors … fidelity to the corporation and all of its shareholders and does not recognize a special duty on the part of directors elected by a special class to the class electing them.” 

While the Airgas directors’ conflict arose in a highly-publicized battle for control of a public company, issues also arise in privately held companies where investors often condition their investment on the receipt of preferred stock and board representation. 

For example, in In re Trados Incorporated Shareholder Litigation, 2009 WL 2225958 (Del. Ch. July 24, 2009), the Court of Chancery sustained a complaint on behalf of a class of stockholders who complained that directors designated by preferred stockholders, constituting a majority of the board, had interests that diverged from the interests of the common stockholders in approving a sale transaction.  This divergence arose because the preferred stockholders received a substantial portion of their liquidation preference from the sale, while common stockholders received nothing.  The preferred stockholder designated directors also held interests in entities which held preferred stock of the selling company.  Those relationships bore on the court’s decision to treat the preferred stock designees as having interests potentially different from, and in conflict with, the interests of the common stockholders.  As a result of this finding, the court denied a motion to dismiss because the plaintiffs’ allegations were sufficient to rebut the presumption of the business judgment rule.

These cases teach that directors designated by particular stockholders or investors owe duties generally to the company and all of its stockholders. Where the interests of the investor and the company and its common stockholders potentially diverge, the directors cannot favor the interests of the investor over those of the company and its common stockholders. 

Conflicts also are likely to arise over the use of confidential information supplied to the designated directors.  Designating directors who owe their livelihood or materially benefit from relationships with the designating investor sharpens the likelihood of conflicts of interest. Companies, investors and directors and their counsel should consider carefully the implications of directors designated by particular stockholders serving on boards of Delaware corporations. 
 

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Court Of Chancery Explains Confidentiality Limits

Espinoza v. Hewlett-Packard Company, C.A. 6000-VCP (March 17, 2011)

Occasionally a complaint or other document is filed under seal in the Court of Chancery.  This decision explains how to do that and the limits on confidentiality you can expect.  As the courts are public institutions with a need to have their proceedings out in the open, the short answer is that do not expect much to remain confidential no matter how embarrassing it may be to you or your client.

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Court Of Chancery Explains Valuation Technique Preferences

S. Muoio & Co. v. Hallmark Entertainment Investments Co., C.A. 4729-CC (March 9, 2011)

There are several different ways to value an enterprise.  For a while, discounted cash flow seemed to be the courts' preference.  Then when the markets were thought to be "efficient," market values were given weight.  This opinion is a good example of the current state of flux where the Court is inclined to take into account all approaches, test to see if there are any outliers, look at the business realities involved and thoroughly analyze the parties' contentions before reaching a determination.  In short, it no longer is as simple as it once was and the new business world we live in seems to warrant  that approach.

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Justice Jacobs and Others Analyze Hostile Takeovers in Developed and Emerging Markets

In the most recent issue of the Harvard International Law Journal, John Armour, Justice Jacobs and Curtis Milhaupt analyze how hostile takeovers arise under similar circumstances in different countries and how countries enact substantially different regulatory responses to hostile takeovers.  The article focuses primarily on hostile takeovers in the United States, United Kingdom and Japan, but also considers the possible trajectory of hostile takeovers in emerging markets like China, India and Brazil.

 

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Court Of Chancery Explains Right To Inspect After Demand Refused

Louisiana Municipal Police Employees Retirement System v. Morgan Stanley & Co. Inc., C.A. 5682-VCL (March 4, 2011)

This decision explains why a stockholder is entitled to inspect the documents surrounding a corporation's refusal to pursue derivative litigation when the board appears independent enough to be able to properly refuse the demand to sue.  The Court carefully reviews past Delaware precedent and outlines what documents the stockholder may review.

The decision makes major points.  First, the stockholder who has made a pre-suit demand does not thereby conclusively concede the board is independent and disinterested.  Second, the decision to not sue is subject to the business judgment rule but that presumption may be rebutted by a showing the decision was not in good faith or was unreasonable.  [Note that it is generally thought that the BJR precludes a reasonableness review but we will see if that is still true in this limited area.  Most likely what the Court meant is that the decision has to be so unreasonable that no director in good faith could reach that conclusion.]  Third, the Court of Chancery has, according to a federal court, exclusive jurisdiction over books and records cases under Delaware law.

This is an important decision because it shows the way much future derivative litigation must proceed.  Books and records cases are fairly easy to litigate.  This then permits plaintiffs to get behind the usual demand-refused letter that just states the process used and the conclusion not to sue and fails to say why.  Of course, it remains to be seen if any plaintiff can make a showing after inspection to overcome a rejection of a demand to sue.

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Court Of Chancery Explains Disclosure Rules For Adviser Fees

In re Atheros Communications Inc. Shareholder Litigation, C.A. 6124-VCN (March 4, 2011)

This decision outlines what must be disclosed to shareholders asked to approve a merger.  As to the financial adviser giving a fairness opinion, the disclosures should include whether its fee is contingent on a closing and if so, how much of the fee is contingent. The amount of the fee should  also be disclosed.

The decision also held that when the CEO learned he would be employed by the acquiror, that should have been disclosed as well.

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Court Of Chancery Denies Receiver For LP

Steven M. Mizel Roth IRA v. Laurus U.S. Fund LP, C.A. 5566-VCN (February 25, 2011)

This decision has a good summary of the past decisions holding that it is rare for a receiver to be appointed for an LP.  This is particularly true for an investment fund that is still in the business of investing even if the plaintiff is unhappy with the results.

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Court Of Chancery Imposes Fees For Late Discovery

Mickman v. American International Processing LLC, C.A. 4368-VCP (February 23, 2011)

This decision reaffirms the settled rule that if you fail to obey a court order to provide discovery, the Court will assess fees for a motion to compel and few excuses will change that result.

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Court Of Chancery Re-affirms Board's Use Of Poison Pill To Block Inadequate Tender Offer

Air Products and Chemicals, Inc. v. Airgas, Inc., C.A. No. 5249-CC / In re Airgas Inc. Shareholder Litigation, C.A. No. 5256-CC (February 15, 2011)

The Court of Chancery denied an application by Air Products and Chemicals, Inc. to force the board of Airgas, Inc. to redeem its poison pill so as to allow the stockholders of Airgas to decide whether to tender into Air Products' all-cash, all-shares offer.  The Court in this 153-page opinion carefully applies Delaware Supreme Court precedent in holding that the Airgas board reasonably believed that the Air Products offer was inadequate and that its decision to maintain its pill was a reasonable response to that threat.  A major factor in upholding the reasonableness of the Airgas board's actions was that three directors nominated by Air Products supported the decision to maintain the pill.  While some have questioned the continued vitality of doctrine that allows the board to maintain a poison pill in the circumstance of an all-cash, all-shares and fully financed offer, this decision re-affirms Delaware's director-centric approach to corporate governance.  The description in the opinion of the process followed by the Airgas board serves as a primer for how a board might defend against a tender offer it believes is inadequate.

 

 

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