Posts tagged Fiduciary Duty

Court Of Chancery Sets Pleading Rule For Self Dealing Claim

Monroe County Employees' Retirement System v. Carlson, C.A. 4587-CC (June 7, 2010)

Because "self dealing" sounds so bad, sometimes a plaintiff thinks that all she needs to do is say those words in a complaint to state a claim.  Not so.  As this decision points out, self dealing may still be fair if the price is right.  Hence, to state a claim a complaint must state facts that show the deal was not fair.

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Court Of Chancery Explains Duties Owed To Preferred Stockholders

Fletcher International LTD v. ION Geophysical Corp., C.A.  5109-VCP (May 28, 2010)

Preferred stockholders like to claim, in addition to the rights  they have to be "preferred" under the certificate of incorporation, that they also have the right to enforce fiduciary duties to them by the board.  Not so as this decision explains.  When the preferred stock's "contract" touches on a topic, such as the right to share in merger consideration, then that defines their rights and they cannot resort to fiduciary duty law to expand those rights.

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The Court of Chancery Reaffirms the Vitality of Claims Asserting Insider Trading as a Breach of the Fiduciary Duty of Loyalty

 Pfeiffer v. Toll, C.A. 4140-VCL (March 3, 2010)

Vice Chancellor Laster recently affirmed the continuing vitality of state law “Brophy” claims for Delaware corporations injured by their fiduciaries’ insider trading.  In so ruling, the Court clarified the elements of a Brophy claim, explained why the claim is firmly grounded in the duty of loyalty applicable to Delaware fiduciaries and discussed why such claims complement and do not conflict with the federal securities law regime. Less clear and undecided by the decision are the elements of damage the corporation might recover.

The Toll Brothers decision arose in the context of a motion to dismiss a shareholder derivative complaint brought for the benefit of Toll Brothers Inc. against eight of the eleven directors of the corporation. The complaint alleged they sold significant amounts of their Toll Brothers stock during the period from December 2004 through September 2005. The complaint further alleged that they did so while in possession of material nonpublic information about Toll Brothers’ future prospects that contradicted the Company’s upbeat disclosures about its business prospects and expected growth and earnings. When the Company in December 2005 suddenly revised its public growth forecast for 2006 net income downward from 20% to 0.5%, its stock price precipitously dropped.

A federal securities lawsuit followed joining the individual defendants and alleging they made material misrepresentations and omissions of material fact in connection with projections for 2006 and 2007 that were “knowingly unreasonable” when made. The federal action also alleged insider trading in violations of Section 10(b)(5). The federal court upheld the securities claims against a motion to dismiss under the rigorous standards for pleading securities fraud and the case moved to merits discovery.

The Delaware derivative action followed in November 2008. The Delaware complaint had two counts. The first alleged breach of fiduciary duty under Brophy v. Cities Service, 70 A.2d 5 (Del. Ch. 1949) for harm caused by insider trading. The second count was a generalized claim for indemnification and contribution for harm to the Company resulting from the federal securities fraud action. The director defendants moved to dismiss both counts on various grounds including that Brophy is an outdated precedent that should be rejected.

The Court rejected all of the defendants’ arguments challenging the Brophy claim. The Court first stated the elements of claim:  “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because he was motivated, in whole or in part, by the substance of that information.”

The Court found that the complaint sufficiently pled a reasonable basis from which the fiduciaries’ knowledge could be inferred. The inference was based on specific allegations of the defendants’ knowledge and reliance on core metrics the Company used to measure and forecast growth and earnings, the contrast between the defendants’ public statements and the underlying trends indicated by the Company’s metrics, and the defendants’ contemporaneous massive sale of securities. The Court ruled the allegations supported a pleading stage inference that the Sellers took advantage of confidential corporate information not yet available to the public to unload significant blocks of shares before the market’s views of Toll Brother’s prospects dramatically changed. The Court contrasted this case from those cases dismissed at the pleading stage where evidence of accounting improprieties were disclosed in a subsequent restatement and senior officers and directors sold stock during the period covered by the restatement. Those cases the Court noted lacked allegations supporting an inference that the fiduciaries would have known of the particular accounting problems, in contrast to the core operational information involved in the Toll Brothers case.

The Court also addressed and rejected the assertion that Brophy was an anachronism that predated the current federal insider trading regime and should no longer be followed. Brophy involved a corporate secretary who knew of Cities Service’s planned open market purchases that would likely boost its stock price. The fiduciary bought for his personal account in advance of the corporate purchase and later sold the shares at a profit after the market price rose. Rejecting the argument that the corporation suffered no harm, the Brophy Court said “Public policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss.” 

Vice Chancellor Laster in the Toll case explains why the Brophy claim does not duplicate the federal securities laws and does provide a meaningful remedy for corporate harm. First, a Brophy claim does not exist to recover losses by contemporaneous traders, nor does it automatically require disgorgement of reciprocal insider trading gains; rather it is to remedy harm to the corporation. Pointing to Delaware Supreme Court precedent rejecting claims of breach of fiduciary duty or fraud as a basis for the class-wide recovery of trading losses, the Court agreed with Vice Chancellor Strine in his recent AIG opinion upholding a Brophy claim that it is harm to the corporation that is of primary concern. Vice Chancellor Laster wrote that harm in the case of insider trading might include the costs and expense the corporation incurred for regulatory proceedings involving the insider trading, internal investigations, fees paid to counsel and other professionals, fines paid to regulators and judgments in litigation. In this case and the recent AIG case, both of which involved companion securities law litigation naming the corporation a defendant, the Court noted that the defendants’ breaches of the duty of loyalty, involving trading on confidential information and material misrepresentations and omissions, may subject the corporation to a substantial judgment or settlement in the federal securities action.

The Court left to another day the precise type of damages or remedy that would be available if plaintiff proved its case. It noted, however, that Delaware remedies to protect the corporation and non-duplicative of the federal remedies that might be granted, were necessary and available to remedy breaches of the fiduciary duty of loyalty based on insider trading.  Avoiding damages duplicative of the federal securities laws and satisfying public policy concerns regarding indemnification for securities fraud violations remain significant issues in fashioning a damage award for successful derivative plaintiffs. See e.g., Richard A. Booth, The Missing Link Between Insider Trading and Securities Fraud, 2 J. Bus. & Tech. L. 185-206 (2007).

The Court’s opinion also dealt quickly with defendants’ arguments that the derivative complaint failed to plead demand futility adequately under Rule 23.1 and was barred by the statute of limitations. Using the Rales standard, the Court concluded that demand was excused because a majority of the Board could not consider the merits of a demand without being influenced by improper considerations. Because of the potential personal liability a majority of the directors faced in the federal securities action, they faced a sufficiently substantial threat of personal liability to compromise their ability to act impartially on a demand.

As to the statute of limitations, the Court acknowledged that the complaint was filed more than 3 years after the alleged insider trading, but it found the pleading supported a basis for equitable tolling. Because the complaint alleged wrongful self-dealing and shareholders’ reasonable reliance on the competence and good faith of the director fiduciaries until December 2005 when management officially abandoned its previous growth projections, the Court ruled the running of the limitations period was equitably tolled until then.

Finally, the Court acknowledged the tension between allowing the concurrent prosecution of the shareholder derivative action for the benefit of the corporation at the same time the corporation seeks to defend itself from liability in the federal securities action. Not wanting to have the derivative action burden the corporation’s ability to defend itself in the securities action, the Court urged the parties to coordinate the actions and acknowledged the possibility of a stay of the derivative action pending the outcome of the securities action as was done in the AIG case.

 

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Court Of Chancery Explains Rights Of Preferred Stock

 LC Capital Master Fund, Ltd. v. James,  C.A. 5214-VCS (March 8, 2010)

 Lately, there seems to be a lot of interest in the rights of preferred stock compared to the rights of common stock and how the board of directors should act when caught in the middle of their conflicting claims. This decision summarizes the past decisions and explains what to do.

Here are some "rules" to go by:

1. When the certificate of incorporation speaks to the preferred stock's rights on an issue, that controls and the board does not need to consider granting greater rights to the preferred. The charter ends the discussion.

2. When the certificate of incorporation is silent on an issue and leaves the preferred in the same position as the common [such as on the right to get the highest price for the company in a merger] then the board needs to consider the preferred and common as having the same rights and owed the same fiduciary duty.

3. When the issue somehow falls in a gap between the preferreds rights under the certificate of incorporation and the rights of the common stock, get a good lawyer. Seriously, the board needs to do its best to strike a  fair balance under the circumstances.

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Court Of Chancery Affirms Business Judgment Rule Applies In Bet The Company Case

In re The Dow Chemical Company Derivative Litigation, C.A. 4319-CC (January 11, 2010)

In an era when "too big to fail" seems to be an accepted reason to do the extraordinary, in this case the plainitffs tried to argue that a 'bet-the-company" deal requires a board to be right or be held for the consequences. The Court soundly rejects that argument and held the business judgment rule protects the board from second guessing in even the biggest deals.

This decision is also an excellent summary of the law dealing with when demand must be made on a board before filing a derivative suit. The Chancellor was once a law professor and his teaching skills are on full display in this case.

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Court of Chancery Clarifies Duties Under Stockholder Agreements

Latesco, L.P. v. Wayport, Inc., C.A. 4167-VCL (July 24, 2009).

The question sometimes arises over what are the disclosure duties of the buyer under a stockholder agreement that compels a stockholder to sell her stock upon some triggering event, such as retirement. This decision clarifies the rules that apply.

In general, when the sale is strictly pursuant to the stockholder agreement, then that agreement determines if any disclosure is required. However, it is not always clear whether the sale is "strictly" pursuant to the agreement as sometime other terms are discussed, extra stock added [as was the case here] and the agreement for some reason not followed. When that happens, the rules change.

While the corporation itself may not have any disclosure duties, the directors as fiduciaries do have those duties. Thus, if they are the buyers, then they need to disclose material facts when they purchase a stockholder's shares outside the provisions of a stockholder's agreement.

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Court of Chancery Clarifies Directors Duties in Common/Preferred Stock Conflict

In re Trados Incorporated Shareholder Litigation, C.A. 1512-CC (July 24, 2009).

Directors sometimes face a conflict between what is best for the common stockholders compared to what is best for the preferred stockholders. While it is generally recognized that preferred stockholder rights are largely contractual and not based on fiduciary duties, that does not resolve all conflicts with common stockholders. The certificate of incorporation just cannot deal with every possible conflict. Here the Court  held that common stock is to be favored in any conflict with the preferred that is not resolved by the terms of the certificate of incorporation. That will not solve all the problems, of course, and in this case, the Court held that a full trial might be needed to reach a final decision on how the preferred/common conflict should be resolved.

Where then does that leave a board of directors faced with such a conflict in the interests of the common and preferred stockholders? The answer probably lies in the case law dealing with what to do when a company is insolvent and the creditors are the residual risk holders. In that instance, the stockholders want the board to use every last dollar to reverse the company's fortunes, while the creditors want asset preservation and liquidation to get what they can. The Delaware Courts have held in that circumstance, the board is charged with making a business judgment over what is the best course for the entity to follow. That is easier said than done but may boil down to a risk/benefit analysis somewhat like a card player makes when deciding if it is time to fold his hand. So long as the board acts in good faith, its decision should be upheld.

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Allegations of Accounting Schemes and Material Misstatements Survive Motion to Dismiss

Collins & Aikman Corp. v. Stockman, Civ. No. 07-265-SLR-LPS (D. Del. May 20, 2009)

Magistrate Judge Leonard P. Stark considered the plaintiffs’ state law claims of breach of fiduciary duty and denied the defendants’ motion to dismiss these claims against certain individual defendants. The complaint alleged that the individual defendants, each of whom were directors or officers of Collins & Aikman, owed “fiduciary duties of loyalty, good faith and care to the Company” and breached those duties “by orchestrating, encouraging or utilizing various accounting schemes . . . which materially misstated the financial condition of the Company.”  The Court rejected the defendants’ argument that, with regard to the duty of care claims, C&A’s § 102(b)(7) exculpatory provision eliminated or limited personal liability.  The Court took judicial notice of the exculpatory provision and found it inapplicable as the complaint alleged facts implicating breaches beyond that of due care.
 

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Corporation's Ability to Take Advantage of Corporate Opportunity an Issue of Material Fact

Norman v. Elkin, C.A. No. 06-005-JJF (D. Del. Apr. 28, 2009)

The district court denied motions for summary judgment for claims of breach of contract, usurpation of corporate opportunities, breaches of fiduciary duty, breach of the duty of disclosure, conversion and misappropriation, and fraudulent representation.  In their motion, the defendants responded to the plaintiff’s usurpation of corporate opportunity and misappropriation claim by arguing that the claim failed as matter of law, because the defendant corporation did not have the financial capability to participate in an auction for certain licenses. The district court cited the Court of Chancery’s standard for establishing that a corporation is financially unable to take advantage of a corporate opportunity. “[S]uch financial inability must amount to insolvency to the point where the corporation is practically defunct.” The district court agreed with the plaintiff that a reasonable jury could find that the defendant was not practically defunct and could have raised funds necessary to participate in the auction.

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Court of Chancery Reaffirms The Business Judgment Rule

In re Citigroup Inc. Shareholder Derivative Litig., C.A. 3338-CC (Del. Ch. Feb. 24, 2009)

 

After the recent decision in the AIG case denying a motion to dismiss a complaint, there was some concern that perhaps the Court of Chancery was loosening the pleading requirements to state a claim under the Caremark line of case law. Caremark, of course, suggested that directors might be liable for failing to properly supervise management even when the directors did not receive any personal benefit as a result.

 

In this latest decision, the Chancellor has put those fears to rest. He distinguished the AIG decision and strongly affirmed that the business judgment rule protects directors when they make business decisions, even those that involve risk to the entity.

 

Thus, it is important to read the AIG decision and this decision together to get a full picture of how the Court is reacting to the calls to assign blame in the current financial crisis.

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Supreme Court Clarifies Stockholder Ratification Law

Gantler v. Stephens, C.A. 132,2008 (Del. Jan. 27, 2009)

 

This is an important decision because it limits when stockholder approval of a transaction has the effect of ratifying director action. Moreover, it limits the effect of stockholder ratification by holding that the business judgment level of review still applies to the directors' action, rather than holding that ratification extinguishes any claim.

 

The ratification holding is that stockholder ratification only occurs when the stockholders approve a transaction that the directors are empowered to take without the approval of the stockholders. For example, because directors are able to issue stock without stockholder approval, the added approval of the stockholders would ratify their decision to sell stock. In contrast, because a merger already requires stockholder approval, the approval of the stockholders does not constitute "ratification" of the directors' decision to recommend the merger. They approve it but do not "ratify" it. How is that for a distinction?

 

The rationale for this tightly reasoned result lies in the difference under Delaware law between complying with a controlling statute's requirements to carry out a transaction and having a good reason for doing the transaction in the first place. In other words, in Delaware just because you have the power to act (the stockholders voted for it) does not mean you should act (a decision that is measured by Delaware's law of fiduciary duty).

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Court of Chancery Clarifies Statutory Trust Law

Cargill, Incorporated v. JWH Special Circumstance LLC, C.A. 3234-VCP (Del. Ch. Nov. 7, 2008)

 

In this major opinion, the Court of Chancery held that a manager of a Delaware Statutory Trust has a fiduciary duty to the Trust absent a clear exclusion of that duty in the trust instrument. This conclusion has broad implications including that the owners of the manager may also have such duties in connection with transactions that arguably benefit the owner. That is consistent with a long line of Delaware case law in other contexts, such as for corporations and limited partnerships.

 

This once again illustrates the need for very careful drafting in these alternative entities where the governing instrument may set the rules of the game. Failure to do so means that principles of corporate law, or in this case, trust law, will control by default. That will defeat the whole purpose of using an alternative to the traditional corporate form to gain the right to draft rules for that particular transaction.

 

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Court of Chancery Details Board Duties in a Merger

Ryan v. Lyondel Chemical Company, C.A. 3176-VCN (July 29, 2008)

This decision is a textbook explanation and summary of the Delaware case law on the duties of a board of directors when considering a takeover proposal. The Court first sets out the Revlon duties in detail including the effect on those duties when the Barkin "exception" may apply. Next, the Court explains how to comply with the principles of both Omnicare and Unocal concerning defensive measures that protect the proposed transaction. Finally, the Court explains why in the context of a summary judgment motion that the otherwise disinterested board may have its good faith questioned.

This last part of the decision is surely its most controversial. While the Delaware statute protects directors from attacks on their decisions based on their lack of care, the loophole has always been that the statute does not protect from act not taken in good faith. When does a lack of care turn into a lack of good faith is the question.

In a series of decisions such as the Disney case, the Delaware Supreme Court has tried to set out some guidance on this issue. However, the test to be applied is still vague and in the context of a summary judgment motion when all inferences must be drawn in favor of the plaintiff, the test becomes even more difficult in application. This decision illustrates that problem and is worth reading for that issue alone.

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Court of Chancery Divides Settlement Among Shareholders In Class Action Suit

The plan of allocation approved in Ginsburg v. Philadelphia Stock Exchange et. al., C.A. No. 2202-CC is a landmark decision for those in the business of litigation arbitrage, buying shares of a company that is involved in a class action that may lead to substantial settlement proceeds. More ›

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Court of Chancery Issues Major Disclosure Law Decision

In re Transkaryotic Therapies, Inc., C.A. 2776-CC (Del Ch. June 19, 2008)

The law of Delaware on when damages may be awarded for failing to make proper disclosures to stockholders in a proxy statement has been unsettled. This major decision resolves much of that uncertainty. The Court has now held:

“. . . this Court cannot grant monetary or injunctive relief for disclosure violations in connection with a proxy solicitation in favor of a merger three years after that merger has been consummated and where there is no evidence of a breach of the duty of loyalty or good faith by the directors who authorized the disclosures.”

The opinion carefully reviews and harmonizes precedent to reach this final conclusion. The net effect then is that the remedy for negligent disclosure violations is an injunction. Of course, as the opinion makes clear, damages may still be available in circumstances where there was a conflict of interest by the directors or they acted in bad faith. The latter would occur, for example, if the directors omitted substantial materials from the proxy statement deliberately to mislead.

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