FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF … · 2000-07-12 · FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS MORRISON &FOERSTER LLP Christopher

FIDUCIARY DUTIES AND OTHERRESPONSIBILITIES OF CORPORATE DIRECTORS AND OFFICERS

Morrison & Foerster LLP

Christopher M. ForresterCeleste S. Ferber

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FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIESOF CORPORATEDIRECTORS ANDOFFICERS

MORRISON & FOERSTER LLP

Christopher M. ForresterCeleste S. Ferber

RR Donnelley Global Capital Markets

Copyright© 2008 Morrison & Foerster LLP(No claim to original U.S. Government works)

All rights reserved. No part of this publication may be reproduced, stored in a retrievalsystem, or transmitted in any form or by any means, electronic, mechanical, photocopying,recording, or otherwise, without the prior written permission of Morrison & Foerster LLP.

This publication reflects the views of its authors only and does not necessarily reflect theviews of Morrison & Foerster LLP or any of its clients. Because this publication isintended to convey only general information, it may not be applicable in all situations andshould 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 isrequired, the services of a professional should be sought.

Printed in the United States of America.

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About This Handbook

This Handbook 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 toprovide both an authoritative resource and a practical hands-on tool for addressing varioussituations 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 thelaw to the real world challenges faced each day by directors and officers of U.S. corpo-rations.

Given that a majority of publicly traded U.S. corporations are incorporated in Delawareand 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, unlessotherwise noted. This handbook is limited to the laws that affect corporations, as comparedto 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 adviceor establish an attorney-client relationship with Morrison & Foerster LLP or any of itsattorneys, and you should not rely on any of the information in this Handbook withoutchecking with your legal counsel as to your specific circumstances.

This handbook was prepared and published as of December 2008 and does not reflectdevelopments or events occurring after that time.

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About the Authors

Christopher M. Forrester

Mr. Forrester is a partner in Morrison & Foerster’s Corporate and Securities Group. Hispractice focuses on representing emerging growth and established companies in all aspectsof corporate matters. Mr. Forrester has considerable experience representing the boardsand special committees of public corporations in complex merger and acquisition trans-actions, as well as investigations and related-party matters. Mr. Forrester also has sub-stantial experience in public offerings, having been involved in over 50 public offerings ofequity and debt securities. He is a recipient of the American Jurisprudence Award forSecurities Regulation. Mr. Forrester was named to the 2007 Top 40 Under 40 persons inthe finance industry by Investment Dealers Digest in December 2007.

Mr. Forrester received his B.A. from St. Mary’s College in 1993, his J.D., with distinction,from the University of the Pacific, McGeorge School of Law in 1996, where he also servedas managing editor of the law review, and his LL.M. in Securities and Finance Regulationin 2002 from Georgetown University Law Center. Mr. Forrester has been a partner withMorrison & Foerster since 2006. Prior to joining Morrison & Foerster, Mr. Forrester was apartner with Pillsbury Winthrop Shaw Pittman LLP.

Celeste S. Ferber

Ms. Ferber is a senior associate in the Business Department of Morrison & Foerster’s SanDiego office. Her practice focuses on general corporate, transactional and securities mat-ters. She has extensive experience in public and private securities offerings, mergers andacquisitions, securities law compliance and general corporate matters. Ms. Ferber beganher legal career as an associate at Fenwick & West LLP in San Francisco.

Ms. Ferber received her B.A. in Economics from Bucknell University in 1997 and her J.D.from University of California, Hastings College of the Law in 2001. She is a member ofthe State Bar of California.

Contributing Authors

The following Morrison & Foerster partners provided assistance in the editorial process forthis work: Jay de Groot, G. Larry Engel, Jordan Eth, Katherine I. Johnstone, Adam A.Lewis, Sean T. Prosser, Darryl P. Rains, Steven Rowles, Scott M. Stanton and Robert S.Townsend.

The following Morrison & Foerster associates provided substantial contributions to the prepa-ration of this Handbook: Jeannette V. Filippone, Kimberly Harbin, J. Nathan Jensen, R. Mat-thew Steiner, Ramin Tohidi, Ryan Gunderson, Nathan Cooper, James Krenn and YonatanHagos. The Authors also wish to thank Lisa Holcombe, Ying Huang and Jennifer Steiger,each of whom assisted in the editorial process of preparing this Handbook.

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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OFCORPORATE DIRECTORS AND OFFICERS

TABLE OF CONTENTS

Page

OVERVIEW OF THE HANDBOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

CHAPTER 1 MANAGING THE BUSINESS AND THE ROLES OF DIRECTORSAND OFFICERS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1The Interaction Among the Board, the Chief Executive Officer and the Other Officers . . . . 2Board Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4Appointment to Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7Identifying the Constituents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Governing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Mitigating Liability Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

CHAPTER 2 GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OFDIRECTORS AND OFFICERS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13Determining the Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13Duty of Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Duties of Loyalty and Good Faith . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19Duty to Disclose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Entire Fairness Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Director Liability and Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

CHAPTER 3 FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESSCOMBINATION TRANSACTION

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Board Considerations When a Sale or Break-Up of the Corporation is Not Implicated . . . . . 35Additional Considerations in Any Business Combination Transaction . . . . . . . . . . . . . . . . . 37Revlon and a Sale or Break-Up of the Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Review of Directors Duties in the Context of a Business Combination Transaction . . . . . . . 41Unocal and Defending Against Hostile Takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42Special Case: Use of a Poison Pill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47Special Case: Director Duties in the Face of Activist Stockholder Demands . . . . . . . . . . . . . 50

CHAPTER 4 FIDUCIARY DUTIES IN THE CONTEXT OF A GOING PRIVATETRANSACTION

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56Common Transaction Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56SEC Requirements and Scrutiny of Going Private Transactions . . . . . . . . . . . . . . . . . . . . . . . 60Procedural Safeguards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

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Page

CHAPTER 5 THE USE OF SPECIAL COMMITTEESIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Committee Composition: Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64Committee Charter: Be Informed and Active . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66The Committee’s Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67Legal Duties of Special Committee Members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69Overview–When Should a Special Committee be Considered? . . . . . . . . . . . . . . . . . . . . . . . 70

CHAPTER 6 FIDUCIARY DUTIES IN THE CONTEXT OF A DISSOLUTION ORINSOLVENCY

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71Determining When a Corporation Has Become Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Duties to Creditors When the Corporation is Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Duty of Loyalty Considerations in the Context of Insolvency—Delaware’s Rejection of

Deepening Insolvency Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Duties During Bankruptcy Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79Duties After Dissolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80Things to Remember When Managing a Business on the Verge of Insolvency . . . . . . . . . . . 82

CHAPTER 7 ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXTIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84Scope of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84Types of Privileged Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88Privilege Versus Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91Waiver of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93Examples of Waiver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94Privilege in Derivative Suits and Class Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Role of Attorney in Special Investigations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

CHAPTER 8 INDEMNIFICATION AND INSURANCEIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107Indemnification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

CHAPTER 9 PERSONAL LIABILITY AND PIERCING THE CORPORATE VEILIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130Instrumentality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131Alter Ego Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132Estoppel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134Alternative Theory of Stockholder Liability: Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134Veil Piercing in the Context of Fiduciary Duty Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

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OVERVIEW OF THE HANDBOOK

Chapter 1 discusses the general relationship of directors and officers with theircorporation, including reviewing the process surrounding election and appointment totheir positions, their general powers, authorities and responsibilities, the rules thatgovern their actions, the constituents served by directors and officers and potentialliabilities that they face.

Chapter 2 provides an overview of the business judgment rule, and the duties ofcare, loyalty, good faith and fair dealing and disclosure. The rule is a court-developeddoctrine that is designed to provide directors and officers with the latitude to exercisetheir judgment in furtherance of managing the corporation’s business and affairs with-out fear of having every one of their actions second-guessed by litigious stockholdersand courts.

Chapter 3 provides a more detailed application of the business judgment rule tospecific transactions and other situations, such as mergers and acquisitions, hostiletakeovers 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 againstclaims of a breach of the duty of loyalty and to safeguard against potential conflicts ofinterest.

Chapter 6 addresses the duties of directors and officers when a business becomesinsolvent and the particular duties that directors owe not only to the corporation and itsstockholders, but also in some cases to the creditors of the corporation.

Chapter 7 provides an overview of the attorney-client privilege and a discussionof the work product doctrine. It explains the complicated relationships between thecorporation, 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 essentialinformation on who can be indemnified by a corporation and special issues that shouldbe considered in selecting director and officer liability insurance.

Chapter 9 discusses the concepts of piercing the corporate veil and agency, twotheories by which stockholders may be liable for any lawsuits brought against thecorporation if the corporate form is not properly respected.

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CHAPTER 1

MANAGING THE BUSINESS AND THE ROLES OF DIRECTORSAND OFFICERS

INTRODUCTION

U.S. corporate laws provide that the board of directors is responsible for themanagement of the corporation’s business and affairs. In managing such business andaffairs, boards typically act in a supervisory role, and delegate the details of theday-to-day management of the business to the officers of the corporation. This con-struct provides a balance between the managers (officers) who have actual and appa-rent authority to direct and control the daily activities of the business and the overseers(directors) who have the ultimate responsibility for the corporation and the power andresponsibility to supervise the managers. While the officers are clearly agents of thecorporation in the strict legal sense and so have the power individually to bind thecorporation to obligations and take actions, the directors in their capacity as such arenot agents and generally can act only as a group. Nevertheless, the directors clearly

are fiduciaries of the corporation and as a grouphave the ultimate power and authority over themanagement of the business through their ability tohire, supervise and replace the managers.1

In addition to having the responsibility tosupervise and, if necessary, replace the managers,the board is also charged by law with the power andresponsibility to approve major corporate actions,

such as issuing securities, entering into a merger, converting the form of the businessfrom a corporation to a limited liability company, partnership or other form, disposingof substantially all of the assets of, or dissolving the corporation. Further, through theirsupervisory powers, boards frequently require the managers to obtain board approvalfor events that are not fundamental to the business, but are nevertheless sensitive ormaterial – for example, entering into a significant acquisition, licensing, financing orother contractual arrangement. In contrast, officers are charged with the dailymanagement of the business and have the power under the Delaware General Corpo-

The officers are chargedwith managing theday-to-day operations ofthe corporation while theboard is responsible for theoverall management of thecorporation and super-vision of the officers.

1 8 Del. C. §141(a).

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ration Law (the “DGCL”) to bind the corporation; however, they do not have theauthority, acting without board approval, to cause the corporation to take the type offundamental corporate actions described above.2

This balance between the directors and the officers is created by the DGCL andDelaware case law, which together provide that every corporation shall have a board ofdirectors, and establish the responsibility of that board to manage the affairs of thecorporation. The DGCL also provides for the appointment of certain officers – whichcommonly include a president, treasurer, secretary and one or more vice presidents – tomanage the daily activities of the corporation.3 However, the DGCL also provides acorporation with latitude to customize various aspects of its governance structurethrough its charter documents (i.e., its certificate of incorporation and bylaws).4 Onecommon example is that many U.S. corporations appoint a chief executive officer astheir most senior officer in lieu of a president pursuant to bylaw provisions.

It is important to note that each corporation may approach the roles of, and inter-action between, management and the board somewhat differently. The decision as tohow much power and authority to vest in the management and what level of involve-ment the board will have in the activities of the business is a decision for each board tomake, which is then memorialized in the corporation’s charter, bylaws and corporateresolutions, as well as board practices and meeting agendas.

THE INTERACTION AMONG THE BOARD, THE CHIEF EXECUTIVE OFFICER

AND THE OTHER OFFICERS

In general, most boards seek tofulfill their obligation to supervisethe managers primarily by consult-ing with the corporation’s mostsenior officer (usually the chiefexecutive officer) on major deci-sions affecting the business, andreviewing, guiding and ultimatelysupervising the performance of the chief executive officer. The chief executive officer,

Although the board bears responsibilityfor supervising the activities of all of theofficers in managing the business, typi-cally, the chief executive officer reports tothe board, and the other “C-level” officers,including the chief operating and chieffinancial officers and vice presidents,report to the chief executive officer.

2 See, e.g., 8 Del. C. §§151, 152, 251-66, 271-85.3 8 Del. C. §142.4 See, e.g., 8 Del. C. §142.

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in turn, will generally be charged with the power and authority to supervise the otherofficers, who will report directly to the chief executive officer rather than the board.Notwithstanding this practical chain of command, most corporations’ bylaws providethat senior officers are selected by the board, meaning that while practical reportingchain considerations dictate that typically the officers other than the chief executiveofficer report to the chief executive officer, the board will remain actively involved inestablishing and evaluating the duties and performance of those officers. Beyond thechief executive officer, typical officer positions and their general responsibilities are asfollows:

• President. The president generally is the most senior position in the orga-nization absent the presence of a separate chief executive officer. The presi-dent is responsible for the supervision of the other officers and theday-to-day management of the business.

• Secretary. The secretary is the person responsible for keeping the booksand records of the corporation, including the corporate minute book.5 Assuch, the secretary attends board meetings to keep minutes, although outsidecounsel is sometimes charged with preparing the initial draft of the minutes.As the official keeper of the books and records, the secretary is generallyresponsible for certifying the accuracy of corporate documents to third par-ties, such as banks, financing sources and acquirers.

• Treasurer. The office of treasurer is generallythe most senior financial position in the corpo-ration, although companies often use the titlechief financial officer as the most senior levelfinancial position. The treasurer is charged withmaintaining the corporation’s funds as well assupervising the accounting functions of thebusiness. In larger companies, it is common notonly to have a chief financial officer whoserves the role of treasurer, but also to havea controller who performs the accounting functions and a vice president offinance who is in charge of the financing aspects of the business.

Officer positions andresponsibilities aregenerally establishedby the corporation’sbylaws and the boardis free, to a largedegree, to customizethose provisionsunder Delaware law.

5 8 Del. C. §142(a).

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• Vice President. Vice presidents can be appointed to oversee specific busi-ness functions, such as sales, marketing, research and development, finance,etc. Although generally vice presidents are appointed by and report to theboard, the bylaws may provide that certain vice presidents may be appointedby (and report to) the officers of the corporation, such as the chief executiveofficer or president.

• Other Officers. The DGCL contemplates that the corporation may createadditional officers and it is quite frequent that companies create such posi-tions in their bylaws, such as chief technology officer or chief marketingofficer. If these positions are designated by the bylaws as officer positions inthe corporation, then they will have the authority as such, and their specificduties and reporting structure will be specified in the bylaws. However,many companies draw distinctions between executive officers and officers,the latter generally being viewed as the primarily corporate officers whilethe former is considered a class of junior officers but without the samepowers or responsibilities. As noted above, in order to truly ascertain thepower, responsibility and reporting authority of officers of a particularcorporation, it is necessary to consult its bylaws.

• Executive Chairperson. It is notable that although the DGCL con-templates that directors are not officers and therefore cannot act to bind thecorporation, in some states by law and in many companies by virtue of theirbylaws, the chairperson of the board also is specifically designated as anofficer position.6 Again, to ascertain whether the chairperson of a particularcorporation is or is not an officer, one must consult the bylaws of suchcorporation, unless the state of incorporation provides by law that thechairperson is an officer.

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 thechairperson of the board is empowered to call board meetings, set the agenda for theboard meetings and preside over board meetings. The specific manner and timing of

6 See, e.g., Cal. Corp. Code §312.

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calling board meetings is specified in a corporation’s bylaws, but many corporationsuse as a default rule that board meetings can be called on some minimum advancenotice (e.g., four days’ notice if the notice is given by mail or 48 hours’ notice if thenotice is given by telephone or other electronic means, such as email). Further, noticeof meetings may always be waived by directors at any time either in writing or by theirpresence at a meeting. The agenda for meetings and supporting materials should bedistributed in advance whenever possible so that the directors have an opportunity toprepare for the meeting and provide meaningful contributions.

Convening a board meeting requires that a quorum of directors be present at themeeting. Generally, the specific number of directors required for a quorum will be

specified in the bylaws (but in no event will be less thanone third of the total number of directors); in the absenceof a specific quorum requirement, the DGCL provides adefault rule of not less than a majority of the boardmembers.7 Once a board meeting is duly convened and aquorum is present, in the absence of a specific provisionin the bylaws otherwise, the vote of a majority of thedirectors present and voting at the meeting will besufficient to constitute an action of the board.8 In addition

to taking action at a properly convened meeting, a board may take action by signing awritten consent, which must be signed by all directors. Unanimous written consentsare effective on the date upon which all signatures have been obtained.9

Not infrequently board members may speak of having the power to vote byproxy. Unlike stockholders, however, board members may not vote by proxy.10 Theessence of the board’s effectiveness is its ability to engage in meaningful discussionsin which all members of the board can be heard and can hear one another. The conceptthat one or more board members may be individually briefed on a topic privately andthen deliver their vote privately by proxy is antithetical to the concept of a robustboard deliberation.

The chairperson ofthe board is generallyresponsible formanaging the affairsof the board, includ-ing calling meetingsand setting agendas.

7 8 Del. C. §141(b).8 Id.9 8 Del. C. §141(f).

10 In re Acadia Dairies, Inc., 15 Del. Ch. 248 (1927).

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Extra care should always be given to trying to arrange for meeting schedules thatpermit the attendance of all or as many of the board members as possible, particularlyfor sensitive and important matters. The importance of directors’ participation andattendance at board meetings is underscored by the factthat the rules and regulations of the U.S. Securities andExchange Commission require that reporting companiesunder the Securities Exchange Act of 1934 (the “ExchangeAct”) disclose the attendance records of their boards intheir annual proxy statements or on their websites.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 example of this is the audit committee. The Exchange Act specifi-cally requires that reporting companies maintain an audit committee composed entirelyof “independent directors.”12 Independent directors are defined as directors who,among other things, are not part of management and who do not otherwise have a roleor relationship with the corporation that has the potential of creating any conflict of

interest. In addition, members of a publiccompany’s audit committee are expected,through formal education or experience, tohave enhanced skills in reading and under-standing financial statements and in account-ing matters generally. The audit committee ischarged with approving the corporation’sauditors, supervising the chief accountingofficer of the corporation in the preparationof the corporation’s financial statements,

monitoring complaints by employees regarding financial matters, and other importantfinancial and accounting-related matters.13

In addition to the audit committee, many companies utilize a nominating and/orcorporate governance committee and compensation committee to help to manage the

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 17 C.F.R. 240.10A-3.13 Id.; See also 15 U.S.C.S. §78j-m.

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Attendance at boardmeetings is criticallyimportant and boardmembers may not actby proxy.

Although the Exchange Actrequires a board to have an auditcommittee, many corporationsalso utilize nominating and com-pensation committees composedof independent directors. Use ofindependent directors on thesecommittees satisfies stockexchange rules as well.


affairs of the corporation. Generally, the members of the nominating committeeand the compensation committee are independent directors within the meaning ofspecific definitions established by any applicable stock exchange rules. Nominatingcommittees generally evaluate directors’ performance and interview and nominatedirector candidates for board and stockholder consideration. Compensation commit-tees are charged with establishing and reviewing the compensation policies and proce-dures for the senior officers, as well as administering the corporation’s compensationand equity incentive plans. In addition, approval of compensation packages bycompensation committees composed of non-employee directors can provide certainrequired approvals under the Internal Revenue Code necessary to make certain of thecorporation’s compensation payments tax-deductible. Boards may also delegate otherduties and functions to committees of the board, with certain limitations in the DGCL.

Generally, each committee is managed by a chairperson. Similar to the role of thechairperson of the board, the chairperson of the committee is charged with calling

committee meetings, setting the agenda, and reportingback to the board on the business of the committee.

Though directors who serve on one or morecommittees or as a chairperson of the board or acommittee take on additional responsibilities in thoseroles, they are subject to the same fiduciary dutiesapplicable to regular directors.14

APPOINTMENT TO POSITIONS

Directors

Directors are elected to hold office by the stockholders of the corporation at anannual 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 mayalso be filled by a vote of the board pending the next annual meeting of stockholders.

Being designated as the“audit committee finan-cial expert” does notplace additional liabilityon the individual des-ignated.

14 Lyman P.Q. Johnson, Corporate Compliance Symposium: The Audit Committee’s Ethical and LegalResponsibilities: The State Law Perspective, 47 S. Tex. L. Rev. 27, 39 (2005). Similarly, although publiccompanies are required under the Exchange Act to designate at least one member of the audit committeeas the “audit committee financial expert,” such designation does not place additional liability on theindividual designated. 17 C.F.R. 229.407(d)(5)(iv)(B).

15 8 Del. C. §211(b).

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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 consent ofstockholders, if applicable, will be electedto office. Recently, many public companieshave modified their charters to require thatdirectors must actually receive a majority ofthe outstanding votes, or at least a majorityof the shares voted at the meeting in orderto be elected or, alternatively, if a directorreceives fewer votes for reelection thanwithheld votes, the director must submit aresignation for consideration by the board.

Although the default rule under Dela-ware law is that directors hold office forone-year terms, the DGCL permits the stratification of a board into two or threeclasses, with each class having terms that expire in successive years.16 This is com-monly referred to as a classified or staggered board. The most frequent example is aboard of three classes with each class having a three-year term and expiring on succes-sive years. Some believe that classified boards provide stability by ensuring that at anyone election, only a portion of the board will be re-elected. On the other hand, classi-fied boards have been used as a device to resist hostile takeovers, and many stock-holder rights activists believe that classified boards unduly impair the stockholders’fundamental right to change the board if they believe the corporation is not beingmanaged appropriately. Use of classified boards in the context of takeover defenses isdiscussed further in Chapter 3 of this Handbook.

Officers

As noted above, the board has the power, authority and responsibility under theDGCL to appoint the officers of the corporation.17 Many boards feel, and rightly so,that in order to effectively discharge their duties to manage the business and affairs ofthe corporation, they should regularly evaluate, counsel and supervise the entiremanagement team to some degree. For this reason, although a board may delegate the

Although the default rule underthe DGCL is that directors whoreceive a vote of the plurality ofthe shares voted (i.e., the most) areelected to office, many publiccorporations are modifying theirbylaws to specifically require thatdirectors must receive a specifiedminimum number of sharesapproving their candidacy beforethey will be elected.

16 8 Del. C. §§141(d), 211.17 8 Del. C. §142.

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management and performance review of the lesser officers of the corporation to thechief executive officer, most boards exercise some level of supervision over the mostsenior officers of the corporation including the chief financial officer, chief operationsofficer, president, vice presidents, and the other so-called “C-level” officers.

IDENTIFYING THE CONSTITUENTS

One of the most difficult tasks for a board and management team is to balance thecompeting interests of multiple constituents of a business. There are employees,vendors, creditors, contract counterparties, 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 management team is quite easy. The difficulty arises whendecisions 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 primaryobligation, above all others, to the stockholders, to maximize the value of the equity ofthe corporation. Fiduciary duty is a core legal concept, perhaps the most fundamentallegal concept that underlies the manner inwhich U.S. corporations are managed. Afiduciary owes an utmost duty of care, candorand confidence to its constituent. A fiduciarymust act with a high standard of care withrespect to its constituent and must avoidconflicts of interests, including taking actionsthat would advantage the fiduciary to thedisadvantage of the constituent.

Directors and officers of a corporation are fiduciaries of the stockholders. Con-sequently, decisions made in furtherance of managing the business should first andforemost focus on what is in the best interests of the stockholders. Notwithstanding theapparent oversimplification, it is frequently advisable to consider what might be theimpact on other constituents of the business, for example, its employees, vendors,creditors and contract counterparties, in order to maximize the long-term value of thestockholders. Indeed, a daily focus of the managers of a business is to ensure that thebusiness meets its contractual obligations, satisfies its creditors, cares for its employ-ees and vendors, and pleases its customers. Fortunately, doing these things generally

In a solvent business, directorsand officers are bound by afiduciary duty to manage thebusiness in order to maximizethe interests of the stockholdersfirst and foremost.

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will result in building the business for the stockholders, so that the interests ofconstituents are aligned.

Unfortunately, as business conditions change, boards and managers may beunable to make decisions that satisfy all constituents and instead must focus on max-imizing value for the stockholders. These decisions may be difficult and may involvedamaging long-standing and important personal relationships—for example, sub-stantial lay-offs for the benefit of the business and mergers or acquisitions that mayresult in the shutdown or wind-up of business units. When these challenging decisionsmust be made, it is critical to remember the board’s fundamental obligation to act inthe best interest of the stockholders. After all, it is the stockholders who have selectedthe directors and the directors who have selected the officers who are entrusted tomanage the corporation for the stockholders’ benefit.

The duties of directors and officers to care for the interests of stockholderschange dramatically when a business falters and becomes insolvent. When a businessis insolvent, the creditors become the residual risk-bearers (the position typically held

by stockholders). Therefore, the primary duties of theboard and management shift from protecting theinterests of the stockholders to protecting the interestsof the corporation’s creditors. These situations presentboards and managers with some of the most difficultdecisions. The specific and complicated duties and

demands placed on boards and managers when a corporation becomes insolvent arediscussed 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. Managers must be aware of federal and state statutes and regulationsas well as local ordinances that may affect the facilities and local activities of the busi-ness. For example, state employment laws can be complex and provide for substantialpenalties and fines if they are disregarded. Federal and state laws affecting employeebenefits and healthcare often are Byzantine and implicate corporate, employment andtax considerations as well as frequently complicated contractual obligations with third-party insurers and administrators.

The duties of the boardshift from stockholders tocreditors when a businessbecomes insolvent.

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Many states, such as California, seek to impose their corporate laws oncorporations domiciled in other states but that engage in substantial business activitiesin the concerned state.18 Federal, state and foreign income tax and state sales tax lawsapply to corporations in varying degrees and are aggressively enforced. Federal andstate securities laws affect the manner in which a corporation markets and sells itsequity and debt securities to investors. Disclosure laws also affect the manner andextent to which corporations communicate with their investors.

There are many other federal and state statutes and regulations, as well as courtdecisions and local ordinances that may affect individual businesses, including but notlimited to laws pertaining to environmental, foreign corrupt practices, anti-trust, dis-ability, copyright, trademark, patent, property and criminal matters. Application ofthese and other laws varies widely from business to business. It is important that acorporation familiarize itself with the laws to which it may be subject and tailor itsoperations accordingly.

Beyond the realm of statutes, regulations, ordinances and court decisions, there arealso industry standards and guidelines that have a substantial impact on a corporation.The books and records of a U.S. corporation typically must comply with GenerallyAccepted Accounting Principles, or GAAP. Further, many corporations doing businessoutside the United States must also maintain their books and records in accordance withthe International Financial Reporting Standards or other local requirements. Stockexchange rules require companies to establish various committees and promulgate andpolice procedures and canons. On top of these demands, many companies also seek toimplement best practices.

MITIGATING LIABILITY CONCERNS

Managers and boards face the tough challenge of navigating a path to profitabilitywhile making various nuanced business decisions. The last thing that directors andofficers should have to worry about is a court second-guessing their decisions with thebenefit of hindsight, particularly given that such decisions are frequently tough andmust be made under stressful conditions in real time on imperfect information. For-tunately, there are several protections that have developed to provide directors andofficers with some assurance that their decisions will be respected in the future.

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18 See, e.g., Cal. Corp. Code §2115.


The most fundamental of protections for directors and officers is the businessjudgment rule. The business judgment rule is a judicially developed doctrine thatrecognizes that directors and officers are generally best situated to make difficult deci-sions that affect the rights of stockholders, and provides strong deference to theintegrity of those decisions in the face of claims of malfeasance or negligence. Giventhe central importance of the business judgment rule, most of this Handbook isdevoted to discussing the applicability of the business judgment rule to various sit-uations. Directors and officers would be well counseled to learn about the businessjudgment rule in some level of detail and to ensure that their actions are best situatedto enjoy the protection of the business judgment rule. The business judgment rule isdiscussed generally beginning in Chapter 2 of this Handbook and specifically in sev-eral further chapters.

Additional protections potentially available for directors and officers includecertificate of incorporation provisions that can eliminate or limit directors’ personalliability to the corporation and its stockholders as permitted by the DGCL, mandatoryand permissive indemnification protections available under the DGCL, indemnificationprovisions contained in a corporation’s certificate of incorporation and bylaws, con-tractual indemnification agreements, and directors’ and officers’ insurance policies.These protections are designed to provide further assurance to directors and officers sothat they feel comfortable exercising their business judgment in a manner that theybelieve best advances the interests of the corporation’s stockholders, withoutunnecessary fear of personal liability. These devices are also discussed in greater detailin Chapter 8 of this Handbook.

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CHAPTER 2

GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OFDIRECTORS AND OFFICERS

INTRODUCTION

The business judgment rule is a judicially developed doctrine that recognizes thatdirectors and officers are generally best situated to make difficult decisions that affectthe rights of stockholders, and provides strong deference to the integrity of those deci-sions in the face of claims of malfeasance or negligence.19 The business judgment ruleis a critical component of corporate jurisprudence that is designed to assist companiesin attracting talented directors and officers to operate the corporation by limiting thecircumstances in which those persons can be liable for the corporation’s activities.

DETERMINING THE STANDARD OF REVIEW

Generally, so long as directors and officers com-ply with their basic fiduciary duties – the duty of careand the duty of loyalty – they are entitled to the pro-tections of the business judgment rule.20 The businessjudgment rule contemplates that directors’ and officers’decisions are “presumed to have been made on aninformed basis, in good faith and in the honest beliefthat the action taken was in the best interests of the corporation.”21 When the businessjudgment rule applies, a court will not substitute its own views for those of directors orofficers or second-guess the outcome of business decisions by holding a director orofficer personally liable for a mistake in judgment.

19 The business judgment rule historically has protected the actions and decisions of directors; however,there has been some recognition by courts and commentators that the business judgment rule should alsobe applied to actions and decisions of officers. See, e.g., Selcke v. Richard Bove, et al. 629 N.E. 2d 747(1994); Rosenfield v. The Metals Selling Corporation, 643 A. 2d 1253 (Conn. 1994); Kelly v. Bell, 254 A.2d 62 (Del. Ch.1969). For purposes of this Handbook, the authors assume that the principles of the busi-ness judgment rule would be extended to officers.

20 Some courts and commentators describe fiduciary duties as three separate duties — the duties ofcare, loyalty and good faith, while others describe the duties as two separate duties — the duties of careand loyalty, with the duty of good faith being a subset of the duty of loyalty. See, e.g., In re Walt DisneyCo. Derivative Litigation, 906 A.2d 27 (Del. 2006).

21 Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1341 (Del. 1987).

The business judgmentrule presumes that direc-tors acted on an informedbasis, in good faith andwith the best interests ofthe corporation in mind.

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When the business judgment rule applies, it is the plaintiff’s burden to rebut thepresumption and establish that a fiduciary duty was breached. This requires the plain-tiff to produce evidence and persuade the court that the evidence demonstrates that theboard members breached their fiduciary duties. In contrast, when the business judg-ment rule is inapplicable, courts will closely examine the circumstances surroundingany challenged business decision and require the directors and officers to demonstratethat the particular challenged action was “entirely fair” to the corporation and its con-stituents. The entire fairness standard is a much more exacting standard requiring thedirectors and officers to demonstrate fair price and fair dealing, as discussed in detailbelow under the caption “Entire Fairness Review.”22 Directors and officers who areunable to meet the applicable standard of review can be personally liable to the corpo-ration and its constituents for their actions.

In certain instances, the business judgment rule will not apply automatically to theactions of directors and courts may apply a more enhanced level of scrutiny to chal-lenged actions. For example, courts may not apply the business judgment rule when:

• The subject transaction or challenged item involves interested directors andapproval of the fully informed disinterested directors or stockholders has notbeen obtained;23

• The subject transaction or challenged item involves a sale of control of thecompany 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 having received a purchase offer;

• An unsolicited third-party bid after a transaction with respect to the companyhas been announced; or

• The company adopts defensive tactics or provisions that are not reasonablein relation to a threat posed to the company or that otherwise constitute anabuse of discretion.

22 Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983).23 See, e.g., Marciano v. Nakash, 535 A.2d 400, 405 n3 (Del.1987).

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In these instances, courts will impose a more rigorous standard, which mayinvolve requiring the directors to demonstrate the entire fairness (discussed below) oftheir actions to the stockholders or applying the heightened review standards of Revlonor Unocal. The Revlon and Unocal standards are discussed in Chapter 3 of this Hand-book.

It is also important to note that although directors’ fiduciary duties are generallydescribed as consisting of two (or sometimes three) separate duties—the duty of careand the duty of loyalty (some courts and commentators also consider the duty of goodfaith and fair dealing to be a separate duty while other courts and commentatorsconsider the duty of good faith and fair dealing to be a subset of the duty of loyalty).Nevertheless, courts may evaluate the duties more fluidly, and acts that may constitutea breach of the duty of care may be found to be sufficiently egregious to constitute abreach of the duty of loyalty as well.

DUTY OF CARE

The duty of care requires directors and officers to act prudently in light of allreasonably available information in overseeing the corporation’s business and makingdecisions on its behalf. Specifically, directors and officersshould employ the following practices, among others, tothe 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;

• Review and monitor the performance of the chief executive and other seniorofficers;

• Remain informed about the corporation’s operations, performance and chal-lenges; and

The duty of carerequires directors tofully inform them-selves and deliberatecarefully beforemaking corporatedecisions.

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• Implement and monitor reporting and information systems to check for fail-ures to comply with laws and regulations.

Breaches of the duty of care are typically not found where directors and officersmerely fail to follow best practices. Rather, breaches of the duty of care occur whendirectors and officers engage in conduct that is grossly negligent, act with recklessindifference to stockholders’ concerns or act in a manner that is completely irrationalwith respect to their decision-making process.24 Further, as noted above, courts areincreasingly finding that sufficiently egregious breaches of the duty of care may alsoconstitute a breach of the duty of loyalty. Consider, for example, several prominentcases:

• Breach of Duty of Care Where Directors Take Substantially No Actions toInform 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 directorswere unaware that a merger was even contemplated, although the dead-line imposed by the proposed buyer for signing the merger agreementwas the next day;

O During the chief executive officer’s short oral report regarding the termsof the deal, the directors did not question the role that he had played inorchestrating the sale and were unaware that he had suggested the pershare purchase price to the buyer; and

O The board approved the agreement in a two-hour long meeting, duringwhich they neither reviewed the agreement nor questioned the determi-nation of the purchase price.25

• No Breach of Duty of Care Where Directors Approved a SubstantialSeverance Arrangement for an Executive Without Following BestPractices or Consulting a Compensation Consultant. In In re Walt DisneyCo. Derivative Litigation, no breach of the duty of care was found inconnection with the directors’ approval of an employment agreement that

24 Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).25 Id.

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resulted in a $130 million severance payment to a president terminated afteronly one year of employment even though the court found that the boardfailed to take actions consistent with best practices, including informingthemselves of the estimated severance payments for each year ofemployment or conferring with the compensation expert who had assisted inpreparing compensation figures for the president. The court determined thatthe directors had acted on an informed basis, in good faith and in the honestbelief that they were taking action in the best interests of the company.26

• No Breach of Duty of Care When Directors Failed to Detect Violations ofLaw by Employees Where Directors Had Preventative Systems in Placeand Had No Reason to Know About the Violations. In In re CaremarkInternational Inc. Derivative Litigation27, no breach of the duty of care wasfound where the directors failed to detect violations of laws by employees ofthe corporation – specifically, employees had been compensating health carepractitioners who referred Medicare and Medicaid patients to Caremarkfacilities in violation of the law.28 The court noted that generally a directorwill be liable only if he or she knew or should have known about violationsof the law, he or she did nothing to address or remedy those violations, andthose violations were the cause of the losses to the corporation complainedof in the lawsuit.29 Further, the court stated that a director may be liable if heor she failed to ensure that systems were put in place to check compliancewith applicable laws or failed to monitor those systems even where therewere no red flags indicating violations.30 The court determined that, had itbeen presented with the question, it would not have found the Caremarkdirectors liable because they did not and had no reason to know of the viola-tions and had systems in place to check for violations.31

26 906 A.2d 27 (Del. 2006).27 698 A.2d 959 (Del. Ch. 1996).28 Id. at 961-62.29 Id. at 971.30 Id. at 970.31 Id. at 971-72.

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• 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. InStone v. Ritter,32 the court held that directors may breach their duty of loyaltywhere they fail to implement any reporting or information system controls,or having implemented such a system fail to monitor or oversee itsoperations.33 Significantly, the court held that such directors breached theduty of loyalty (as opposed to their duty of care) by failing to institute a legalcompliance system because such failure constituted a failure to act in goodfaith.33 This is notable because corporations cannot indemnify directors andofficers for breaches of the duty of loyalty where the director or officer hasacted in bad faith as they can for breaches of the duty of care.

• Breach of Duty of Care When Directors Were Given Sufficient Notice ofSafety Violations and Failed to Act. In In re Abbott Labs DerivativeShareholders Litigation, the courtfound a breach of the duty of carewhen the FDA repeatedly servednotices of safety violations over a 6-year period and the directors took nosteps to remedy the violations, result-ing in large monetary losses to thecompany. The court determined that,due to a set of facts indicating theirawareness of the problem, the board’sinaction appeared to be intentionaland, consequently, the directors’ deci-sions were not made in good faith.34

• Breach of Duty of Loyalty Where Directors Abdicated Responsibilities toManagement and Engaged in Rush Sale of Business. In the recent case ofIn re Bridgeport Holdings, Inc., directors were held to have breached theirduty of loyalty by abdicating crucial decision-making authority in the sale ofthe company to an officer of the company, failing to monitor the officer’s

32 911 A.2d 362 (Del. 2006).33 Id. at 370.34 325 F.3d 795 (7th Cir. 2003).

The decisions in Caremark,Stone, Abbott Labs and Bridge-port suggest that if directorshave failed to act in good faithin adhering to their duty ofcare obligations, they may befound to also have violatedtheir duty of loyalty and havepersonal liability for whichindemnification is notavailable.

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execution of an abbreviated and uninformed sale process, and ultimately,approving the sale of the business for grossly inadequate consideration. Thecourt held that the board’s actions were tantamount to an intentional dis-regard of their duty of care, and thus constituted a breach of their duty ofloyalty, notwithstanding the fact that the plaintiff did not allege self-dealingby the board or a lack of independence.35

Reliance on Experts

In discharging the duty of care, directors and officers are often encouraged toseek the advice of experts, such as accountants, investment bankers and attorneys.Under Delaware law, directors and officers are entitled to rely on the advice andrecommendations of such experts so long as such reliance is reasonable and in goodfaith.36 However, if a director has reason to know that the information presented by theexpert is incorrect, then such reliance is not reasonable and the duty of care may not besatisfied. Also, experts should be selected with reasonable care – an expert’s qual-ifications and experience should be considered in detail. Additionally, an expert’sindependence should be evaluated – experts who stand to earn significant fees basedon the success of a transaction may not be able to deliver an unbiased opinion.37

Finally, directors must not blindly rely on experts’findings. Directors should probe and test an expert’sassumptions, analysis and conclusions.

DUTIES OF LOYALTY AND GOOD FAITH

The Duty of Loyalty

Directors owe a fiduciary duty of loyalty to the cor-poration and to its stockholders. The duty of loyalty requires directors and officers toact in good faith, to act in the best interests of the corporation and its stockholders, andto refrain from receiving improper personal benefits as a result of their relationship

35 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008); see also Ryan v. LyondellChemical Company, C.A. No. 3176-VCN (July 29, 2008).

36 8 Del. C. §141(e).37 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’sadvice to a special committee would be considered independent when the bank’s entire fee was contingentin nature on the transaction economy. Fairness opinion fees are generally bifurcated so that the fee for theopinion is payable regardless of whether a transaction proceeds.

The duty of loyaltyrequires directors to putthe corporation’s interestsabove their personalinterests in evaluatingopportunities.

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with the corporation. The duty of loyalty prohibits self-dealing and usurpation of corpo-rate opportunities by directors without the informed consent of the corporation,through either its disinterested directors or stockholders. “Essentially the duty of loy-alty mandates that the best interest of the corporation and its shareholders takes prece-dence over any interest possessed by a director, officer or controlling shareholder andnot shared by the shareholders generally.”38

Duty of loyalty issues typically arise in various contexts, including:

• A conflict of interest – where any director or officer has an interest in atransaction contemplated by the corporation;

• Misappropriation of corporate opportunities – where a director or officerexploits 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 informationare used by an officer or director for non-corporate purposes; or

• Egregious Conduct – conduct that is deemed to be sufficiently egregious to beviewed as not having been taken in good faith, including completely abdicatingthe director’s responsibilities to the corporation.

Note that, unlike the duty of care, liability for breaches of the duty of loyaltycannot be limited by a provision in the corporation’s certificate of incorporation, anddirectors and officers may not have access to contractual indemnification for breachesof the duty of loyalty that involve bad faith.39

38 Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993).39 8 Del. C. §102(b)(7).

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What Defines a “Conflict of Interest”?

A director is “interested” in a particular transaction or corporate decision whenhis or her exercise of judgment with respect to such transaction or corporate decision iscompromised by the presence of one or moreexternal factors relating to the transaction. Such“interests” most commonly exist when a directorhas a material economic interest in a particulartransaction or decision, such as when a director hasa financial stake in another party with which thecorporation is seeking to do business, when adirector stands to receive a financial payment aris-ing out of a transaction (such as a finder’s fee) or where a director or officer stands tobenefit from a continuing relationship with the other party to a transaction (such as anemployment relationship following the transaction). Conflicts of interest also can existin interlocking or overlapping governance arrangements – for example when a directorapproves compensation for a chief executive officer who in turn sits on the board of acorporation that employs that director. However, interested party transactions are notinherently detrimental to a corporation. As long as a transaction is fair to the corpo-ration, no confidential relationship is betrayed, and there is no misappropriation ofcorporate property, the duty of loyalty may not breached, regardless of whether certaincorporate directors and officers will profit as a result of it.

“[The Delaware] Court has never held that one director’s colorable interest in achallenged transaction is sufficient, without more, to deprive a board of the protectionof the business judgment rule presumption of loyalty. . . . To disqualify a director, forrule rebuttal purposes, there must be evidence of disloyalty. Examples of such mis-conduct include, but certainly are not limited to, the motives of entrenchment, fraudupon the corporation or the board, abdication of directorial duty, or the sale of one’svote (citations omitted).”40

40 Cede, 634 A.2d at 363.

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One of the most fertilegrounds for breach of fidu-ciary duty claims is ininstances in which directorshave a potential conflict ofinterest, and thus their dutyof loyalty is implicated.


Mitigating Duty of Loyalty Issues

Duty of loyalty issues can be mitigated if actions involving potential conflicts areapproved by an independent decision-making body, which serves to mitigate the riskthat the decision in question is motivated by an improper purpose. The independentdecision-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 deci-sion-maker must be fully informed of the conflict ofinterest as well as the terms of the corporate actionand must act in good faith.41 Boards commonly uti-lize disinterested director approval mechanisms orspecial committees comprised of disinterested andindependent directors in an effort to mitigate duty of

loyalty concerns and to try to preserve the application of the business judgment rule tothe 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 anypotential breach of fiduciary duty back to the plaintiff. Where no independentdecision-maker is present and where the business judgment rule does not apply, dutyof 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-holders.42 However, entire fairness can be difficult, time-consuming and costly toestablish, as discussed in detail in this Chapter. The use of special committees is dis-cussed 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 opportunitydoctrine provides that corporate directors and officers are prohibited from exploitingbusiness opportunities that might be of interest to the corporation that they serve.Corporate opportunity issues often arise when corporate officers or directors areinvolved with multiple corporations, including affiliated entities or entities that com-pete or operate in related markets; these scenarios can be particularly complicatedbecause such officers or directors have a duty of loyalty to each entity. Corporate

41 8 Del. C. §144.42 Id.

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Duty of loyalty concernscan often be mitigated byobtaining approval ofdisinterested directors orstockholders of a subjecttransaction.


opportunity issues also arise where an officer or director has personal business inter-ests that compete with the corporation’s business interests in certain business oppor-tunities. Directors who are industry experts and serve as directors, promoters andprincipals at multiple entities must be particularly sensitive to this issue.

What Constitutes a Corporate Opportunity?

A corporate opportunity exists, and a corporate officer or director is prohibited fromtaking such business opportunity for his or her own without first offering it to the corpo-ration, if:

• The corporation has an interest orexpectancy in the opportunity;

• The corporation is financially able toexploit the opportunity;

• The opportunity is within the corpo-ration’s line of business; and

• By taking the opportunity for his or her own, the corporate fiduciary willthereby be placed in a position inimical to his or her duties to the corporation.

The corollary to the above rule is that a director or officer may generally take acorporate opportunity without breaching the duty of loyalty, if:

• The opportunity is presented to the director or officer in his or her individualand 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 thecorporation in pursuing or exploiting the opportunity.43

Of course, the safest course of action with respect to a transaction involving apotential conflict over a corporate opportunity is to have the subject transactionapproved by the disinterested directors or stockholders after the full disclosure of itsterms.

43 See Guth v. Loft, Inc., 5 A.2d 503, 509 (Del. Ch. 1939). See also Broz v. Cellular Info. Sys., 673 A.2d148 (Del. 1996).

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Many corporations buildextensive guidelines into theiremployee conduct codes in aneffort to avoid potential conflictsof interest and corporate oppor-tunity issues with their execu-tives and directors.


Mitigating Corporate Opportunity Issues

Corporations employ a wide range of practices in dealing with issues of corporateopportunity. Some alternatives include the following:

• Limit fields of interest in which directors and officers can participate outsideof their activities on behalf of the corporation to avoid potential overlapswith the corporation’s business;

• Define the activities and duties of the affected director or officer. For exam-ple, each of the corporation and any competing entity with which an officeror director is affiliated could adopt a policy on confidentiality that wouldrelease the affected director or officer from any obligation to disclose over-lapping opportunities, and would prohibit members of the board of directorsof each entity from bringing to the other opportunities learned of throughparticipation in its meetings and deliberations;

• Renounce the corporation’s interest or expectancy in a particular field oropportunity as permitted under the DGCL such that directors and officers donot have an obligation to refrain from participating in, or an obligation tooffer the corporation the right to participate in, such activities if presented tothe directors or officers;

• Recuse the director or officer from deliberations with the corporation or theother 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 positionwith 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 tothe corporation or the other entity, there should be full disclosure of the potential con-flicts to the board of directors of each of the corporation and such competing entity.

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Duty of Good Faith

The duty of good faith is a subset of the duty of loyalty requiring directors andofficers to act in the best interests of the corporation and its stockholders at all times.44

However, bad faith is not simply bad judgment or negligence, but rather implies theconscious doing of a wrong because of a dishonest purpose or a state of mindaffirmatively operating with furtive design or ill will. Breaches of the duty of goodfaith have been found in the following circumstances:

• Directors knowingly or deliberatelywithheld information they knew to bematerial for the purpose of misleadingstockholders;45

• A transaction was authorized for pur-poses other than to advance corporatewelfare and in violation of applicablelaws;46

• A director’s decision was primarilymotivated by personal interest and not the best interests of the corporation;47

• Actions were consciously taken with a dishonest purpose or moral obliquity;48

and

• Directors failed to prevent waste or self-dealing by another director orcorporate officer.49

There has been ambiguity surrounding the duty of good faith in recent years,including some confusion regarding whether the duty of good faith is an independentduty or an element of the duty of loyalty. Two recent Delaware Supreme Court cases

44 Guth, 5 A.2d at 509; Stone v. Ritter, 911 A.2d 362 (Del. 2006).45 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).46 Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 n.2 (Del. Ch. 1996).47 Washington Bancorp. v. Said, 812 F. Supp. 1256, 1269 (D.D.C. 1993).48 Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1208 n.16

(Del. 1993).49 In re Nat’l Century Financial Enterprises Inv. Litigation, 504 F. Supp. 2d 287, 313 (S.D. Ohio 2007).

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The duty of good faith is asubset of the duty of loyalty.Duty of good faith violationsoccur when directors con-sciously disregard their dutyto act in the best interests ofthe corporation and itsstockholders.


have settled the issue. In In re Walt Disney Co. Derivative Litigation,50 the court out-lined 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 thecorporation or with ill will (subjective bad faith).51

• Category 2 – Grossly negligent conduct, without more.52

• Category 3 – The fiduciary intentionally acts with bad faith dereliction ofduty, a conscious disregard for one’s responsibilities.53 For example, thefiduciary acts with a purpose other than that of advancing the best interestsof the corporation; the fiduciary acts with the intent to violate applicablepositive law; or the fiduciary intentionally fails to act in the face of a knownduty to act, demonstrating a conscious disregard for his or her duties.54

While the court decided that Categories 1 and 3 described behaviors that wouldbe classified as bad faith, grossly negligent conduct, without more (Category 2), couldnot constitute a breach of the fiduciary duty to act in good faith.55

Following the 2006 Disney decision, the Delaware Supreme Court againaddressed the duty of good faith in Stone v. Ritter.56 In Stone, the Court clarified thatthe duty of good faith is an element of the duty of loyalty, not an independent fiduciaryduty. Specifically, the Stone court said that “the obligation to act in good faith does notestablish an independent fiduciary duty that stands on the same footing as the duties ofcare and loyalty.”57

50 906 A.2d 27 (Del. 2006).51 Id. at 64.52 Id.53 Id. at 66.54 Id. at 67.55 Id. at 64.56 911 A.2d 362 (Del. 2006).57 Id. at 370.

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Consider, for example, the following cases regarding the duties of loyalty andgood faith:

• No Breach of Fiduciary Duty When Decisions Are Made in Good FaithWithout Self-Dealing or Improper Motive. In Gagliardi v. TriFoodsInternational, no breach of fiduciary duty was found when a shareholderalleged mismanagement and waste by the corporation. The court held thatwithout a showing of self-dealing or improper motive, a corporate officer ordirector cannot be held liable for losses suffered as a result of a decisionmade by the officer or authorized by the director unless the facts indicatethat no person would authorize the transaction in good faith.58

• 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 foundwhen shareholders filed suit to enjoin a distribution of special dividends thatwould cause the corporation to lose $8,000,000 in tax savings, claimingwaste of corporate assets. The court held that the directors were protected bythe business judgment rule. The court refused to interfere with the decisionsof the board unless powers had been illegally or unconscientiously executedor the acts were fraudulent, collusive, or destructive to shareholders’ rights.Errors in judgment, without more, were not sufficient grounds for judicialinterference.59

• Breach of Fiduciary Duty When Directors Knowingly Committed IllegalActivities. In Miller v. AT&T, the court found a breach of fiduciary dutywhen the company had given an illegal campaign contribution in violation offederal law. The business judgment rule does not insulate directors fromliability after they knowingly committed illegal activities.60

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58 683 A.2d 1049 (Del. Ch. 1996).59 383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976).60 507 F.2d 759 (3d Cir. 1974).


• Breach of Duty of Loyalty Where Directors Abdicated Responsibilities toManagement and Engaged in Rush Sale of Business. In the recent case ofIn re Bridgeport Holdings, Inc. case, directors were held to have breachedtheir duty of loyalty by abdicating crucial decision-making authority in thesale of the company to an officer, failing to monitor the officer’s executionof an abbreviated and uninformed sale process, and ultimately approving thesale of the business for grossly inadequate consideration. The court held thatthe board’s actions were tantamount to an intentional disregard of their dutyof care, and thus constituted a breach of their duty of loyalty, notwithstand-ing the fact that the plaintiff did not allege self-dealing by the board or a lackof independence.61

Summary

Delaware courts still recognize a triad of director duties, including care, loyalty andgood faith; however, following Disney and Stone v. Ritter, it appears that the duty ofgood faith is not always viewed on the same level as the duties of care and loyalty. TheDelaware Court of Chancery has observed that by definition, a director cannot simulta-neously act in bad faith and loyally towards the corporation and its stockholders because“bad faith conduct. . . would seem to be other than loyal conduct.”62 Today, directors areadvised to demonstrate their good faith (and loyalty) by documenting the business pur-poses or stockholder-oriented reasons for their decisions and/or recusing themselves ifthere is the potential appearance of impropriety.

DUTY TO DISCLOSE

Stemming from their fiduciary duties of care, loyalty and good faith, corporatedirectors also have a duty of disclosure or candor.63 Disclosure violations constitute abreach of the duty of care when the misstatement or omission was made as a result of adirector’s erroneous judgment, but was nevertheless made in good faith. If the boardlacks good faith in approving a disclosure, the violation also implicates the dutyof loyalty.64 When directors do seek to make a disclosure, such as in seeking

61 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008).62 In re ML/EQ Real Estate Partnership Litigation, No. 15741, 1999 Del. Ch. LEXIS 238 (Del. Ch.

Dec. 20, 1999).63 Malone v. Brincat, 722 A.2d 5, 11 (Del. 1998).64 In re Tyson Foods, Inc. Consol. Shareholder Litigation, 919 A.2d 563, 597-98 (Del. Ch. 2007).

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stockholder approval, Delaware courts have held that they need to “disclose fully andfairly all material information within the board’s control.”65 Further, the court said thatwhen directors recommend stockholder action, they have an affirmative duty to dis-close all information material to the action being requested and “to provide a balanced,truthful account of all matters disclosed in the communications with stockholders.”66

Likewise, directors have a duty of candor that requires that they disclose to the boardinformation 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 acorporation does speak to its investors, the directors need to be sure that any disclosureof material information is truthful, accurate and complete. Consistent with federalsecurities 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 alterthe ‘total mix’ of information available.67

ENTIRE FAIRNESS REVIEW

Overview

In situations in which the presumption of the business judgment rule is not avail-able, directors will be required to establish the entire fairness of the transaction inquestion. When engaging in an entire fair-ness review, a court will determine whetherthe transaction is entirely fair to stock-holders and should therefore be upheld,notwithstanding any deficiencies on the partof the board.68 This standard of review isrigorous and the board bears the burden ofnot only providing the evidence to the court but also persuading the court that theevidence demonstrates that the directors have met their burden. The practicalimplication of a rebuttal of the business judgment rule is that the chances that a trans-

The entire fairness test requiresdirectors to produce evidence thatdemonstrates that the subjecttransaction was the product of fairdealing and produced a fair pricefor the stockholders.

65 Malone, 722 A.2d at 10 (Del. 1998).66 Id.67 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).68 See, e.g., Citron v. E.I. Du Pont de Nemours & Company, et al., 584 A.2d 490 (1990).

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action may be set aside are greatly increased. As a result, it is of the utmost importancethat boards try to manage their actions and the circumstances surrounding them tohave the best chance of preserving application of the business judgment rule.

As noted previously, a rebuttal of the business judgment rule most frequentlyoccurs when a director may have an interest in the transaction, or when there is evi-dence that the directors may have breached their fiduciary duties. In addition, theentire fairness test will be applied when a corporation consummates a transaction witha controlling stockholder, unless the corporation obtains the approval of disinteresteddirectors, disinterested stockholders, or both. Although such disinterested approvalmay result in the board receiving the benefit of the business judgment rule, a courtmay nonetheless require a defendant controlling stockholder to demonstrate the entirefairness of the challenged transaction. Absent a disinterested approval process, thedefendant may be required to bear the burden of providing evidence and convincingthe court that the transaction was entirely fair to the minority stockholders. If a disin-terested approval process was used, a court may shift the burden of proof from thedefendant controlling stockholder to the plaintiff (who would then be required todemonstrate that the transaction was not entirely fair).69 A shift in the burden of proofcan have a meaningful impact on whether the court ultimately declares that the trans-action was entirely fair.

Fair Dealing and Fair Price

In order to satisfy an entire fairness review of a challenged transaction, a boardmust demonstrate that the transaction was the product of both fair dealing and fairprice. This analysis is not necessarily bifurcated.70 A court considering the issue ofwhether the board has met its obligations under the entire fairness test may blur thelines between the two tests, and the results of one test may influence whether the othertest was satisfied.

69 See Weinberger v. UOP, Inc., 457 A.2d 701 (Del 1983).70 Id. at 711.

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Fair Dealing

In determining whether a board engaged in fair dealing, Delaware courts willcarefully examine the board’s actions. Specifically, in assessing entire fairness, Dela-ware courts will consider:

• The process the board followed – for example:

O Was the process initiated by a related party or by an independent subsetof the board?

O Did the board take care to ensure that the negotiation process was freeof any taint of related-party concerns?

O Was the structure designed so as to be unduly advantageous to oneparty or another?

O Was the board fully apprised of all material facts surrounding thetransaction, including any material relationships?

O Was a methodical, fully informed, disciplined approval processfollowed for the board’s approval, and stockholders’ approval, ifrequired?

• The quality of the result the board achieved – for example:

O On balance did the end result provide a fair treatment to thestockholders?

O Did the directors satisfy their fiduciary duties of care, loyalty and goodfaith in recommending the transaction?

• The quality of the disclosures made to the stockholders to allow them toexercise such choice as the circumstances could provide.71

71 See Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1140 (Del. Ch. 1994), aff’d 663 A.2d 1156(Del. 1995).

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Fair Price

In addition to evaluating whether the board engaged in fair dealing, the Delawarecourts will consider whether a fair price was obtained. A fair price does not mean thehighest price financeable or the highest price that a fiduciary could afford to pay. Atleast in the non-self-dealing context, it means a price that a reasonable seller, under allthe circumstances, would regard as within a range of fair value; one that such a sellercould reasonably accept.72 In the context of competing bids, the directors would beexpected 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 ofincorporation eliminating or limiting the personal liability of a director to the corpo-ration or its stockholders for monetary damages for breach of fiduciary duty, providedthat 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 itsstockholders;

• Acts or omissions that are not in good faith or that involve intentional mis-conduct or a knowing violation of law;

• Unlawful dividends, stock purchases and redemptions by the corporation; or

• For any transaction from which the director derived an improper personalbenefit.73

Exculpation provisions such as these provide substantial comfort to directors and maydirectly impact their willingness to serve in that capacity, and as a result the certifi-cates of incorporation of both publicly and privately held corporations commonlycontain them. Directors and persons contemplating accepting a directorship shouldcarefully consider whether and to what extent their liability to the corporation and itsstockholders is eliminated or limited under the corporation’s certificate ofincorporation.

72 Id. at 1143.73 8 Del. C. §102(b)(7).

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In the event a board becomes subject to an entire fairness review, the board’sfailure to demonstrate entire fairness under the analysis discussed above is a basis fora finding of substantive liability.74 If the breach that triggered application of the

entire fairness standard was a breach of the dutyof care, provisions in a corporation’s certificateof incorporation eliminating or limiting the per-sonal liability of directors for breaches of thisfiduciary duty would likely shield directors frompersonal liability.75 However, as noted above, abreach of the duty of loyalty or the related duty

of good faith may not be eligible for these protections.76 To further complicate matters,the Delaware courts have sometimes blurred the distinction between what constitutes abreach 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 itsbylaws in circumstances where they have acted in good faith and in a manner whichthey reasonably believe is in the best interest of the corporation. Directors also mayhave in place indemnification agreements providing contractual rights toindemnification, and may be protected under an insurance policy (commonly known as“D&O insurance”). However, as already noted, the availability of these protections infavor of directors may be limited when they breach their duties of good faith andloyalty. Indeed, many indemnification agreements specifically provide that a directoris not entitled to indemnification if he or she is ultimately determined to have actedwith gross negligence or willful disregard of his or her duties. Indemnification ofdirectors and officers and D&O insurance are discussed in detail in Chapter 8 of thisHandbook.

A director who has been foundto have breached his duty ofloyalty or good faith may notbe entitled to indemnificationfrom the corporation underDelaware law.

74 Cinerama, 663 A.2d at 1164.75 See 8 Del. C. §102(b)(7).76 See id.

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CHAPTER 3

FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESSCOMBINATION TRANSACTION

INTRODUCTION

Generally, when a board of directors is presented with a business combination, itsactions will be reviewed against the standard of the traditional business judgment rule,assuming the directors have observed their duties of care and loyalty. Thus, when pre-sented with a transaction, directors are advised to take a number of steps to best positionthemselves to receive the benefit of the business judgment rule.

• First, directors should inquire diligently with all parties as to any relation-ships with the potential counterparty so as to ensure that if facts give rise topotential duty of loyalty considerations, they are identified and mitigated.

• Second, directors should collect as muchrelevant information regarding the poten-tial transaction as reasonably possible,review the information carefully, andconsider seeking the advice of experts,including lawyers, bankers and account-ants, if necessary, to ensure that the direc-tors have a complete understanding of thematerials that have been presented.

• Third, directors should investigate, to areasonable extent, the assumptions andinformation provided to the directors.Although directors are absolutely per-mitted to rely on information provided to them by management and outsideadvisors, they cannot do so blindly and will be expected to have, at a mini-mum, probed and tested the assumptions and information provided to givethemselves a level of comfort and assurance as to its accuracy, veracity andcompleteness.

When faced with a poten-tial transaction, directorsshould always:• Inquire as to potential

conflicts;• Investigate and fully

inform themselves ofthe facts;

• Test assumptions usedby experts andmanagement; and

• Deliberate beforemaking a decision.

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• Fourth, directors should carefully consider their options and deliberate amongthemselves. Robust discussion will bring issues to the surface and promotethorough consideration by the board in making its decision.

These steps, taken together, will best position the board to enjoy the benefits ofthe business judgment rule. Nevertheless, as noted in Chapter 2, there are instances inwhich the business judgment rule may not apply. In these instances, greater judicialscrutiny may be applied to the directors’ decision-making process. Specifically,

• Where directors may have been found to have violated their duty of care orduty of loyalty, they may be required to demonstrate the entire fairness ofthe transaction to the stockholders;

• When contemplating a sale or break-up of the corporation, directors will beheld up to the so-called Revlon duties;77 and

• When defending against a change in control of the corporation, directors’actions may be reviewed against the heightened standard set forth in theUnocal decision.78

BOARD CONSIDERATIONS WHEN A SALE OR BREAK-UP OF THE

CORPORATION IS NOT IMPLICATED

In general, in reviewing a proposed business combination, directors shouldconsider multiple factors, including the following:

• An assessment of a merger partner (in the case of a share-for-share trans-action) and the prospects of the combined corporation (including synergiesof the combination, composition of the management team and the board andfactors affecting stock price and performance);

• 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;

77 Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).78 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).

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• The advice of advisors concerning the terms of the transaction;

• Alternative proposals and the “standalone” prospects for continuing businesswithout undertaking a transaction;

• The impact of the transaction on the corporation’s long-term strategic plans;

• Integration risks of the transaction;

• The legal terms of the proposed business transaction, including pricing,conditions to closing, restrictions prior to closing and any other key terms ofthe transaction;

• Deal protection terms including “no shop” provisions, “break up” or termi-nation fees, etc.;

• Accounting and tax treatment of the transaction;

• The right of the corporation’s stockholders, if applicable, to vote on the trans-action;

• Conditions to the proposed transaction and the risk that conditions, such asfinancing for the transaction, may not be fulfilled;

• Circumstances of the corporation’s business and industry;

• The impact of the transaction on various other constituencies, such asemployees, suppliers and customers;

• The results of due diligence review for the proposed transaction; and

• The legal or other approval requirements needed to complete the transaction,such as antitrust clearances.

There can be no “one size fits all” solution to the issues that a board may considerin its deliberations for a particular transaction. Certain factors will have much greaterweight assigned to them depending on the circumstances of the particular project. Forinstance, price may be a paramount consideration in a sale of control transaction,whereas longer-term strategic considerations might be more relevant in the case ofsome share-for-share business combination transactions.

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ADDITIONAL CONSIDERATIONS IN ANY BUSINESS COMBINATION

TRANSACTION

In addition to the factors discussed above, directors should always take intoaccount the following important considerations in the context of any potential businesscombination:

• The path of considering one or more possible business combination trans-actions is highly confidential. All aspects of information flow and disclosureneed to be tightly coordinated;

• Care should be taken to avoid trading by any insiders in the securities of thecorporation or any counterparty;

• Efforts should be made to coordinate communications with members of theboard, management and the corporation’s advisors so as to assure the mosteffective overall process;

• Discussions with investors, the press and securities market professionalsshould not be undertaken except where approved as part of the overall trans-action process; and

• Notes that directors choose to keep, if any, should be carefully prepared notonly to assure accuracy, but also to avoid comments that can be taken out ofcontext in the event of litigation or other proceedings concerning the trans-action.

REVLON AND A SALE OR BREAK-UP OF THE CORPORATION

Introduction

Once a board makes the decision to sell the corporation, Revlon duties areinvoked that require the board to change its focus from the preservation of the corpo-ration as a corporate entity to the maximization of the corporation’s value at a sale forthe stockholders’ benefit.79 In its most basic form, Revlon duties can be described asthe duty of the board to maximize the value to be received by stockholders. OnceRevlon duties apply, instead of relying on the business judgment of the directors,

79 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).

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courts will more closely scrutinize the board’s process and actions in order to ensurethat the directors took the steps necessary to maximize stockholder value.80

Applicability of the Revlon Duties

Whenever a sale of control is implicated, Revlon duties will likely apply. Gen-erally, sale of control is implicated in any transaction in which corporate control passesto a third party, including:

• A sale or merger for cash or debt securities;

• A merger for securities (even a strategic merger) that transfers control to aprivate corporation or to a public corporation with a majority stockholder;

• A transaction or business reorganization that will cause a clear break-up ofthe corporation; or

• A sale of equity securities by a controlling stockholder that results in achange of control.

In contrast, Revlon duties do not apply in the following situations:

• Where a board rejects an unsolicited offer as not in the best interest of itsstockholders;

• In a merger or business combinationtransaction in which sale of control ofthe corporation is not implicated;

• In a merger or business transaction inwhich sale of control of the corporationis implicated if the transaction is a“merger of equals.” A “merger ofequals” involves a merger of two companies with large and diverse stock-holder bases where following the transaction, a majority of the voting secu-rities of the combined company remain in the hands of investors in thepublic markets;

• In a situation in which a board is considering acquiring another business andthat acquisition would not involve a change of control to the acquirer.

80 See id.

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Unless a board has otherwisesubjected itself to Revlonduties, it has no legal duty toengage in discussions or tonegotiate with respect to ahostile or otherwiseunsolicited takeover offer.


Revlon duties arise at the time that the directors have or are deemed to havedecided to sell a controlling interest in the corporation.81 For example, Revlon dutiesmay attach when the directors have authorized corporate officers or a board committeeto negotiate a sale, or when the directors have formally resolved to conduct a sale. Incontrast, Revlon duties typically will not apply if the directors never authorize the sale

of the corporation, never indicate any inevitablecommitment to sell the corporation to anyone, ormerely authorize the exploration of a variety ofalternatives intended to enhance profitability,including a possible sale. As most sales are pre-ceded by such informal investigations, directorsshould be aware of Revlon duties when such aprocess commences and avoid commitments thatmight make it difficult to meet their Revlon dutiesif they should arise later.

Revlon Duties and Guidelines

Once Revlon duties arise, the board of directors should adhere to the followingguidelines:

• Highest Value. The responsibility of the directors is to get the highest possi-ble value reasonably attainable for the stockholders. There is “no singleblueprint” that directors must follow in seeking the highest value.82 In evalu-ating competing offers where differing consideration is offered, a board isnot limited to considering only the amount of cash involved, and may takeinto account the future value of the strategic alliance. For example, ifacquirer A is offering all cash, and acquirer B is offering a mixture of cashand stock or other consideration, directors should consider the aggregatevalue of each of the proposed transactions. In addition, directors shouldconsider the likelihood that a potential acquirer is financially capable ofcompleting the transaction, as well as other factors that could affect the like-lihood of a particular transaction being completed. In short, directorsconsidering competing transactions should analyze the entire situation andevaluate the consideration being offered from each transaction in a dis-ciplined manner with the objective of maximizing value for the stockholders.

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81 See id.82 Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 44 (Del. 1994).

Once implicated, Revlonduties require directors to:• Obtain the highest value;• Act with neutrality

between bidders;• Ensure a fair auction

or sale process; and• Conduct a reasonable

market check.


• Neutrality. The board must act in a neutral manner to encourage the highestpossible price for the stockholders. Furthermore, courts have repeatedlyhighlighted that the active involvement of a corporation’s independentdirectors is critical to satisfying a board’s Revlon duties.

• Deal Protection Measures. Although deal protection measures are common inbusiness combination transactions, these measures are frequently subjected toheightened scrutiny. Common measures include lock-ups, no-talk, force-the-vote and no-shop provisions, commitments to recommend, stock optiongrants, break-up and termination fees, voting agreements and similararrangements. In contrast, many recent transactions have utilized go-shopprovisions in an effort to ensure that maximum value has been achieved.These provisions permit the target after executing the acquisition agreement toaffirmatively seek a potential alternative acquirer for a specific period of time.Deal protection provisions or any other defensive tactic that might impair theauction process, unfairly favor one bidder over another, or precludestockholders from having a meaningful opportunity to determine whether toapprove the transaction may be carefully scrutinized in considering whetherthe board met its Revlon duties. In addition, preclusive or aggressive dealprotection measures may violate the Unocal standard described below.

• Market Check. A market check, meaning an exploratory review of whetherother potential bidders exist and if so, what price they might pay, may berequired where the board is considering a single offer and no bidding contestis present. A “market check” may assist the board in considering whether aproposed change of control transaction maximizes stockholder value.

No Obligation to Sell or Negotiate

It is important to emphasize that a board is not obligated to put a corporation upfor sale or to negotiate with a party that indicates an interest in acquiring the corpo-ration so long as the board is acting in good faith. Similarly, a board is not obligated tosell the corporation, even if a premium price is offered, if the board makes a goodfaith, informed decision that it is in the best interests of the corporation to reject theoffer. If a board does elect not to put a corporation up for sale in response to anunsolicited offer, care should be taken that the directors have engaged in a thoughtfulanalysis of why they believe stockholder value can be enhanced by not selling thecorporation and should appropriately document that thought process.

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REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF A BUSINESS

COMBINATION TRANSACTION

In light of the foregoing discussion, directors should consider the following inconnection with a 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 toall material aspects of the transaction and key documents;

• Make Good Disclosures:

O Disclose all actual and potential conflicts of interest;

O Take care to ensure complete and accurate disclosure to stockholderswhose approval of a particular transaction is sought;

• Deliberate:

O Engage in robust and extensive deliberations with the board in orderto surface and consider issues and perspectives;

O Create a record of the decision-making process, includingcorrespondence with third parties discussing the merger;

• Act in Good Faith:

O Always act in the very best interests of the stockholders;

O Avoid taking any actions (i.e., adopting deal protection devices) thatlimit the board’s ability to exercise its fiduciary duties;

O Avoid making any decisions that would favor one group ofstockholders over another; and

O Avoid taking any action that might have the effect of favoring arelated party over the stockholders.

In addition, if Revlon duties apply, directors should redouble their efforts tomaximize stockholder value and follow the guidelines discussed previously in thischapter.

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UNOCAL AND DEFENDING AGAINST HOSTILE TAKEOVERS

Introduction

In contrast to situations where a board’s actions contemplate the sale or break-up ofa corporation (i.e., where Revlon duties apply), in circumstances where a boardreceives a hostile or unsolicited acquis-ition proposal and resists the proposal byadopting a defensive takeover measure,the Unocal standard will apply. Defensivetakeover measures are myriad and includestockholder rights plans (or “poison pills,”more fully discussed below), protectiveprovisions in the corporation’s charter andby-laws, such as a classified board,limitations on stockholders’ rights to act by written consent, call special meetings andremove directors, and supermajority vote requirements. Boards may also seek to stop ahostile takeover by implementing an alternative transaction with a friendly acquirer ora separate transaction making the capitalization of the corporation undesirable to thehostile party. Several of these techniques can be implemented either in direct responseto a hostile bid or in preparation for the possibility of a future hostile bid. In caseswhere such measures are adopted in the absence of an existing threat (i.e., a pending orthreatened hostile offer), the actions of the board in adopting such measures should beentitled to the protections of the business judgment rule; however, where such meas-ures are adopted in response to a threat, the heightened standard of Unocal will beapplied by a court reviewing challenged actions of the board.83 Nevertheless, a boardadopting a poison pill even in the absence of an existing threat should be mindful ofthe Unocal standard.

Under the Unocal standard, a board must show that its actions satisfy atwo-pronged test. First, the board must demonstrate that it had reasonable grounds forbelieving that a danger or threat to corporate policy and effectiveness existed.84 Sec-ond, the board must demonstrate that its response was reasonable and proportionate tothe threat.85

83 As discussed in greater detail below in the section “Special Case: Use of a Poison Pill,” institutionalshareholders typically oppose defensive measures.

84 See Unocal, 493 A.2d at 955.85 See id.

Defensive measures adopted by aboard in the face of a hostile bid mustbe reasonable and proportionate tothe threat posed and the board musthave reasonable grounds to believethe threat to corporate policy andeffectiveness actually exists.

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Reasonableness Test

Under the reasonableness inquiry of the Unocal Standard, the board must demon-strate that it had reasonable grounds for believing that a danger or threat to corporatepolicy and effectiveness existed.86 A threat to corporate policy can exist from, amongother things, inadequate or coercive tender offers, or offers timed so as to disruptstrategic goals. This prong could be established by a board’s showing that it engagedin a reasonable investigation of the facts surrounding the takeover offer. This showingwill be buttressed if the majority of the board was independent and disinterested.87

In examining the threat posed in connection with a hostile takeover bid, directorsshould take into account, among other considerations:

• The inadequacy of the price offered;

• The nature and timing of the offer;

• Questions of illegality;

• The impact on “constituencies other than stockholders”;

• The risk of non-consummation;

• The quality of securities being offered in the exchange, if any;

• The loss of the opportunity for the corporation’s stockholders to select asuperior alternative;

• The risk that disparate treatment of non-tendering stockholders may distorttheir tender decisions; and

• The risk that stockholders will mistakenly accept an under-priced offerbecause they disbelieve management’s representation of intrinsic value.88

86 See id.87 See Unitrin Inc. v. American General Corp., 651 A.2d 1361, 1375 (Del. 1995).88 See Unocal, 493 A.2d 946; Unitrin, 651 A.2d 1361.

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Proportionality Test

Proportionality requires that the board’s actions to thwart a hostile takeover bidbe 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,” and therefore not “draconian.”89 A response will be “preclusive” if itdeprives stockholders of the right to receive all tender offers or precludes a bidderfrom seeking control by fundamentally restricting proxy contexts or otherwise.90 Aresponse will be “coercive” if it forces a management-sponsored alternative uponstockholders.91

Second, assuming the response was not draconian, the board must prove that itwas within a “range of reasonableness.”92 When determining whether an action iswithin the “range of reasonableness,” the court will look to, among other things,whether the action was (i) a statutorily authorized form of business decision which aboard may routinely make in a non-takeover context, (ii) limited and corresponded indegree or magnitude to the degree or magnitude of the threat, and (iii) responded to theneeds of stockholders.93

Under Delaware law, boards should be given some level of deference in showingproportionality.94

Consider the following court decisions regarding reasonableness and proportion-ality of defensive measures:

• A defensive measure is reasonably related to the takeover threat if themeasure does not force a management-sponsored plan on stockholders. InParamount Communications, Inc. v. Time Inc., the court refused to enjoinTime’s consummation of a tender offer to its stockholders made in response

89 Unitrin, 651 A.2d at 1367.90 Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 935 (Del. 2003).91 Id.92 Id.93 Unitrin, 651 A.2d at 1389.94 See id. at 1388.

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to a competing merger offer when the offer was not aimed at “crammingdown” a plan on stockholders, but rather had as its goal continuing a pre-existing transaction in an altered form.95

• Defensive measures may be both preclusive and coercive if the measuresconstitute a fait accompli. In Omnicare, Inc. v. NCS Healthcare, Inc., dealprotection devices approved by the board of directors operated in concert tohave a preclusive and coercive effect because the defensive measures madeit mathematically impossible and realistically unattainable for any alternativeproposal to succeed, no matter how superior the proposal.96

• A defensive measure may be found to be disproportionate if anti-takeoverprovisions cannot be unilaterally revoked by the board of directors. In AirLine Pilots Ass’n, International v. UAL Corp. an embedded defense—a termembedded in a contract with a nonstockholder counterparty that has an anti-takeover effect—was found to be unreasonable and therefore disproportionatebecause the takeover defense could not be rescinded by the company.97

95 571 A.2d 1140, 1154-1155 (Del. 1989).96 818 A.2d 914 (Del. 2003).97 897 F.2d 1394 (7th Cir. 1990).

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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 inconnection with responding to a hostile takeover:

• Act in good faith and on an informed basis;

• Consider and evaluate factors that bear on the existence of a threat tocorporate policy or effectiveness;

• Respond to threats in a reasonable and proportionate manner;

• Obtain approval of the transaction from a majority of outside independentdirectors; and

• Avoid deal protection measures or actions that unduly limit ability toexercise fiduciary duty.

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SPECIAL CASE: USE OF A POISON PILL

Overview and Mechanics

There are several options available to a corporation that is seeking to discouragethe threat of abusive takeover attempts, particularly when there is no known takeoverattempt on the horizon.98 One of the most common of these options is a stockholderrights plan, also known as a “poison pill.”

Over the past twenty years or so, stockholder rights plans have been a commonlyused agreement adopted by companies for discouraging and fending off undesirableand abusive advances from hostile offerors. However, in recent years stockholderrights plans have fallen into disfavor as activist stockholder groups have argued thatthe plans facilitate the entrenchment of management and deprive stockholders of theability to receive maximum value for the business. Poison pills generally are designedto deter certain abusive takeover devices and tactics. These devices and tactics include:

• Acquisitions of a controlling interest without paying a premium or at amarket price which may not reflect actual value; and

• Partial or two-tier tender offers inwhich all of the stockholders of acorporation are not treated equally(i.e., where the hostile bidderoffers cash for a controlling por-tion of the shares but a lower pershare amount, possibly in theform of securities rather than cash, for the remaining shares which are takenout in a merger following the tender offer).

A stockholder rights plan can be very useful because it may afford the board timeto 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 alter-

98 As noted above and below under the caption “Fiduciary Duties,” a board’s determination to adopt adefensive measure in the absence of a threat (i.e., a pending or hostile offer) is more likely to receive thebenefit of being reviewed under the business judgment rule standard of review whereas a board’s adoptionof such measures in response to a threat will be subject to the heightened Unocal standard of review by acourt considering a challenge to the board’s action.

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Stockholder rights plans, orso-called “poison pills,” have beenused by boards for many years toincrease leverage for boards innegotiating potentially hostileacquisitions.


natives to such an offer, thereby enhancing the board’s negotiating power and its corre-sponding ability to promote equality for all stockholders of the corporation.

A stockholder rights plan can be adopted by a corporation’s board of directorswithout stockholder approval. The basic feature of a stockholder rights plan is the dis-tribution of rights to all holders of common stock to purchase additional shares ofeither the same class of stock or a class of preferred stock. Certificates evidencing therights are issued, but not exercisable, upon the earlier of either:

• A public announcement that a person or group of affiliated or associatedpersons owns or has the right to own a “designated ownership limit”(typically 15% to 20%) of the then outstanding shares of the corporation’scommon stock; or

• A certain period of time following the commencement of a tender offer orexchange offer that would result in a person surpassing the designatedownership limit. Such person or group of affiliated persons that successfullyacquires beneficial ownership that meets or exceeds the designated owner-ship limit is typically referred to as an “acquiring person.” The rights haveno real economic value, and are not exercisable, unless and until there is atriggering event, which is deemed to occur when a party actually becomes anacquiring person.

The rights generally expire somewhere between five and ten years from the estab-lishment of the stockholder rights plan.

The exercise price of a right is typically 200%–500% of the market value of theunderlying common stock at the time the stockholder rights plan is adopted. Therights, therefore, are “out of the money” at the time of issuance. Upon a triggeringevent, the rights become exercisable for the purchase of securities, either commonstock or preferred stock of the target or the acquirer, at a significant discount (usually50%) to the then-current market price. Any rights held by an acquiring person are notexercisable. Thus, the effect of a triggering event is to substantially dilute the acquir-ing person’s interest in the target and make any acquisition prohibitively expensive.

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Fiduciary Duties

Given the recent rise in activist stockholder activity regarding stockholder rightsplans, directors should proceed prudently when enacting or maintaining such plans.While the general legality of poison pills has been well established by Delaware caselaw, courts have given increasing scrutiny to instances in which boards have used rightsplans to interfere with stockholder choice at the conclusion of an auction99 or where useof the plan violates another principle of takeover law (i.e., utilizing a rights plan in adiscriminatory manner favoring one change-in-control transaction over another).100

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 threat posed to the directorsthemselves and the possibility that they will act in their self-interest, a board’s plan-ning for a hostile takeover defense in advance can benefit the well-being of the corpo-ration and its stockholders. Therefore, courts are more likely to give a board thedeference that is given to most routine corporate decisions under the business judg-ment rule when defensive measures such as stockholder rights plans are adopted at atime other than in the face of a hostile offer. On the other hand, if a stockholder rightsplan is enacted in response to a hostile takeover bid, or if a board refuses to terminatethe plan when such a bid is presented, the heightened Unocal standard will likelyapply. Boards considering such a situation should carefully consider the adequacy ofthe offer and the effect enacting the plan would have on stockholder value.

One notable exception to the general rule is the adoption in advance of a hostiletakeover 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 acquirerfrom terminating the plan (and by doing so, impede the potential acquisition), or mayrestrict the time period in which such termination can take place. Dead hand pills have

99 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.), 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 ofcases 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 ofdirectors”).

100 Paramount Communications Inc. v. QVC Network, Inc., 637 A. 2d 34 (Del. 1994).

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been struck down by Delaware courts on several occasions for a variety of reasons,including under the Unocal standards.101

SPECIAL CASE: DIRECTOR DUTIES IN THE FACE OF ACTIVIST

STOCKHOLDER DEMANDS

In the past few years, directors have increasingly faced a new challenge – activiststockholders and their demands. Activist stockholders are stockholders who typicallyplace significant demands on a corporation’s board and officers to take actions thatmay not have been within the strategic plan of the corporation prior to the demand bythe activist.

Who are Activist Stockholders and What do They Want?

Activist stockholders include, among others, hedge funds, corporate governanceorganizations, state pension funds and corporate raiders. When attempting to effectchange at a corporation, activist stockholders are more likely to focus on specific keyissues and exert pressure to acquire influence, rather than control of a company.Common demands include:

• Change the composition and members of the board of directors;

• Change the strategy or management of the company;

• Effect dividend payments, a stock repurchase, or a divestiture of assets;

• Direct corporate governance changes;

• Force a sale of the company; or

• Initiate or stop a strategic transaction.

A common goal of activist stockholders is to force an event to trigger value creationfor the stockholders.

101 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).

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Arguments For and Against Stockholder Activism

Supporters of stockholder activism argue that activists force companies to beaccountable for their actions and provide the catalyst for value-enhancing strategic andfinancial actions. Further, supporters argue that activist stockholders are better alignedwith stockholders’ interests than with management’s interests. Critics of stockholderactivism note that activists often focus on measures, such as stock price, that emphasizeresults in the short term and prevent the board of directors from focusing on and direct-ing the long-term success of the company. In addition, critics argue that stockholderactivism does not usually create value for the other stockholders unless the company isput up for sale and even then there is little change in the stock performance of a com-pany 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 theirobjectives, including:

• Proxy contests;

• Withhold-the-vote campaigns;

• Negative press and other activism to influence analysts, press andRiskMetrics Group;

• “Wolf packs;”102

• Stockholder proposals;

102 The “wolf pack” is a hedge fund phenomenon that typically consists of multiple hedge funds sharingideas and acquiring several small positions in a company quickly and stealthily. In this scenario, smallnetworks of hedge funds direct the activism and it can result in the rapid destabilization of the stockholderbase. Similarly, hedge funds have historically avoided the ownership disclosure requirements of theExchange Act by utilizing equity swaps instead of acquiring the securities of the target company. Notably,a recent decision by the United States District Court in the Southern District of New York held that stock-holders accumulating interests in a corporation through the purchase of equity swaps are subject to thereporting requirements of Section 13(d) of the Exchange Act, and the failure to disclose those positionswas fraudulent. CSX Corp. v. The Children’s Investment Fund Management, 08Civ. 2764, 2008 U.S. Dist.LEXIS 46039 (S.D.N.Y. June 11, 2008).

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• 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 forstockholder input, such as the process of corporate governance, and so long as theproposal does not preclude the directors’ ability to exercise their fiduciary duties. Forexample, in a recent decision, the Delaware Supreme Court considered whether stock-holders have a right to require a corporation to include in its proxy for consideration bystockholders a proposed modification to the corporation’s bylaws requiring the corpo-ration to reimburse stockholders for costs associated with nominating directors whoare subsequently elected, with certain exceptions. The corporation’s board resisted theproposal on the basis that it infringed on the board’s right to manage the business andaffairs of the corporation under Section 141 of the DGCL and that it would precludethe directors from exercising their fiduciary duties in determining whether it was alegitimate 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 assuch, the bylaw did not infringe on the directors ability to manage the business andaffairs of the corporation; however, the court also found that the bylaw had the effectof 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 bestinterest of the corporation.103

103 CA, Inc. v. AFSCME, (Del. 2008) No. 329, 2008. This decision arose out of a request from the SECunder a new certification procedure.

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What Should Directors and Officers Do When Confronted with an ActivistStockholder Demand?

When so confronted, it is imperative that boards react quickly but thoughtfully tostockholder demands. To fulfill their duty of care obligations, members of the boardmust carefully consider the demands made by the stockholder and their potentialimplications on the short- and long-term business goals of the corporation. Whiledoing so, the board must be very sensitive to any implication that the judgment ofindividual directors or officers may be compromised by duty of loyalty considerationsif the stockholder proposals could be viewed as conflicting with the personal interestsof the board or officers. By definition, many activist investor demands may place theboard and the officers of the corporation in a situation in which their duties of loyaltymay be implicated.

Further, many activist investors request a change in the board composition, eitherby replacing directors that they view as not functioning in accordance with their per-ceived agenda for the corporation, or by adding new director positions to the board.Many other demands seek to institute significant corporate governance changes, suchas requiring stockholder approval of officer compensation plans, effecting dividendpayments or making other divestitures.

Boards facing demands from activist stockholders, particularly demands thatinvolve the replacement of directors or management, may consider the advisability ofestablishing a working subset of the board (whether acting as a formal committee ornot) of individuals who are disinterested and independent and who can investigate theproposal. This step is intended to substantially mitigate against any claims by the acti-vist stockholder of management or board entrenchment. Extra care should be taken toensure that these directors have access to the corporation’s management, as well asoutside and independent legal counsel, accountants and investment bankers, as needed.In addition, the directors should have access to other experts as needed, including aproxy solicitation firm and a public relations firm to manage and address any activiststockholder matters.

The directors should educate themselves on the proposal put forth by the activiststockholder, and on the potential benefits and risks to the corporation’s stockholders ofpursuing that proposal. If there are competing proposals by the officers of the corpo-ration or others, the directors should also carefully consider those proposals. The

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directors should also consider whether there are any alternative courses of action, andhow the proposal and each alternative may benefit the long-term interests of the stock-holders. In these considerations, the directors should meet frequentlyso that they may share their views with each other as well as collect information fromthe corporation’s management and advisors.

Additional factors the directors may consider include the credibility, reputationand ownership level of the activist stockholder. Attention should be given to thestockholder’s past behavior, track record and any possible relationships or alliances thestockholder may have with other stockholders of the corporation.

As part of this process, the directors should consider meeting with the activiststockholder to discuss any proposals and how they differ, if at all, from the long-termstrategies and goals being pursued by the board. Ultimately, the directors shouldrecommend a concrete response plan to the demand for full board consideration.

How Should the Corporation Apprise its Stockholder Base of the Demand and ItsReaction to the Demand?

Communication is critical when dealing with activist stockholders. In addition tocommunicating with the activist stockholder, the corporation should consider whetherit should communicate generally with its stockholder base regarding the demand, theboard’s response to the demand, and the reasons for the response. If the board decidesnot to comply with the demand, robust disclosure of the reasons why the board hasdetermined not to accede to the demand should be considered. Specifically, boardsmay consider explaining why the demand is not, in the view of the board, in the bestlong-term interests of the stockholders of the corporation.

Ultimately, activist stockholder demands may prove to be expensive and time-wasting exercises for a board, or may prove to be useful exercises to increase value forthe corporation’s stockholders. In any event, boards and officers will want to ensurethat they act responsibly in adequately addressing a particular stockholder demand.

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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 inconnection with responding to activist stockholder demands:

• Establish and provide resources for a disinterested and independent work-ing board subset or special committee to analyze the issue;

• Investigate the basis, benefits and risks for the demands;

• Identify the proposal’s implications on the corporation’s short and longterm business goals;

• Evaluate alternative courses of action;

• Consider meeting with proposal’s proponents to discuss available options;

• Recommend a concrete response plan for full board consideration; and

• Consider disclosing reasoning for recommended action to stockholders atlarge.

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CHAPTER 4

FIDUCIARY DUTIES IN THE CONTEXT OFA GOING PRIVATE TRANSACTION

INTRODUCTION

A “going private” transaction is generally one in which an individual or group(often a controlling stockholder or outside investor and/or the corporation’s manage-ment team) acquires all of a public corporation’s shares not already owned by theindividual or group. Once the number of registeredstockholders is reduced to less than 300, the corpo-ration can deregister under the Exchange Act. Goingprivate transactions frequently implicate compli-cated fiduciary and disclosure issues for the board,the management and the buying group. In additionto state law fiduciary duty concerns, going private transactions are also subject toextensive regulation under Rule 13e-3 of the Exchange Act. As such, if a corporationis considering a going private transaction, it would be well counseled to proceed judi-ciously in order to minimize the potential for any exposure to the parties involved.

The most popular structures for going private are a tender offer followed by a short-form merger or a cash-out merger. Another, less popular option, is going private througha reverse stock split. Each of these approaches has its own fiduciary duty risks.

COMMON TRANSACTION STRUCTURES

Tender Offer

One popular approach to going private is to structure the transaction as a tenderoffer by a controlling stockholder, followed by a short-form merger after at least 90%of the outstanding shares are tendered. In a series of recent cases, Delaware courts haveprovided important guidelines for going private transactions structured as controllingstockholder tender offers.104 These cases provide that the business judgment rule willapply to a going private transaction effectuated by a tender offer followed by a short-form merger as long as the transaction is not coercive and all applicable disclosure

Going private transactionspresent complex fiduciaryduty and disclosure issuesfor the board, managementand the buying group.

104 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).

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obligations are fulfilled. If the transaction is considered coercive or disclosure obliga-tions are not met, the more demanding entire fairness standard of review may apply.

A tender offer by a controlling stockholder has been held not to be coercive whenall three of the following conditions were met:

• It is subject to a non-waivable majority of the minority tender provision (in otherwords, at least a majority of the shares held by stockholders other than the control-ling stockholder are tendered);

• The controlling stockholder agrees to complete a short-form merger, at the sameprice and as soon as practicable after completion of the tender offer, if it obtains90% of the shares; and

• The controlling stockholder has not made any retributive threats.105

In addition, the target and controlling stockholder must provide full disclosure ofinformation that a reasonable investor would consider important in tendering his or herstock. This would include, for example, disclosing the content and background of anyfairness opinion that may have been delivered to the parties in connection with negoti-ating the particular transaction.106

Tender offers by controlling stockholders maybe pursued either with or without prior approval ofthe board of directors of the target. As describedabove, a tender offer may not be considered coercivedespite failing to obtain approval of the target’s boardor an independent committee thereof. Although atender offer need not be negotiated or approved by anindependent committee,107 the target must make fulldisclosure of all relevant information regarding the transaction to its stockholders,including whether the tender offer was considered by the board of directors or by acommittee and whether or not the target recommends it to its stockholders. The rulesand regulations of the Securities and Exchange Commission also require that boardsprepare a written recommendation to the stockholders in response to a tender offer andfile the recommendation with the Securities and Exchange Commission.

105 In re Pure Resources, 808 A.2d at 445.106 Id. at 449.107 In re Siliconix, 2001 Del. Ch. LEXIS 83.

Tender offer transactionsby controlling stock-holders that do not meetspecific standards willlikely be consideredcoercive and subject tothe entire fairness stan-dard of review.

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In one recent case, a Delaware court proposed that, contrary to the currentstandard, the entire fairness standard should be imposed on controlling stockholdertender offers unless they receive approval of the target’s independent directors.108 As

such, going private transactions are anexample of a situation where the use of aspecial committee or group of otherwisedisinterested and independent directors maywork to mitigate the risk of a courtinvalidating a transaction.

Cash-Out Merger

In a going private transaction effectuated through a cash-out merger, a majoritystockholder typically seeks to acquire the minority interest in the target through amerger of a newly formed corporation with the target. The acquirer engages in directnegotiations regarding the transaction with the target and enters into a merger agree-ment with the target. Shares are typically acquired for cash. The merger requires theapproval of the majority of the outstanding shares of the target.

Although the end result (going private) is the same in a transaction structured as amerger transaction as in the tender offer structure, Delaware courts have not appliedthe same standard of review to controlling stockholdertender offers and controlling stockholder mergers.109 Inthe case of going private transactions structured asmergers requiring stockholder approval, Delawarecourts have typically applied the entire fairness stan-dard.110 There are certain procedural protections that thetarget and acquirer can take, however, to try to shift theburden of showing that the transaction is unfair back to the minority stockholders.Most importantly, the burden of proof will be shifted to the plaintiffs if the transactionwas evaluated and approved by a well-functioning independent committee of the board

The use of special committeescomposed of independent anddisinterested directors can sub-stantially benefit a going privateprocess.

Boards should considerutilizing protectivemeasures, such as amajority of the minor-ity approval require-ment.

108See In re Cox Communications, No. 613-N, 2005 Del. Ch. LEXIS 79 (Del. Ch. June 6, 2005).109See id. where V.C. Strine discusses the “jarring doctrinal inconsistency” in the standards applied to

the two types of transactions. See also In re Pure Resources, 808 A.2d at 441.110Kahn v. Lynch Communication Systems, 638 A.2d 1110 (Del. 1994).

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of directors.111 The independent committee should have the power to negotiate andapprove a merger transaction with the controlling stockholder and should be providedwith adequate resources and the ability to hire its own independent legal and financialadvisors. In addition, the board of directors or independent committee should evaluatewhether the merger consideration is fair to the stockholders and consider whether tosolicit additional proposals for the sale of the corporation.112

One recent Delaware case proposed that Delaware courts should consider apply-ing the business judgment rule to going private transactions effectuated by a merger ifthe merger is approved by both the target’s independent directors and a majority of theminority stockholders.113 If this were to become the law, it would represent a promis-ing development for boards of directors that are considering going private transactions.

Reverse Stock Split

A corporation may also use a reverse stock split to reduce the number of stock-holders of record to below the applicable deregistration threshold, suspending thecorporation’s Securities and Exchange Commission reporting requirements. If theacquirer’s interest in the corporation is larger than any other unaffiliated holder, theacquirer may attempt to execute a reverse stock split, in which the corporation issuesone new share in exchange for a number of old shares in excess of the largestunaffiliated block of shares. Completion of a reverse stock split typically involves cashpayments for unaffiliated holders in lieu of fractional shares, generally without theavailability of appraisal rights for such stockholders. However, because the charter ofthe target corporation must be amended, a reverse stock split requires approval byholders of a majority of the corporation’s stock.

Delaware law permits the cashing out of stockholders through the mechanism of areverse stock split.114 The compensation of cashed-out stockholders must be at a fairprice and the reverse stock split must be designed in good faith and have a legitimatebusiness purpose.115 Delaware courts have held that the business judgment rule applieswith respect to board recommendations for a charter amendment, in the absence of a

111 Id. at 1117.112 In re Cysive Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003).113 In re Cox Communications, 2005 Del. Ch. LEXIS 79.114 8 Del. C. §155.115 Id.; Applebaum v. Avaya, Inc., 812 A.2d 880, 886-87 (Del. 2002).

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violation of fiduciary duty.116 Although it is not entirely clear how a challenge to agoing private transaction effected through a reverse stock split would be treated byDelaware courts, it is advisable to utilize any procedural protections reasonably avail-able in implementing such a transaction, for example, requiring approval by anindependent committee or subset of the board of directors comprised of disinterestedand independent directors.117

SEC REQUIREMENTS AND SCRUTINY OF GOING PRIVATE TRANSACTIONS

Acquirers in going private transactions must satisfy disclosure requirements pur-suant to Rule 13e-3 under the Exchange Act, which is designed to protect minoritystockholders in a going private transaction by requiring disclosure as to the fairness ofthe transaction and any related material information. In addition to the acquirer’s ten-der offer filing obligations, the target corporation is required to file a Schedule 14d-9as to whether it believes that the transaction is fair to the minority stockholders andany factors supporting that belief and any reports, opinions and appraisals by financialadvisers. It also may have to file a Schedule 13e-3 if its board of directors or a specialcommittee of directors recommends the acquirer’stender offer to stockholders. If stockholder approvalis required for a cash-out merger transaction or areverse split, the corporation will generally berequired to file a proxy statement to solicit proxies fora vote at a special meeting. The proxy statement willrequire similar disclosures.

The Securities and Exchange Commission care-fully reviews filings made in connection with goingprivate transactions, and companies should considerallocating appropriate time to provide for responses to any SEC review. Among otherthings, the Securities and Exchange Commission will review disclosures relating tovaluation, fairness of the transaction price, transaction background and history, and theindependence of directors and any independent committee recommending or approv-ing the transaction.

Boards should be mindfulthat Securities andExchange Commissionrequirements mandateextensive disclosure of theentire process involved innegotiating and approv-ing a going private trans-action.

116 Williams v. Geier, 671 A.2d 1368 (Del. 1996).117 See, e.g., Applebaum, 812 A.2d 880; Williams, 671 A.2d 1368.

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PROCEDURAL SAFEGUARDS

When a going private transaction is challenged in court, the manner in which thetransaction was negotiated among the interested parties will be viewed critically withregard to fiduciary duties and fair dealing. For this reason, the parties to a going pri-vate transaction are well advised to implement procedural safeguards, including,among others, those described below during the negotiation process.

First, boards should consider the advisability of creat-ing a working subset of the board composed of disinterestedand independent directors or a special committee composedof independent and disinterested directors to deal with offersby potential acquirers. The use of a working group of disin-terested and independent directors may not only assist inmeeting the fair dealing requirement but may also result in ahigher negotiated purchase price for the minority stock-holders. 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 subset of buyers is made or the deal isheavily negotiated.118 Extra care should be taken to ensure that interested directors andmanagement are isolated from the negotiation, deliberation and decision-making proc-ess of the disinterested and independent directors. The disinterested and independentdirectors should be empowered with real bargaining power in the process and access tothe resources they need, including access to management, information about the busi-ness and the potential acquiring group and the ability to choose independent legalcounsel, financial advisers, accountants and other experts. In that regard, thedisinterested and independent directors will likely seek to obtain a fairness opinionfrom an independent investment bank as to the consideration to be paid in the trans-action. The use of a working group of disinterested and independent directors may notonly assist in meeting the fair dealing requirement but may also result in a highernegotiated purchase price for the minority stockholders.

118 See In re Lear Corporation Shareholder Litigation, 2007 WL 1732588 (Del. Ch.) (where the courtcriticized the board for forming a special committee only after the CEO had negotiated a private deal withthe leader of a private equity fund) and In re Netsmart Technologies, Inc. Shareholder Litigation, 2007WL 1576151 (Del. Ch.) (where the court criticized the board for forming a special committee only afterthe company had chosen to focus on private equity bidders to the exclusion of strategic buyers).

Boards shouldstrongly considerobtaining a fairnessopinion from aninvestment bankbefore approving agoing privatetransaction.

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Second, approval of a going private transaction by a vote of a majority of theminority stockholders also helps to address any charges of unfairness to the minoritystockholders. As discussed above, in the case of a tender offer, boards should considermaking the tender offer subject to a non-waivable requirement that the majority of theshares held by minority stockholders are tendered.

Third, extra care should be taken to ensure that all material information necessaryfor an informed investment decision concerning the transaction is made available tothe stockholders.

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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-dealingwhere one person or group is on both sides of a transaction. Although there is norequirement under Delaware law that aboard of directors utilize a special commit-tee comprised of independent119 and disin-terested120 directors when considering arelated-party transaction, Delaware courtshave indicated that the absence of such acommittee (or a group of the board’s disin-terested and independent directors function-ing in an equivalent manner) in connectionwith a related-party transaction mayevidence the transaction’s unfairness. Not only might a controlling party have a fidu-ciary duty to the minority in this context, but in the event of an alleged breach of fidu-ciary duty, it is the controlling party that generally bears the burden of proving theentire fairness of the transaction (the entire fairness test is discussed more fully inChapter 2).

Transactions involving a corpo-ration and a related party aresubject to careful scrutiny byDelaware courts – boards are welladvised to consider utilizing aspecial committee comprised ofindependent and disinteresteddirectors when considering suchtransactions.

119 The concept of “independence” in the context of approval of a related-party transaction pertains towhether the director is capable of making an independent decision not influenced by extraneous consid-eration or influences other than the corporate merits of the subject before the board. This definition differsfrom the concept of “independence” contemplated by stock exchange rules requiring that a majority of aboard be composed of independent directors.

120 The concept of “disinterested” in the context of approval of a related-party transaction pertains towhether the director would derive any personal benefit from the subject transaction not shared by allstockholders.

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While the defendant generally bears the burden of proof under the entire fairnesstest, under Delaware law the burden of proving entire fairness can be shifted to theplaintiff if the defendant can show that the corporation was represented in the trans-action by a disinterested and independent, fully informed committee of directors thatactively negotiated the transaction on an arm’s-length basis.121 In assessing whetherthe burden should be shifted, Delaware courts have considered a variety of factors,including:

• Whether the committee members were disinterested and independent;

• Whether the committee and its representatives were informed and activelyengaged in a negotiation process; and

• The extent of the powers granted to the committee.

COMMITTEE COMPOSITION: DISINTERESTED AND INDEPENDENT

In order to be effective, the committee members should be disinterested andindependent.

Disinterested

Delaware courts have found that directors are interested where they personallyreceive a material benefit as a result of the challenged transaction that is not shared byall stockholders. A benefit is considered material if it makes it improbable that thedirector could perform his or her fiduciary duties without being influenced by apersonal interest. Delaware courts have also found that a director is interested wherethe 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 theyreceive a benefit that relates to the transaction – for example, further business or otherdeals with the other party that would not be available but for the challenged trans-action.

121 The approval of the transaction by informed stockholders holding a majority of the outstandingshares (excluding, for that purpose, the controlling party) also can have the effect of shifting the burden ofproof on the issue of fairness from the defendant to the plaintiff. See also, e.g., Citron v. E.I. Du Pont deNemours & Company, et al., 584 A.2d 490 (1990).

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Independent

Even if a director is disinterested, he may still be deemed to be incapable ofmaking an independent decision if his decision would be based on extraneousconsiderations or influences rather than the meritsof the transaction being considered by the board.In this regard, courts often look to whether thedirector is controlled by or beholden to anotherperson or entity, or whether other outsideinfluences affect his business judgment. Forexample, in In re Maxxam, Inc./FederatedDevelopment Shareholders Litigation,122 specialcommittee members were found to lackindependence where they received significantcompensation from employment by entitiescontrolled by the individual who controlled thecorporation’s major stockholder. In contrast, the Delaware Court of Chancery hasfound that a personal friendship between a special committee member and aninterested party, without more, will not result in such special committee memberlacking independence.123

In addition to ensuring that the members of the special committee are independentand disinterested, the committee should carefully consider whether any of the advisorsit selects have a material relationship with the related parties in the transaction.Delaware courts have expressed reservations about a special committee’sindependence where the committee’s advisors had financial ties to the controllingparty.124 Although such financial ties are only one of a number of factors consideredby the courts, they are likely to cause greater scrutiny of the committee’s process. Aspecial committee may rely on the corporation’s existing advisors and utilizing one ormore of the corporation’s existing advisors may be justified depending on the facts andcircumstances; however, the committee’s perceived independence may be enhanced if

To be effective, specialcommittees should:• Be composed of

independent anddisinterested directors;

• Be informed as to theprocess and terms of thetransaction; and

• Be active in thenegotiations process.

122 In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760 (Del. Ch. 1995).123 Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002); Beam v. Stewart, 845 A.2d 1040 (Del. 2004).124 See, e.g., In re Tele-Communications, Inc. Shareholders Litigation, No. 16470, 2005 Del. Ch.

LEXIS 206 (Del. Ch. Dec. 21, 2005).

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it retains advisors with no prior relationship with the corporation and125 use of thecorporation’s existing advisors may be viewed by a court as detracting from thecommittee’s independence.126 Finally, although the DGCL permits a committee to becomposed of one member, it is advisable that boards consider appointing more thanone member to a committee.127

COMMITTEE CHARTER: BE INFORMED AND ACTIVE

To be informed, the committee must be knowledgeable concerning the corpo-ration’s business and must be involved in or kept abreast of the ongoing negotiations.To be active, the members should either be involved in the negotiations or frequentlycommunicate with the person designated to negotiate the transaction. Further, thecommittee should meet and consult with its advisors frequently to ensure that it hasknowledge of the essential aspects of the transaction.128 Situations where Delawarecourts have held that committees were not informed and active include where:

• The committee never negotiated for a better price;129

• The committee failed to choose its own independent advisors;130

• The committee members failed to attend the informational meetings with thecommittee’s special advisors;131

• The committee did not understand its mandate, relied on the corporation’slegal and financial advisors and was not informed about the corporation’shistorical trading price or the premium to be paid to the high-vote stock;132

and

• The committee failed to consider an important alternative to the proposedtransaction, failed to critically evaluate and compare reports, and failed touse the corporation’s leverage to negotiate the lowest available price.

125 Citron v. E.I. Du Pont de Nemours & Company, 584 A.2d 490 (Del. Ch. 1990).126 See, e.g., Kahn v. Tremont Corp., 696 A.2d 422 (Del. 1997).127 The laws of some states, for example, California, prohibit committees of only one member. See, e.g.,

Cal. Corp. Code § 311.128 Kahn v. Tremont, 696 A.2d 422, 430 (Del. 1997).129 In re Maxxam, Inc.,/Federated Development Shareholders Litigation, 659 A.2d 760, 768-70.130 Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261 (Del. 1989).131 Kahn v. Tremont Corp., 696 A.2d 422, 429-30 (Del. 1997).132 In re Tele-Communications, Inc. Shareholders Litigation at 49.

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In contrast, Delaware Court of Chancery held that committees were informed andactive where:

• The committee bargained hard, held out to get a higher price and ensured thatthe committee retained sufficient flexibility to accept a higher bid;133 and

• The committee was advised by competent and independent legal and finan-cial experts, acted deliberately and in a fully informed manner, and met morethan twenty times, including a two-day meeting prior to final approval of theproposed merger.134

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 itsindependence.135 However, thepower to say “no” alone may notbe sufficient to shift the burden onentire fairness. The committeeshould be empowered to activelynegotiate with the related party ina manner that approximates

an arms length transaction.136 For example, in In re Republic American CorporationLitigation,137 the Delaware Court of Chancery held that a special committee that hadonly been empowered to pass on the fairness of the transaction price did not havesufficient power to shift the burden on entire fairness. In addition, a board should con-sider 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;

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.”

133 In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 546 (Del. Ch. 2003).134 Kohls v. Duthie, 765 A.2d 1274, 1285 (Del. Ch. 2000).135 In re First Boston, Inc. Shareholders Litigation, No. 10338, 1990 Del.Ch. LEXIS 74 (June 7, 1990).136 Rabkin v. Olin Corp., 1990 Del. Ch. LEXIS 50.137 1989 Del. Ch. LEXIS 31, (Del. Ch. Apr. 4, 1989).

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• Whether the board will agree not to recommend the proposed transaction tothe stockholders (or otherwise approve the transaction) without the favorablerecommendation from the committee;

• Whether the committee may consider only one transaction, or whether it hasbroader discretion to pursue alternative transactions; and

• Whether the committee may utilize defensive measures.

In general, the board action creating the special committee should include resolutionsthat empower the committee to do such other acts as are necessary or advisable incarrying out its duties, and provide sufficient authority for the committee to have ameaningful say in determining whether, and how, to proceed with any transaction.138

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 committeemust exercise that power remains. Specifically, the extent to which a special commit-tee is permitted or required to implement defensive measures under certain circum-stances is still an open question. However, Delaware courts have suggested that aspecial committee must aggressively defend against a transaction that they deem unfairto the minority, which may involve considering whether to implement a poison pill orother deterrent.139

LEGAL DUTIES OF SPECIAL COMMITTEE MEMBERS

The legal obligations of directors serving on the special committee are no 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 thisregard, directors may rely on the opinions of experts, including financial advisors andlegal counsel, as to matters which are reasonably within the professional or expertcompetence of such experts.

138 It is notable, however, that special committees cannot be granted unlimited power. Specifically, theDGCL and Delaware court decisions limit the extent of authority that can be granted to a committee. Forexample, a committee cannot be granted authority to recommend to the stockholders for their approvalthat the corporation consummate a merger—rather the full board of directors must act to approve a mergerand provide the necessary board function of recommending the merger to the stockholders for approval.See, e.g., 8 Del. C. §142(c)(2); Krasner v. Moffett, 826 A.2d 277 (Del. 2003).

139 In re Pure Resources, Shareholder Litigation, 808 A.2d 421 (Del. Ch. 2002).

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Directors serving on a special committee are also under a duty of loyalty, whichobligates 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 replicate a transaction betweenthe corporation and an unrelated third party. The utilization of a properly functioningspecial committee provides “powerful evidence of fairness.”140 The legal benefitsresulting from special committee approval of a transaction will accrue, however, onlyif the special committee is independent, active, informed and has real bargainingpower. Also, when considering whether to form a special committee, boards shouldconsider whether a working subset of the board composed of disinterested andindependent directors can provide the same services as a distinct special committee.

140 In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 550 (Del. Ch. 2003).

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OVERVIEW–WHEN SHOULD A SPECIAL COMMITTEE BE CONSIDERED?

Whenever a board is considering a transaction that may involve a counterpartywith whom one or more of the directors have a material interest, boards shouldconsider whether use of a special committee might enhance the process. If a spe-cial committee is to be used, it will be viewed as being most effective if it oper-ates under the following guidelines:

• Committee Formation: The board should authorize the creation of thecommittee but it is recommended that the members of the committee bechosen solely by independent and disinterested directors.

• Committee Composition: Directors chosen to serve on the committeeshould be independent and disinterested in the transaction.

• Committee Resources: The committee should be empowered to haveaccess 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 itsown advisors in lieu of using the company’s advisors.

• Committee Power and Authority. Within the limits of Delaware law, thecommittee should be empowered with real bargaining power, includingthe power to say “no” to a particular transaction.

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CHAPTER 6

FIDUCIARY DUTIES IN THE CONTEXT OFA DISSOLUTION OR INSOLVENCY

INTRODUCTION

The challenges that directors face when the corporation is under financial distressbecome increasingly complex. In addition to their efforts to turn around the corpo-ration’s flagging financial condition or to buy time to allow previously implementedstrategies a chance to succeed, directors often find themselves answering the pointedcalls of increasingly vocal corporate constituents, such as creditors and stockholders,seeking to recover their investments. At times such as these, it is critical that directorsfocus 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 changewhen a corporation approaches or enters insolvency. Indeed, directors continue to owethe same fiduciary duties of care and loyaltywhen a corporation approaches and entersinsolvency, and directors can still be held liablefor actions or omissions that breach those dutiesor are otherwise tortious or illegal. However, thebeneficiaries of those duties expands from thestockholders of the corporation to include thecreditors of the corporation, when thecorporation becomes insolvent. Because actions that directors may take when trying tomanage the business during solvency for the benefit of stockholders may differ fromactions they may take to maximize value for creditors, it is important to be able toidentify when the corporation has become insolvent and, thus, when the recipient ofthe fiduciary duties changes.

While some variations may occur in best practices for these purposes, directorsshould 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 businessby cost-effective operations, without becoming ensnared in debates about who wouldbenefit or not benefit from particular activities. On the other hand, if the directors of aninsolvent corporation are perceived as gambling funds that could pay creditors on a

Directors’ fiduciary duties donot change when the corpo-ration approaches or entersinsolvency, but when thecorporation entersinsolvency, the beneficiariesof the duties do expand.

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“long shot” for the sole benefit of equity holders, that could create liability for thosedirectors. In making informed decisions on such issues, directors usually benefit fromthe advice of qualified distress professionals. However, directors cannot abdicate theirduties 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 increasinglydifficult for directors to obtain current and accurate information on a real-time basis.Management is often frantically trying to save the business during these times and isnot 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 anaccrual basis as required by Generally Accepted Accounting Principles means thatmanagement 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 corporationmay delay payment or not pay at all. Nevertheless, in the midst of this chaos, directorsare expected to know when the corporation crosses the line from solvency toinsolvency under applicable laws.

Delaware courts have traditionally used one of two tests to determine whether anentity is insolvent at a particular point in time:

• Balance Sheet Test – A corporation is insolvent when its total liabilitiesexceed the fair market value of its total assets; and

• Equitable Insolvency Test – A corporation is insolvent when it is unable topay its debts as they become due.

Additional tests employing other criteria, as well as modifications of these traditionaltests, are used from time to time by Delaware courts, depending on the particular cir-cumstances of the case. Furthermore, recent Delaware decisions have seemingly addedan additional requirement to the balance sheet test, defining insolvency as “a defi-ciency of assets below liabilities with no reasonable prospect that the business can besuccessfully continued in the face thereof.”141

141 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 438 (Del. 2007).

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Because there is no bright-line test of what constitutes insolvency under Delawarelaw, directors should closely monitor the financial status of their corporation if there isany 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 thesolvency question, with the benefit of hindsight.

While facts apparent at the time of decision should not be second-guessed fromhindsight, the reality is that solvency generally is decided with finality and partic-ularity in a subsequent bankruptcy case. The bankruptcy case typically liquidates boththe amount of the liabilities and the assets (either by sale or court valuation in the planconfirmation process). Having determined that reality, it is often 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.

Distressed corporations often engage experienced bankruptcy/restructuringadvisers to assist them in making more sophisticated assessments of solvency thanreflected in normal accounting and financial reporting. Experienced distressed com-pany advisers are also helpful in supporting directors regarding many other businessjudgment questions, although directors cannot delegate their duties to such pro-fessionals.

DUTIES TO CREDITORS WHEN THE CORPORATION IS INSOLVENT

The Introduction of the Vicinity of Insolvency Concept

Although the question of when directors’ fiduciary duties shift from stockholdersto creditors is now settled, Delaware and bankruptcy courts introduced significantuncertainty into this question in the early 1990s in a series of decisions that focused onthe so-called “vicinity of insolvency” test.

The Delaware Court of Chancery first introduced the “vicinity of insolvency”concept in its 1991 decision in Credit Lyonnaise Bank Nederland, N.V. v. PatheCommunications Corp.142 In addressing the question of to whom directors of finan-cially distressed companies owe their fiduciary duties, the Court of Chanceryobserved: “At least where a corporation is operating in the vicinity of insolvency, aboard of directors is not merely the agent of the residual risk bearers, but owes its duty

142 No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991).

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to the corporate enterprise.”143 The court noted that “[t]he possibility of insolvency cando curious things to incentives, exposing creditors to risks of opportunistic behaviorand creating complexities for directors.”144 Directors must realize that to manage thebusiness affairs of a solvent corporation in the vicinity of insolvency, circumstancesmay arise when the right (both the efficient and the fair) course to follow for thecorporation may diverge from the choice that the stockholders (or the creditors, or theemployees, or any single group interested in the corporation) would make if given theopportunity to act.145

Unfortunately, the courts did not provide clarity as to when exactly a corporationwould be deemed to have entered into the vicinity of insolvency. There was simply nobright-line test to determine when a director became legally obligated to look after thebest interests of the corporation’s creditors or reconcile that obligation with therequirement that the director also look after the best interests of the corporation’sstockholders. 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 thatis on the verge of bankruptcy would generally be more favorably disposed to thecorporation taking risky actions in the short or long term to salvage the enterprise.Creditors of the same corporation would often prefer a more conservative approachdesigned to preserve existing assets, despite the fact that it is unlikely that thoseactions would ultimately turn around the corporation’s fortunes.

Clarification of Direct Claims Versus Derivative Claims

Delaware courts later provided directors of financially distressed corporationssignificant peace of mind by flatly rejecting the idea that additional direct fiduciaryduties to creditors are imposed when a corporation is in the vicinity of insolvency. In2006, the Delaware Court of Chancery decided North American Catholic EducationalProgramming Foundation, Inc. v. Gheewalla,146 holding that “no direct claim forbreach of fiduciary duties may be asserted by creditors of a solvent corporation operat-ing in the zone of insolvency.”147

143 Id. at *108.144 Id. n.55.145 Id.146 2006 Del. Ch. LEXIS 164.147 Id. at *65.

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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 ideathat an insolvent corporation’s creditors (having been effectively placed ‘in the shoesnormally occupied by the shareholders—that of residual risk bearers’) should be grantedstanding because they are the principal remaining constituency with a material incentiveto pursue derivative claims on behalf of the corporation has significant intuitive andpersuasive merit.”148 However, the court did not address the merits of those particulararguments due to the simple fact that the plaintiffs’ case was based on a direct claim ofbreach of fiduciary duty (i.e., a breach of a duty owed directly to the creditors) and not aderivative claim of breach of fiduciary duty (i.e., a breach of a duty owed to the corpo-ration, but brought on behalf of the corporation by the creditors).

The Court of Chancery noted that the court “has traditionally been reluctant toexpand existing fiduciary duties, including the range of persons by whom those dutiesmay be enforced and, therefore, whom fiduciaries might feelcompelled to consider.”149 Since creditors have existingprotections afforded by other sources, additional protectionthrough direct claims of breaches of fiduciary duty isineffecient.

On appeal, the Delaware Supreme Court affirmed thetrial court’s holdings, noting that “the need for providing directors with definitive guid-ance compels us to hold that no direct claim for breach of fiduciary duties may beasserted by the creditors of a solvent corporation that is operating in the zone ofinsolvency. When a solvent corporation is operating in the zone of insolvency, the focusfor Delaware directors does not change: directors must continue to discharge their fidu-ciary duties to the corporation and its stockholders by exercising their business judgmentin the best interests of the corporation for the benefit of its stockholder owners.”150

Operating in thezone of insolvencydoes not changedirectors’ fiduciaryduties.

148 Id. at *55-56.149 Id. at *62.150 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92,

101 (Del. 2007).

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The Delaware Supreme Court Provides Additional Clarity

The Delaware Supreme Court provided further guidance to directors, reasoningthat “when a corporation is solvent [fiduciary] duties may be enforced by its

stockholders, who have standing tobring derivative actions on behalf ofthe corporation because they are theultimate beneficiaries of the corpo-ration’s growth and increased value.When a corporation is insolvent,however, its creditors take the placeof the stockholders as the residualbeneficiaries of any increase in

value. Consequently, the creditors of an insolvent corporation have standing to main-tain derivative claims against directors on behalf of the corporation for breaches offiduciary duties.” The Supreme Court held that “individual creditors of an insolventcorporation have no right to assert direct claims for breach of fiduciary duty againstcorporate directors. Creditors may nonetheless protect their interest by bringingderivative claims on behalf of the insolvent corporation or any other direct non-fiduciary claim that may be available for individual creditors.”151

The Gheewalla decisions have greatly clarified directors’ duties when their corpo-ration is insolvent or operating in the difficult-to-define zone of insolvency. Whileplaintiff creditors of a solvent corporation clearly have no standing to sue other than ondirect 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 tothe 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). Hence, as apractical matter, it may only be rational for an individual creditor to bring a derivativeclaim against the directors, where the recovery would go to the corporation itself(ostensibly for the benefit of all creditors), instead of to the plaintiff creditor, in a fairly

When a corporation becomes insolvent,creditors take the place of stockholders asthe residual beneficiaries of any increasein value. Consequently, creditors of aninsolvent corporation have standing tobring derivative claims against directorsfor breaches of fiduciary duty.

151 Id. at 103. It is also noteworthy that if a corporation files for bankruptcy, the U.S. Trustee for thecorporation may waive the corporation’s attorney-client privilege for the benefit of corporation’s estate,including creditors. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1985).

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unique set of circumstances, such as where the plaintiff creditor had a relatively largestake in the outcome vis-a-vis other creditors.152

It may also be worth noting, however, that since there is no warning bell wheninsolvency occurs, directors and officers of a distressed, but not yet insolvent, corpo-ration in the zone of insolvency, while not facing any derivative liability in creditoractions after Gheewalla, still should be thinking carefully about what they choose todo in terms both of their duties to stockholders and the possibility that those duties willexpand to include creditors at some unknown moment if and when the corporationslips into insolvency. In addition, there are other potential pitfalls for directors to con-sider as the business approaches insolvency. For example, directors can be personallyliable for the payment of withholding taxes if those taxes are not withheld and paid bya corporation. Consequently, close monitoring of the corporation’s financial conditionas 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 companies are often torn between attempts toturn around the corporation’s fortunes or terminate the corporation’s existence througha sale of the corporation or, in particularly diresituations, liquidation and dissolution or bank-ruptcy. The threat of deepening insolvencyclaims would influence directors to terminatetheir corporation’s existence, rather than pro-long its life with the hope of providing a greaterbenefit to stockholders in the long run.

In 2001, the Third U.S. Circuit Court of Appeals recognized153 for the first timethe deepening insolvency claim. The crux of the claim is that creditors of a corporationare 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.

Deepening insolvency is nolonger recognized by Delawarecourts as an independent causeof action, but it may bepermitted as a measure ofdamages on other claims.

152 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 Del. Ch.LEXIS 164, at *47 (Del. Ch. Sept. 1, 2006).

153 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001).

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In 2006, the Delaware Court of Chancery flatly rejected deepening insolvencyclaims 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 directorsmay, in the appropriate exercise of their business judgment, take action that might, if itdoes not pan out, result in the firm being painted in a deeper hue of red. The fact thatthe 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 expandthe inadequate pie such that the firm’s creditors get a greater recovery. By doing so,the directors do not become a guarantor of success.”154

Strategies that result in continued or even deepening insolvency do not inthemselves give rise to a cause of action. “Rather, in such a scenario the directors areprotected by the business judgment rule.”155

The court did, however, specifically note that “[t]he rejection of an independentcause of action for deepening insolvency does not absolve directors of insolventcorporations 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.”156

Furthermore, while Delaware courts have expressly rejected deepeninginsolvency as an independent cause of action (and do not recognize duty of care andother claims that are merely disguised deepening insolvency claims), subsequentbankruptcy cases have allowed deepening insolvency to be argued as a theory ofdamages for valid causes of action (e.g., a breach of the duty of loyalty).157 As a result,directors of Delaware corporations should be mindful of the deepening insolvencyconcept and the possibility that it could be invoked to measure a plaintiff’s allegeddamages on another cause of action.

154 906 A.2d 168, 174 (Del. Ch. 2006), aff’d 931 A.2d 438 (Del. 2007).155 Id. at 205.156 Id.157 See, e.g., In re Brown Schools, 2008 Bankr. LEXIS 1226 (Bankr. D. Del. Apr. 24 2008).

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DUTIES DURING BANKRUPTCY PROCEEDINGS

The directors of a corporate debtor-in-possession in a bankruptcy proceeding pur-suant to Chapter 11 of Title 11, United States Code (the “Bankruptcy Code”) have two setsof fiduciary duties: those prescribed by state corporate law and those prescribed by federalbankruptcy law. In instances where the two conflict, a director’s federal bankruptcy lawduties are paramount. The following discussion focuses on these federal bankruptcy lawduties as they have been articulated in the Bankruptcy Code and case law. The standardstate law fiduciary duties (i.e., duty of care and duty of loyalty) remain as described inChapter 2 and elsewhere in this Handbook.

Unless a trustee has beenappointed in a Chapter 11 case, theexisting corporate governanceremains in place and the directorsassume the fiduciary duties of a debtor-in-possession.158 Pursuant to Section 1107(a) of theBankruptcy Code, a debtor-in-possession functions as a trustee, and is given all of thepowers and duties of a trustee, with the exception of certain investigative functions.159

Thus the various statutory provisions and legal doctrines defining the fiduciary duties of aChapter 11 trustee are equally applicable to a debtor-in-possession.160 It should be noted,however, that some courts have indicated that a Chapter 11 trustee running the business ofa debtor may be subject to less court oversight than a debtor-in-possession.161

A debtor-in-possession owes a fiduciary duty to all interested parties, creditorsand stockholders alike.162 The substance of these federal bankruptcy law fiduciary

Debtors-in-possession owe fiduciary dutiesunder state and federal bankruptcy law toboth creditors and stockholders.

158 In re FSC Corp., 38 B.R. 346, 349 (Bankr. W.D. Pa. 1983).159 11 U.S.C.S. §1107(a) (1984).160 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). Seealso 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 reHappy Time Fashions, Inc., 7 B.R. 665, 669 (Bankr. S.D.N.Y. 1980) (debtor-in-possession under ChapterXI is in “same position” as a trustee in bankruptcy).

161 See In re Lifeguard Industries, Inc., 37 B.R. 3, 17 (Bankr. S.D. Ohio 1983); In re AirliftInternational, 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).

162 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).

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duties is drawn from the duties of care and loyalty found in state law. Under federalbankruptcy law, a debtor-in-possession is held to a standard of care, skill and diligencethat an ordinarily prudent person would exercise under similar circumstances.163 Thedebtor-in-possession has a duty of loyalty to “maximize the value of the estate,”164

refrain from self-dealing, and treat all parties fairly in “resolv[ing] the tension whichresults from the sometimes conflicting objectives of [the diverse] constituencies.”165

Since virtually any corporate transaction that is not strictly in the ordinary courseof business requires court approval in bankruptcy, the corporation’s directors and offi-cers may have the protection of court approval of any transaction that they bringbefore the court for approval on proper disclosure. This feature of bankruptcy arguesfor 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 courtapproval (and protection) for any transaction.

DUTIES AFTER DISSOLUTION

Upon the dissolution of a Delaware corporation, directors continue to owe theirstandard fiduciary duties to both the corporation’s stockholders and its creditors. Thecorporation’s assets are essentially heldin trust for the benefit of its stockholdersand creditors.166 Directors that serve afterthe dissolution of a corporation will thuscontinue to have potential liability forbreaches of fiduciary duty, as well as liability commonly arising from distributions ofassets to stockholders without payment or making inadequate provisions to repay allknown 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

Directors of a corporation can mini-mize their personal liability exposureby relying on statutory proceduralsafeguards in the dissolution process.

163 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).

164 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 352 (1985).165 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).166 8 Del. C. §§278, 279.

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assets. Directors can minimize their potential liability in connection with distributionsof the corporation’s assets as part of a plan of dissolution following the proceduralsafeguards contained in Section 280 of the DGCL (which requires notice to knowncreditors 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 othercontingent liabilities). Directors can also minimize their potential liability stemmingfrom dissolution by seeking the appointment of trustees or receivers to execute thedissolution and liquidation under court supervision.167 This allows the appointed trust-ees to reduce their risk of personal liability by seeking express court approval ofactions during the dissolution and winding up of the corporation.

167 Del. C. §§279, 291.

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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 ofinformed 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 officerswhile 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 tothe residual beneficiaries of the corporation, which are creditors until theyhave been repaid in full, and stockholders thereafter.

• Continue to act in the same manner as to your fiduciary duties. The dutieshave not gone away when the corporation became insolvent. You shouldcontinue to exercise your business judgment for the benefit of maximizingthe corporation’s estate.

• Make informed decisions and keep a good record of the decisions and thedecision-making process.

• Continue to seek advice from bankruptcy counsel and other experienceddistressed business advisers. However, take care to ensure that the board

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does not abdicate its duties by excessively deferring to those persons orimproperly delegating the board’s duties.

• Duly consider all reasonable options.

• Focus on maintaining sufficient liquidity to preserve value and a respon-sible resolution.

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CHAPTER 7

ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXT

INTRODUCTION

Attorney-client privilege, one of the oldest of the privileges known to commonlaw, protects confidential communications between a lawyer and his or her client.168

The essence of the privilege is that communications between a lawyer and his or herclient are not subject to discovery in litigation, with certain exceptions.

SCOPE OF PRIVILEGE

Attorney-client privilege “encourage[s] full and frank communication betweenattorneys and their clients and thereby promote[s] broader public interest in theobservance of law and administration of justice.”169 In addition, “privilege exists toprotect not only the giving of professional advice to those who can act on it, but alsothe giving of information to the lawyer to enable him to give sound informedadvice.”170 Attorney-client privilege appliesto verbal statements as well as documentsand tangible objects conveyed by the clientto an attorney in confidence for the purposeof legal advice.171 Privilege applies to bothoral and written confidential communica-tions, either originating from the client orfrom the lawyer in response to a client’s inquiries.172 However, privilege protects onlythe communications, and not the underlying facts that have been communicated.173 Inaddition, attorney-client privilege is inapplicable to the information the attorneyreceives from independent non-client sources.

The privilege protects only the dis-closure of the communicationsbetween the client and the lawyer,and not the disclosure of the under-lying facts.

168 8 JOHN H. WIGMORE, EVIDENCE §2290 (John T. McNaughton rev. ed., 1961).169 Upjohn v. United States, 449 U.S. 383, 389 (1981).170 Id. at 390.171 Haines v. Ligget Group, 975 F.2d 81, 90 (3d Cir. 1992).172 Upjohn v. United States, 449 U.S. 383, 389 (1981).173 Id. at 395.

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There are certain exceptions that can result in the loss of the attorney-client priv-ilege. The attorney-client privilege can be waived either intentionally or by inadvertentdisclosure of privileged information. The attorney-client privilege cannot be assertedto protect communications that further an ongoing crime or fraud, known as the crime-fraud exception. In the context of a derivative stockholder action, a claim of attorney-client privilege can be defeated upon a showing of “good cause,” as describedbelow.174

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 inhis or her capacity as such;

The attorney-client privilegeis designed to protect therelationship between thelawyer and the client byproviding that communica-tions between the lawyerand client are not subject todiscovery, with certainexceptions.

• When the communications relate to the pur-pose of receiving legal advice;

• When the communications are made in con-fidence by the client;

• When the communications are, at the client’sinsistence, permanently protected from dis-closure by himself or by the legal advisor;and

• When the protection is not waived.175

174 Garner v. Wolfinbarger, 430 F. 2d 1093 (5th Cir. 1970).175 8 JOHN H. WIGMORE, EVIDENCE §2292 (John T. McNaughton rev. ed., 1961).

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Attorney-client privilege in the corporate context is difficult to define. When alawyer is representing a corporation, the lawyer’s professional duties are owed to an

entity, rather than to any officer, director, employee, stockholderor other constituent of the corporation. A lawyer representing acorporation must communicate with, and receive direction from,the client through its officers, directors and employees.176 Inaddition, “an otherwise privileged communication by a lawyerto a corporate agent does not lose its protected status simplybecause the agent then conveys the attorney’s opinion to acorporate committee charged with acting on such issues.”177

Over time, the state and federal courts have developed the fol-lowing three different methods to determine whether certaincommunications are considered privileged in the corporate con-text:

• 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 ofcontrol and are able to direct the action the corporation might take inresponse to the legal advice they receive.178 As noted in the discussion of theUpjohn test below, this test has beencriticized by Federal courts as too nar-row179 and inadequate.180

• Subject Matter Test. The subject mattertest extends privilege to communicationswith lower-level employees or corporateagents, so long as the communication with legal counsel is related to thesubject matter of representation.181

In general, whendealing with acorporation, theprivilege belongsto the corpo-ration. It cannotbe asserted byofficers or direc-tors for theirpersonal benefit.

In the context of a corpo-ration, the scope of theattorney-client privilegemay be limited and may notextend to all employees.

176 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: AJeremiad for Upjohn, 61 BUS. LAW. 95, 97 (2005).

177 Shriver v. Baskin-Robbins Ice Cream Co., 145 F.R.D. 112, 114 (D.Colo. 1992).178 Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D.Pa. 1962).179 Upjohn v. United States, 449 U.S. 383, 392 (1981).180 Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 491 (7th Cir. 1970).181 Id.; Diversified Industries v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977).

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• Upjohn Test. The Upjohn test provides that attorney-client privilege in thecorporate context is determined on a case-by-case basis and involvesevaluating the following factors:182

O whether the communications are made by employees to corporate coun-sel in order for the corporation to secure legal advice;

O whether the employees are cooperating with corporate counsel at thedirection of corporate supervisors;

O whether the communications concern matters within the employee’sscope of employment; and

O was the information available from upper-echelon management.183

In Upjohn v. United States, a corporation, throughits chairperson, instructed its general counsel to carryout an internal investigation into certain payments madeto foreign government officials by the corporation’ssubsidiary. During the investigation, the general coun-sel distributed confidential questionnaires to managersseeking information regarding the payments and inter-viewed corporate personnel. The corporation then dis-closed certain of the information to the Securities and

Exchange Commission. Subsequently, the Internal Revenue Service commenced itsown investigation and issued summons requiring production of all files relating to thecorporation’s internal investigation, specifically including the questionnaires. Thecorporation claimed that the attorney-client privilege applied to the files of the internalinvestigation. The Appellate Court applied the control-group test and held that priv-ilege did not apply to communications with middle management employees who couldnot direct the corporation’s response to the legal advice received. However, the

Directors and officersshould take extra pre-cautions when dealingwith sensitive legalcommunications topreserve the maximumscope of the attorney-client privilege.

182 Upjohn, 449 U.S. at 396-7.183 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 orproposed conduct within the scope of employee’s employment; (4) with an attorney who is authorized bythe management to inquire into the subject; and (5) when the attorney is seeking information to assist himor her in either (a) evaluating whether the employee’s conduct is binding on the corporation; (b) assessingthe legal consequences of the employee’s conduct; or (c) preparing legal responses to actions of othersregarding that conduct. Id. at 403.

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Supreme Court reversed, finding the control-group test too limited, and held that thecommunications by the corporation’s employees to counsel were covered by theattorney-client privilege insofar as the responses to the questionnaires and any notesreflecting responses to interview questions were concerned.184

While state courts have used both the control group test and subject matter test inthe past, the Upjohn test is the prevailing test used by federal courts and many statecourts to evaluate when the attorney-client privilege applies in the corporate context.

TYPES OF PRIVILEGED COMMUNICATIONS

Given that corporations are entities and not individuals, courts have had todetermine which corporate agent’s communications are worthy of the protection of theattorney-client privilege. Information provided by certain corporate agents to the law-yer in the course of seeking legal advice on behalf of the corporation typically is con-sidered privileged.185 Corporate attorney-client privilege applies only to the corporateentity. Communications involving personal or individual concerns of a corporate agentoften are not entitled to the privilege because they are independent from the concernsof the corporation and are considered separate from the engagement of the lawyer.186

The benefits of attorney-client privilege inthe corporate context belong to the corpo-ration. Accordingly, an individual cannotassert the attorney-client privilege and preventdisclosure of communications between himselfand the corporation’s counsel if the corpo-ration has waived privilege.187 In a fewcircumstances, if an employee of a corporationseeks legal advice from the corporation’s counsel for himself or if that corporate coun-sel acts as a joint attorney and dual representation may exist, the employee may beable to invoke the privilege.188

Disclosing confidential and priv-ileged communications toindividuals outside the corpo-ration, such as the corporation’saccountants or investmentbankers, likely may result inloss of the privilege.


185 Id. at 392-93.186 Id. at 112.187 Diversified Industries v. Meredith, 572 F.2d 596, 611 n.5 (8th Cir. 1977).188 Id.

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Usually if communications are disclosed to third parties, not for the purpose ofassisting the attorney in rendering legal advice, the privilege is lost.189 However, underthe joint defense theory, in the context of an internal corporate investigation, dis-closure by in-house counsel of privileged communications to present and formeremployees, or other co-defendants and their attorneys would not result in the loss ofthe confidentiality protections of the attorney-client privilege.190 Effectively, the jointdefense theory is meant to support the “advantages of, and even, the necessity for, anexchange or pooling of information between attorneys representing parties sharingsuch common interest in litigation, actual or prospective.”191

Work Product Doctrine

Similar to the doctrine of attorney-client privilege, the work product doctrine alsoprotects the confidentiality of certain materials related to a client and a corporateinvestigation. Federal Rule of Civil Procedure 26(b)(3), codifying the work productdoctrine as it was set forth in Hickman v. Taylor,192 outlines the elements of the workproduct doctrine for federal courts as follows:

“[A] party may obtain discovery of documents and tangible things . . . prepared inanticipation of litigation or for trial by or for another party or by or for that other par-

ty’s representative only upon a showing thatthe party seeking discovery has substantialneed of the materials in the preparation of theparty’s case and that the party is unable with-out undue hardship to obtain the substantialequivalent of the materials by other means. Inordering the discovery of such materials when

the required showing has been made, the court shall protect against disclosure of themental impressions, conclusions, opinions, or legal theories of an attorney or otherrepresentative of a party concerning the litigation.”193

The work product doctrine isdesigned to protect the attorney’sdrafts and notes that reflect theattorney’s considerations andstrategies. It cannot be used toshield facts from discovery.

189 Thomas R. Mulroy & Eric J. Muñoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM.L.J. 49, 61-62 (2002).

190 Id. at 61-62.191 Id. at 62. See also Transmirra Prods. Corp. v. Monsanto Chem. Co., 26 F.R.D. 572, 579 (S.D.N.Y.

1960).192 329 U.S. 495 (1947).193 Fed. R. Civ. P. 26(b)(3).

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The purpose behind the work product doctrine is to “preserve a zone of privacy inwhich a lawyer can prepare and develop legal theories and strategy ‘with an eyetoward litigation,’ free from unnecessary intrusion by his adversaries.”194 In general,the work product doctrine protects documents or tangible things prepared in antici-pation of litigation, or for trial by or for another party or that party’s representative,unless the party seeking discovery demonstrates both substantial need for thosematerials and inability, without undue hardship, to obtain the equivalent of those mate-rials.195

In-House Counsel

Recently there have been additional concerns regarding the applicability ofattorney-client privilege to communications between the corporation and in-housecounsel. Generally, internal communications betweenin-house counsel and corporate employees may becovered by attorney-client privilege if thecommunications concern matters within the scope ofthe employee’s corporate duties and the employees aresufficiently aware that questions posed to them byin-house counsel are for the purpose of the corporationobtaining legal advice.196 In-house counsel typically communicate with a broaderrange of corporate agents than outside counsel, including agents who are involved inthe daily implementation of corporate policies and are most likely to be aware ofissues and problems that may arise (rather than only upper-level management).Attorney-client privilege works to promote free communication between employeesand in-house counsel in the corporate context; without such protection, internal corpo-rate counsel could face difficulty in assisting the corporation with resolving and reme-dying legal matters.197

In-house counsel shouldexercise extra care toensure that their con-fidential communica-tions are entitled to theprivilege.

194 United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998).195 Fed. R. Civ. P. 26(b)(3).196 Upjohn v. United States, 449 U.S. 383, 403 (1981).197 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A

Jeremiad for Upjohn, 61 BUS. LAW. 95, 128-29 (2005).

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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 remainconfidential. If the client intended that theinformation be published or distributed toothers, the privilege will not apply.198

Maintaining Confidentiality

In general, concerns regarding the con-fidentiality of corporate attorney-clientcommunications emerge following theinadvertent disclosure of privileged information by the corporation, such as in discov-ery during litigation. A corporation can be forced by the court to support its claims ofconfidentiality by setting out the steps it took to ensure confidentiality; for example,showing who had access to documents and how they were stored in order to maintainand preserve attorney-client privilege.199 Courts also have determined that a personmay relay a confidential communication through or in the presence of a third personwithout breaching its confidentiality only “if the [third] person’s participation isreasonably necessary to facilitate the client’s communication with a lawyer or anotherprivileged person and if the client reasonably believes that the person will hold thecommunication in confidence.”200

Differences Between a Lawyer’s Duty of Confidentiality and Attorney-ClientPrivilege

There are important differences between evidentiary privilege given to attorney-client communications and the broader duty of confidentiality that lawyers owe to their

The attorney-client privilege isonly intended to protectdisclosure of confidentialinformation. If the information isnot maintained in confidence, theprivilege will be lost as to thatinformation.

198 In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984).199 Scott Paper Co. v. United States, 943 F. Supp. 489, 499 (1996); see also 1 JOHN K. VILLA, CORPO-

RATE COUNSEL GUIDELINES §1:12 (2007).200 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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clients.201 “[T]he chief difference between the professional duty of confidentiality andthe evidentiary attorney-client privilege is that the former applies to virtually allinformation coming into a lawyer’s hands concerning a client, and forbids virtually alldisclosures, whereas the latter only applies when the question is whether a lawyer can

be compelled to testify about [his or] her pro-fessional communications with a client.”202 Priv-ilege exists to protect specific types ofcommunications between a client seeking legaladvice and the lawyer from whom such advice issought and may be waived intentionally orinadvertently by a client.203

The lawyer’s ethical obligation pertains to the information relating to the repre-sentation, whether disclosed by the client or brought to the lawyer’s attention fromanother source.204 Disclosures contrary to the ethical obligation of confidentiality maybe made only in those limited circumstances permitted under relevant ethical rules (orin compliance with other legal rules) or with the informed consent of the client.205 Ingeneral, the professional duty of confidentiality remains a central part of the lawyer’sethical obligations, and continues to encompass far more, and to be more broadlyapplicable, than the attorney-client privilege.206

As a fiduciary, a lawyer’sobligation to maintain theconfidentiality of a client’sconfidential information ismuch broader than theattorney-client privilege.


202 Id.203 Id.204 Id.205 Id.206 Id. at 102.

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WAIVER OF PRIVILEGE

General

Attorney-client privilege can be intentionally or inadvertently waived.207 Becausethe attorney-client privilege belongs to the corporation, only the corporation can assertthe privilege.208 Typically, in the corporate context,the ability to waive attorney-client privilege lieswith the corporation’s management.209 In addition,waiver can be asserted by a corporate representativewho is authorized to do so under the laws ofagency.210 However, an officer acting within thescope of his or her authority may waive theprivilege by his or her deliberate actions, eventhough waiver of privileged information was not theofficer’s intention.211 One common example of this type of waiver occurs whenofficers share legal advice with other members of a corporation’s advisory team, suchas investment bankers or accountants. Also, former employees are usually notconsidered agents of the corporation and typically do not have the authority to waiveprivilege.212

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’sattorney-client privilege passes as well.213 Only the new managers may assert or waivethe privilege, even as to communications made by former directors and officers.214

Similarly, the power to assert and waive a subsidiary’s privilege passes to new owners;

Although the attorney-client privilege belongs tothe corporation, it can bewaived, even inadvertently,by an officer or directoracting within the scope ofhis or her duties.

207 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 73-74 (D. Md. 1998); 1 JOHN K.VILLA, CORPORATE COUNSEL GUIDELINES §1:21 (2007).

208 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:22 (2007).209 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 348 (1985).210 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §78; Sicpa North America, Inc. v.

Donaldson Enterprises, Inc., 430 A.2d 262, 264 (N.J. Super. Ct. Law Div. 1981).211 Computer Network Corp. v. Spohler, 95 F.R.D. 500, 502 (D.D.C. 1982).212 United States v. Chen, 99 F.3d 1495, 1502 (9th Cir. 1996).213 Commodity Futures Trading Comm’n, 471 U.S. at 349.214 Id.

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once control of the subsidiary passes, the parent corporation can no longer prevent thesubsidiary from waiving privilege.215

EXAMPLES OF WAIVER

Inadvertent Waiver

An inadvertent waiver usually occurs during litigation, when a corporation fails toassert the privilege when a question is asked about a written communication or mis-takenly includes a privileged document in response to a request.216 However, mostcourts conclude that such inadvertent and mistaken disclosure of information does notresult in waiver if the company or client took reasonable precautions to keep theinformation confidential.217 Other courts hold that because a client is the only one whocan waive the privilege, the accidental and inadvertent disclosure of confidentialinformation alone is insufficient to constitute a waiver.218 Federal rules and most stateethics rules require that when an attorney receives materials that relate to anotherattorney’s representation of his or her client and knows or reasonably should know thematerials were sent inadvertently, that person should promptly notify the other party ofsuch disclosure so he or she can take protective action. 219 In the event a document isinadvertently produced, the lawyer can move for return of the document and that it bebanned from use in the litigation in order to maintain privilege. 220

Deliberate Waiver

Occasionally, a corporation may decide to deliberately breach the confidentialityof a communication and waive privilege in order to further a corporate objective. Forexample, corporations may choose to disclose such normally protected informationwhen responding to a government investigation, renewing insurance, responding to anauditor inquiry, supplying information to a government agency, negotiating a merger,or filing a registration statement with the Securities and Exchange Commission.221 In

215 Id. at 349.216 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:23 (2007).217 Id.218 Id.219 Id.220 Id.221 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 72 (D. Md.1998).

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addition, if a corporation does disclose privileged information to an entity with whichit does not share a common legal interest (government or public), most courts, forreasons of fairness, will find that the disclosure waives privilege.222

Crime-Fraud Exception

Attorney-client privilege does not apply to communications by a client with his orher lawyer that furthers ongoing criminal activities. This is known as the crime-fraud

exception. The crime-fraud exception to privilegeattempts to protect legitimate inquiries for legal advice,without permitting clients to use their attorneys as know-ing or unknowing participants in ongoing criminal activ-ity. Attorney-client privilege is designed to encourageclients to make full disclosure of past crimes in order toobtain complete legal advice; it does not justify protectingcommunications that are designed to facilitate an ongoingor future crime or fraud.223 Most courts follow a two-pronged test to overcome 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 suchconduct when seeking the advice of counsel, or that he or she committed acrime of fraud subsequent to receiving the benefit of counsel’s advice; and

• A showing that the attorney’s assistance was obtained in the furtherance ofthe criminal or fraudulent activity or was closely related to it.224

Selective Waiver

The doctrine of selective waiver works to preserve attorney-client privilege andwork product protection against third parties on certain privileged documents ormaterials that have been previously disclosed to a government agency.225 Selectivewaiver was recognized in Diversified v. Meredith when the court asserted that the right

The attorney-clientprivilege may not beused to shield dis-closure of informationthat is provided tocounsel as part of aplan or scheme toengage in wrongful orillegal conduct.

222 United States v. Billmyer, 57 F.3d 31, 36-37 (1st Cir. 1995).223 In re Grand Jury Proceedings (Corporation), 87 F. 3d 377, 381 (9th Cir. 1996).224 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §82.225 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)],” 46Washburn L.J. 479 (2007); see also Diversified Indus., Inc. v. Meredith, 572 F. 2d 596, 611 (8th Cir.1977).

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to disclose investigative material to a federal agency should result in the limitedwaiver of the attorney-client privilege for that purpose.226 However, the view inDiversified v. Meredith is the minority view. The majority of the U.S. courts haverefused to recognize selective waiver of attorney-client privilege. Most recently, in2006 the court in In re Qwest Communications International Inc. Securities Liti-gation227 rejected Qwest’s assertion that it did not have to produce thousands ofdocuments in a class action litigation simply because it had previously produced suchdocuments to the Securities and Exchange Commission and the Department of Justiceunder confidentiality agreements that provided for selective waiver during an inves-tigation. The court in Qwest rejected the selective waiver argument and found that thecompany had waived its attorney-client privilege by producing such documents to theSecurities and Exchange Commission and the Department of Justice.228

PRIVILEGE IN DERIVATIVE SUITS AND CLASS ACTIONS

Attorney-client privilege applies in the context of derivative suits and classactions. A derivative suit is a legal action brought by a constituent in the name of thecorporation against one or more of its officersor directors seeking a recovery on behalf of theinjured corporation for wrongful conduct bysuch officer or directors. The purpose of thederivative action is to enforce a corporate rightthat the corporation has refused to assert.229 Inorder for a derivative suit to be brought by astockholder under Delaware law:

• The plaintiff must be a stockholder of the defendant corporation at the timeof the wrong complained of and remain so through the duration of thederivative suit;

• The derivative plaintiff must make a demand on the directors of the corpo-ration to assert the corporate claim unless such demand would be futile; and

A derivative suit is a legal actionbrought by a constituent in thename of the corporation againstone or more of its officers ordirectors seeking a recovery onbehalf of the injured corpo-ration for wrongful conduct bysuch officer or directors.

226 Diversified Industries, 572 F.2d at 611 (8th Cir. 1977).227 450 F.3d 1179 (10th Cir. 2006).228 Id.229 1 R. FRANKLIN BALOTTI & JESSIE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND

BUSINESS ORGANIZATIONS §13.10 p. 13-20.

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• The derivative plaintiff must be an adequate representative of the corpo-ration’s other stockholders.230

In comparison, in a class action suit, the claims of a number of affected partiesare prosecuted as if they were before the court. A class action is a “procedural device

so that mere numbers would not disablelarge groups of individuals, united ininterest, from enforcing their equitablerights.”231 A class action is nothing morethan an aggregation of individual claimsbeing prosecuted by one or more persons

on behalf of the entire group.232 “Aggregated individual claims are to be contrastedwith a derivative action, which is brought to redress alleged wrongs to the corporationdirectly, rather than wrongs to the stockholders.”233

The Garner Doctrine and Privilege in Derivative Actions

Garner v. Wolfinbarger concerned a stockholder derivative suit chargingmanagement with fraud and a direct suit chargingfraud and violation of the securities laws.234 Whenstockholders sought discovery of communicationsbetween management and the corporation’s attorneys,the corporation asserted the attorney-client privilege.The court noted tensions between protecting theintegrity of management’s decision-making processand the stockholders’ interest. The court articulatedthe need to balance “the injury that would inure to therelation by the disclosure of the communications” against the benefit gained “for thecorrect disposal of litigation.”235 Further, the court stated “the corporation is notbarred from asserting [privilege] merely because those demanding information enjoy

A class action is a legal actionbrought against the corporation by agroup of plaintiffs together seeking arecovery as a result of wrongfulconduct of the corporation.

In derivative actions,directors and officers whohave been charged withwrongdoing are unlikelyto be able to use the priv-ilege to avoid disclosureof communications withthe corporation’s counsel.

230 Id. at 13-21; 8 Del. C. §327.231 Schneider v. Wilmington Trust Co., 310 A.2d 897, 902 (Del. Ch. 1973).232 1 R. FRANKLIN BALOTTI & JESSE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND

BUSINESS ORGANIZATIONS §13.20, p. 13-109.233 Id.234 430 F.2d 1093, 1103 (5th Cir. 1970).235 Id. at 1100.

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the status of stockholders. But where the corporation is in suit against its stockholderson charges of acting inimically to stockholders’ interests, protection of those interestsas well as those of the corporation and of the public require that the availability of theprivilege be subject to the right of the stockholders to show cause why it should not beinvolved in this particular instance.”236

The court established a list of factors to consider in the balancing process todetermine if there is “good cause” to disregard the attorney-client privilege that hasbeen asserted, including:

• The number of stockholders and the percentage of stock they represent;

• 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 theinformation and the availability of it 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 doubtfullegality;

• Whether the communication is related to past or to prospective actions;

• Whether the communication is of advice concerning the litigation itself;

• The extent to which the communication is identified versus the extent towhich 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.237

In general, Garner asserts that there is a sufficient mutual interest between man-agement and stockholders in communications with attorneys to bar any assertion bymanagement of an absolute privilege against the stockholders.238 Therefore, in a

236 Id. at 1103-4.237 Id. at 1104.238 Ward v. Succession of Freeman, 854 F.2d 780, 784 (5th Cir. 1988).

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derivative action shareholders can gain access to privileged corporate communications,so long as there is “good cause” to waive the attorney-client privilege and disclose theinformation, such information should be disclosed. Even though the Garner test isflexible, there are generally accepted limitations to the rule, including, among otherthings, that Garner does not allow for disclosure of privileged communications thatresult in remedial measures or privileged communications made during the course ofthe derivative suit. 239

Sandberg v. Virginia Bankshares, Inc.

In Sandberg v. Virginia Bankshares, Inc.,240 the court considered a claim of priv-ilege for communications made during a meeting between officers of a corporation andits counsel where the counsel and officers for a third-party corporation were also pres-ent at the meeting. The meeting was called to discuss a stockholder’s action to stop aproposed merger between the corporation’s subsidiary and the third party. Assumingthat the corporate parties had common interest sufficient to permit such a meetingwithout loss of privilege,241 the court held Garner required the production of the notestaken at the meeting and indicated “the shareholders’ interest is particularly strong”where the communications at issue were shared with counsel for a third party “whoseinterests are potentially adverse to those of the executive’s stockholders.”242

ROLE OF ATTORNEY IN SPECIAL INVESTIGATIONS

Government Investigations

Section 307 of the Sarbanes-Oxley Act of2002 requires the Securities and ExchangeCommission to issue rules setting forth mini-mum standards for professional conduct ofattorneys appearing and practicing before theSecurities and Exchange Commission, including such rules requiring attorneys to“report-up” within the organization any evidence of a material violation of securities

In internal investigations, corpo-rations may voluntarily elect towaive the privilege in order tobetter situate themselves withgovernment investigators.

239 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1.27 (2007).240 979 F.2d 332 (4th Cir. 1992).241 Id. at 350-51.242 Id. at 354.

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law or fiduciary duty (or similar duty) by an issuer or any agent thereof.243 The rule-making under Section 307 demonstrates the increased surrounding pressures placed onthe rights of attorney-client privilege and related confidentiality concerns.244

When a corporation is being investigated for alleged criminal or fraudulent activ-ity, a normal reaction of the board and managers may be to announce an intention tocooperate fully with the investigation.245 Frequently, prosecutors demand that corpo-rations make a determination as to whether they intend to cooperate with the inves-tigation early on, which poses concerns for attorney-client privilege.246 Specifically, inpast years the Department of Justice has evaluated whether a corporation has chosen tocooperate based on its willingness to waive attorney-client privilege and work productprotections. These positions originated in internal memoranda of the Department ofJustice, commonly referred to as the Holder Memorandum, the Thompson Memo-randum and the McNulty Memorandum. However, as a result of pressure from Con-gress, the Department of Justice announced on August 28, 2008 that it hassignificantly changed its policies regarding cooperation with an investigation. Underthe new policies, cooperation is measured on whether a corporation voluntarily dis-closes relevant facts as opposed to whether it agrees to waive its privileges. Discussedbelow are the prior Department of Justice memorandums as well as the newlyannounced guidelines and the Congressional response.

Holder Memorandum247

In June 1999 Deputy Attorney General Eric Holder issued a memorandum toDepartment of Justice personnel and U.S. Attorneys stating that: “[I]n determiningwhether to charge a corporation [with federal criminal violations], that corporation’stimely and voluntary disclosure of wrongdoing and its willingness to cooperate withthe government’s investigation may be relevant factors. In gauging the extent of the

243 15 U.S.C.S. §7245 (2002).244 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A

Jeremiad for Upjohn, 61 BUS. LAW. 95, 115 (2005).245 Id.246 Id.247 Memorandum from Eric H. Holder, Deputy Attorney General, to Component Heads and United

States Attorneys (June 16, 1999), http://www.abanet.org/poladv/priorities/privilegewaiver/1999jun16_privwaiv_dojholder.pdf.

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corporation’s cooperation, the prosecutor may consider the corporation’s willingnessto identify the culprits within the corporation, including senior executives, to makewitnesses available, to disclose the complete results of its internal investigation, and towaive the attorney-client and work product privileges.”248 Adhering to the suggestionsof the Holder Memorandum results in the corporation’s effective waiver of privilegesthat would likely provide a viable defense in a potential action, leaving the corporationvulnerable.

Thompson Memorandum249

In January 2003, Deputy Attorney General Larry D. Thompson issued a revisedstatement that focused on proposed revisions to the principles set forth in the HolderMemorandum. These revisions, in particular, increased the emphasis on and the scru-tiny of the authenticity of a corporation’s cooperation with the investigation.250 “Toooften business organizations, while purporting to cooperate with a Department inves-tigation, in fact take steps to impede the quick and effective exposure of the completescope of wrongdoing under investigation.”251 The Thompson Memorandum providedsupport for the corporation’s voluntary disclosure, identification of culpable corporateagents and waiver of applicable privileges that were originally encouraged by theHolder Memorandum.252

McNulty Memorandum253

In December 2006, Deputy Attorney General Paul J. McNulty announced a formalprocedure for prosecutors to follow when seeking waiver of the attorney-client andwork-product protections. The McNulty Memorandum revised and superseded theHolder and Thompson Memoranda. Under the McNulty guidelines, before asking

248 Id.249 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.


251 Memorandum from Larry D. Thompson, Deputy Attorney General, to Heads of DepartmentComponents and United States Attorneys (Jan. 20, 2003), http://www.usdoj.gov/dag/cftf/business_organizations.pdf.

252 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: AJeremiad for Upjohn, 61 BUS. LAW, 95, 116 (2005).

253 Memorandum from Paul J. McNulty, Deputy Attorney General, to the Heads of DepartmentComponents and United States Attorneys (Dec. 12, 2006), http://www.usdoj.gov/dag/speeches/2006/mcnulty_memo.pdf.

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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 benefitthe government’s investigation;

• Whether the information sought can be obtained in a timely and completefashion 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.254

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 completeand thorough investigation. Also, before requesting a privilege waiver from the corpo-ration, the prosecutor was required to obtain formal written approval to make therequest. Formal approval was not needed if the corporation voluntarily offered priv-ileged documents without a government request.

The specific procedure for obtaining approval differed depending on the type ofinformation sought, which the McNulty Memorandum segregated into two categories.Category I information was factual information relating to the underlying misconductand includes, for example, copies of key documents, witness statements, factual inter-view memoranda and factual summaries or reports documenting facts uncovered dur-ing an internal investigation by counsel. To request a corporation’s waiver of privilegefor Category I information, prosecutors were required to obtain written authorizationfrom their United States Attorney. After receiving approval, the United States Attorneywas required to communicate the waiver request to the corporation in writing.

Category II information consisted of attorney-client communications ornon-factual work product, and included legal advice given to the corporation “before,during, and after the underlying misconduct occurred.”255 Prosecutors were required toseek a further disclosure of Category II privileged information if the factualinformation provided an incomplete basis to conduct an investigation. To request a

254 Id.255 Id.

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waiver of privilege for Category II information, the United States Attorney wasrequired to obtain written authorization from the Deputy Attorney General and thencommunicate the request for a waiver to the corporation in writing.

Excluded from Category II information were certain communications betweencounsel and the corporation where a privilege would not apply or may have beenwaived, including:

• Legal advice contemporaneous to the underlying misconduct when thecorporation or an employee relies upon an advice-of-counsel defense; and

• Legal advice/communications furthering a crime or fraud.

In these two instances, a request for disclosure would be subject to the procedurefor Category I information.

The McNulty Memorandum allowed prosecutors to consider a corporation’sresponse to the government’s request for a waiver of privilege regarding Category Iinformation in determining whether a corporation has cooperated in the government’sinvestigation. However, the McNulty Memorandum emphasized that prosecutors couldnot count a corporation’s refusal to provide a waiver for privileged Category IIinformation against them. Nevertheless, “[p]rosecutors may always favorably considera corporation’s acquiescence to the government’s waiver request in determiningwhether a corporation has cooperated in the government’s investigation.”256

The McNulty Memorandum has been widely criticized as being coercive andunfair. In particular, it has been suggested that “the environment created by prose-cutorial pressure for early waivers—whether or not such pressure is ‘fair’ in a philo-sophical sense—has certainly contributed to the increasing perception that theattorney-client privilege has become, as a practical matter, irrelevant in a significantcorporate investigation.”257 Further, the “slippery slope toward diminution or evenelimination of the corporate attorney-client privilege insofar as it relates to gov-ernmental investigations and prosecutions may well have a chilling effect oncommunications between corporate client representatives and corporate lawyers,

256 Id.257 William W. Horton, A Transactional Lawyer’s Perspective on the Attorney-Client Privilege: A

Jeremiad for Upjohn, 61 BUS. LAW. 95, 119 (2005).

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which is likely to lead in turn to less effective lawyering in the corporate and transac-tional context and diminished legal compliance by corporations.”258

Congressional Intervention and the Newly Issued Guidelines Under the FilipMemorandum

In response to criticism of the McNulty Memorandum, the U.S. Senate JudiciaryCommittee commenced deliberations as to whether legislation should be enacted toprovide a set of guidelines for the handling of attorney-client privilege in corporatefraud investigations. In response, the Department of Justice indicated that such legis-lation is unnecessary and that internal changes to its policies are preferable to legis-lation.259

In an effort to head off legislation, the Department of Justice wrote a letter to theSenate Judiciary Committee in July 2008 indicating that it intended to change theMcNulty Memorandum. Subsequently, on August 28, 2008, the Department of Justice,in the Filip Memorandum announced significant changes to its policy regarding appli-cation of the attorney-client privilege in government investigations as follows:

• First, cooperation with a government investigation will no longer be meas-ured on whether a corporation under criminal investigation chooses to waiveattorney-client privilege – rather it will depend on whether the corporationhas timely disclosed relevant facts;

• Second, federal prosecutors may no longer demand privileged attorney-client communication or attorney work product (so called Category II,information under the McNulty Memorandum);

• Third, the Department of Justice will no longer consider whether a corpo-ration has advanced attorneys’ fees to its employees in evaluating coopera-tion;

• Fourth, the Department of Justice will not penalize corporations that haveentered into joint defense agreements, provided they refrain from sharinginformation the Department of Justice disclosed in confidence; and

258 Id. at 126.259 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 ConferenceAnnouncing Revisions to Corporate Charging Guidelines, August 28, 2008.

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• Fifth, the Department of Justice will not evaluate cooperation on a compa-ny’s action against its employees.260

Although these are significant changes from the McNulty Memorandum, itremains to be seen whether the Senate Judiciary Committee will refrain from enactingany legislation pending an opportunity for the Department of Justice to evaluate theeffectiveness of the new policy.

Internal Investigations

A corporation may initiate an internal investigation in response to a stockholderlawsuit, government agency investigation, subpoena; or through either a complaint orgrievance from an employee or group of employees.261 Regardless of whether theinvestigation begins from inside or outside of the corporation, the corporation has asignificant interest in protecting the confidentiality of counsel’s findings in the inves-tigation.262 In the context of an internal investigation and in order to maintain theattorney-client privilege, corporate counsel should always consider, regardless of thenature of their work, that their participation in the investigation must be seen chiefly asa provider of legal advice to the corporation. Otherwise, there is a risk that the attor-ney-client privilege will not apply.263 Corporate counsel is in a much stronger positionto assert privilege as to communications and other investigative material which,although representing factual and non-legal information, has as its main purpose therendering of legal advice.264 Finally, the documentation by counsel that the particularcommunications at issue were made in order to obtain legal advice increases chancesof maintaining privilege. In addition, investigative material that is the product of anattorney-client relationship should be protected; this is supported by the Upjohnopinion.265

260 Id.261 Thomas R. Mulroy & Eric J. Munoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM.

L.J: 49 (2002).262 Id. at 49.263 Id. at 58.264 Id.265 Id.

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CONCLUSION

In the corporate context, the courts continue to explore different methods fordetermining when attorney-client privilege applies and who can assert or waive suchprivilege. With the increased scrutiny of corporate disclosure and willingness ofcorporations to cooperate in government investigations, it is important for corporatecounsel, directors, officers and other employees to be informed and implement corpo-rate policies that enable the corporation to be in the best position to assert the attorney-client privilege.

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CHAPTER 8

INDEMNIFICATION AND INSURANCE

INTRODUCTION

Indemnification and directors’ and officers’ (“D&O”) liability insurance are twointerrelated and indispensable devices to protect the personal assets of directors andofficers from claims arising from their service for the corporation. Indemnificationallows a corporation to reimburse its directors and officers for losses they incur as aresult of certain claims regarding their service, with certain exceptions. Whileindemnification is not permitted in all circumstances (e.g., with breaches of the fidu-ciary duty of loyalty where the director or officer acted in bad faith), it is permitted ina wide variety of circumstances and generally provides the affected officer or directorwith the most expedient and reliable form of relief. In addition, in certain instances,indemnification is mandatory under the DGCL.

For situations in which indemnification is notavailable (e.g., due to statutory prohibition orinsolvency of the corporation or because it was notgranted by the corporation), D&O insurance can pro-vide a last line of defense. While D&O insurance isgenerally subject to numerous exceptions andexclusions, it provides directors and officers with anadded level of risk management comfort in a wide variety of circumstances and isindispensable when the corporation either cannot or will not provide directindemnification. Companies should carefully evaluate their indemnification and D&Oinsurance programs on a regular basis, and revise and update them when necessary toreflect the changing needs and circumstances of the corporation and its directors andofficers.

INDEMNIFICATION

Statutory Indemnification Under the DGCL

Section 145 of the DGCL permits, and in some situations mandates, corporationsto indemnify their directors and officers as part of an underlying policy to induce the

Indemnification andD&O insurance protectdirectors and officersagainst incurringpersonal liability fortheir actions on behalf ofthe corporation.

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most capable and responsible persons to serve in corporate management.266 A corpo-ration generally has the statutory authority267 to indemnify any person who was or is aparty or is threatened to be made a party to any threatened, pending or completed

direct legal proceeding (civil, criminal or otherwise)by reason of the fact that the person is or was adirector, officer, employee or agent of the corpo-ration (or who serves in certain capacities withanother entity at the request of the corporation), aslong as the person acted in good faith and in a

manner the person reasonably believed to be in the best interests of the corporation (or,in the case of criminal proceedings, had no reasonable cause to believe the person’sconduct was unlawful).

If the relevant action is a derivative proceeding (meaning that it is brought onbehalf of the corporation against one of its directors or officers by a third party such asa stockholder or creditor) no indemnification is permitted with respect to any claim,issue or matter as to which the person is judged to be liable to the corporation unlessand only to the extent that the court determines that, despite the adjudication ofliability but in view of all the circumstances of the case, the person is fairly andreasonably entitled to indemnity for such expenses that the court deems proper. Sec-tion 145 provides that indemnification in either of the foregoing circumstances can bemade only upon a determination – generally by the board of directors, but sometimesby independent legal counsel – that the potentialindemnitee has met the applicable standards ofconduct required by Section 145. The importance ofD&O insurance is heightened in such cases whereindemnification is not allowed because of anadverse finding. While typically insurers resistpaying any amounts in a settlement that would flowdirectly to the nominal plaintiff corporation, they typically do stand up to pay attor-neys’ fees and, ultimately, could be responsible for paying a judgment levied againstthe officer or director defendant.

The DGCL provides thecorporation with the abil-ity to indemnify directorsand officers, with certainexceptions.

The DGCL also providesmandatory indemnificationfor an officer or directorwho has successfullydefended against claims ofmisconduct.

266 Merritt-Chapman & Scott Corp. v. Wolfson, 264 A.2d 358, 360 (Del. Super. Ct. 1970).267 All references to statutory authority or requirements in this chapter are to 8 Del. C. §145.

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To the extent a present or former director or officer of a corporation has beensuccessful on the merits or otherwise in the defense of any direct or derivative action,suit or proceeding arising from the person’s service as an officer or director, then thecorporation must indemnify him or her against expenses actually and reasonablyincurred in connection with the suit. Indemnification under Section 145, whether per-missive or mandatory, can cover expenses (including attorneys’ fees), judgments, finesand settlement amounts actually and reasonably incurred by the indemnitee in con-nection with the proceeding.

Section 145 also permits corporations to advance expenses (including attorneys’fees) to directors or officers if the director or officer agrees to repay the advancedfunds if it is ultimately determined that the person is not entitled to indemnification.The ability to advance expenses can be very important because the costs of litigating acase, regardless of its merit or ultimate outcome, can be prohibitively expensive inrelation to the resources a typical officer or director might have at his or her personaldisposal. The Delaware Court of Chancery is vested with exclusive jurisdiction to hearand determine all actions for advancement of expenses or indemnification. Addition-ally, the Court of Chancery is permitted to summarily determine a corporation’sobligation to advance expenses (including attorneys’ fees), which provides an avenuewhereby a person seeking advancement of expenses can obtain a relatively speedyjudicial determination of their request. The indemnification and advancement ofexpenses provided by the DGCL and the corporation’s charter and bylaws will gen-erally 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 admin-istrators. However, if the expense provision is removed from the charter or bylawsafter a former director or officer has left office and before the former director or officerhas been named in an action for which expense reimbursement is sought, the formerdirector or officer may not be entitled to such reimbursement unless he or she has anaffirmative contractual right to the reimbursement – for example, by reason of anindemnification agreement.268

268 See, e.g., Schoon v. Troy Corp., 948 A. 2d 1157 (Del. Ch. 2008) appeal pending.

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Additional Sources of Indemnification Rights

In addition to the mandatory indemnification provided by the DGCL, most corpor-ations provide for indemnification to the maximum extent allowed by Delaware law

in their charter and bylaws. In addition, many corpo-rations enter into specific indemnification agreementswith their directors and officers. Due to the significantrisks of stockholder lawsuits and other potential liabilitiesthat directors and officers face as a result of their roleswith their corporations, the vast majority of qualifieddirector and officer candidates expect, and oftentimeswill not serve without, robust indemnification and relatedrights.

Directors and officers should be familiar with thevarious provisions of the corporation’s charter documents and their individual agree-ments with the corporation that address their indemnification rights. Those provisionsand agreements should be reviewed by the corporation and the directors and officers(as well as legal counsel or other appropriate advisors) from time to time as circum-stances merit to evaluate whether the indemnification rights and obligations they con-tain continue to be appropriate and adequate in light of the parties’ needs andcircumstances.

Indemnification provisions are often drafted broadly to provide forindemnification to the fullest extent permitted by law. However, care should be takento ensure that the applicable provisions provide (or at least do not foreclose theimplication) that if the law is amended in the future to expand permittedindemnification beyond that which was permitted on the date of the particular contractor charter provision, then the directors and officers will get the benefit of thatexpansion in the law. Additionally, care should be taken to ensure that theindemnification provisions in various documents do not conflict with each other.

Certificate of Incorporation Provisions

Most corporations include provisions in their certificate of incorporation thatprovide for indemnification of directors and officers to the full extent permitted bySection 145. While these provisions are not required to permit a corporation to

Given the proliferationof suits against corpor-ations, the vastmajority of qualifieddirector and officercandidates expect thata corporation providefor robustindemnification rights.

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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 andofficers because they cannot be modified orrescinded without stockholder action to amendthe certificate of incorporation. Without such aprovision or other contractual right toindemnification, the availability of indemni-fication for directors and officers would be atthe discretion of the board. Whether a boardwould grant indemnification under particularcircumstances may depend on a number offactors, and cannot be guaranteed. Broad indemnification provisions contained in acorporation’s certificate of incorporation, in addition to provisions eliminating orlimiting a director’s liability to the corporation and its stockholders for certain breachof fiduciary duty claims, can provide directors with significant protections againstliability so long as the directors have acted in good faith.

Bylaw Provisions

Many corporations also include provisions in their bylaws that provide forindemnification of its directors and officers to the full extent provided by Section 145.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 subsequentlynarrowed or rescinded altogether. For example, one recent Delaware case held that aformer director was not entitled to the benefit of an expense reimbursement provisionwhen the bylaws were amended to remove the right to receive the reimbursementbefore the former director was named in an action for which reimbursement wassought (this case is currently on appeal).269

Contractual Indemnification Rights

Many corporations enter into indemnification agreements with directors and offi-cers that provide an additional layer of comfort above and beyond the statutory provi-sions and provisions contained in the charter and bylaws. These agreements typically

Indemnity provisions containedin a corporation’s charter can-not be modified without astockholder vote, and thereforeprovide greater protection fordirectors and officers thanprovisions contained in thecorporation’s bylaws.

269Schoon v. Troy, 948 A.2d 1157 (Del. Ch. 2008), appeal pending.

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provide for indemnification and advancement of expenses to the fullest extent permit-ted by Delaware law. These direct contractual arrangements most commonly take theform of a stand-alone indemnification agreement between the corporation and theindividual, but can sometimes be found in employment agreements and similararrangements as well. Typically a corporation has a standard form of indemnification

agreement. If the corporation entersinto indemnification agreements withits directors and executive officers, itshould consider seeking stockholderapproval of those agreements inaccordance with the interested directortransaction provisions of the DGCL to

reduce the ability of third parties to challenge their enforceability on that basis. Appli-cable listing requirements of the New York Stock Exchange, NASDAQ and otherstock exchanges further require that indemnification arrangements, as well as manyother arrangements between the corporation and its directors and officers and otherrelated parties, be approved or recommended for approval by the corporation’s auditcommittee or another committee of independent directors.

Well-crafted indemnification agreements directly between the corporation and theaffected 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 enterbankruptcy (in which case appropriate D&Oinsurance, as discussed below, takes on anadded measure of significance), if the directoror officer has an indemnification agreementdirectly with the corporation, the corporationwill generally be obligated to fulfill itsindemnification obligations to that individualas set forth in the contract, regardless ofwhether the indemnification provisions of thecorporation’s certificate of incorporation or bylaws are subsequently modified byactions of the corporation’s board of directors or stockholders in a manner adverse tothe corporation’s directors and officers. Indemnification agreements generally include

Corporations should consider obtainingstockholder ratification ofindemnification agreements with offi-cers and directors so as to reduce chal-lenges to the enforceability of suchrelated party agreements.

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Contractual agreements withdirectors and officers providingfor indemnification rightsgenerally provide the highestlevel of comfort for the direc-tors and officers because theycannot be modified withouttheir consent.


very specific procedural mechanisms (regarding advancement of defense costs, etc.)and other provisions (e.g., imposing on the corporation an obligation to maintain direc-tors’ and officers’ insurance on behalf of the indemnitee) that provide added comfortto the affected individual.

Securities and Exchange Commission Position on Indemnification for SecuritiesLaw Violations

The Securities and Exchange Commission maintains a long-standing position thatthe indemnification of directors and officers of a corporation for liabilities arisingunder the Securities Act of 1933 (the “Securities Act”) is against public policy asexpressed in the Securities Act and is therefore unenforceable. While not universallyaccepted by courts throughout the country, this Securities and Exchange Commissioninterpretation has been judicially affirmed on occasion. As a result, directors and offi-cers should not assume that their indemnification rights will be upheld if challenged bythe Securities and Exchange Commission even if Delaware law would otherwise per-mit indemnification.

D&O INSURANCE

Overview

A corollary to Delaware’s statutory indemnification provisions is its position withrespect to D&O liability insurance. The DGCL permits a corporation to purchase andmaintain insurance on behalf of any person who is orwas a director, officer, employee or agent of the corpo-ration or who serves in certain capacities with anotherentity at the request of the corporation. The underlyingpublic policy stems from the fact that, as discussedabove, a corporation is not legally permitted toindemnify its directors and officers in certain circum-stances (e.g., to pay adverse judgment or settlementamounts in the event of a derivative claim on behalf of the corporation against theindividual directors and officers). D&O insurance thus assists corporations to attracttalented directors and officers by providing an additional layer of comfort from fearthat their personal assets would be at risk from their actions on behalf of the corpo-ration.

D&O insurance is anessential part ofmanaging the risk thatdirectors and officersexpose themselves tothrough their service tothe corporation.

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D&O insurance should be evaluated in light of the corporation’s indemnificationobligations under its certificate of incorporation, bylaws and other contractualarrangements. While the existence of D&O insurance provides significant comfort todirectors and officers, they will generally find it much easier and more expeditious toseek redress directly from the corporation through indemnification. As a result, D&Oinsurance should be viewed by directors and officers as a fallback for situations wheretheir corporation either cannot or will not indemnify them against particular losses, orwhere available indemnification is insufficient to cover the losses incurred.

D&O insurance policies are complex documents and the market for D&Oinsurance, 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 planto invest a significant amount of time (30 to 60 days is generally necessary) and effort

in seeking competing proposals fromreputable insurers and carefully reviewingand negotiating the terms and conditions ofthe policy that they ultimately purchase.Like all forms of insurance, the real value ofa D&O policy is often not realized until

the insured needs the insurer to cover a claim. Time and effort spent negotiating agood policy at the outset will be well worth the expense if it means that the insured canavoid the unpleasant surprise of finding out that a particular claim that they thoughtwould be covered is in fact not. It is important to remember that employees of aninsurance company’s claims department are paid to find ways to avoid coverage.Corporations can minimize the risk of having coverage denied by negotiating carefullycrafted policy provisions that provide broad coverage.

While it is often possible to purchase endorsements or other riders to expand thescope 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 withsome foresight and to negotiate coverage of claims that, while they may seem unlikelyat the time, may come to pass in the future. For example, a corporation that is financiallysound at the time it purchases its D&O policy would be well-advised to consider thepolicy’s bankruptcy exclusions despite the fact that bankruptcy is unlikely at the time. Acorporation that has to reopen negotiations with its insurance carrier after its circum-stances have worsened may find that its risk profile has changed such that the expandedcoverage is simply unavailable or prohibitively expensive.

Careful upfront negotiation of aD&O policy may pay substantialdividends when a claim is pre-sented by reducing the risk thatthe claim is denied by the carrier.

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Furthermore, a D&O policy should be reviewed by the corporation at leastannually to determine whether the coverage is sufficient (in both its terms and cover-age limits) under the corporation’s present circumstances, as well as in light offoreseeable circumstances in which the corporation may find itself. Directors and offi-cers should personally familiarize themselves with their corporation’s D&O insuranceprogram and regularly review that program to determine whether changes are merited.

While public companies should con-sider D&O insurance to be indispensable,private companies should consider purchas-ing D&O insurance as well, particularly ifthey are engaged in mergers and acquisitionsor capital raising through securities offerings. These activities can expose their direc-tors and officers to substantial litigation risks from acquirers, minority stockholdersand securities purchasers. Most D&O carriers offer policies geared specifically toprivate 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 willlikely need to obtain an endorsement providing IPO coverage or a new D&O policyprior to commencing its IPO.

Basic Structure of a D&O Policy

A public corporation’s D&O liability insurance program typically contains threetypes 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 anadditional “stand-alone” Side A policy issued by the insurer directly to them as ameans 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 claimsexpressly covered under the applicable base policy, for an additional fee almost allD&O carriers offer endorsements that can broaden the definition of claims covered bythe policy such as to cover ERISA or employment-related claims, and otherwiseincrease the scope or coverage of the policy in a way that is beneficial to the insuredsin their particular circumstances.

Coverage limits under a typical D&O policy are shared. In other words, the limitsof coverage under the Side A, Side B and Side C components of the policy are shared

Although virtually essential to apublic company, private compa-nies are increasingly consideringpurchasing D&O policies as well.

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and are subject to the retention applicable to the policy. Thus, each insured should beaware that claims made by other insureds could exhaust a policy before their claimarises and thereby leave them without coverage.

Side A Coverage

Side A coverage generally covers costs and expenses incurred by directors andofficers in maintaining their defense and as a result of payouts under settlements andjudgments, in each case where they are not indemnified by the corporation for thosecosts and expenses (e.g., in a situation where state law prohibits indemnification due tothe insolvency of the corporation or the claim being made derivatively on behalf of thecorporation).

Side B Coverage

Side B coverage generally provides reimbursement to the corporation in the eventit is permitted or required to indemnify an applicable director or officer in connectionwith a claim. Due to the fact that most claims against directors and officers areindemnifiable, Side B coverage is the most commonly invoked portion of a D&Opolicy.

Side C Coverage

Side C coverage, which is also often referred to as “entity coverage,” covers thecorporation itself. For public companies, Side C coverage typically only covers claimsarising 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 frominsurer to insurer, they generally provide cover-age in situations where other coverage wouldnot be available to the individual insured direc-tor or officer (e.g., when the primary D&Oinsurer 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 (e.g., they often exclude claimsagainst fiduciaries under employee benefit plans and other ERISA claims), so thesepolicies should be carefully scrutinized as well. Because stand-alone Side A DIC

Directors and officers shouldcarefully review the D&Opolicy to educate and familiar-ize themselves as to the scopeand amount of coverage.

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coverage can only be used when the director’s or officer’s two primary sources ofrecourse – indemnification from the corporation and the primary D&O policy – areunavailable, they are oftentimes not worth the additional cost of the coverage. Addi-tionally, the benefits of stand-alone Side A DIC coverage can be further reduced if theSide A coverage in the primary D&O policy has the added reliability of beingnon-rescindable.

Employment Practices Liability Insurance

In addition to, and in connection with a D&O policy, many corporations arepurchasing Employment Practices Liability Insurance (“EPLI”) to protect againstemployment related claims. An EPLI policy can insure against employment relatedclaims 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, negligentevaluation, failure to employ or promote, deprivation of career opportunity, wrongfulinfliction 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 isdetermining who will represent the corporation and its executives if covered litigationoccurs. Prior to purchasing the policy, the corporation can generally negotiate to havesuch matters handled by its firm of choice. Further, while EPLI policies can varygreatly, certain terms such as a “duty to defend” and a “hammer clause” should becarefully considered. A “duty to defend” clause requires the EPLI carrier to defendagainst claims brought under the policy, regardless of whether the deductible amountor out-of-pocket expense amount has been met. A “hammer clause” permits the carrierto recommend settlement at a certain amount. If the carrier’s recommendation is notfollowed, 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.There are other “hammer clauses” that permit a carrier to recommend an alternativedispute resolution to the claim.

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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, thehigher the retention applicable to the policy, thelower the premium. The amount of the retentionapplicable to the policy is negotiable, but thecorporation should typically negotiate itsretention considering the worst-case scenario.Regardless of the corporation’s financial situation at the time it obtains the policy, it ispossible that at the time it needs to make a claim under the D&O policy its financialwherewithal may be significantly taxed (i.e., insurance claims are often made whenthings are not going particularly well and the corporation’s financial resources aremore limited). The appropriate retention amount under a particular policy can only bedetermined with reference to the facts and circumstances applicable to a particularinsured, but when determining the appropriate amount companies (particularly publiccompanies), should consider the deductible amount they anticipate they would be ableto pay within a particular period without causing an unacceptable negative effect ontheir financial condition and operating results.

Insureds Under the Policy

The specific language of the term “Insured” or “Insured Person” (or a similarapplicable term) should be carefully evaluated to determine who is covered under theD&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 withrespect to specified claims (e.g., employment). Whether an in-house lawyer acting inthe capacity of a lawyer (as opposed to in the capacity of an officer) will be includedamong the insureds is generally subject to negotiation. The applicable definitions andother provisions in the policy that delineate who is covered as an insured should becarefully scrutinized and negotiated to ensure that it fits the corporation’s particularneeds and circumstances.

Companies should regularlyreview their D&O policies toanalyze the scope of coverage,retention and exclusions.

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Claims Made

D&O policies are “claims made” policies, which generally means that the timethat the particular claim is made dictates which D&O policy, if any, is applicable tothe claim. As a result, it does not typically matter when the particular events orcircumstances giving rise to the claim occurred – it only matters when the claim ismade. However, the underlying events and circumstances giving rise to the claim arenot irrelevant because almost all D&O policies specify that, regardless of whether aclaim is made, the policy will not cover the claim if its underlying events and circum-stances occurred on or before a designated date in the past, which is typically someperiod 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 befamiliar with their claim reporting obligations under the policy (including what con-stitutes a “claim” that must be reported, as the definitions are often broadly writtensuch that some events that would not generally be considered a “claim” in commonparlance are deemed to be such for purposes of the policy). In addition, the corporationshould implement adequate controls and procedures to ensure that claims are properlyreported up the chain within the corporation so that they can be timely reported to theinsurance carrier. Insureds typically have a specified period of time after they receiveor become aware of a claim (which can be as short as 30 days) to report the claim tothe 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 certainindividuals within the corporation become aware of potential claims.

Tail Policies

Under certain circumstances, a corporation may purchase a “tail” insurancepolicy to extend the coverage period of time coverage for claims arising out of eventsthat occurred while the original D&O policy was in effect (despite the fact that theclaims themselves arise afterwards). For example, D&O policies insure against claimsmade prior to the effective date of a merger or other acquisition, but if the corporationconsummates a merger or is otherwise acquired, it may need to obtain a tail insurancepolicy to cover itself and the directors and officers against wrongful acts that occurredprior to the completion of the merger or acquisition. Some D&O policies have auto-matic tail coverage available at the insured’s option in the event of a merger or acquis-ition.

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Additionally, if a corporation is acquired and its employees and assets do notexceed certain limitations contained in the acquiring corporation’s D&O policy, thetarget corporation may be treated as asubsidiary and have coverage under theacquiring corporation’s D&O policy.Directors and officers of a target corpo-ration engaged in acquisition negotia-tions should consider who will bear thecost of a necessary tail policy, and yourD&O carrier should be consulted wellin advance of the transaction closing toensure that there is no gap in coverage.Directors and officers also should be mindful of situations where their D&O policywill lapse or otherwise terminate. If a new, replacement D&O policy will not be inplace at the time of termination of the old policy, they should carefully considerwhether a tail policy is appropriate and, if so, take necessary measures to ensure thatone 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 carefully reevaluate their changing D&O insurance needs and cir-cumstances a least a couple of months prior to the expiration of their current policy sothat they have sufficient time to negotiate new or revised terms with their current car-rier or 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 requirecareful consideration, negotiation and periodic review. Below are summaries of sev-eral areas of particular concern. However, these are by no means the only areas ofconcern, and directors, officers and their companies should always seek the guidanceof an expert in D&O insurance matters when evaluating or purchasing a D&O policy.

D&O policies are not generally off-the-shelf, unchangeable form documentsoffered by insurers. Depending on the market and the particular insurers there may besignificant latitude in negotiating and revising the specific language of particularprovisions in the initial form of the policy the insurer proposes. Because the specific

Many D&O policies do not survivesignificant corporate events such as amerger or bankruptcy filing. Whencontemplating such an event, thepolicy should be carefully reviewed todetermine whether a “tail” policy willbe needed and allot sufficient time andfunds to timely acquire such a policy.

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language of each provision in the D&O policy can be the difference between receivingand being denied coverage in the future, it is well worth the expense to negotiate apolicy before buying it and obtain the guidance of an expert in D&O insurance issuesin 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’slimits with the corporation and other directors and officers. If claims by other insuredsdeplete the limits of the policy, a director will generally find himself or herself withoutcoverage. This problem can be alleviated by ensuring that the policy contains an orderof payments provision, which basically provides that, with respect to a particularclaim, 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(reimbursement to the corporation for indemnification amounts paid to directors andofficers) or Side C (coverage for the corporation itself). Another way of addressingthis issue is through a stand-alone Side A DIC policy as described above, which wouldprovide the affected insured with a separate, stand-alone policy that would not beaffected by the exhaustion of coverage under the primary D&O policy.

Severability Issues

D&O insurance policies are issued by insurers based on their evaluation of an appli-cation submitted by the person or entity seeking insurance. Applications for D&Oinsurance are generally very extensive in the amount and type of information theyrequire from the applicant corporation. In addition to requiring extensive informationabout the nature of the corporation’s business, its recent claims history, and the membersof its board and management team, applications by public companies also generallyrequire the corporation to attach its financial statements and certain Securities andExchange Commission filings, thereby including them in the information the insurer isentitled to consider when reviewing the application. Furthermore, while a broad group ofdirectors and officers are generally beneficiaries under D&O insurance policies, theapplications typically are submitted and signed by one or two of the corporation’s topmanagement members (generally the chief executive officer and chief financial officer).

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As with other forms of insurance, misstatements or omissions in the corporation’sapplication, including in any Securities and Exchange Commission filings or otherdocuments 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 suedby stockholders who allege that the corporation’s publicly filed financial statements orother Securities and Exchange Commission filings contained material misstatementsor omissions that caused the stockholders to lose all or a significant portion of theirinvestment when the corporation’s stock price plummeted after a recent release ofnegative financial results. If the financial statements and Securities and ExchangeCommission filings that are the subject of the plaintiffs’ lawsuit were also submitted aspart of the corporation’s application for D&O insurance, the directors and officers mayface a situation where their D&O coverage is void based on the very set of factualcircumstances that gives rise to the insured’s claim for coverage.

While rescission is generally only permitted in the case of material misstatementsand omissions that, if known, would have affected the insurer’s willingness to providethe insurance, the materiality of misstatements and omissions is necessarily evaluatedin hindsight and in the face of a pending claim, and information in the application cantake on new significance under those circumstances. Furthermore, misstatements andomissions do not need to be intentional in order to form the basis for rescission, whichmeans that even unintentional errors can lead to a catastrophic voiding of coverage.

Similar issues are raised by misconduct exclusions contained in almost all D&Opolicies. These exclusions generally provide that the insurer is not obligated to providecoverage for claims based on fraud or other misconduct of any of the insureds. Inessence, a broad misconduct exclusion could create a situation where the misconductof one key officer or director could lead to the denial of coverage for all the directorsand officers, even if the others had no knowledge of the misconduct. Most securitiesclass action lawsuits, as well as many other claims against the directors and officers ofa corporation (e.g., claims based on alleged options backdating and similar improperpractices 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 andofficers. Since it is often the case that the allegedly improper conduct did not in factextend to all of the directors and officers, those “innocent” insureds have an obviousinterest in ensuring that their D&O coverage is not denied as a result of the bad acts ofsomeone else.

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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 voidedcan be mitigated by the inclusion of a strong severability clause. If a broad severabilityclause cannot be negotiated into the policy, a severability clause applicable to themisconduct exclusion can have the same prophylactic effect. Good severability clausesgenerally provide that, in the event that the insurance application contained misstate-ments or omissions or particular insureds are guilty of misconduct, the policy is onlyrescinded or coverage denied as to the insureds that had knowledge of the misstate-ments and omissions in the application or committed or were aware of the bad acts.

It should be noted that the knowledge of certain persons (e.g., the corporation’schief executive officer and chief financial officer), may be imputed to other insuredsregardless of whether the other insureds had any actual knowledge of the misstate-ments or omissions in question. As a result, it is worth the time and effort for the otherinsureds to review the application and talk with anyone whose knowledge will beimputed to them to increase the likelihood that the application is correct and complete.It is also sometimes possible to avoid an application altogether, or to submit an abbre-viated application, if the corporation is simply renewing its D&O policy with its cur-rent carrier. Companies should generally seek to minimize the amount of informationrequired to be included in or appended to the application in order to reduce the risk ofinadvertent misstatements or omissions.

In addition to negotiating a broad severability provision in a D&O policy, theconcern 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 misconductexclusion applying to the bad acts of someone else, can also be alleviated through astand-alone Side A DIC policy. Some D&O carriers also offer non-rescindable Side Acoverage 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, thatthe insurer will not be required to cover claims where there is one or more insuredsacting as or working in concert with the person making the claim. The rationale of theinsured vs. insured exclusion is relatively clear and non-controversial – the insurerwants to avoid being required to, and few companies would argue that the insurer

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should have to, cover a claim where one insured is suing another insured (or the corpo-ration) in a collusive manner.

The difficulty and controversy surrounding the insured vs. insured exclusion, as istypical with most D&O policy provisions, arises from the often very broad languagethat applies to the exclusion and the fact that it can be triggered in many situationswhere there is no collusion between insureds. For instance, insured vs. insuredexclusions often extend to void coverage when an insured assists the plaintiffs in theclaim, which in some situations may entail somewhat tangential assistance as a wit-ness.

Furthermore, a broad definition of who constitutes an “insured” under the policy,which is generally considered a benefit to the corporation and its officers, directors andothers who are insured under the policy, can inadvertently create additional situationsin which the insured vs. insured exclusion would apply and end up voiding coveragealtogether as to the applicable claim. For instance, because former directors andofficers are generally considered to be insureds under a typical D&O policy, if one ofthose persons (who is also likely a stockholder of the corporation) either acts as namedplaintiff in a derivative claim against the corporation and its current directors andofficers or provides material assistance to the named plaintiffs by supplyinginformation or otherwise, the insurer will likely seek to invoke the insured vs. insuredexclusion to deny coverage. Issues can also arise in connection with claims in mergerand acquisition, whistleblower and bankruptcy contexts. As a result, it is veryimportant to closely scrutinize the language of the insured vs. insured exclusion in acorporation’s D&O policy, and to seek to narrow the applicability of the exclusion tothe extent possible.

Defense Costs Provisions

While most D&O policies provide that defense costs and expenses, includingattorneys’ fees, are covered under the policy, the terms of policies can vary widely asto when those costs are reimbursed. Some policies provide that the costs and expensesare only paid by the insurer after the matter is fully resolved. This type of a provisioncould 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 costhundreds of thousands of dollars or more to defend and can take years before a finalresolution is reached. Essentially, in addition to paying its own defense costs, the

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corporation would be required to advance all defense costs to its officers and directors,and could have to wait for 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&Opolicy, 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 significance due to prohibitions contained in the Sarbanes-OxleyAct of 2002 against corporate loans to directors and officers, because in some sit-uations, the advancement of legal expenses to directors and officers could be construedas prohibited loans.

Bankruptcy Issues

Bankruptcy can have significant adverse effects on coverage available under aD&O policy. Bankruptcy courts have held, although not frequently, that a D&O policyis an asset of the bankruptcy estate and should therefore be available to pay creditors’claims against the bankrupt corporation. In order to preserve the bankrupt corpo-ration’s assets, these courts have denied the requests of directors and officers to havetheir defense costs advanced. As a result, D&O carriers now generally require that abankruptcy court issue an order permitting them to advance defense costs to the direc-tors before they will do so. Such an order can, unfortunately, sometimes take a sig-nificant amount of time to obtain.

One way to address this situation is to ensure that the D&O policy contains anappropriate order of payments provision, as described above, that provides that thedirectors and officers take priority over the corporation with respect to payments underthe policy. This helps support an argument, if necessary, that the corporation’s rightsin the D&O policy are subordinate to the rights of the directors and officers, and thatthe policy is therefore not an asset that must be used to satisfy the claims of the corpo-ration’s creditors in bankruptcy. Additionally, if a bankruptcy trustee chooses to suethe bankrupt corporation’s former directors and officers, the insurer may seek to assertthe insured vs. insured exclusion discussed above to deny coverage on the theory thatthe trustee is asserting the rights of one insured (the corporation) against otherinsureds. Many D&O insurance carriers offer policies that expressly provide coveragein this type of situation, but the particular language should be closely scrutinized toensure that it is sufficiently broad.

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Directors and officers of a corporation that is contemplating bankruptcy shouldcarefully review their D&O policy, with assistance from an expert with regard to D&Oinsurance matters. They will often find that their policy does not provide them with thecoverage they expected to have in connection with the bankruptcy, and the time toobtain that coverage is prior to filing the bankruptcy petition. Due to the corporation’sincreased risk profile on the eve of a potential bankruptcy, the cost of that additionalcoverage could be significant.

Venue, Choice of Forum and Other Boilerplate Provisions

D&O policies contain extensive provisions that most insureds would consider tobe mere boilerplate. However, all of those boilerplate provisions should be carefullyscrutinized, and negotiated if necessary,before purchasing the D&O policy. Forexample, there are generally provisionsspecifying the applicable venue and forum inthe event of a dispute under the policy. Ifresolving a dispute in the insurer’s preferredlocale would present significant burdens for insureds located long distances from thatplace (including the costs of paying for travel and other expenses of witnesses andexperts required to attend the proceedings), the corporation should seek to negotiate amore convenient venue and forum. Sometimes the boilerplate provisions also requirearbitration of disputes before arbitrators with insurance expertise (read: people whowill likely have ties to the insurance industry). Furthermore, most D&O policiesrequire that disputes be resolved under New York law, which is generally more favor-able to insurers. The corporation’s ability to negotiate these and other boilerplateprovisions of the policy will, as with any other provisions, be significantly dependenton the market for D&O insurance is at the time of purchase.

Boilerplate provisions in D&OPolicies should be carefullyreviewed as they may containimportant substantive provisions.

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D&O Insurance Terms to Consider

In considering the terms of a D&O Policy, a company would do well toevaluate its current and future needs as regularly as possible in determining theimportance and applicability of the following terms to their particular situation:

• Retention & 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 coveredunder the policy; directors and officers, or other employees.

• Claims Made: Under a “claims made” policy the relevant time period isnot 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 areunder the policy.

• Tail Policy: A tail policy extends the period of coverage for claims aris-ing 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 bepaid, and in what order. Directors and officers will want to ensure thattheir claims are paid before claims of the company, or else there mightnot be any coverage remaining.

• Severability Issues: Severability refers to the ability of the insuranceprovider to rescind coverage of other (and sometimes all) insuredsbased on misstatements or omissions on the application, or due to mis-conduct or fraud of one or more individuals. If the severabilitydefinition is too broad, a misstatement or fraud committed by only oneofficer or one director could potentially lead to the denial of coveragefor all other insureds.

• Insured v. Insured: This term refers to the fact that the insurer will typi-cally not cover claims where there is one or more insureds acting as, orworking in concert with, the person making the claim.

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• Defense Cost Provisions: This term determines when attorneys’ feesand defense costs are reimbursed. If these costs are reimbursed afterresolution of the claim, rather than advanced, the financial burden offunding a legal defense may fall upon the company or other defendants.

• Bankruptcy Issues: Because some bankruptcy courts have held thatcreditors can attack D&O insurance if the company files for bank-ruptcy, the company must ensure that the order of payment specifiesthat directors and officers take priority over the company. If not, cred-itors can use the policy to relieve the company’s debts, leaving nothingto cover the claims against directors and officers.

• Venue & Choice of Forum: Venue and choice of forum refer to where aclaim is to be adjudicated. A company would be wise to require claimsbe defended in close proximity to their headquarters to avoid paying fortravel and other travel related expenses.

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CHAPTER 9

PERSONAL LIABILITY AND PIERCING THE CORPORATE VEIL

INTRODUCTION

Chapters 2 and 3 of this Handbook present several situations in which directorsand 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 heldliable for the actions of a corporation, notwithstanding the fact that the corporation wascreated to avoid such liability.

Stockholder liability for actions of a properly functioning corporation are rare, andare premised on the “piercing the corporate veil” theory. In general, liability for the actsof the corporation under a piercing the corporate veil theory involves a flagrant dis-regard and disrespect for the corporate entity and its formalities or the presence offraud. Classic examples are co-mingling of assets and failure to obtain any corporateapprovals. Although piercing claims are brought most frequently against parent corpo-rations of wholly owned subsidiaries,individual stockholders (such as sole ormajority stockholders) are also sometimessued under this theory.

By asserting that a court should piercethe corporate veil, a plaintiff is requestingthe court to ignore the separate existence ofa corporation, because of fraud or othersimilar injustice, and hold the stockholderspersonally liable for any damages sustainedby the plaintiffs. A court will uphold this request if it would be inequitable or unfairnot to do so. “Persuading a Delaware court to disregard the corporate entity is a diffi-cult task,” and therefore corporate veil piercing is rarely successful.270 Because it is sorare, interpretations of the theory vary among the Delaware federal and state courts.The reasoning of the cases that discuss whether a parent corporation will be held liablefor the obligations of its subsidiary has not always been uniform or clear. Some courtshave referred to a subsidiary as the mere instrumentality or alter ego of the parent,

When the corporate existence isflagrantly disregarded or abused,it is possible that parent corpo-rations or substantial stockholdersof a corporation may be found tobe liable for the actions of thecorporation under a theoryreferred to as “piercing the corpo-rate veil.”

270 Harco National Insurance Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114 at *10(Del. Ch. Sept. 19, 1989).

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others have referred to an agency relationship between the two corporations, while stillothers have referred to “piercing the corporate veil.”271 Regardless of the term used bydifferent courts, the presence of fraud is generally one of the court’s main consid-erations when deciding whether or not to “pierce the corporate veil.”

FRAUD

Delaware courts have stated that “fraud has traditionally been a sufficient reasonto pierce the corporate veil.”272 For example, in Gadsden v. Home Preservation Com-pany, Inc.,273 the plaintiff sued the defendant corporation for failure to perform homerepairs pursuant to a contract. The plaintiff obtained a judgment, but was unable to

enforce it when she learned that thecorporation had no assets. Shesought to pierce the corporate veil sothat she could enforce the judgmentagainst the defendant sole stock-holder, who was also the sole direc-tor and employee of the corporation.The court held that the “businesspractices of [the defendants] con-stituted a fraud, contravention ofcontract, and a public wrong” andfound the sole stockholder liable forthe judgment.274 Several factorssupported the court’s decision in theGadsden case, including thefollowing facts:

• The corporation had no funds in its bank account, and any money that wasplaced there was quickly withdrawn by the stockholder;

• The corporation had no assets – all tools and equipment used to perform homerepairs were owned by the stockholder. Nonetheless, the corporation con-tinued to fraudulently guarantee its repairs for 10- and 20-year periods;

A court held a stockholder liable under afraud theory in a situation where:

• The corporation held no money in itsaccounts;

• The stockholder withdrew all amountsplaced in the corporation’s accounts;

• All assets used by the corporationbelonged to the stockholder;

• The stockholder always presumed thathe would be liable for the acts of thecorporation; and

• The plaintiff was an individual.

271 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 839 (D. Del. 1978).272 Harco National Insurance, 1989 Del. Ch. LEXIS at *10.273 No. 18888, 2004 Del. Ch. LEXIS 14 (Del. Ch. Feb. 20, 2004).274 Id. at *18.

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• The stockholder testified that he always intended to be personally respon-sible for the obligations of Home Preservation; and

• The plaintiff was a homeowner rather than a more sophisticated and knowl-edgeable creditor.275

After considering these factors, the court held the defendant stockholder personallyliable because “to uphold the corporate status of Home Preservation in these circum-stances would be tantamount to blessing a scheme for business owners to defraudcreditors routinely.”276

INSTRUMENTALITY

Alleging that a corporation is a mere instrumentality of an individual stockholderor a parent corporation is another way plaintiffs may attempt to make stockholdersliable for a corporation’s wrongs. This theory can be successfully asserted without ashowing of fraud.277 Two cases provide an illustration of 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 thecorporation’s stock for an employee,with the corporation serving astrustee.278 In an attempt to replacethe trust, the defendant, rather thanthe trustee corporation, entered intoan agreement with the employee tomake an outright gift of the shares.The actual shares were nevertransferred, and after the employee’s death, the defendant refused to give theshares to her executor because he argued that the gift was not an enforceablepromise. The court ignored the existence of the trustee corporation, not onlybecause of the number of shares that he owned and the tremendous controlhe exercised over the corporation, but also because his testimony indicatedthat “he considered himself as the trustee and, both directly and indirectly. . .

275 Id. at *16.276 Id. at *18.277 Walsh v. Hotel Corp. of America, 231 A.2d 458, 461 (Del. 1967).278 99 A.2d 490 (Del. 1953), modified, 102 A.2d 538 (Del. 1954).

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Where a stockholder uses acorporation solely as aninstrumentality or an alter egoand does not respect itsexistence, courts have found thestockholder to be liable for theacts of the corporation.


regarded himself as the corporation.”279 The court found the promiseenforceable because the employee had given up the trust in consideration ofthe outright gift. It did not matter that the offer was made by the defendantrather than the trustee corporation because the corporation was considered aninstrumentality of the defendant.

• In Walsh v. Hotel Corp. of America, the court allowed the plaintiff to amendher complaint to assert that the defendant was liable for the acts of its whollyowned subsidiary.280 The plaintiff was injured while staying at a motel oper-ated by the subsidiary and sued the defendant parent corporation. Given thatthe defendant’s name was the only one displayed in the lobby and on themotel’s stationary and that the defendant was listed as the operator of themotel in a reputable financial handbook, the court held that there were suffi-cient facts to permit the amendment and allow additional investigations insupport of the instrumentality theory of liability.

ALTER EGO THEORY

The alter ego theory of liability has been characterized as another name for theinstrumentality theory,281 as a method of piercing the corporate veil, and as a closerelative of the veil-piercing theory.282 Regardless of the way it is described, the ele-ments of the theory generally are similar to the instrumentality or veil-piercing theo-ries. Before a court will ignore the corporate form and hold stockholders liable on thisground, it will consider the following factors:

• Whether the corporation had adequate access to the capital needed for thecorporate undertaking;

• Whether the corporation was solvent;

• Whether dividends were paid;

• Whether corporate records were kept;

• Whether directors and officers functioned properly;

279 Id. at 493-94.280 Walsh, 231 A.2d at 461.281 Id.282 Harper v. Delaware Valley Broadcasters, Inc., 743 F. Supp. 1076, 1085 (D. Del. 1990).

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• 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 thedominant stockholder.283

Furthermore, it is important to note that “no single factor could justify a decisionto disregard the corporate entity, but that. . . an overall element of injustice or unfair-ness must always be present as well.”284 This “element of injustice” does not need toequate to a finding of fraud, but without it, a plaintiff cannot successfully assert thealter ego theory.

Harper v. Delaware Valley Broadcasters, Inc.provides an example of a court’s analysis of thealter ego theory.285 In Harper, an independent con-tractor was hired by Delaware Valley BroadcastersLimited Partnership, and after the partnership failedto compensate him fully, he sued the partners alongwith the defendant Delaware Valley Broadcasters,Inc. under an alter ego theory. In support of thetheory, he alleged that the only directors of thedefendant were the partners, one of which was alsoa majority stockholder of the defendant; that the

partnership was the only source of funds for the defendant, and that the defendant’sonly business was to provide management services to the partnership. Without discus-sing the sufficiency of these factors, the court determined that the element of injusticewas not present in this case. Like the court in Gadsden, the court focused its attentionon the sophistication of the plaintiff. Here, the plaintiff was a stockholder and directorof the defendant and was aware of the relationship between the partnership and thedefendant. Beyond the loss of compensation, no other injustices existed, and the courtrefused to ignore the separate legal existence of the defendant.

In addition to indicia ofdisregard of the corporateentity, an element ofinjustice must nearlyalways be present before acourt is likely to determinethat piercing is appro-priate under the alter egoor fraud theories ofliability.

283 Harco National Insurance Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *11-12(Del. Ch. Sept. 19, 1989) (quoting United States v. Golden Acres, Inc., 702 F. Supp. 1097, 1104 (D. Del.1988)).

284 Id.285 743 F. Supp. 1076 (D. Del. 1990).

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ESTOPPEL

Equitable estoppel is another theory that courts have relied upon in finding astockholder liable for the acts of a corporation. For example, in Mabon, Nugent & Co.v. Texas American Energy Corp,286 the court held that when “a party by his conductintentionally or unintentionally leads another, in reliance upon that conduct, to changeposition to his detriment,”287 the party cannot later avoid liability by denying responsi-bility for the unpaid debt obligations of its wholly owned subsidiary. In reaching itsdecision, the court noted that:

• The consolidated assets and liabilities of both the parent and subsidiarycompanies were identical;

• The parent and subsidiary companies were jointly managed, financed by ajoint agreement and had entered into several inter-corporate transfers;

• The parent corporation’s Form 10-K and various credit rating services statedthat the debt obligations of the subsidiary were the obligations of the parentcorporation; and

• The plaintiffs actually relied on these factors.288

As a result, the court refused to allow the defendants to deny their responsibility forthe debt obligations of the subsidiary.

ALTERNATIVE THEORY OF STOCKHOLDER LIABILITY: AGENCY

Parent corporations may also be held liable for the acts of their subsidiaries on atheory of agency. For example, if a court finds that a parent controls its subsidiarysuch that the subsidiary is in essence only an agent of the parent, then the parent maybe found liable for any wrongdoing by the subsidiary. Factors that may support ashowing of control are common:

• Stock ownership;

• Directors and officers;

286 No. 8578, 1988 Del. Ch. LEXIS 11 (Del. Ch. Jan. 27, 1988).287 Id. at *11 (quoting Wilson v. American Ins. Co., 209 A.2d 902, 904 (Del. 1965)).288 Id. at *10-11.

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• Financing arrangements;

• Responsibility for day-to-day operations;

• Arrangements for payment of salaries and expenses; and

• Origin of the subsidiary’s business and assets.289

No single factor is sufficient to prove that an agency relationship exists, but thefact 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 forthe subsidiary’s acts.290

Importantly, some courts have held that holding aparent company liable for the acts of the subsidiary doesnot require a showing of fraud or other inequity, aswould be required for a showing of liability under atheory of corporate veil piercing.291 However, demon-strating that a subsidiary is an agent of a parent is a

difficult burden for a plaintiff. For example, in Japan Petroleum Co., the court held thata subsidiary was not the agent of a parent company despite the facts that:

• The companies had joint operations;

• The companies shared common directors and officers; and

• The parent exerted control over the subsidiary’s finances.292

Agency is an alternativetheory of parent liabilityfor a subsidiary corpo-ration that does notgenerally require ashowing of fraud orinequity.

289 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 841 (D. Del. 1978).290 Id.291 Id. at 840.292 Id. at 840-45.

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VEIL PIERCING IN THE CONTEXT OF FIDUCIARY DUTY BREACH

This chapter discussed the circumstances by which a stockholder, who may ormay not be a director, could be found liable for the actions of a corporation. The doc-trine of corporate veil piercing has only been explicitly used in stockholder liabilitycases, but the idea behind it, that of ignoring a corporation’s separate existence, hasalso surfaced in director liability cases. For example, in Grace Brothers, Ltd. v. Uni-Holding Corp.,293 a court rejected claims by defendant directors that they could not beliable for acts of a subsidiary because they were directors of a parent corporation. Inreaching this decision, the court noted that one director was the chairperson of thesubsidiary and that all directors knew about the challenged transaction of the sub-sidiary and could have acted to cause the subsidiary to avoid the action. While GraceBrothers should not be viewed as a traditional corporate veil piercing case, it doesshow how the doctrine plays a role in more traditional director liability cases and setsforth the responsibilities directors have with regard to their subsidiary corporations.

293 No. 17617, 2000 Del. Ch. LEXIS 101 (Del. Ch. July 12, 2000).

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