Fiduciary Duties and Other Responsibilities

Fiduciary Duties and Other Responsibilities of Corporate Directors and OfficersSixth Edition

Christopher M. ForresterShearman & Sterling LLP

Celeste S. Ferber, Esq.

Foreword by John BuleyProfessor of the Practice of FinanceDuke UniversityFuqua School of Business

FIDUCIARY DUTIES ANDOTHER RESPONSIBILITIESOF CORPORATEDIRECTORS ANDOFFICERS

Christopher M. ForresterShearman & Sterling LLP

Celeste S. Ferber, Esq.

Foreword by John BuleyProfessor of the Practice of FinanceDuke UniversityFuqua School of Business

Sixth Edition

Copyright© 2008–2016 Christopher M. Forrester & Celeste S. Ferber(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 the authors.

This publication reflects the views of its authors only and does not necessarily reflect theviews of Shearman & Sterling LLP or any clients of any such firm. Because this pub-lication is intended to convey only general information, it may not be applicable in all sit-uations and should not be relied upon or acted upon as legal advice. It does not constitutelegal, 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 substantial majority of publicly traded U.S. corporations are incorporated inDelaware and that courts in other jurisdictions often look to Delaware court decisions forguidance, the information provided in the Handbook is premised principally on Delawarelaw, unless otherwise noted. This handbook is limited to the laws that affect corporations,as compared to other forms of business entities, such as partnerships and limited liabilitycompanies.

None of the information contained in this Handbook is intended to constitute legal adviceor establish an attorney-client relationship with the authors or Shearman & Sterling LLP orany of the attorneys in that firm, and you should not rely on any of the information in thisHandbook without consulting with your legal counsel as to your specific circumstances.

This handbook was prepared and published as of March 2016 and does not reflect develop-ments or events occurring after that time.

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About the Authors

Christopher M. ForresterAs a partner in Shearman & Sterling LLP, Christopher M. Forrester’s practice focuses on therepresentation of public and private companies and investment banks in general corporate andfinance matters, with an emphasis on mergers, acquisitions and strategic transactions, publicand private securities offerings and corporate governance and compliance.

Celeste S. FerberCeleste Ferber is former counsel in Shearman & Sterling LLP’s Capital Markets Group andnow serves as Associate General Counsel of Aduro Biotech, Inc. Ms. Ferber has extensiveexperience representing issuers and underwriters in public and private securities offerings andon a broad range of transactional, securities and corporate governance matters.

Contributing AuthorsThe following Shearman & Sterling LLP partners provided assistance in the editorial processfor this work: Robert Evans, Michael Kennedy, Patrick Robbins and Fredric Sosnick.

The following Shearman & Sterling LLP associates provided substantial contributions to thepreparation of this Sixth Edition of the Handbook: Antonio Herrera Cuevas, Chen Ye, JeremyCleveland, Nathan Mee, Patrick Fischer, Scott Lucas and Yian Huang.

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FIDUCIARY DUTIES AND OTHER RESPONSIBILITIES OFCORPORATE DIRECTORS AND OFFICERS

TABLE OF CONTENTS

Page

FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv

OVERVIEW OF THE HANDBOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi

CHAPTER 1 MANAGING THE BUSINESS: THE ROLES OF DIRECTORS ANDOFFICERS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1The Interaction Among the Board, the Chief Executive Officer and the Other Officers . . . . 2Board Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5Appointment to Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8Identifying the Constituents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Governing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12Mitigating Liability Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

CHAPTER 2 GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OFDIRECTORS AND OFFICERS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Determining the Standard of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Duty of Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Duties of Loyalty and Good Faith . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22Duty to Disclose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Entire Fairness Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Director Liability and Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

CHAPTER 3 FIDUCIARY DUTIES IN THE CONTEXT OF A BUSINESSCOMBINATION TRANSACTION

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Board Considerations in any Business Combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38Precautions in any Business Combination Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39Revlon and a Sale of the Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40Review of Directors’ Duties in the Context of a Potential Business Combination

Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46Unocal and Defending Against Hostile Takeovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47Review of Directors’ Duties in the Context of Responding to a Hostile Takeover . . . . . . . . . 53Special Case: Use of a Poison Pill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54Special Case: Director Duties in the Face of Activist Stockholder Demands . . . . . . . . . . . . . 57Review of Directors’ Duties in the Context of Responding to Activist Stockholder

Demands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

CHAPTER 4 FIDUCIARY DUTIES IN THE CONTEXT OF A GOING PRIVATETRANSACTION

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Standards of Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63SEC Requirements and Scrutiny of Going Private Transactions . . . . . . . . . . . . . . . . . . . . . . . 71

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CHAPTER 5 THE USE OF SPECIAL COMMITTEESIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Committee Composition: Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Committee’s Charge: Be Informed and Active . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75The Committee’s Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Legal Duties of Special Committee Members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79Overview–When Should a Special Committee be Considered? . . . . . . . . . . . . . . . . . . . . . . . 80Considerations in Determining Whether an Individual or Firm May be Viewed as

Disinterested and Independent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

CHAPTER 6 FIDUCIARY DUTIES IN THE CONTEXT OF A DISSOLUTION ORINSOLVENCY

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83Determining When a Corporation has Become Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84Duties to Creditors When the Corporation is Insolvent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86Duty of Loyalty Considerations in the Context of Insolvency—Delaware’s Rejection of

Deepening Insolvency Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90Duties During Bankruptcy Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Duties After Dissolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94Things to Remember When Managing a Business on the Verge of Insolvency . . . . . . . . . . . 95

CHAPTER 7 ATTORNEY-CLIENT PRIVILEGE IN A CORPORATE CONTEXTIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Scope of Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Invoking and Waiving Privilege . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100Examples of Waiver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102Privilege Versus Confidentiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105Privilege in Derivative Suits and Class Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108Privilege in Corporate Investigations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

CHAPTER 8 INDEMNIFICATION AND INSURANCEIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116Indemnification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122D&O Insurance Terms to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

CHAPTER 9 PERSONAL LIABILITY AND PIERCING THE CORPORATE VEILIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138Instrumentality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139Alter Ego Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140Estoppel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

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Alternative Theory of Stockholder Liability: Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143Veil Piercing in the Context of Fiduciary Duty Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

CHAPTER 10 NONPROFIT ORGANIZATIONSIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145Managing the Business and the Roles of Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . 145Fiduciary Duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146The Use of Committees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147Attorney-Client Privilege in a Nonprofit Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148Indemnification and Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148Personal Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

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FOREWORD

I am honored to write the Introduction to the Sixth Edition of Fiduciary Dutiesand Other Responsibilities of Corporate Directors and Officers. I am grateful to myfriends Chris Forrester and Celeste Ferber, and their colleagues at Shearman & Ster-ling for providing an accessible resource for managers, directors, investors and otherlawyers.

While a business practitioner, I often referred to prior editions of this book for itsconcise, comprehensive, jargon-free, practical guide to the roles of officers and direc-tors. This book’s lessons proved valuable in numerous business combinations, divest-itures, financings and insolvency and bankruptcy proceedings. As an academic, I betterappreciate its utility in training current and future business leaders. Understanding theroles and duties of officers and directors to the corporation is critical; and under-standing the relationship between the corporation and its shareholders is increasinglyimportant in the current business climate.

It was not always so. Until the late 1980s, corporate governance in general andthe role of officers and directors was not of great interest to academics, business pro-fessionals or all but very specialized lawyers.

How times have changed. The merger waves of the past three decades, the lever-aged buyout boom, and the advent of poison pills and other defensive tactics have shineda spotlight on the duties and responsibilities of officers and directors to their companiesand shareholders. Business practitioners read, “The business and affairs of every corpo-ration…shall be managed by or under the direction of a board of directors” but neededbetter understanding of that phrase in order to hold their positions and exercise theirresponsibilities. Directors and officers were well aware that they should “act in the bestinterests of the corporation,” but what exactly did that term mean? To some, the termmeant exactly what it said. A few academics invented the phrase “maximizing share-holder value” in the short term despite long term or potential negative consequences tolong-term interests of corporations, other stakeholders or long term shareholders.

Scandals at Adelphia, Enron, WorldCom, Global Crossing, Tyco and others high-lighted the need for informed, knowledgeable business professionals who not onlyunderstand their businesses but who also understand the governance frameworkagainst which they are held accountable. Officers and directors of public and privatecompanies sharpened their understanding of Delaware Corporate Law using prior edi-tions of this book, not to replace the need for legal advice but to understand the contextin which legal advice is provided. A new federal law, Sarbanes-Oxley, was enacted toenhance governance and insert specific rules into the corporate governance so thatsuch scandals, and the judicial rulings discussed in this book, would never again occur.

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It was not to be. The Global Financial Crisis of the next decade and failures ofcorporate governance at Bear Stearns, Lehman Brothers and many other financialinstitutions demonstrated (as if further demonstration was needed) that men andwomen engaged in business need to have basic legal principles in a single source as areference tool to understand the context upon which their conduct and decisions wouldbe judged. This book is also helpful in understanding the context of the legal adviceprovide by in-house and outside counsel.

We do not know what the next decade will bring, but we do know that nearly allpublic company mergers and acquisitions result in litigation claiming officers anddirectors were not “acting in the best interests of the corporation.” We can expect thatshareholders and activist investors will continue to fight “the battle for corporate con-trol” between shareholder democracy and Board of Director independence. We canalso expect the next edition of this book to be longer.

This book is written with a keen eye towards the needs of business practitioners,senior officers and directors, and persons advising the above. It is an important compi-lation of relevant, highly readable, indexed chapters on each of the issues facingcorporate managers and directors and those who advise them. Corporate governance isimportant and a wealth of academic research demonstrates shareholders will pay apremium for shares of public companies with good corporate governance.

To you, the reader, I offer the same advice I have given to hundreds of MBAstudents who have received this book—When air turbulence hits the plane at 35,000feet, you know you should have listened to the safety instructions and read the safetycard instead of checking email before the fasten seat belt sign came on. Just as youinstinctively reach for the printed instructions in the seatback in front of you to figureout where the nearest exit may be, carry this book with you, even if you do not read itcover to cover. You never know when you will have to excuse yourself from a meetingto read the clear, specific, precise and practical guidance contained in this book.

John BuleyProfessor of the Practice of FinanceDuke UniversityFuqua School of BusinessJanuary 2016

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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 the 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 business judgment rule isa court-developed doctrine that is designed to provide directors and officers with thelatitude to exercise their judgment in furtherance of managing the corporation’s busi-ness and affairs without fear of having every one of their actions second-guessed bylitigious stockholders and 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.

Chapter 10 discusses fiduciary duties and other responsibilities of officers anddirectors of non-profit corporations generally.

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CHAPTER 1

MANAGING THE BUSINESS: THE ROLES OF DIRECTORSAND OFFICERS

INTRODUCTION

Corporate laws in the United States provide that the board of directors is respon-sible for the management of the corporation’s business and affairs. In managing thebusiness and affairs of corporations, boards typically act in a supervisory role, anddelegate the details of the day-to-day management of the business to the officers of thecorporation. This construct provides a balance between the officers who have actualand apparent authority to direct and control the daily activities of the business and theboard of directors which has the ultimate responsibility for the corporation and thepower and responsibility to supervise the officers. While the officers are 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 directorsare not agents and generally can act only as a group. The directors are fiduciaries ofthe corporation and as a group have the ultimate power and authority over the manage-

ment of the business through their ability to hire,supervise and replace the officers.1

In addition to having the responsibility tosupervise and, if necessary, replace the officers, theboard is charged by law with the power andresponsibility to approve major corporate actions,such as issuing securities, entering into a merger,converting the business from a corporation to a

limited liability company, partnership or other form, disposing of substantially all ofthe corporation’s assets or dissolving the corporation. Further, through their super-visory powers, boards frequently require the officers to obtain board approval forevents 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-

1 8 Del. C. §141(a).

The officers are chargedwith managing the day-to-day operations of thecorporation while the boardis responsible for the overallmanagement of the corpo-ration and supervision ofthe officers.

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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 boardof directors, 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 –to manage 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, or in addition to, a president pursuant to bylawprovisions.

It is important to note that eachcorporation may approach the rolesof, and interaction between, man-agement and the board somewhatdifferently. The decision as to howmuch power and authority to vest inthe management and what level ofinvolvement the board will have inthe activities of the business is a decision for each board to make, which is then memo-rialized in the corporation’s charter, bylaws and corporate resolutions, as well as boardpractices, committee charters and meeting agendas.

THE INTERACTION AMONG THE BOARD, THE CHIEF EXECUTIVE OFFICER

AND THE OTHER OFFICERS

In general, most boards seek to fulfill their obligation to supervise the managersprimarily by consulting with the corporation’s most senior officer (usually the chiefexecutive officer) on major decisions affecting the business, and reviewing, guiding

2 See, e.g., 8 Del. C. §§151-52, 251-66, 271-85.3 8 Del. C. §142.4 See, e.g., 8 Del. C. §142.

Although the board ultimately supervisesthe activities of all of the officers inmanaging the business, typically the chiefexecutive officer reports directly to theboard, and the other “C-level” officers,including the chief operating and chieffinancial officers, and vice presidents,report to the chief executive officer.

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and ultimately supervising the performance of the chief executive officer. The chiefexecutive officer, in turn, generally is charged with the power and authority to super-vise the other officers, who report directly to the chief executive officer rather than theboard. Notwithstanding this practical chain of command, most corporations’ bylawsprovide that senior officers are selected by the board, meaning that, while the officersother than the chief executive officer report to the chief executive officer, the boardwill remain actively involved in establishing and evaluating the duties and perform-ance of those officers. Beyond the chief executive officer, typical officer positions andtheir general responsibilities are as follows:

• President. The president is responsible for the supervision of the other officersand the day-to-day management of the business. If an organization does nothave a separate chief executive officer, then the president is generally the mostsenior position in the organization. If an organization has both a chief executiveofficer and a president, those officers generally work very closely to supervisethe other officers and manage day-to-day operation of the business.

• Secretary. The secretary is the person respon-sible for keeping the books and records of thecorporation, including the corporate minutebook.5 As such, the secretary attends boardmeetings to keep minutes, although the corpo-ration’s legal counsel is sometimes chargedwith preparing the initial draft of the minutes.As the official keeper of the books and records,the secretary generally is responsible forcertifying the accuracy of corporate documentsto third parties, for example, banks or financingsources.In many companies, this position is held by the General Counsel.

• Treasurer. The treasurer is generally the most senior financial position in thecorporation, although companies often use the title chief financial officer asthe most senior level financial position. The treasurer is charged with main-taining the corporation’s finances as well as supervising the accountingfunctions of the business. In larger companies, it is common not only to have

5 8 Del. C. §142(a).

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


a chief financial officer who serves the role of treasurer, but also to have acontroller who performs the accounting functions and a vice president offinance who is in charge of the financing aspects of the business.

• Vice President. Vice presidents can be appointed to oversee specific busi-ness functions, such as sales, marketing, research and development, humanresources, information technology or finance. Although generally vicepresidents are appointed by and report to the board, the bylaws may providethat certain vice presidents may be appointed by (and report to) other offi-cers of the corporation, such as the chief executive officer 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 authority as such, and their specificduties and reporting structure will be specified in the bylaws. However,many companies draw distinctions between executive officers and non-executive officers, with executive officers being viewed as the primarycorporate officers while the non-executive officers are considered a class ofjunior officers without the same powers or responsibilities. As noted above,to truly ascertain the power, responsibility and reporting authority of officersof a particular corporation, it is necessary to consult its bylaws.

• Executive Chairperson. It is notable that although the DGCL contemplatesthat non-management directors are not officers and therefore cannot act tobind the corporation, in some states by law, the chairperson of the board alsois specifically designated as an officer position.6 Also, many companiesspecifically create an office of the Executive Chairman in their bylaws, inwhich case the Executive Chairman typically is designated an officer.Executive Chair positions may be created to separate the CEO and Chairmanrole, to allow for support of a CEO by a strong Executive Chair, or for otherreasons in the discretion of the board. To ascertain whether the chairpersonof a particular corporation is or is not an officer, and to understand thatofficer’s powers and authority, one must consult the bylaws of the corpo-ration and resolutions of the board.

6 See, e.g., Cal. Corp. Code §312.

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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 ofcalling 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). Notice of meet-ings may always be waived by directors at anytime either in writing or by their presence at ameeting. The agenda for meetings and support-ing materials should be distributed in advancewhenever possible so that the directors have anopportunity to prepare for the meeting andprovide 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 bespecified in the bylaws (but in no event will be less than one third of the total numberof directors); in the absence of a specific quorum requirement, the DGCL provides adefault rule of not less than a majority of the board members.7 Once a board meeting isduly convened and a quorum is present, in the absence of a specific provision in thebylaws otherwise, the vote of a majority of the directors present and voting at the meet-ing will be sufficient to constitute an action of the board.8 In addition to taking action ata properly convened meeting, a board may take action by written consent, which mustbe signed or electronically consented to by all directors. Unanimous written consentsare not effective until all signatures or electronic consents have been obtained.9

7 8 Del. C. §141(b).8 Id.9 8 Del. C. §141(f). However, in the case of publicly listed companies, in many cases specific actions

must be approved by a majority of the board’s “independent” directors or a committee comprised solely ofindependent directors. In these cases, the definitions of independence are specified by rules of the U.S.Securities and Exchange Commission or the stock exchange on which such Company’s shares are listed.

The chairperson of the board isgenerally responsible formanaging the affairs of theboard, including calling meet-ings and setting agendas.

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Not infrequently board members may speak of having the power to vote byproxy. Unlike stockholders, however, board members cannot vote by proxy.10 Theessence of the board’s effectiveness is its ability to engage in meaningful discussionsand deliberations where all members of the board can express their views and debatethe potential risks and benefits of a particular course of action. The concept that one ormore board members may be individually briefed on a topic privately and then delivertheir vote privately by proxy is contrary to the concept of a robust board deliberation.

Extra care should used to permit the attendance of all or as many of the boardmembers as possible, particularly for sensitive and important matters. The importanceof directors’ participation and attendance at board meet-ings is underscored by the fact that the rules and regu-lations of the U.S. Securities and Exchange Commission(“SEC”) require that reporting companies under the Secu-rities Exchange Act of 1934 (the “Exchange Act”) dis-close if directors have failed to attend 75% of board andcommittee meetings.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 examples of this are the audit committee and the compensationcommittee. The rules of the SEC and the listing rules of the national securitiesexchanges, such as the New York Stock Exchange and The Nasdaq Stock Market,specifically require that reporting companies whose stock is listed on a national secu-rities exchange maintain an audit committee and a compensation committee, eachcomposed entirely of “independent directors.”12 Independent directors are defined asdirectors who, among other things, do not receive compensation from the companyother than in their role as a director, are not part of management and who do nototherwise have a role or relationship with the corporation that has the potential of

10 In re Acadia Dairies, Inc., 15 Del. Ch. 248 (1927). This rule is commonly misunderstood becausesome jurisdictions, such as the Cayman Islands, do permit directors to vote by proxy.

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 Nasdaq Listing Rule 5605; NYSE Listing Rules 303A.05 and 303A.06; see also 17 C.F.R. 240.10A-3 and 17 C.F.R. 240.10C-1.

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

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The rules of the SEC and the list-ing rules of the national securitiesexchanges, require a board tohave an audit committee com-posed of independent directorsand that includes a designated“audit committee financialexpert.”

The listing rules of the nationalsecurities exchanges require thata board have a nominatingcommittee and compensationcommittee composed ofindependent directors.

creating any conflict of interest. In addition, members of a public company’s auditcommittee are expected, through formal education or experience, to have enhanced skillsin reading and understanding financial statements and in accounting matters generally.

The audit committee is charged withapproving the corporation’s auditors, super-vising the chief accounting officer of thecorporation in the preparation of the corpo-ration’s financial statements, monitoringcomplaints by employees regarding financialmatters, and other important financial andaccounting-related matters.13

The compensation committee is charged with establishing and reviewing thecompensation policies and procedures for the senior officers, as well as administer-ing the corporation’s compensation and equity incentive plans. In addition, approvalof compensation packages by compensation committees composed of non-employeedirectors can provide certain required appro-vals under the Internal Revenue Code neces-sary to make certain of the corporation’scompensation payments tax-deductible. Inaddition, many companies utilize a nominat-ing and/or corporate governance committeeto help manage the affairs of the corporation(the national securities exchanges also require independent oversight of director nomi-nations – either through a formal committee, or approval of the independent membersof the board). Nominating committees generally evaluate directors’ performance andinterview and nominate director candidates for board and stockholder consideration.Boards may also delegate other duties and functions to committees of the board, withcertain limitations specified in the DGCL.

13 Id.; see also 15 U.S.C.S. §78j-m.


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.Nominees for director can be made by any shareholder or by the board of directors.Public companies generally do not include directors nominated by shareholders in theproxy materials that are prepared and filed with the SEC. Given that many share-holders vote in advance of the meeting by proxy, the fact that the director nominees ofshareholders are not included in the proxy materials can effectively preclude suchnominees from having a meaningful opportunity to be elected. In an effort to modifythis trend, in August 2010, the SEC modified the proxy rules to adopt newRule 14a-11 to require, among other things, that a company include in its annual proxystatement the names of directors nominated by shareholders who have held shares forat least three years and who hold at least three percent of the company’s outstandingcommon stock. Rule 14a-11, however, was vacated in 2011 by a federal court thatfound the SEC had exceeded its authority (although Rule 14a-8 remains and provides

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 is not intended to place additional liability onthe individual designated. 17 C.F.R. 229.407(d)(5)(iv)(B).

15 8 Del. C. §211(b).

Being designated as the“audit committee finan-cial expert” is notintended to place addi-tional liability on theindividual designated.

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shareholders some ability to influence matters included in proxy statements).16 Theconcept has nonetheless been picked up by shareholders and shareholder rights groups,and currently many public companies are being pressured to implement, and some areimplementing, policies and procedures that permit shareholder nominees to beincluded in company proxy materials even though they are not required to do so bylaw. Even if proxy access rules become operative, a company may still require stock-holders to give advance notice of their intention to propose nominees for director by anappropriate bylaw provision.

The default rule under the DGCL is that the slate of directors receiving the mostvotes (a plurality) at a properly convened meeting of stockholders or by written con-sent of stockholders, if applicable, will be elected to office. Recently, many publiccompanies have modified their charters to require that directors must actually receive amajority of the outstanding votes, or at least a majority of the shares voted at the meet-ing to be elected or, alternatively, if a director receives fewer votes for reelection thanwithheld votes, the director must submit a resignation 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 strat-ification of a board into classes, with eachclass having a term that expires in succes-sive years.17 This is commonly referred toas a classified or staggered board. The mostfrequent example is a board of three classeswith each class having a three-year term andexpiring on successive years. Some believethat classified boards provide stability byensuring that at any one election, only aportion of the board will bere-elected. On the other hand, classified boards have been used as a device to resisthostile takeovers, and many stockholder rights activists believe that classified boardsunduly impair the stockholders’ fundamental right to change the board, if they believe

16 Business Roundtable and Chamber of Commerce of the United States of America v. Securities &Exchange Commission (D.C. July 22, 2011).

17 8 Del. C. §§141(d), 211.

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, in response toshareholder pressure, some publiccorporations have modified theirbylaws to specifically require thatdirectors must receive a specifiedminimum number of sharesapproving their candidacy beforethey will be elected.

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that the corporation is not being managed appropriately. Use of classified boards in thecontext of takeover defenses is discussed 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.18 Many boards feel, and rightly so,that to effectively discharge their duties to manage the business and affairs of thecorporation, they should regularly evaluate, counsel and supervise the entire manage-ment team to some degree. For this reason, although a board may delegate themanagement and performance review of the subordinate officers of the corporation tothe chief executive officer, most boards exercise some level of supervision over themost senior officers of the corporation including the chief financial officer, chief oper-ations officer, president and vice presidents.

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, ven-dors, creditors (and bondholders), contract counterparties, customers, communities,society and, of course, stockholders to consider. Whom do you serve first? So long asa particular decision benefits all parties equally, the decision of a board and manage-ment team is quite easy. The difficulty arises when decisions do not affect all partiesequally.

Although not always easy in application, there is a clear legal answer to the ques-tion: a corporation’s board and managementowe a fiduciary duty as their primary obliga-tion, above all others, to the stockholders, tomaximize the value of the equity of the corpo-ration.19 Fiduciary duty is a core legal concept,perhaps the most fundamental legal conceptthat underlies the manner in which U.S. corpo-rations are managed. A fiduciary owes an

18 8 Del. C. §142.19 There is increasing support in the public and various state legislatures for new corporate forms that

allow or require directors to consider the interests of constituencies other than shareholders, such as theiremployees, communities and the natural environment, in making decisions.

In a solvent business, directorsand officers of a Delawarecorporation are bound by afiduciary duty to manage thebusiness to maximize the inter-ests of the stockholders first andforemost.

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utmost duty of care, candor and confidence to its constituent. A fiduciary must act witha high standard of care with respect to its constituent and must avoid conflicts of inter-ests, including taking actions that would advantage the fiduciary to the disadvantage ofthe constituent.

Directors and officers of a solvent corporation are fiduciaries of the commonstockholders. Consequently, decisions made in furtherance of managing the businessshould first and foremost focus on what is in the best interests of the stockholders.Notwithstanding the apparent oversimplification, it is frequently advisable to considerwhat might be the impact on other constituents of the business, for example, itsemployees, vendors, creditors and contract counterparties, to maximize the long-termvalue of the stockholders. Indeed, a daily focus of the managers of a business is toensure that the business meets its contractual obligations, satisfies its creditors, caresfor its employees and vendors, and pleases its customers. Fortunately, doing thesethings generally will result in building the business for the stockholders, so that theinterests of constituents are aligned.

Unfortunately, as business conditions change, boards and officers may be unableto make decisions that satisfy all constituents and instead must focus on maximizingvalue for the stockholders. These decisions may be difficult and may involve damag-ing long-standing and important personal relationships – for example, substantial lay-offs for the benefit of the business and mergers or acquisitions that may result in theshutdown or wind-up of business units or may otherwise affect the status of employ-

ees. When these challenging decisions must be made,it is critical to remember the board’s fundamentalobligation to act in the best interest of the stock-holders. After all, it is the stockholders who haveselected the directors and the directors who have

selected the officers who are entrusted to manage 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 heldby stockholders). Therefore, the primary duties of the board and management shiftfrom protecting the interests of the stockholders to protecting the interests of the

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

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corporation’s creditors. These situations present boards and officers with some of themost difficult decisions they face. The specific and complicated duties and demandsplaced on boards and officers when a corporation becomes insolvent are discussed indetail 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. Directors and officers must be aware of federal and state statutesand regulations as well as local ordinances that may affect the facilities and localactivities of the business. For example, state employment laws can be complex andprovide for substantial penalties and fines if they are disregarded. Federal and statelaws affecting employee benefits and healthcare often are byzantine and implicatecorporate, employment and tax considerations as well as complicated contractual obli-gations with third-party insurers and administrators.

Some states, such as California, seek to impose their corporate laws on corpo-rations domiciled in other states but that engage in substantial business activities in theconcerned state.20 Federal, state and foreign income tax and state sales tax laws applyto corporations in varying degrees and are aggressively enforced. Federal and statesecurities laws affect the manner in which a corporation markets and sells its equityand debt securities to investors. Disclosure laws also affect the manner and extent towhich 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, antitrust, 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.

20 See, e.g., Cal. Corp. Code §2115.

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Beyond the realm of statutes, regulations, ordinances and court decisions, thereare also industry standards and guidelines that have a substantial impact on a corpo-ration. The books and records of a U.S. corporation typically must comply with Gen-erally Accepted Accounting Principles or GAAP. Further, many corporations doingbusiness outside the United States must also maintain their books and records inaccordance with International Financial Reporting Standards or other local require-ments, and transactions between U.S. corporations and foreign investors or entitiesmay be subject to national security scrutiny. Stock exchange rules require companiesto establish various committees and promulgate and police procedures and canons. Ontop of these demands, many companies also seek to implement best practices that gobeyond what is required.

MITIGATING LIABILITY CONCERNS

Directors and officers face the tough challenge of navigating a path to profit-ability while making various nuanced business decisions. The last thing that directorsand officers should have to worry about is a court second-guessing their decisions withthe benefit 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.

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, much 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.

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Additional protections potentially available for directors and officers include cer-tificate 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,indemnification provisions contained in a corporation’s certificate of incorporation andbylaws, contractual indemnification agreements, and directors’ and officers’ insurancepolicies. These protections are designed to provide further assurance to directors andofficers so that they feel comfortable exercising their business judgment in a mannerthat they believe best advances the interests of the corporation’s stockholders, withoutunnecessary fear of personal liability. These protections are also discussed in greaterdetail in 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 generally are 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.21 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 their actions on behalf of thecorporation.

DETERMINING THE STANDARD OF REVIEW

Generally, so long as directors and officers complywith their basic fiduciary duties – the duty of care andthe duty of loyalty – they are entitled to the protectionsof the business judgment rule.22 The business judgmentrule provides that directors’ and officers’ decisions are“presumed to have been made on an informed basis, in

21 The business judgment rule historically has protected the actions and decisions of directors and,while Delaware courts and commentators had extended the protections to officers as well by implication,no Delaware court decision had explicitly confirmed the application to officers until recently. In 2009, theSupreme Court of Delaware explicitly extended the scope of the business judgment rule to encompass theactions and decisions of corporate officers. Gantler v. Stephens, 965 A.2d 695, 708-09 (Del. Sup. 2009)(“In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary dutiesof care and loyalty, and that the fiduciary duties of officers are the same as directors. We now explicitly sohold.”). Although corporate officers will receive the protection of the business judgment rule, if theybreach their fiduciary duties, the consequences of the breach will not necessarily be the same as for direc-tors. Under 8 Del. C. § 102(b)(7), a corporation may adopt a provision in its certificate of incorporationexculpating its directors from monetary liability for an adjudicated breach of their duty of care. Althoughlegislatively possible, there currently is no statutory provision authorizing comparable exculpation ofcorporate officers.

22 Some commentators describe fiduciary duties as three separate duties – the duties of care, loyalty andgood faith, although the Delaware courts have now clarified that there are two separate duties – the dutiesof care and loyalty, with the duty of good faith being a subset of the duty of loyalty. See, e.g., In re WaltDisney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006).

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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good faith and in the honest belief that the action taken was in the best interests of thecorporation.”23 When the business judgment rule applies, a court will not substitute itsown views for those of directors or officers or second-guess the outcome of businessdecisions by holding a director or officer personally liable for a mistake in judgment.

Rather, the plaintiff will have the burden of rebutting the presumption and estab-lishing that a fiduciary duty was breached. This requires the plaintiff to produce evi-dence and persuade the court that the evidence demonstrates that the board membersor officers breached their fiduciary duties. In contrast, when the business judgmentrule is inapplicable, courts will closely examine the circumstances surrounding anychallenged business decision and require the directors and officers to demonstrate thatthe particular challenged action was “entirely fair” to the corporation and the con-stituents to whom a duty was owed. The entire fairness standard is a much more exact-ing standard requiring the directors and officers to demonstrate fair price and fairdealing, as discussed in detail on page 32 under the caption “Entire FairnessReview.”24 Directors and officers who are unable to meet the applicable standard ofreview can be personally liable to the corporation and its constituents for their actions.

In certain instances, the business judgment rule will not apply automatically tothe actions of directors and courts may apply a more enhanced level of scrutiny tochallenged actions, such as when:

• The subject transaction or challenged decision involves interested directorsor stockholders;25

• 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 receiving a takeover offer;

• An unsolicited third-party bid is received after a transaction with respect tothe company has been announced; or

23 Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1341 (Del. 1987).24 Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983).25 See, e.g., Marciano v. Nakash, 535 A.2d 400, 405 n3 (Del.1987); see also In re Southern Peru Cop-

per Corporation Shareholder Derivative Litigation, 30 A.3d 60 (Del. Ch. 2011).

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• 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.

In these instances, courts may impose a more rigorous standard which mayrequire the directors to demonstrate the entire fairness of their actions to the stock-holders, or courts may apply the heightened review standard of Revlon or Unocal. TheRevlon and Unocal standards are discussed in Chapter 3 of this Handbook.

It is also important to note that although directors’ fiduciary duties generally aredescribed as consisting of two separate duties – the duty of care and the duty of loyalty– some commentators also consider the duty of good faith and fair dealing to be aseparate duty. However, other commentators and the Delaware courts consider theduty of good faith and fair dealing to be a subset of the duty of loyalty. Nevertheless,courts often evaluate the duties more fluidly, and acts that may constitute a breach ofthe duty of care may be found to be sufficiently egregious to constitute a breach of theduty 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;

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

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

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

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

Breaches of the duty of care typically are 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, such as failing toreview or discuss board materials, act with reckless indifference to stockholder con-cerns or act in a manner that is completely irrational with respect to their decision-making process.26 Consider, for example, several prominent cases:

• 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.27

26 Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).27 Id.

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• No Breach of Duty of Care Where Directors Approved a Substantial Sev-erance Arrangement for an Executive Without Following Best Practices orConsulting a Compensation Consultant. In In re Walt Disney Co.Derivative Litigation, no breach of the duty of care was found in connectionwith the directors’ approval of an employment agreement that resulted in a$130 million severance payment to a president terminated after only oneyear of employment even though the court found that the board failed to takeactions consistent with best practices, including failing to inform themselvesof the estimated severance payments for each year of employment and fail-ing to confer with the compensation expert who had assisted in preparingcompensation figures for the president. The court determined that the direc-tors had acted on an informed basis, in good faith and in the honest beliefthat they were taking action in the best interests of the company.28

• 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 Litigation,29 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.30 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.31 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.32 The court determined that, had itbeen presented with the question, it would not have found the Caremark

28 906 A.2d 27 (Del. 2006).29 698 A.2d 959 (Del. Ch. 1996).30 Id. at 961-62.31 Id. at 971.32 Id. at 970.

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directors liable because they did not and had no reason to know of the viola-tions and had systems in place to check for violations.33

Further, as noted above, courts increasingly are finding that sufficiently egregiousbreaches of the duty of care may also constitute a breach of the duty of loyalty:

• 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,34 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 its oper-ations.35 Significantly, the court held that such directors breached the duty ofloyalty (as opposed to their duty of care) by failing to institute a legal com-pliance system because such failure constituted a failure to act in goodfaith.36 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.

• Potential Breach of Duty of Good Faith When Directors Were GivenSufficient Notice of Safety Violations and Failed to Act. In In re AbbottLabs Derivative Shareholders Litigation, the court found facts sufficient toestablish a breach of good faith when the FDA repeatedly served notices ofsafety violations over a six-year period and the directors took no steps toremedy the violations, resulting in large monetary losses to the company.The court determined that, due to a set of facts indicating their awareness ofthe problem, the board’s inaction appeared to be intentional and, con-sequently, the directors’ decisions were not made in good faith.37 These find-ings were made in connection with the denial of a motion to dismiss, andthis matter was settled prior to a full evaluation of the facts in a trial.

33 Id. at 971-72.34 911 A.2d 362 (Del. 2006).35 Id. at 370.36 Id. at 373.37 325 F.3d 795 (7th Cir. 2003).

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• Breach of Duty of Loyalty Where Directors Abdicated Responsibilities toManagement and Engaged in Rush Sale of Business. In the case In reBridgeport Holdings, Inc.,directors were held to havebreached their duty of loy-alty by abdicating crucialdecision-making authority inthe sale of the company to anofficer of the company, fail-ing to monitor the officer’sexecution of an abbreviatedand uninformed sale process,and ultimately, approving the sale of the business for grossly inadequateconsideration. The court held that the board’s actions were tantamount to anintentional disregard of their duty of care, and thus constituted a breach oftheir duty of loyalty, notwithstanding the fact that the plaintiff did not allegeself-dealing by the board or a lack of independence.38

Reliance on Experts

In discharging the duty of care, directors and officers often are 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 suchreliance is reasonable and in good faith.39 How-ever, if a director has reason to know that theinformation presented by the expert is incorrect,then such reliance is not reasonable and the duty ofcare may not be satisfied. Accordingly, expertsshould be selected with reasonable care – anexpert’s qualifications and experience should be considered in detail. Additionally, anexpert’s independence should be evaluated – experts who stand to earn significant fees

38 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008).39 8 Del. C. §141(e).

In considering an expert’sfindings, directors shouldprobe and test an expert’sassumptions, analysis andconclusions.

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The decisions in Caremark, Stone,Abbott Labs and Bridgeport suggest thatif directors have failed to act in goodfaith in adhering to their duty of careobligations, they may also have violatedtheir duty of loyalty and have personalliability for which indemnification is notavailable.


based on the success of a transaction may not be able to deliver an unbiased opinion.40

Finally, directors must not blindly rely on experts’ findings. Directors should probeand test an expert’s assumptions, analysis and conclusions and should probe any con-flicts the expert may have.

DUTIES OF LOYALTY AND GOOD FAITH

The Duty of Loyalty

Directors owe a fiduciary duty of loyalty to the corporation and to its stock-holders. The duty of loyalty requires directors and officers to act in good faith, to act inthe best interests of the corporation and its stockholders, and to refrain from receivingimproper personal benefits as a result of their relationship with the corporation.

The duty of loyalty prohibits self-dealing andusurpation of corporate opportunities by directorswithout the informed consent of the corporation,through either its disinterested directors or stock-holders. “Essentially the duty of loyalty mandatesthat the best interest of the corporation and its share-holders takes precedence over any interest possessedby a director, officer or controlling shareholder andnot shared by the shareholders generally.”41

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

• A conflict of interest – where any director or officer has an interest in a trans-action contemplated by the corporation;

40 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 completion of the transaction. Fairness opinion fees generally are bifurcated so that thefee for the opinion is payable regardless of whether a transaction proceeds. Furthermore, if a board isaware that a financial advisor may also benefit from fees related to financing an acquisition, careful con-sideration should be given to any conflict of interest, and thus whether reliance on that financial advisor asan expert is reasonable. See In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL (Del.Ch. March 7, 2014).

41 Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993).

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


• 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; and

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

Unlike the duty of care, liability for breaches of the duty of loyalty cannot belimited by the corporation’s certificate of incorporation, and directors and officers mayalso not have access to contractual indemnification for breaches of the duty of loyaltythat involve bad faith.42

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 whom thecorporation is seeking to do business, when adirector stands to receive a financial paymentarising out of a transaction (such as a finder’s fee) or where a director or officer standsto benefit from a continuing relationship with the other party to a transaction (such asan employment relationship following the transaction). Conflicts of interest also canexist in interlocking or overlapping governance arrangements – for example, when a

42 8 Del. C. §102(b)(7).

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

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director approves compensation for a chief executive officer who in turn sits on theboard of a corporation that employs that director. However, interested party trans-actions are not inherently detrimental to a corporation. As long as a transaction is fairto the corporation, no protected confidences are betrayed, and there is not a mis-appropriation of corporate property, the duty of loyalty may not breached, regardlessof whether certain corporate 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 . . .there must be evidence of disloyalty. Examples of such misconduct include, but cer-tainly are not limited to, the motives of entrenchment, fraud upon the corporation orthe board, abdication of directorial duty, or the sale of one’s vote.”43

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 reduces the risk that thedecision in question is motivated by an improper purpose. The independent decision-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 independentdecision-maker must be fully informed of the conflictof interest as well as the terms of the corporate actionand must act in good faith.44 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-

43 Cede, 634 A.2d at 363.44 8 Del. C. §144.

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


holders.45 However, entire fairness can be difficult, time-consuming and costly toestablish, as discussed in detail later in this Chapter. The use of special committees isdiscussed 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. Corporateopportunity issues also arise where an officer or director has personal business inter-ests that compete with the corporation’s interests in certain business opportunities.Directors who are industry experts and serve as directors, promoters and principals atmultiple entities must be particularly sensitive to this issue.

What Constitutes a Corporate Opportunity?

In general, a corporate opportunity exists, and a corporate officer or director isprohibited from taking such business opportunity for his or her own without first offer-ing it to the corporation, if:

• The corporation has an interest or expectancy in the opportunity;

• The corporation is financially able to exploit the opportunity;

• The opportunity is within the corporation’s line of business; and

• By taking the opportunity for his or her own, the corporate fiduciary willthereby be placed in a position contrary to his or her duties to the corpo-ration.

45 Id.

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The corollary to this rule is that a director or officer may generally take a corpo-rate 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.46

Of course, the safest course of action with respect to a transaction involving apotential conflict over a corporate opportunity is approval of the subject transaction bythe disinterested directors or stockholders after the full disclosure of its terms.

Mitigating Corporate Opportunity Issues

Corporations employ a wide range of practices to mitigate the risk of corporateopportunity issues. Some alternatives include:

• 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 ofthe affected director or officer. Forexample, each of the corporationand any competing entity withwhich an officer or director isaffiliated could adopt a policyon confidentiality that would release the affected director or officer from anyobligation to disclose overlapping opportunities, and would prohibit mem-bers of the board of directors of each entity from bringing to the other oppor-tunities learned of through participation 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 do

46 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 build extensiveguidelines into their employeeconduct codes in an effort to avoidpotential conflicts of interest andcorporate opportunity issues withtheir executives and directors.


not 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 boards of directors of the corporation and the competing entity.

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.47

Bad faith is not simply bad judgment or negligence, but rather implies the consciousdoing of a wrong because of a dishonest purpose or a state of mind affirmatively oper-ating with furtive design or ill will. Breaches of the duty of good faith have been foundin the following circumstances:

• Directors knowingly or deliberatelywithheld information they knew to bematerial for the purpose of misleadingstockholders;48

• A transaction was authorized for pur-poses other than to advance corporatewelfare and in violation of applicablelaws;49

47 Guth, 5 A.2d at 509; Stone v. Ritter, 911 A.2d 362 (Del. 2006).48 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).49 Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 n.2 (Del. Ch. 1996).

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The duty of good faith is asubset of the duty of loyalty.Duty of good faith violationsmay occur when directorsblatantly disregard their dutyto act in the best interests ofthe corporation and itsstockholders.


• A director’s decision was primarily motivated by personal interest and notthe best interests of the corporation;50

• Actions were consciously taken with a dishonest purpose or moral obliq-uity;51 and

• Directors failed to prevent waste or self-dealing by another director or corpo-rate officer.52

There was some ambiguity surrounding the duty of good faith, including someconfusion regarding whether the duty of good faith is an independent duty or an ele-ment of the duty of loyalty. Two Delaware Supreme Court cases settled the issue. In Inre Walt Disney Co. Derivative Litigation,53 the court outlined three categories ofbehavior 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).54

• Category 2 – Grossly negligent conduct, without more.55

• Category 3 – The fiduciary intentionally acts with bad faith dereliction ofduty, a conscious disregard for one’s responsibilities.56 For example, thefiduciary acts with a purpose other than advancing the best interests of thecorporation; the fiduciary acts with the intent to violate applicable positivelaw; or the fiduciary intentionally fails to act in the face of a known duty toact, demonstrating a conscious disregard for his or her duties.57

50 Washington Bancorp. v. Said, 812 F. Supp. 1256, 1269 (D.D.C. 1993).51 Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1208 n.16

(Del. 1993).52 In re Nat’l Century Fin. Enter. Inv. Litig., 504 F. Supp. 2d 287, 313 (S.D. Ohio 2007).53 906 A.2d 27 (Del. 2006).54 Id. at 64.55 Id.56 Id. at 66.57 Id. at 67.

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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.58

Following the 2006 Disney decision, the Delaware Supreme Court againaddressed the duty of good faith in Stone v. Ritter.59 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.”60

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.61

• 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.

58 Id. at 64.59 911 A.2d 362 (Del. 2006).60 Id. at 370.61 683 A.2d 1049 (Del. Ch. 1996).

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Errors in judgment, without more, were not sufficient grounds for judicialinterference.62

• Breach of Fiduciary Duty When Directors Knowingly Committed IllegalActivities. In Miller v. AT&T, the court found a breach of fiduciary dutywhen the company made an illegal campaign contribution in violation offederal law. The business judgment rule does not insulate directors fromliability after they knowingly commit illegal activities.63

• Breach of Duty of Loyalty Where Directors Abdicated Responsibilities toManagement and Engaged in Rush Sale of Business. In the case In reBridgeport Holdings, Inc., the directors were held to have breached theirduty of loyalty by abdicating crucial decision-making authority in the sale ofthe company to an officer, failing to monitor the officer’s execution of anabbreviated and uninformed sale process, and ultimately approving the saleof the business for grossly inadequate consideration. The court held that theboard’s actions were tantamount to an intentional disregard of their duty ofcare, and thus constituted a breach of their duty of loyalty, notwithstandingthe fact that the plaintiff did not allege self-dealing by the board or a lack ofindependence.64

Summary

Delaware courts still recognize a triad of director duties, including care, loyaltyand good faith; however, following Disney and Stone v. Ritter, it appears that the dutyof good faith is viewed as a subset of the duty of care and does not stand on the samelevel as the duties of care and loyalty. The Delaware Court of Chancery has observedthat by definition, a director cannot simultaneously act in bad faith and loyally towardsthe corporation and its stockholders because “bad faith conduct . . . would seem to beother than loyal conduct.”65 Today, if considering an action or decision that might raiseduty of loyalty considerations, directors are advised to demonstrate their good faith

62 383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976).63 507 F.2d 759 (3d Cir. 1974).64 In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008).65 In re ML/EQ Real Estate Partnership Litigation, No. 15741, 1999 Del. Ch. LEXIS 238 (Del. Ch.

Dec. 20, 1999).

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(and loyalty) by documenting the business purposes or stockholder-oriented reasonsfor their decisions and/or recusing themselves if there is the potential appearance ofimpropriety.

DUTY TO DISCLOSE

Stemming from their fiduciary duties of care and loyalty, corporate directors alsohave a duty of disclosure, sometimes referred to as the duty of candor.66 Disclosureviolations constitute a breach of the duty of care when the misstatement or omissionwas made as a result of a director’s erroneous judgment, but was nevertheless made ingood faith. If the board lacks good faith in approving or failing to make a disclosure,the violation also implicates the duty of loyalty.67 When directors do seek to make adisclosure, such as in seeking stockholder approval, Delaware courts have held thatthey need to “disclose fully and fairly all material information within the board’scontrol.”68 Further, the court said that when directors recommend stockholder action,they have an affirmative duty to disclose all information material to the action beingrequested and “to provide a balanced, truthful account of all matters disclosed in thecommunications with stockholders.”69 Likewise, directors have a duty of candor thatrequires that they disclose to the board information known to them that is relevant tothe 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.70

66 Malone v. Brincat, 722 A.2d 5, 11 (Del. 1998).67 In re Tyson Foods, Inc. Consol. Shareholder Litigation, 919 A.2d 563, 597-98 (Del. Ch. 2007).68 Malone, 722 A.2d at 10 (Del. 1998).69 Id.70 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).

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ENTIRE FAIRNESS REVIEW

Overview

In situations where the presumption of the business judgment rule is not avail-able, directors will be required to establish the entire fairness of the transaction ordecision in question. When engaging in an entire fairness review, a court willdetermine whether the transaction or decision is entirely fair to stockholders andshould therefore be upheld, notwithstanding any deficiencies on the part of the board.71

This standard of review is rigorous and the board bears the burden of not only provid-ing the evidence to the court but also persuading the court that the evidence demon-strates that the directors have met their burden. The practical implication of a rebuttalof the business judgment rule is that the chances that a transaction may be set aside aregreatly increased. As a result, it is of the utmost importance that boards manage theiractions and the circumstances surrounding them to have the best chance of preservingapplication 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 isevidence that the directors may havebreached their fiduciary duties. In addition,the entire fairness test will be applied whena corporation consummates a transactionwith a controlling stockholder unless thecorporation obtains the approval of disin-terested directors through a properlyformed, empowered and functioning committee and disinterested stockholders.72

Although such disinterested approval may result in the board receiving the benefit ofthe business judgment rule, a court may nonetheless require a defendant controllingstockholder to demonstrate the entire fairness of the challenged transaction. Absent adisinterested approval process, the defendant would be required to bear the burden ofproviding evidence and convincing the court that the transaction was entirely fair tothe minority stockholders. If a disinterested approval process was used, a court mayshift the burden of proof from the defendant controlling stockholder to the plaintiff

71 See, e.g., Citron v. E.I. Du Pont de Nemours & Company, et al., 584 A.2d 490 (1990).72 See, e.g., In re S. Peru Copper Corp. S’holder Derivative Litig., 30 A.3d 60 (Del. Ch. 2011).

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


(who would then be required to demonstrate that the transaction was not entirelyfair).73 A shift in who bears the burden of proof has a significant impact on both thecost and difficulty of litigation, as well as the probability of success. Additionally, incertain circumstances, approval by an independent committee of the board and disin-terested stockholders may result in the application of the business judgment rule asdiscussed in greater detail in Chapter 4 below.

Fair Dealing and Fair Price

To satisfy an entire fairness review of a challenged transaction, a board mustdemonstrate that the transaction was the product of both fair dealing and fair price.This analysis is not necessarily bifurcated.74 A court considering the issue of whetherthe board has met its obligations under the entire fairness test may blur the linesbetween the two tests, and the results of one test may influence whether the other testwas satisfied.

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, in particular:

• 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?

73 See Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983); Kahn v. Lynch Comm. Sys., Inc., 638 A.2d1110 (Del. 1994).

74 Id. at 711.

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

O On balance was the end result fair to the stockholders?

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.75

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 buyer could afford to pay. At leastin the non-self-dealing context, it means a price that a reasonable seller, under all thecircumstances, would regard as within a range of fair value; one that such a sellercould reasonably accept.76 In considering that price, directors may consider the eco-nomic and financial considerations of the proposed merger, including all relevant fac-tors: assets, market value, earnings, future prospects and any other elements that affectthe intrinsic or inherent value of a company’s stock. In the context of competing bids,the directors would be expected to consider not only the absolute price offered bycompeting bidders, if any, but also the likelihood that the stockholders would actuallyreceive 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;

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

76 Id. at 1143.

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

• Any transaction from which the director derived an improper personal bene-fit.77

Exculpation provisions such as these provide substantial comfort to directors andmay directly impact their willingness to serve in that capacity, and as a result bothpublicly and privately held corporations commonly include such provisions in theircertificates of incorporation. Directors and persons contemplating accepting adirectorship should carefully consider whether and to what extent their liability to thecorporation and its stockholders is eliminated or limited under the corporation’scertificate of incorporation.

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.78 If the breach that triggered application of the entire

fairness standard was a breach of the duty ofcare, provisions in a corporation’s certificate ofincorporation eliminating or limiting thepersonal liability of directors for breaches of thisfiduciary duty likely would shield directors frompersonal liability.79 However, as noted above, abreach of the duty of loyalty or the related duty

of good faith may not be eligible for these protections.80 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 in

77 8 Del. C. §102(b)(7).78 Cinerama, 663 A.2d at 1164.79 See 8 Del. C. §102(b)(7).80 See id.

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A director who has been foundto have breached his duty ofloyalty or good faith may not beentitled to exculpation orindemnification from thecorporation under Delaware law.


favor of directors may be limited when they breach their duties of good faith and loy-alty. Indeed, many indemnification agreements specifically provide that a director isnot entitled to indemnification if he or she is ultimately determined to have acted withgross negligence or willful disregard of his or her duties. Indemnification of directorsand officers and D&O insurance are discussed in detail in Chapter 8 of this Handbook.

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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 potential business combi-nation, its actions will be reviewed against the standard of the traditional businessjudgment rule, assuming the directors have observed their duties of care and loyalty.Thus, in such a situation, directors are advised to take a number of steps to best posi-tion themselves to receive the benefit of the business judgment rule.

• First, directors should diligently inquire with all parties as to any relation-ships with potential counterparties so as to ensure that any facts that give riseto potential duty of loyalty considerations are identified and mitigated oreliminated.

• Second, directors should collect as muchrelevant information regarding the poten-tial transaction as reasonably possible,review the information carefully, and seekthe advice of experts, including lawyers,bankers and accountants, as appropriate,to ensure that the directors have a com-plete understanding of the transaction.

• Third, directors should investigate, to areasonable extent, the information providedto the directors and any related underlyingassumptions. Although directors arepermitted to rely on information provided to them by management and out-side advisors, they cannot do so blindly and will be expected to have, at aminimum, probed and tested such information to give themselves a level ofcomfort and assurance as to its accuracy, veracity and completeness.

• Fourth, directors should consider carefully the options available to the corpo-ration and openly deliberate among themselves the merits of the potential

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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transaction. 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 directors 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 subject transaction, including the directors’decision-making process with respect thereto. Specifically:

• Under certain circumstances directors may be required to demonstrate theentire fairness of the transaction to the stockholders;

• When a board of directors determines to sell or break-up a corporation, thedecision of the directors will be evaluated under the Revlon standard;81 and

• When defending against a threatened or proposed change in control of thecorporation, directors’ actions may be reviewed against the standard set forthin the Unocal decision and its progeny.82

BOARD CONSIDERATIONS IN ANY BUSINESS COMBINATION

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

• 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;

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

• Alternative proposals and the prospects for the continuing business withoutundertaking a transaction;

• In the case of a stock-for-stock transaction: (a) an assessment of the potentialcounterparty and the prospects of the combined corporation following theclosing (including synergies from the combination, perceived strengths andweaknesses of the management team and the directors and factors affecting

81 Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).82 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).

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stock price and performance), (b) the impact of the transaction on the corpo-ration’s long-term strategic plans and (c) integration risks of the transaction;

• The legal terms of the potential business transaction, including pricing, con-ditions to closing, restrictions prior to closing and any other key terms of thetransaction;

• Deal protection terms including “no shop” provisions, “break up” or termi-nation fees and similar devices;

• The accounting and tax treatment of the transaction;

• The right of the corporation’s stockholders to vote on the transaction, if appli-cable;

• The risk that proposed conditions to the transaction, such as receipt of financ-ing and regulatory approvals, may not be satisfied;

• The outlook for the corporation’s business and industry;

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

• The legal or other approval requirements needed to complete the potentialtransaction, 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. When a transaction is challenged, cer-tain factors may have much greater weight assigned to them depending on the circum-stances of the particular matter. For instance, price may be a paramount considerationin a sale of control transaction, whereas longer-term strategic considerations might bemore relevant in the case of a share-for-share business combination transaction.

PRECAUTIONS 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 process for considering one or more possible business combination trans-actions is highly confidential; all aspects of information flow and disclosureneed to be tightly coordinated;

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• Care should be taken to avoid trading by any insiders in the securities of thecorporation or any counterparty, to avoid both signaling the market andpotential violations of law;

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

• Communications with directors, management and the corporation’s advisorsshould be coordinated to assure an informed decision-making process; and

• Notes and other records that directors choose to keep, if any, should be pre-pared carefully, not only to assure accuracy but also to avoid comments thatcan be taken out of context in the event of litigation or other proceedingsconcerning the transaction.

REVLON AND A SALE OF THE CORPORATION

Introduction

Once a board makes the decision to sell a corporation, Revlon duties arise andrequire the board to change its focus from the preservation of the corporation as acorporate entity to the maximization of the corporation’s value in a sale for the stock-holders’ benefit.83 While Delaware courts have emphasized that there is no “singleblueprint” that directors can follow to satisfy their Revlon duties, the duties can bedescribed as the board’s responsibility to maximize the short-term value to be receivedby stockholders.84 Once Revlon duties apply, even in the context of a transaction inwhich the business judgment rule otherwise applies, courts are more likely to scruti-nize the board’s process and actions in order to ensure that the directors took the stepsnecessary to maximize stockholder value.85

83 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).

84 Barker v. Amsted Industries, Inc., 567 A.2d 1279, 1286 (Del. 1989).85 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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Applicability of the Revlon Duties

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

• A transaction involving a sale or merger for cash or debt securities;

• A merger involving stock-for-stock consideration (even a strategic merger)that transfers control to a private corporation or to a public corporation witha majority stockholder;

• A transaction or business reorganization that will result in a break-up of thecorporation; or

• A sale of equity securities that results in a change of control.

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

• Where a board (or a controlling stockholder) rejects a third-party offer(whether solicited or unsolicited) as not in the best interest of its stock-holders;86

• In a merger or other business combina-tion transaction in which sale of controlof the corporation is not implicated;

• In a merger or other business combina-tion transaction in which sale of controlof the corporation is implicated if thetransaction is a “merger of equals.” A“merger of equals” involves a mergerof two companies with large and diverse stockholder bases where, followingthe transaction, a majority of the voting securities of the combined companyremain in the hands of investors in the public markets; or

• Unless a board’s actions have otherwise subjected it to Revlon duties, it hasno legal duty to engage in discussions or to negotiate with respect to a hos-tile or otherwise unsolicited takeover offer.

86 Frank v. Elgamol, 2014 WL 957550, at *21 (Del. Ch. Mar. 10, 2014).

Unless a board’s actions haveotherwise subjected it toRevlon duties, it has no legalduty to engage in discussionsor to negotiate with respect toa hostile or otherwiseunsolicited takeover offer.

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Notwithstanding the historical notion that Revlon does not apply to a “merger ofequals” transaction87, the Delaware Chancery Court has held that Revlon may applywhen the transaction is mixed cash and stock consideration, depending on the circum-stances. In In re Smurfit-Stone Container, the court held that Revlon would likelyapply even though target stockholders would own approximately 45% of post-closingbuyer stock with the balance of the stock held by a diverse stockholder base. The courtreasoned that enhanced judicial scrutiny was in order because a significant portion “ofthe stockholders’ investment . . . will be converted to cash and thereby deprived of itslong-run potential,” and that the transaction “constitutes an end-game for all or a sub-stantial part of a stockholder’s investment.” The court twice noted, however, that theissue remains unresolved by the Delaware Supreme Court, and that the “conclusionthat Revlon applies [to a mixed-consideration merger] is not free from doubt.”88

Revlon duties arise at the time that the directors have or are deemed to havedecided to sell control of the corporation.89 Generally, Revlon duties do not arise whenthe directors merely have authorized corporate officers or a board committee to nego-tiate a sale, but may arise when the directors have formally resolved to conduct a sale.Thus, Revlon duties typically will not apply if the directors never authorize the sale ofthe corporation or indicate any inevitable commitment to sell the corporation to a par-ticular buyer, or if they merely authorize the exploration of a variety of alternativesintended to enhance profitability, including a possible sale. As most sales are precededby such informal investigations of alternatives, directors should be aware of Revlonduties when such a process commences and avoid commitments that might make itdifficult to meet their Revlon duties if they should arise later. The Delaware SupremeCourt clarified in Lyondell Chem. Co. v. Ryan that the Revlon duties apply only when acorporation embarks upon a transaction – on its own initiative or in response to anunsolicited offer – that will result in a change of control.”90 Until the board decides

87 The Delaware Court of Chancery recently reinforced this notion by noting that Revlon did not applyto a stock-for-stock merger of equals transaction in which ownership of [the corporation] would remain“in a large, fluid, changeable and changing market” following the merger. See In re TriQuint Semi-conductor, Inc. Stockholders Litigation, C.A. No. 9415-VCN (Del. Ch. June 13, 2014).

88 In re Smurfit-Stone Container Corp. S’holder Litig., C.A. 6164-VCP (May 20, 2011).89 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).90 Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242 & n.23 (Del. 2009).

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actively to pursue a change-of-control transaction, directors can assume a “wait andsee” approach with respect to activities of third parties or reject an unsolicited offerwithout triggering obligations under Revlon.91

Revlon Duties and Guidelines

Once Revlon duties arise, the board should adhere to the following guidelines:

• Obtain the Highest Value. Directorshave a responsibility to conduct a proc-ess reasonably designed to obtain thehighest value reasonably attainable forthe stockholders. There is “no singleblueprint” that directors must follow inseeking the highest value.92 In evaluat-ing competing offers where differingamounts or types of consideration areoffered and one or more of the bidding parties offers its own securities aspart of the merger consideration, a board is not limited to considering onlythe amount of cash involved, and may take into account the future value ofthe strategic alliance. For example, if acquirer A is offering all cash, andacquirer B is offering a mixture of cash and stock or other consideration,directors may consider the aggregate value of each of the proposed trans-actions, including in the case of acquirer B the perceived value of the stockconsideration. In addition, in a Revlon transaction (just as in any businesscombination), directors should consider the likelihood that a potentialacquirer is financially capable of completing the transaction, as well as otherfactors that could affect the likelihood of a particular transaction beingcompleted. In short, directors considering competing transactions under theRevlon standard should analyze the entire situation and evaluate the consid-eration being offered from each transaction in a disciplined manner with theobjective of maximizing short-term value for the stockholders.

91 Id. at 237; Gantler, 965 A.2d at 706 & n.29.92 Paramount Communications Inc. v. QVC Network Inc., 637 A.2d at 44; see also Lyondale Chemical

Co. v. Ryan, 970 A.2d 235 (Del. 2009).

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

exceptions to deal pro-tection measures; and

• Consider a market check


• Act with Neutrality. The board must act in a neutral manner with bidders toencourage the highest possible price for the stockholders. Moreover, whereone or more directors have or may have a conflict of interest with respect toone or more of the bidding parties, courts have ruled that the activeinvolvement of a corporation’s independent directors is critical to satisfyinga board’s Revlon duties.

• Establish Appropriate Exceptions to Deal Protection Measures. Althoughdeal protection measures (generally scrutinized under the Unocal standarddescribed below) are common in business combination transactions, andtheir validity can be attacked in any transaction, these measures frequentlyare subjected to heightened scrutiny in Revlon transactions. Common meas-ures include lock-ups, no-talk provisions, force-the-vote provisions andno-shop provisions, commitments to recommend the transaction, stockoption grants, break-up and termination fees, voting agreements and similararrangements. In a number of transactions in recent years involving Revlonduties, target corporations have insisted upon “go-shop” provisions in aneffort to maximize the likelihood that the stockholders are receiving thegreatest short-term value for their shares. These provisions permit the target,after executing the acquisition agreement, affirmatively to seek a potentialalternative acquirer for a specific period of time (in other words, the“no-shop” provision does not apply during such “go-shop” period). But evenin the absence of a go-shop provision, directors should consider including inthe acquisition agreement other exceptions to deal protection measures, suchas permitting the target corporation’s board (or if applicable, a committee ofthe board) to change its recommendation in favor of the transaction, or eventerminate the acquisition agreement in order to permit the company to enterinto an alternative transaction with a third party that constitutes a “superiorproposal” when compared to the transaction contemplated by the acquisitionagreement. Deal protection provisions and other defensive tactics that mightimpair the sales process, unfairly favor one bidder over another, or otherwisepreclude stockholders from having a meaningful opportunity to determinewhether to approve a transaction, will be carefully scrutinized in consideringwhether the board met its Revlon duties.

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• Consider a Market Check. A market check, meaning an exploratory reviewof whether other potential bidders exist and if so, what price they might pay,may be strongly advisable where the board is considering a single offer andno bidding contest is present. A “market check” may assist the board indetermining whether a proposed change of control transaction maximizesstockholder value. However, there is no particular obligation to conduct amarket check, and a board may, depending on the circumstances, fulfill itsduty of care by including appropriate provisions in the acquisition agreement(such as a go-shop provision, or the right to terminate the transaction infavor of a superior offer) that help enhance the likelihood that the highestshort-term value will be achieved for the stockholders.93

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, even if a premium price is offered, if the board makes a good faith, informeddecision that it is in the best interests of the corporation to remain independent orotherwise reject the offer. If a board does elect not to put a corporation up for sale inresponse to an unsolicited offer, care should be taken to ensure that the directors haveengaged in a thoughtful analysis of why they believe stockholder value can beenhanced by not selling the corporation, and that thought process should be appropri-ately documented.

93 C&J Energy Series, Inc. v. City of Miami General Employees and Sanitation Employees’ RetirementTrust, 2014 WL 7243153 (Del. Dec. 19, 2014).

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REVIEW OF DIRECTORS’ DUTIES IN THE CONTEXT OF A POTENTIAL

BUSINESS COMBINATION TRANSACTION

In light of the foregoing discussion, directors should undertake the followingin connection with a potential 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 to allmaterial aspects of the transaction and key documents;

• Make Good Disclosures:

O Disclose all actual and potential conflicts of interest to each other;

O Make complete and accurate disclosure to stockholders whoseapproval of a particular transaction is sought;

• Deliberate:

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

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

• Act in Good Faith:

O Always act in the best interests of the stockholders;

O Avoid taking any actions (including adopting deal protectiondevices) that improperly limit the board’s ability to exercise itsfiduciary duties;

O Avoid making any decisions that would favor one bidder overanother without appropriate business justification; and

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

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UNOCAL AND DEFENDING AGAINST HOSTILE TAKEOVERS

Introduction

In contrast to situations where a board’s actions contemplate the sale of a corpo-ration, in circumstances where a corporation receives a hostile or unsolicited acquis-ition proposal, and its board of directors determines that the proposal is not in the bestinterests of the corporation and its stockholders and adopts one or more defensivetakeover measures, the Unocal standard will apply. Generally, Unocal requires, in thecontext of a hostile or unsolicited acquisition proposal, that the board demonstrate that(a) it had reasonable grounds for believing that a danger or threat to corporate policyand effectiveness existed and (b) itsresponse was reasonable in relation to thedanger or threat to corporate policies posedby such proposal. Defensive takeovermeasures are myriad and include stock-holder rights plans (or “poison pills”), pro-tective provisions in the corporation’scharter and bylaws, such as a classifiedboard, limitations on stockholders’ rights toact by written consent, call special meetings and remove directors and supermajority vot-ing requirements. Boards may also seek to prevent a hostile or unsolicited takeover byimplementing an alternative transaction with a friendly acquirer or a separate transaction(including recapitalizations) to make the corporation undesirable to the hostile party. Thesetechniques can be implemented either in direct response to a hostile bid or in preparationfor the possibility of a future hostile bid. In cases where such measures are adopted in theabsence of an existing threat (i.e., a pending or threatened hostile offer), the actions of theboard in adopting such measures should be entitled to the protections of the businessjudgment rule; however, where such measures are adopted in response to an actual threat,the heightened standard of Unocal will be applied by a court reviewing challenged actionsof the board.94 Further, defensive measures adopted in the absence of an actual threat maybe tested under Unocal when and if they are later utilized to attempt to thwart a particularhostile or unsolicited action by a third party.

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

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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.


Delaware courts typically analyze the reasonableness of the deal protection provi-sions in a particular transaction holistically, in the aggregate, and not on a one-by-onebasis. Each case is decided based on the particular facts and circumstances involved inthe transaction. Thus, while general guidance is given below, it is often difficult tomake generalizations about the overall permissibility of particular provisions. Forexample, a particular deal protection device might be permissible if it were the onlydeal protection mechanism, but could be found to be in violation of the Unocal stan-dard, as an unreasonable or disproportionate response to the threat perceived, whenincluded in combination with other deal protection devices. This area of Delaware lawis sophisticated, complex, fact-intensive and ever-evolving as boards and committees,and their counsel, struggle to devise deal structures with effective protections that willwithstand judicial scrutiny.

Overview of Common Defensive Takeover Measures

As noted above, there are several anti-takeover measures and variants of thesemeasures. A summary of some of the more common measures includes:

• Staggered Board. Perhaps one of the most common devices, a staggered boarddivides the corporation’s board of directors into several classes, with each classserving a fixed term but elected in different years. For example, class I directorsserving three-year terms beginning in 2017 would expire in 2020, while class IIdirectors’ terms would expire in 2021 and class III directors’ terms would expirein 2022. Thus, even if a substantial amount of the corporation’s stock wereacquired by a single or group of related stockholders, the entire board could notbe replaced at a single election. A staggered board is implemented through anamendment to the corporation’s charter, typically requiring that a majority of theoutstanding shares approve the staggered board. A board may also bede-staggered with an amendment to the charter (again requiring approval of notless than a majority of the outstanding shares). Frequently, staggered boards areimplemented in connection with a corporation’s initial public offering (when thegroup of stockholders is generally much smaller and less disparate) and thestructure is protected by requiring that changes require a supermajority share-holder vote. Consequently, it is sometimes difficult to eliminate a staggeredboard. On the other hand, stockholder rights organizations generally disfavordefensive takeover measures, including staggered boards in particular, so anyproposal to eliminate a staggered board is likely to meet with the approval of

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such organizations and in fact, over the past few years, a substantial number ofcompanies have eliminated their staggered boards in response to shareholderinitiatives. The elimination of a staggered board does not de facto remove direc-tors from office or shorten the terms of directors who are serving terms that donot expire in the year in which the board is de-staggered. Such directors shouldcontinue to serve until their original term is complete, or their earlier death,removal or resignation. Proponents of staggered boards argue that board con-tinuity is beneficial to the company and a staggered board prevents a hostileacquirer from replacing the board in one single election. Opponents argue that astaggered board promotes entrenchment among directors, and at times, theirfavored management.

• Restrictions on Stockholder Action by Written Consent. DGCL Section 228provides that unless prohibited by the corporation’s charter, stockholdersmay act by written consent to approve any action that could otherwise beapproved at a properly convened meeting of stockholders. Many corpo-rations, in implementing anti-takeover strategies, adopt charter provisionsthat restrict stockholders’ ability to act by written consent. This prevents asingle stockholder or group of stockholders acting together from pursuingapproval of action at the stockholder level without a properly convenedmeeting of stockholders. Proponents of restrictions on stockholders’ rights toact by written consent argue that these restrictions, together with otheranti-takeover devices, have the effect of encouraging a potential acquirer tointerface directly with the corporation’s board of directors rather than going“over its head” directly to the stockholders, thus enabling the board to seekthe best value for all the stockholders. Opponents of these restrictions arguethat they deny a majority stockholder its right to exercise one of the basictenets of ownership – the ability to vote shares and by doing so, controlmajor corporate actions.

• Limitations on Stockholders’ Rights to Call a Special Meeting. Manycorporations, through their charter or bylaws, also limit who may call a spe-cial stockholders meeting. Specifically, rather than granting stockholders theright to call a special meeting, such corporations vest the right to call a spe-cial meeting only in the board of directors, chief executive officer, chairmanor president of the corporation. As many corporate actions require stock-

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holder approval, shareholder rights organizations argue that restrictions onstockholders’ rights to act by written consent or call a special meeting havethe practical effect of depriving stockholders of the ability to have a mean-ingful voice as to management of the corporation’s affairs except throughthe election of directors at an annual meeting. Proponents of this mechanismargue that it forces a potential hostile acquirer to interface directly with theboard in any potential takeover attempt.

• Rights Plans (aka Poison Pills). Perhaps the most well-known anti-takeoverdevice, rights plans (also called “poison pills”) are a mechanism that seeks toprevent a stockholder from increasing its ownership of the corporationbeyond a certain percentage (usually 15-20%) without the approval of thecorporation’s board of directors. Rights plans are discussed in detail at theend of this Chapter 3 in the section entitled “Special Case: Use of a PoisonPill.”

The Unocal Test: Reasonable Basis and Proportionate Response

As discussed above, anti-takeover measures generally are reviewed under theUnocal standard. The Unocal standard is a two-pronged test. First, the board mustdemonstrate that it had “reasonable grounds for believing that a danger or threat tocorporate policy and effectiveness existed.”95 Second, the board must demonstrate thatits response was reasonable and proportionate to the threat.96

Reasonableness Test

With respect to the first prong of the Unocal test, a threat to corporate policy canexist from, among other things, the risk that a hostile or unsolicited acquisition pro-posal is inadequate or constitutes a coercive tender offer, or is timed so as to disruptstrategic goals.97 Attempts to satisfy this prong of the test should be supported by areasonable investigation of the facts surrounding the takeover offer by an independentand disinterested majority of the board.98

95 Unocal, 493 A.2d at 946.96 See id.97 Id.98 Id.; see also Unitrin Inc. v. American General Corp., 651 A.2d 1361, 1375 (Del. 1995).

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

• The adequacy of the price offered;

• The nature and timing of the offer;

• Regulatory considerations;

• The risk of non-consummation of the offer;

• 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 if the bid were to succeed; and

• The risk that stockholders will mistakenly accept an underpriced offerbecause they disbelieve management’s representation of intrinsic value.99

Proportionality Test

Proportionality requires that the board’s actions in implementing an anti-takeovermeasure be 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.”100 A response will be “preclusive” if it deprives stockholders of the right toreceive all tender offers or precludes a bidder from seeking control by fundamentallyrestricting proxy contests or otherwise.101 A response will be “coercive” if, amongother things, it forces a management-sponsored alternative upon stockholders.102

Second, assuming the response was not preclusive or coercive, the board mustshow that the response was within a “range of reasonableness.”103 When determiningwhether an action is within the “range of reasonableness,” the court will look to,among other things, whether the action was (i) a statutorily authorized form of busi-ness decision which a board may routinely make in a non-takeover context, (ii) limited

99 See Unocal, 493 A.2d 946; Unitrin, 651 A.2d 1361.100 Unitrin, 651 A.2d at 1367.101 Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 935 (Del. 2003).102 Id.103 Id.

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and corresponded in degree or magnitude to the degree or magnitude of the threat, and(iii) responded to the needs of stockholders.104

Under Delaware law, boards should be given some level of deference in showingproportionality.105

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 responseto a competing merger offer when the offer was not aimed at “crammingdown” a plan on stockholders, but rather had as its goal continuing apre-existing transaction in an altered form.106

• Defensive measures may be both preclusive and coercive if the measuresconstitute a fait accompli. In Omnicare, Inc. v. NCS Healthcare, Inc., thecombination of a “force-the-vote provision” and stockholder voting agree-ments from a majority of the outstanding shares were found, acting in con-cert, to have a preclusive and coercive effect because the defensive measuresmade it mathematically impossible for any alternative proposal to succeed,no matter how superior the proposal.107

• 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 union contract providing the union rights to renegotiate thecontract in the event of a takeover – was found to be unreasonable and there-fore disproportionate because the takeover defense could not be rescinded bythe company.108

104 Unitrin, 651 A.2d at 1389.105 See id. at 1388.106 See Paramount Communications, Inc. v. Time, Inc., 571 A.2d at 1154-1155.107 See Omnicare, 818 A.2d 914.108 See Air Line Pilots Assoc., Int’l. v. UAL Corp., 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 followingin responding to a hostile takeover attempt:

• 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 anti-takeover measures from a majority ofindependent directors; and

• Avoid deal protection measures or actions that limit a board’s ability toexercise its fiduciary duties.

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SPECIAL CASE: USE OF A POISON PILL

Overview and Mechanics

As discussed above, there are several anti-takeover measures available to a corpo-ration that is seeking to reduce the threat of abusive takeover attempts. One of the mostcommon of these options is a stockholder rights plan, also known as a “poison pill.”

Since the 1970s, stockholder rights plans have been a commonly used deviceadopted by companies for discouraging and fending off undesirable and abusiveadvances from hostile offerors. However, in recent years stockholder rights plans havefallen into disfavor as activist stockholder groups have argued that the plans facilitatethe entrenchment of management and deprive stockholders of the ability to receivemaximum value for their shares. Poison pills generally are designed to deter certainabusive takeover devices and tactics, including acquisitions of a controlling interestwithout paying a premium or at a market price which may not reflect actual value.

Proponents of stockholder rights plans argue that a stockholder rights plan can bevery useful because it may afford the board adequate time to consider unsolicitedoffers. In addition, if such offers are deemedto be inadequate, the stockholder rights planmay provide a board with the opportunity toseek alternatives to such an offer, includinga superior proposal from a “white knight”bidder, thereby enhancing the board’snegotiating power and its correspondingability to promote the best interests of thestockholders.

A stockholder rights plan can be adopted by a corporation’s board without stock-holder approval (although doing so may under certain circumstances result in stock-holder rights organizations recommending against the re-election of directorsapproving the plan). The basic feature of a stockholder rights plan is the distribution ofrights to all holders of common stock to purchase additional shares of either the sameclass of stock or a class of preferred stock, which, when “triggered,” entitle such hold-ers to purchase a significant amount of the corporation’s securities at a 50% discountto then-market value, resulting in a significant dilutive effect on the “acquiring person”(the hostile or unsolicited bidder who has triggered the rights by acquiring more than

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


the designated ownership limit (typically 15% to 20%) of the then-outstanding sharesof the corporation’s common stock. Because the rights held by the acquiring person donot become exercisable, the effect of a triggering event is to substantially dilute theacquiring person’s interest in the target and make any acquisition prohibitivelyexpensive.

The rights have no real economic value, and are not exercisable, unless and untilthere is a triggering event, which is deemed to occur when a third party (or group ofaffiliated or associated persons) actually becomes an acquiring person.

The term of stockholder rights plans generally is from three to ten years, and theexercise price of a right is typically anywhere from six to ten times the market value ofthe corporation’s common stock at the time the stockholder rights plan is adopted. Therights, therefore, are significantly “out of the money” at the time of issuance. Rightsplans typically also have “exchange” features that permit a board of directors, insteadof declaring the rights exercisable for cash, simply to issue to all stockholders (otherthan the acquiring person) a share of common stock in exchange for each right. Whilethe dilutive effect of such an exchange is not as great as the dilution that would becaused by a full exercise of the rights, such a procedure is simpler and promotes equal-ity among stockholders, not all of whom will have the financial resources to fullyexercise their rights. In the one reported instance of a third party consciously triggeringa stockholder rights plan by acquiring more than the designated percentage of thecorporation’s outstanding shares, the board of the target company elected to effectsuch an exchange.109

Fiduciary Duties

Given the recent rise in activist stockholder activity regarding stockholder rightsplans, directors should proceed cautiously when considering enacting or maintainingsuch plans. While the general legality of poison pills has been well-established byDelaware case law, courts have given increasing scrutiny to instances in which boardshave used rights plans to interfere with stockholder choice at the conclusion of an auc-

109 Versata Enterprises, Inc. and Trilogy, Inc. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010).

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tion110 or where use of the plan violates another principle of takeover law (e.g., utiliz-ing a rights plan in a discriminatory manner favoring one change-in-control transactionover another).111

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 possibility that “entrenched”directors will act in their own self-interest, a board’s planning for a hostile takeoverdefense in advance, in the context of a corporate environment in which hostile orunsolicited takeover attempts are not uncommon (but prior to the actual commence-ment of such an attempt), will generally be evaluated under the business judgmentrule. On the other hand, if a stockholder rights plan is enacted in response to a partic-ular hostile takeover bid, or if a board refuses to terminate the plan (including byredeeming the rights) in the face of such a bid, the heightened Unocal standard likelywill apply. Because the judicial standard applicable to the adoption of a rights plan inthe face of a hostile bid is identical to the standard applicable to the refusal of a boardto terminate an existing plan at such time, many boards in recent years, rather thanactually adopting rights plans when no threat to corporate independence exists, haveadopted the alternative strategy of putting all of the documents together for a stock-holder rights plan but then placing the plan “on the shelf,” keeping it ready for quickadoption in the future as needed. The benefit of this course of action is that an “on theshelf” plan does not invoke the ire of shareholder rights organizations that are gen-erally opposed to these types of defensive measures.

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 acquirer

110 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. 1988), 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”).

111 Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994). However, inAirgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182 (Del. 2010), the Delaware Supreme Court upheld aboard’s refusal to redeem a rights plan, thus successfully blocking a hostile takeover attempt at a price thatwas a significant premium to market price. A key factor behind the decision was an independent andknowledgeable board with a long-term business plan.

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from 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 havebeen struck down by Delaware courts on several occasions for a variety of reasons,including under the Unocal standards.112

SPECIAL CASE: DIRECTOR DUTIES IN THE FACE OF ACTIVIST

STOCKHOLDER DEMANDS

Since the early 2000s, 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, stockholder rightsorganizations, state pension funds and corporate raiders. Sometimes activist share-holders own a substantial block of stock of the corporation; however, many times acti-vist shareholders have only a small percentage of the corporation’s outstanding stock,but nevertheless make demands for significant control over the corporation. Whenattempting to effect change at a corporation, activist stockholders are more likely tofocus on specific key issues and exert pressure to influence corporate policies, ratherthan seek outright control of the corporation. Common demands include:

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

• Change the strategy or management of the corporation;

• Make dividend payments, repurchase stock or divest assets;

• Effect corporate governance changes;

• Sell the corporation; or

• Initiate or stop a strategic transaction.

112 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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A common goal of activist stockholders is to force an event to trigger “value crea-tion” for the stockholders, which generally means a transaction that creates full orpartial liquidity.

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 current stock price, thatemphasize results in the short term and prevent the board from focusing on and direct-ing the long-term success of the corporation. In addition, critics argue that stockholderactivism does not usually create value for the other stockholders unless the corporationis put up for sale, and even then there is little change in the stock performance of acorporation 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 and share-holder rights organizations;

• Development of “wolf packs”113;

113 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 in a stealthy manner. In thisscenario, small networks of hedge funds direct the activism and it can result in the rapid destabilization ofthe stockholder base. Similarly, hedge funds have historically avoided the ownership disclosure require-ments of the Exchange Act by utilizing equity swaps instead of acquiring the securities of a company.Notably, a decision by the United States District Court in the Southern District of New York held thatstockholders accumulating interests in a corporation through the purchase of equity swaps are subject tothe reporting requirements of Section 13(d) of the Exchange Act, and the failure to disclose those posi-tions was fraudulent. CSX Corp. v. The Children’s Investment Fund Management, 562 F. Supp. 2d 511(S.D.N.Y. 2008), aff’d in part and rev’d in part, 654 F.3d 276 (2d Cir. N.Y. 2011).

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• Stockholder proposals;

• 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 properly exercise their fiduciaryduties. For example, the Delaware Supreme Court has 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.114

114 CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227 (Del. 2008). This decision arose out ofa request from the SEC under a new certification procedure.

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

It is imperative that boards react quickly and thoughtfully to activist stockholderdemands. To help demonstrate that they are fulfilling their fiduciary duties to thecorporation, members of the board should consider carefully the demands made by thestockholder and their potential implications on the short- and long-term business goalsof the corporation. While doing so, the board must be very sensitive to any implicationthat the judgment of individual directors or officers may be compromised by duty ofloyalty considerations if the stockholder proposals could be viewed as conflicting withthe personal interests of the board or officers. By definition, many activist investordemands may place the board and the officers of the corporation in a situation inwhich conflicts of interest are implicated.

Further, many activist stockholders request a change in the board composition,either by replacing directors that they view as not functioning in accordance with theirperceived 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. Sometimes activist stockholders seek to installadvisors or management that will be sympathetic to their agenda.

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 may help the board to more effectively articulate its long-termstrategy for value creation and defend itself against claims by the activist stockholderof management or board entrenchment. Extra care should be taken to ensure that thesedirectors have access to the corporation’s management, as well as outside andindependent legal counsel, accountants and investment bankers, as needed. In addition,the directors should have access to other experts as needed, including a proxy solic-itation firm and a public relations firm to manage and address any activist stockholdermatters.

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 of

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pursuing that proposal. If there are competing proposals by the officers of the corpo-ration or others, the directors should carefully consider those proposals. The directorsshould consider whether there are any alternative courses of action, and how the pro-posal and each alternative may benefit the long-term interests of the stockholders. Inthese considerations, the directors should meet frequently so that they may share theirviews with each other as well as collect information from the corporation’s manage-ment 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 Notify 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. The board alsoshould consider that, although an activist stockholder may not hold a significantamount of the outstanding stock, its views or its demand may be shared by a majorityof the stockholders. If the board decides not to comply with the demand, public dis-closure of the reasons why the board has determined not to comply with the demandshould be considered, including explaining why the demand is not, in the view of theboard, in the best long term interests of the corporation or its stockholders.

Ultimately, activist stockholder demands may prove to be expensive andtime-consuming exercises for a board, or may prove to be useful exercises to increasevalue for the corporation’s stockholders. In any event, boards and officers will want toensure that they act responsibly in adequately addressing a particular stockholderdemand.

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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 followingin connection with responding to activist stockholder demands:

• Establish and provide resources for a special committee (or whereappropriate a disinterested and independent majority of the board) toanalyze the issue;

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

• Identify the proposal’s implications on the corporation’s short-andlong-term business goals;

• Evaluate alternative courses of action;

• Consider meeting with the proposal’s proponents to discuss availableoptions;

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

• Consider disclosing the rationale for the recommended action to stock-holders at large.

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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 affili-ated with a public corporation (often a large or controlling stockholder or an outsideinvestor, such as a private equity firm and the corpo-ration’s management team) acquires all of a publiccorporation’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.Going private transactions frequently implicate complicated fiduciary and disclosureissues for the board, the management team and the acquirer. In addition to state lawfiduciary duty concerns, going private transactions are also subject to extensive regu-lation by the SEC pursuant to Rule 13e-3 under the Exchange Act.

As discussed in detail in Chapter 2 above, transactions with controlling share-holders are typically subject to greater scrutiny absent certain procedural protectionsdesigned to protect minority stockholders. However, the question of what standard ofreview applies under various circumstances has been the subject of debate in Delawarecourts and varies depending on the facts and circumstances surrounding the transactionand, in some circumstances, the structure of the transaction itself.

STANDARDS OF REVIEW

Going private transactions are typically structured as either (i) a cash-out mergeror (ii) a tender offer followed by a back-end merger. Another, less popular option, is toeffect a going private transaction through a reverse stock split. Each of theseapproaches has its own risks and perceived benefits.

Cash-Out Merger

In a going private transaction effectuated through a cash-out merger, a majoritystockholder or other insider typically seeks to acquire the minority interest in the target

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

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through a merger of a newly formed corporation wholly owned by the acquirer withthe target corporation. The acquirer engages in direct negotiations regarding the trans-action with the target’s board (or a special committee thereof) and enters into a mergeragreement with the target after the target board approves the merger agreement.Shares are typically acquired for cash, but the consideration also can be shares of theacquirer. As a statutory matter, the merger requires the approval of a majority of theoutstanding shares of the target.

Historically, going private transactions struc-tured as mergers requiring stockholder approvalwere reviewed under the entire fairness stan-dard.115 However, Delaware courts have held thattwo procedural protections are available to allowthe target and acquirer to try to shift the burden ofshowing that the transaction was unfair back tothe plaintiffs (usually the minority stockholders). Either the transaction could be eval-uated and approved by a properly functioning independent committee of the boardwith the power to negotiate and approve the transaction and with the resources andability to hire its own independent legal and financial advisors, or the transaction couldbe approved by the majority of the minority stockholders.116

Prior to 2013, however, Delaware courts hadnot opined on the standard of review for cash-outmergers where acquirers had used both proceduralprotections. M & F Worldwide changed that,attempting to unify the standard of review forcontrolling stockholder acquisitions via tenderoffers and those via mergers. The Delaware

Supreme Court held that the business judgment rule applies to going-private trans-actions where a controlling stockholder conditions the transaction on the approval ofboth an independent special committee and a vote of a majority of the stockholdersunaffiliated with the controlling stockholder.117

115 Kahn v. Lynch Communication Systems, 638 A.2d 1110 (Del. 1994).116 Id. at 1117.117 Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014); In re MFW Shareholders Litigation, 67

A.3d 496 (Del. Ch. May 29, 2013).

The use of special committeescomposed of independent anddisinterested directors cansubstantially benefit a goingprivate process.

In cash-out mergers, boardsshould consider utilizing pro-tective measures, such asindependent committees and amajority of the minorityapproval requirement.

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Under this unified standard, the Delaware Supreme Court clarified that the busi-ness judgment standard of review is applicable if and only if:

• The controlling stockholder conditions the procession of the transaction onthe approval of both a special committee and a majority of the minoritystockholders;

• The special committee is independent;

• The special committee is empowered to freely select its own advisors and tosay “no” definitively;

• The special committee meets its duty of care in negotiating a fair price;

• The vote of the minority is informed; and

• There is no coercion of the minority stockholders.

The Delaware Court of Chancery’s decision in In re Lear Corporation Share-holder Litigation illustrates the point that material conflicts of interest involving adirector, an officer or a board advisor should be disclosed to stockholders.118 There,the court granted a preliminary injunction based, in part, on inadequate disclosuresregarding the role of the target’s CEO in negotiating the transaction and the benefitsthat he stood to gain from it. One such benefit potentially was to increase the financialsecurity with respect to the ultimate payment of the CEO’s retirement benefits. TheCEO was concerned over the company’s continued financial viability, which could beaffected by a transaction with a stronger buyer regardless of the price paid for shares inthe transaction. The CEO, who also was an inside director, was a principal negotiatorin the transaction. Although the court recognized that the CEO did not actinappropriately, it held that his interests and role should have been disclosed morecompletely to investors.

Tender Offer

Contrary to cash-out mergers, going private transactions structured as a tenderoffer by a controlling stockholder, followed by a back-end merger, have not histor-ically been subject to the entire fairness standard. Under this structure, an acquirermust obtain at least a majority of the outstanding shares in a tender offer (subject to

118 In re Lear Corp. S’holder Litig., 926 A.2d 94 (Del. Ch. 2007)

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certain additional conditions),119 and can then complete a back-end merger via a short-form merger to squeeze out any remaining stockholders who did not originally tendertheir shares.120 Historically, two-step tender offers have been perceived to be morepopular than cash-out mergers because they were subject to less scrutiny by courts ifchallenged and could be completed more quickly. Until 2010, courts relied on the PureResources three-factor plus test to determine whether a tender offer was coercive.121

Under Pure Resources, a tender offer by a controlling stockholder was held not tobe coercive when all three of the following conditions were met:

• It is subject to a non-waivable majority-of-the-minority tender provision (inother words, at least a majority of the shares held by stockholders other thanthe controlling stockholder are tendered);

• The controlling stockholder agrees to complete a short-form merger, at thesame price and as soon as practicable after completion of the tender offer, ifit obtains a majority of the shares; and

• The controlling stockholder has not made any retributive threats.122

In addition, the target and controlling stockholder had to give the target’sindependent directors “free reign and adequate time” to react to the offer, such as byhiring their own advisors to help them evaluate the offer, and had to provide full dis-closure of information that a reasonable investor would consider important in tender-ing his or her stock. This would include, for example, disclosing the content and

119 Prior to the August 2013 amendments to Delaware General Corporation Law Section 251 (“DGCL§251”), acquirers needed to hold at least 90% of outstanding shares following a tender offer to takeadvantage of a short-form merger. Following another round of amendments to DGCL §251 in August2014, controlling stockholders were also allowed to rely on this lower majority threshold for back-endmergers.

120 Under Delaware law, tender offers also can be used by private equity investors working with man-agement to acquire the corporation. However, due primarily to complications with obtaining the financingtypically utilized by private equity firms, such firms generally have avoided tender offers in favor of one-step mergers (with some recent exceptions utilizing top-up options and other structures).

121 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).

122 Id. at 445.

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background of any fairness opinion that may have been delivered to the parties inconnection with negotiating the particular transaction.123

Recent cases, however, have resulted in uncertainty regarding how Delawarecourts will review two-step tender offers.124 Under CNX Gas, the Delaware Court ofChancery held that a tender offer by a controlling stockholder followed by a short-form merger would presumptively be subject to the business judgment standard ofreview if the transaction is conditioned on both:

• the negotiation and approval of an independent special committee; and

• a vote of a majority of the stockholders unaffiliated with the controllingstockholder.

Unlike under Pure Resources where a special committee needed only to evaluatean offer and make a recommendation (or stay neutral) to stockholders as part of aneffort to avoid the burden of proving entire fairness, aspecial committee under CNX Gas had to have the board’sfull power and authority with respect to the tender offerand approve the transaction to be eligible for the businessjudgment standard of review. Thus, under CNX Gas, if thetarget’s independent directors did not approve the tenderoffer, contrary to the Pure Resources standard, the entirefairness standard would be imposed. After CNX Gas, though, the controlling stock-holder, however, could still gain the benefit of shifting the burden of disproving entirefairness to prospective plaintiffs if it obtained an affirmative vote by a majority ofminority shareholders.

In any case, under Delaware law, these varying standards give controlling stock-holders options in structuring going private transactions. They can now rely on eitherprocedural safeguard available to shift the burden of disproving entire fairness to theplaintiffs, or they can use both safeguards to invoke the presumptions of businessjudgment rule.

123 Id. at 449.124 See In re CNX Gas Corporation Shareholders Litigation, 4 A.3d 397 (Del. Ch. 2010); In re Cox

Communications, 879 A.2d 604 (Del. Ch. 2005).

Delaware courts haverecently transitioned toa unified standard ofreview for mergers andtwo-step tender offers.

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Putting aside burdens of review, tender offers by controlling stockholders may bepursued either with or without prior approval of the board (or a committee of the boardof directors – see Chapter 5) of the target. Although a tender offer does not necessarilyneed to be negotiated or approved by the board in all circumstances,125 the target mustmake full disclosure of all relevant information regarding the transaction to its stock-holders, including whether the tender offer was considered by the board (or a commit-tee thereof) and whether or not the target’s board recommends that its stockholderstender their shares into the offer. The rules and regulations of the SEC specificallyrequire that the target corporation’s board prepare a written recommendation to thestockholders in response to a tender offer and file the recommendation with the SEC.

Reverse Stock Split

A corporation may also use a reverse stock split to reduce the number of stock-holders of record to a number below the applicable deregistration threshold, suspend-ing the corporation’s SEC reporting requirements. A prospective acquirer holding aninterest in the corporation that is larger than any other unaffiliated holder may attemptto effectively acquire the corporation through a reverse stock split, in which the corpo-ration issues one new share in exchange for a number of old shares in excess of thelargest unaffiliated block of shares. Completion of a reverse stock split typicallyinvolves cash payments to unaffiliated holders in lieu of fractional shares, generallywithout the availability of appraisal rights for such stockholders. However, because thecharter of the target corporation must be amended, a reverse stock split requiresapproval by holders of a majority of the corporation’s stock.

Delaware law permits the cashing out of stockholders through the mechanism of areverse stock split, but as with everything under Delaware law, the mere power to takean action does not guarantee that the taking of such action, under the circumstances,will not be found to have violated the target board’s fiduciary duties.126 The compensa-tion of cashed-out stockholders must be at a fair price and the reverse stock split must

125 Unlike in a merger, the Delaware corporate statute does not require the target board to approve atender offer. However, in many cases the target board may be required to take some action pursuant toother circumstances, such as to provide a waiver under an existing rights agreement or other contract or toprovide an approval pursuant to state statutes governing transactions with significant stockholders such asSection 203 of the DGCL.

126 8 Del. C. §155.

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be designed in good faith and have a legitimate business purpose.127 Delaware courtshave held that the business judgment rule applies with respect to board recom-mendations for a charter amendment, in the absence of a violation of fiduciary duty.128

Although there is little case law addressing how a challenge to a going private trans-action effected through a reverse stock split would be treated by Delaware courts, itwould be advisable to assume that the standards applied would be similar to thoseapplicable to other forms of going private transactions, and utilize any proceduralprotections reasonably available in implementing such a transaction, such as requiringapproval by independent special committee composed of disinterested andindependent directors.129

Procedural Safeguards

When a going private transaction is challenged in court, and it is alleged that thetarget corporation’s board of directors breached its fiduciary duties, the manner inwhich the transaction was negotiated among the interested parties will be scrutinized.For this reason, the parties to a going private transaction are well advised to implementprocedural safeguards, including, among others, those described above during thenegotiation process. As discussed above, properly established procedural safeguardsare capable of changing the standard of review from entire fairness to that of businessjudgment or shifting the burden of proof under the entire fairness standard.

To avoid costly litigation, boards should consider creating a working subset of theboard composed of disinterested and independent directors or a special committeecomposed of independent and disinterested directors to deal with offers by potentialacquirers. In addition to helping directors satisfy their fiduciary duties, the use of adisinterested and independent subset of the board or special committee may also resultin a higher negotiated purchase price for the minority stockholders. For maximumeffect, the special committee or subset of independent and disinterested directorsshould be established early in the negotiation process, before, for instance, a decisionto focus on a particular buyer or subset of buyers is made or the deal is heav-

127 Id.; Applebaum v. Avaya, Inc., 812 A.2d 880, 886-87 (Del. 2002).128 Williams v. Geier, 671 A.2d 1368 (Del. 1996).129 See, e.g., Applebaum, 812 A.2d 880; Williams, 671 A.2d 1368.

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ily negotiated.130 Extra care should be taken to ensure that interested directors andinterested members of the management team are isolated as much as possible from thenegotiation, deliberation and decision-making process of the special committee. Thespecial committee should be empowered with real bargaining power in the process andaccess to the resources it needs, including access tomanagement, information about the business and theproposed acquirer, the authority to pursue alternativetransactions, the ability to simply say “no” to anyproposed going private transaction, and the ability tochoose and utilize independent legal counsel, finan-cial advisers, accountants and other experts. Amongother things, the disinterested and independent direc-tors likely will seek to obtain a fairness opinion froman independent investment bank as to the consideration to be paid in the transaction (orin the case of a transaction opposed by the independent and disinterested directors,consider obtaining an inadequacy opinion supporting its refusal to approve the deal).

So as to qualify for the business judgment standard of review, the board shouldalso strongly consider seeking approval of a going private transaction by a vote of amajority of the shares held by the minority stockholders (stockholders other than theacquirer and its affiliates and related persons). However, while this may help toaddress any charges of unfairness to the minority stockholders (by shifting the burdenof proof or altering the standard by which the transaction is evaluated), it alsointroduces an element of risk to the proposed transaction, since if the transaction is notapproved by a majority of the minority, a closing condition will not be satisfied andthe acquisition will be terminated. In all cases, extra care should be taken to ensurethat all material information necessary for an informed investment decision concerningthe transaction is made available to the stockholders.

130 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 should considerobtaining a fairness opin-ion from an investmentbank before approvingany business combinationtransaction, but goingprivate transactions inparticular.

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SEC REQUIREMENTS AND SCRUTINY OF GOING PRIVATE TRANSACTIONS

Acquirers in going private transactions must sat-isfy disclosure requirements pursuant to Rule 13e-3under the Exchange Act, which is designed to protectminority stockholders in a going private transactionby requiring disclosure that helps stockholders eval-uate the fairness of the transaction and other materialinformation. In addition to the acquirer’s tender offeror proxy filing obligations, the target corporation isrequired to file a Schedule 14d-9 setting forth itsrecommendation with respect to the tender offer ormerger, any material factors supporting that recommendation and any reports, opinionsand appraisals by financial advisers, as well as a Schedule 13e-3.

The SEC staff carefully reviews filings made in connection with going privatetransactions, and companies should consider allocating appropriate time to provide forresponses to any SEC review. Among other things, the SEC will review disclosuresrelating to valuation, fairness of the transaction price, transaction background and his-tory, and the independence of the directors (or members of the special committee)recommending or approving the transaction.

Boards should be mindfulthat SEC requirementsmandate extensive dis-closure of the entireprocess involved innegotiating and approv-ing a going private trans-action.

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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 nostatutory requirement under Delaware lawthat a board of directors utilize a specialcommittee composed of independent131 anddisinterested132 directors when considering arelated-party transaction, Delaware courtshave indicated that in the absence of such acommittee (or a majority of the board beingcomprised of disinterested and independentdirectors functioning in an equivalentmanner), a going private transaction may bemore likely, under the entire fairness standard, to be unfair to the minority stock-holders. Technically, a special committee is only required where, in the absence of thecommittee, a majority of the board would not otherwise be disinterested andindependent. However, even in circumstances where a majority meets that criteria, theuse of a special committee should be considered to more effectively insulate the proc-ess of the proposed transaction from the directors who are conflicted.

In the event of an alleged breach of fiduciary duty, it is the controlling party thatgenerally bears the burden of proving the entire fairness of the transaction (the entirefairness test is discussed more fully in Chapter 2).

131 In the context of approval of a related-party transaction, “independence” means that the director iscapable of making an independent decision not influenced by extraneous consideration or influences otherthan the corporate merits of the subject before the board. This definition differs from the concept of“independence” contemplated by stock exchange rules requiring that a majority of a board be composedof independent directors.

132 In the context of approval of a related-party transaction, “disinterested” means the director wouldnot derive any personal benefit from the subject transaction that is not shared by all stockholders.

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.

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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 transactionby a disinterested and independent, fully informed committee of directors that activelynegotiated the transaction on an arms-length basis.133 In assessing whether the burdenshould be shifted, Delaware courts have considered a variety of factors, including:

• Whether the committee members were disinterested and independent;

• Whether the committee members and the committee’s representatives wereinformed and actively engaged in a negotiation process; and

• The extent of the powers granted to the committee.

Further, as discussed in Chapter 4 above, the use of a properly functioning specialcommittee together with a requirement that a transaction be approved by a majority ofthe minority stockholders can, in certain circumstances, reduce the standard of reviewfrom the entire fairness standard to the business judgment standard.

COMMITTEE COMPOSITION: DISINTERESTED AND INDEPENDENT

To be effective, the committee members should be disinterested and independent.

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 deal-ings with the other party that would not be available but for the challenged transaction.

133 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, 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 or she may still be deemed to be incapableof making an independent decision if the decision would be based on extraneousconsiderations or influences rather than the meritsof the transaction being considered by the board. Inthis regard, courts often look to whether the directoris controlled by or beholden to another person orentity, or whether other outside influences affect hisor her business judgment. For example, in In reMaxxam, Inc./Federated DevelopmentShareholders Litigation,134 special committeemembers were found to lack independence wherethey received significant compensation fromemployment by entities controlled by the individualwho controlled the corporation’s major stockholder.In In re Oracle Corp. Derivative Litigation,135 two special litigation committee mem-bers who were both Stanford University professors were found to lack independencewhere they had been tasked with deciding whether to pursue insider trading litigationagainst directors including a fellow Stanford professor and two benefactors of theuniversity. In contrast, Delaware courts have found that a personal friendship betweena special committee member and an interested party, without more, will not necessa-rily result in such special committee member lacking independence.136

In addition to ensuring that the members of the special committee are independentand disinterested, the committee should consider carefully whether any of the financialor legal advisors it selects have a material relationship with the related parties in thetransaction. Delaware courts have expressed reservations about a special committee’sindependence where the committee’s advisors had financial ties to the controllingparty, including through the prior provision of professional services to the targetcorporation.137 Although such financial ties are only one of a number of factors consid-

134 In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760 (Del. Ch. 1995).135 In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003).136 Beam v. Stewart, 845 A.2d 1040 (Del. 2004).137 See, e.g., In re Tele-Communications, Inc. Shareholders Litigation, No. 16470, 2005 Del. Ch.

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

To be effective, specialcommittees should:• Be composed of

independent and disin-terested directors;

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

• Be active in the negotia-tions process.

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ered by the courts, they are likely to cause greater scrutiny of the adequacy of thecommittee’s process. A special committee’s use of one or more of the corporation’sexisting advisors may be justified depending on the facts and circumstances; however,the committee’s perceived independence may be enhanced if it retains advisors withno prior relationship with the corporation.138 Use of the corporation’s existing advisorsmay be viewed by a court as detracting from the committee’s independence.139

Although the DGCL permits a committee to be composed of one member, it is advis-able that boards appoint more than one member to a special committee.140 And finally,it is important that the members of the committee be chosen solely by independent anddisinterested directors – the participation by one or more interested or conflicted direc-tors in the selection of the committee can itself taint the process.

In making determinations as to whether an individual or firm is disinterested andindependent, directors likely will want to carefully examine historical financial rela-tionships and other connections. A list of factors and questions to consider is set forthon page 81 under the caption “Considerations in Determining Whether An Individualor Firm May be Viewed as Disinterested and Independent.”

COMMITTEE’S CHARGE: BE INFORMED AND ACTIVE

To be informed, the special committee must be knowledgeable concerning thecorporation’s business and must be involved in or kept abreast of the ongoing negotia-tions. To be active, the members should either be involved in the negotiations or fre-quently communicate with the person designated to negotiate the transaction. Further,the committee should meet and consult with its advisors frequently to ensure that it hasknowledge of the essential aspects of the transaction.141 Situations where Delawarecourts have held that special committees were not informed and active include where:

• The committee never negotiated for a better price;142

• The committee failed to choose its own independent advisors;143

138 Citron v. E.I. Du Pont de Nemours & Company, 584 A.2d 490 (Del. Ch. 1990).139 See, e.g., Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997).140 The laws of some states, for example, California, prohibit committees of only one member. See, e.g.,

Cal. Corp. Code § 311.141 Kahn v. Tremont, 694 A.2d 422, 430 (Del. 1997).142 In re Maxxam, Inc./Federated Development Shareholders Litigation, 659 A.2d 760, 768-70.143 Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261 (Del. 1989).

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• The committee members failed to attend the informational meetings with thecommittee’s special advisors;144

• 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;145

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.146

In contrast, the Delaware Court of Chancery held that committees were informedand active where:

• The committee bargained hard, held out to get a higher price and ensuredthat the committee retained sufficient flexibility to accept a higher bid;147

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.148

144 Kahn v. Tremont Corp., 694 A.2d 422, 429-30 (Del. 1997).145 In re Tele-Communications, Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS at *49.146 In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011).147 In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531, 546 (Del. Ch. 2003).148 Kohls v. Duthie, 765 A.2d 1274, 1285 (Del. Ch. 2000).

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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.149 In Airgas, Inc. v.Air Products and Chemicals,Inc.,150 the Delaware SupremeCourt reaffirmed the principle thatan independent and knowledgeableboard, confident in the corpo-ration’s long-term business plan,

can block a bid that the board determines to be inadequate. After the board of Airgasrejected a fully financed hostile offer made by Air Products at a price significantlygreater than Airgas’ trading price, Air Products launched a proxy contest to replace themembers of Airgas’s staggered board and sought to force the Airgas board to redeemits shareholder rights plan. After the board’s action in refusing to redeem the rightsplan was upheld in court, both at the Court of Chancery and then at the DelawareSupreme Court, Air Products terminated its pursuit of Airgas.

However, the power to say “no” alone may not be sufficient to shift the burden inthe context of a transaction subject to the entire fairness standard. The committeeshould be empowered to actively negotiate with the related party in a manner thatapproximates an arms’ length transaction.151 For example, in In re Republic AmericanCorporation Litigation,152 the Delaware Court of Chancery held that a special commit-tee that had only been empowered to pass on the fairness of the transaction price didnot have sufficient power to shift the burden on entire fairness. Similarly, the court Inre Southern Peru, held that a committee’s failure to actively seek other potential trans-actions as an alternative to a transaction proposed by the company’s majority stock-holder was a factor in concluding that the committee did not have negotiating leverage

149 In re First Boston, Inc. Shareholders Litigation, No. 10338, 1990 Del. Ch. LEXIS 74 (June 7, 1990).150 Airgas, Inc. v. Air Products and Chemicals, Inc., No. 649, 2010 (Del. Nov. 23, 2010)151 Rabkin v. Olin Corp., 1990 Del. Ch. LEXIS 50 (Del. Ch. Apr. 17, 1990).152 In re Republic American Corporation Litigation, No. 10112, 1989 Del. Ch. LEXIS 31 (Del. Ch.

Apr. 4, 1989).

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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.”


and was not properly functioning.153 In addition, a board should consider the followingwhen 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;

• 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.154

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.155 Specifically, the extent to which a specialcommittee is permitted or required to implement defensive measures under certaincircumstances is still an open question. However, Delaware courts have suggested thata special committee must aggressively defend against a transaction that they deemunfair to the minority, which may involve considering whether to implement a poisonpill or other deterrent.156 Also, in empowering a committee, care should be taken not toundermine other procedural protections. For example, the court in In re John

153 In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011).154 It is notable, however, that special committees cannot be granted unlimited power. Specifically, the

DGCL 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. §141(c)(2); Krasner v. Moffett, 826 A.2d 277 (Del. 2003).

155 Although, the court suggests in In re Southern Peru, 30 A.3d 60 (Del. Ch. 2011) that a specialcommittee should critically review and continuously evaluate, instead of merely rationalize, a proposedtransaction and avoid falling into a “controlled mindset.”

156 In re Pure Resources, Inc. Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002).

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Q. Hammons Shareholder Litigation157 declined to apply the business judgment rule inthe context of a challenged transaction in part because a special committee had theability to waive a requirement that the subject transaction be approved by a majority ofminority vote. As the court explained, “an effective special committee, unlike dis-aggregate stockholders who face a collective action problem, has bargaining power toextract the highest price available for the minority stockholders. The majority-of-minority vote, however, provides minority stockholders an important opportunity toapprove or disapprove of the work of the special committee and to stop a transactionthey believe is not in their best interests. Thus, to provide sufficient protection to theminority stockholders, the majority-of-minority vote must not be waivable even by thespecial committee.”158

LEGAL DUTIES OF SPECIAL COMMITTEE MEMBERS

The legal obligations of directors serving on the special committee are not 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.

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 assist the target corporation inreplicating as much as possible the process that would occur in a negotiated trans-action between the corporation and an unrelated third party. The utilization of a prop-erly functioning special committee provides “powerful evidence of fairness.”159 Thelegal benefits resulting from special committee approval of a transaction will accrue,however, only if the special committee is independent and disinterested, active,informed and has real bargaining power.

157 In re John Q. Hammons Shareholder Litigation, 2009 Del. Ch. LEXIS 174.158 Id. at *42.159 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 or other conflict,the board should consider whether use of a special committee might enhance theprocess of evaluating the transaction. If a special committee is used, it will beviewed as being most effective if it operates 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 and the power to consideralternative transactions.

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Considerations in Determining Whether an Individual or Firm Maybe Viewed as Disinterested and Independent

To ascertain potential conflicts in selecting advisors, directors shouldconsider questioning potential advisors regarding any existing, past or con-templated relationships with the company, potential buyer or any of theirrespective affiliates as to the following, among other things:

1. Tell us about any economic or other material relationships you may haveor contemplate with the prospective buyer or any of its affiliates, includingwhether you or any of your officers, directors or principals are investors in, orhave done any material work for, or are seeking to do any material work for, thebuyer or any of its affiliates.

2. Tell us about your historical relationship with the company, includingwhether your firm or any of your officers, directors or principals have beenengaged by the company for any work.

3. Tell us whether your firm, your officers or directors have in the pastworked for any person affiliated with the company or the potential buyer inconnection with any other matter, whether related to the company or not.

4. Have you discussed the contemplated transaction, or any similar trans-action involving the company, with any other person?

5. Please describe any business, family or other non-business relationshipsyou or any member of your firm has with any member of the company, the buyeror any of their respective members or affiliates.

It is important to note that an existing or previous relationship between apotential advisor for a particular situation and the company, the buyer or either oftheir respective affiliates or members, does not necessarily preclude the potentialadvisor from being viewed as disinterested or independent. The board must eval-uate the extent of the relationship, including the size, timing, hiring party,materiality of the investment or fees and any other relevant details and determinewhether any of the facts could lead to a perceived bias for such advisor.

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It is also important to note that it is not always possible, or even advisable,to avoid all conflicts, and in fact the best advisor may be one who has some rela-tionships or other potential conflicts. However, the board should take steps toensure that it understands the potential conflicts and their implications, and con-sider steps to avoid or mitigate the impact of any potential or actual conflict, sothat the board ultimately can decide whether the benefits of a particular advisor(with any mitigating measures) outweigh the detriments of the potential conflicts.The board also should be prepared to disclose the potential conflicts to thecompany’s shareholders.

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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,when the corporation becomes insolvent, thebeneficiaries of those duties expands from thestockholders of the corporation to include thecreditors of the corporation. Because actions thatdirectors may take when trying to manage the business during solvency for the benefitof stockholders may differ from actions they may take to maximize value for creditors,it is important to be able to identify when the corporation has become insolvent and,thus, when the recipient of the fiduciary duties changes.160

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 business

160 Not all states extend such fiduciary duties to creditors during insolvency. See, e.g., In re BosticConstruction, Inc., 435 B.R. 46 (Bankr. M.D.N.C. June 25, 2010) (“In North Carolina, directors of acorporation do not owe a fiduciary duty to the creditors of the corporation.”).

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


by 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“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 often is 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 solvent to insolventunder 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 value of its total assets; and

• Equitable Insolvency Test – A corporation is insolvent when it is generallyunable to pay its debts as they become due.

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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.161

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). In many bankruptcy cases, the aggregate proofs of claim filedby creditors far exceed the balance sheet liabilities, and many assets realize disappoint-ing recoveries, such as receivables that are collected less offsets and defenses by coun-terparties. Moreover, the Bankruptcy Code test for solvency is nearly identical to theDelaware test. With that reality having been determined, it can be 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, even as to some pre-bankruptcytime.

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.

161 See, e.g., North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006Del. Ch. LEXIS 164, at *47 (Del. Ch. Sept. 1, 2006), aff’d, 931 A.2d 92 (Del. 2007), and Quadrant Struc-tured Products Company, Ltd. v. Vertin, 115 A.3d 535, 539 (Del. Ch. 2015).

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DUTIES TO CREDITORS WHEN THE CORPORATION IS INSOLVENT

The Introduction of the Zone of Insolvency Concept

Although the question of when directors’ fiduciary duties shift from stockholdersto creditors is now settled in favor of insolvency as the test, Delaware and bankruptcycourts introduced significant uncertainty into this question in the early 1990s in a ser-ies of decisions that focused on the so-called “zone of insolvency” test creating an ear-lier trigger.

The Delaware Court of Chancery first introduced the “zone of insolvency” con-cept in its 1991 decision in Credit Lyonnaise Bank Nederland, N.V. v. PatheCommunications Corp.162 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 dutyto the corporate enterprise,” which includes both stockholders and creditors.163 Thecourt noted that “[t]he possibility of insolvency can do curious things to incentives,exposing creditors to risks of opportunistic behavior and creating complexities fordirectors.”164 Directors must realize that to manage the business affairs of a solventcorporation in the vicinity of insolvency, circumstances may arise when the right (boththe efficient and the fair) course to follow for the corporation may diverge from thechoice that the stockholders (or the creditors, or the employees, or any single groupinterested in the corporation) would make if given the opportunity to act.165

Unfortunately, the courts did not provide clarity as to when exactly a corporationwould be deemed to have entered into the zone 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 the

162 No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991).163 Id. at *108 and n.55.164 Id. n.55.165 Id .

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corporation 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.

The relevance of this history now is to caution directors of a distressed corpo-ration to begin thinking defensively when the corporation is nearing insolvency. Thisis especially wise because in hindsight most corporations are demonstrated to havebecome insolvent sooner than they realized.

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 zone of insolvency. In2006, the Delaware Court of Chancery decided North American Catholic EducationalProgramming Foundation, Inc. v. Gheewalla,166 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.”167

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 begranted standing because they are the principal remaining constituency with a materialincentive to pursue derivative claims on behalf of the corporation has significantintuitive and persuasive merit.”168 However, the court did not address the merits ofthose particular arguments due to the simple fact that the plaintiffs’ case was based ona direct claim of breach of fiduciary duty (i.e., a breach of a duty owed directly to thecreditors) and not a derivative claim of breach of fiduciary duty (i.e., a breach of aduty owed to the corporation brought on behalf of the corporation by the creditors).

166 2006 Del. Ch. LEXIS 164.167 Id . at *65.168 Id. at *55-56.

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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 feel compelled toconsider.”169 The court noted that because creditors have existing protections affordedby other sources, such as the credit documents, additional protection through directclaims of breaches of fiduciary duty is inefficient.

On appeal, the Delaware Supreme Court affirmed thetrial court’s holdings, noting that “the need for providingdirectors with definitive guidance compels us to hold that nodirect claim for breach of fiduciary duties may be assertedby the creditors of a solvent corporation that is operating inthe zone of insolvency. When a solvent corporation isoperating in the zone of insolvency, the focus for Delawaredirectors does not change – directors must continue to discharge their fiduciary dutiesto the corporation and its stockholders by exercising their business judgment in thebest interests of the corporation for the benefit of its stockholder owners.”170

169 Id. at *62.170 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92,

101 (Del. 2007). An intermediate appellate court in California also held that there is not a duty to creditorswhen a corporation is in the “zone of insolvency,” but after insolvency, creditors are entitled to protectionunder the “trust fund doctrine” to prevent dissipation, diversion or undue risk to assets that might other-wise be used to pay creditors. Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020, 1041(2009). Similarly, the United States District Court for the Southern District of New York has held that“New York State’s corporate directors do not owe a duty of care to a corporation’s creditors when thecorporation is arguably operating within the ‘zone of insolvency.’” RSL Commc’ns PLC v. Bildirici, 649F. Supp. 2d 184, 203 (S.D.N.Y. 2009), aff’d sub nom. RSL Commc’ns PLC, ex rel. Jervis v. Fisher, 412 F.App. 337 (2d Cir. 2011). However, the United States Bankruptcy Court for the Eastern District of Virginiahas held that “once a [Virginia] corporation enters the zone of insolvency, the fiduciary duties owed bythe Directors extend also to the corporation’s creditors.” In re James River Coal Co., 360 B.R. 139, 170(Bankr. E.D. Va. 2007).

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Operating in thezone of insolvencydoes not changedirectors’ fiduciaryduties.


The Delaware Supreme Court Provides Additional Clarity

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

who have standing to bring derivativeactions on behalf of the corporationbecause they are the ultimate benefi-ciaries of the corporation’s growthand increased value. When a corpo-ration is insolvent, however, its cred-itors take the place of thestockholders as the residualbeneficiaries of any increase in value.

Consequently, the creditors of an insolvent corporation have standing to maintainderivative claims against directors on behalf of the corporation for breaches of fidu-ciary duties.” The Supreme Court held that “individual creditors of an insolvent corpo-ration 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.”171

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). As a prac-tical matter, outside of bankruptcy, it may only be rational for an individual creditor tobring a derivative claim against the directors, where the recovery would go to thecorporation itself (ostensibly for the benefit of all creditors), instead of to the plaintiff

171 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 the corporation’sestate, including creditors. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 358 (1985).

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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.


creditor, in a fairly unique set of circumstances, such as where the plaintiff creditorhad a relatively large stake in the outcome vis-a-vis other creditors.172 In a Chapter 11case, however, such claims may be pursued by an unsecured creditors committee inorder enhance the recoveries of all creditors.

It may also be worth noting that since there is no warning bell when insolvencyoccurs, directors and officers of a distressed, but not yet insolvent, corporation in the zoneof insolvency, while not facing any derivative liability in creditor actions after Gheewalla,still should be thinking carefully about what they choose to do in terms both of their dutiesto stockholders and the possibility that those duties will expand to include creditors atsome unknown moment if and when the corporation slips into insolvency. Whether direc-tors owe duties to shareholders, creditors, or both, the business judgment rule applies, andit does not necessarily require that the subject become more conservative and favor cred-itors prophylactically over shareholders once the creditors have become beneficiaries ofthe duty.173 Of course, in light of the same hindsight risk discussed above in connectionwith solvency determinations, as a practical matter officers and directors probably willwant to be more conservative in their decisions. In addition, there are other potential pit-falls for directors to consider as the business approaches insolvency. For example, direc-tors can be personally liable for the payment of withholding taxes if those taxes are notwithheld and paid by a corporation. Consequently, close monitoring of the corporation’sfinancial condition as 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 compa-nies often are torn between attempts to turnaround the corporation’s fortunes and termi-nate the corporation’s existencethrough a sale of the corporation or, in partic-ularly dire situations, liquidation and dissolutionor bankruptcy. The threat of deepeninginsolvency claims would influence directors to

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

173 Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772, 787-88, 790 n.57 (Del. Ch.2004)

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


terminate their corporation’s existence, rather than prolong its life with the hope ofproviding a greater benefit to stockholders in the long run.

In 2001, the Third U.S. Circuit Court of Appeals recognized174 for the first time adeepening insolvency claim. The crux of the claim is that creditors of a corporation areharmed 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.

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.”175

Strategies that result in continued or even deepening insolvency do not in them-selves give rise to a cause of action. “Rather, in such a scenario the directors are pro-tected by the business judgment rule.”176

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.”177

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), subsequent bank-

174 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001).175 906 A.2d 168, 174 (Del. Ch. 2006), aff’d, 931 A.2d 438 (Del. 2007); see also Berg & Berg Enter-

prises, LLC v. Boyle, 178 Cal. App. 4th at 1041 (duty is to avoid “actions that divert, dissipate, or undulyrisk corporate assets that might otherwise be used to pay creditor claims”) (emphasis in original).

176 Id. at 205.177 Id.

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ruptcy cases have allowed deepening insolvency to be argued as a theory of damagesfor valid causes of action (e.g., a breach of the duty of loyalty).178 As a result, directorsof Delaware corporations should be mindful of the deepening insolvency concept andthe possibility that it could be invoked to measure a plaintiff’s alleged damages, onanother cause of action.

DUTIES DURING BANKRUPTCY PROCEEDINGS

The directors of a corporate debtor-in-possession in a bankruptcy proceedingpursuant to Chapter 11 of Title 11, United States Code (the “Bankruptcy Code”) havetwo sets of fiduciary duties: those prescribed by state corporate law and those pre-scribed by federal bankruptcy law. In instances where the two conflict, a director’sfederal bankruptcy law duties are paramount. The following discussion focuses onthese federal bankruptcy law duties as they have been articulated in the BankruptcyCode and case law. The standard state law fiduciary duties (i.e., duty of care and dutyof loyalty) remain as described in Chapter 2 and elsewhere in this Handbook.

Unless a trustee has been appointed in aChapter 11 case, the existing corporate gover-nance remains in place and the directors assumethe fiduciary duties of a debtor-in-possession.179

Pursuant to Section 1107(a) of the BankruptcyCode, a debtor-in-possession functions as atrustee, and is given all of the powers and duties of a trustee, with the exception ofcertain investigative functions.180 Thus, the various statutory provisions and legal doc-trines defining the fiduciary duties of a Chapter 11 trustee are equally applicable to adebtor-in-possession.181 It should be noted, however, that some courts have indicated

178 See, e.g., In re Brown Schools, 2008 Bankr. LEXIS 1226 (Bankr. D. Del. Apr. 24 2008).179 In re FSC Corp., 38 B.R. 346, 349 (Bankr. W.D. Pa. 1983).180 11 U.S.C.S. §1107(a) (1984).181 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).

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Debtors-in-possession owefiduciary duties under stateand federal bankruptcy lawto both creditors and stock-holders.


that a Chapter 11 trustee running the business of a debtor may be subject to less courtoversight than a debtor-in-possession.182

A debtor-in-possession owes a fiduciary duty to all interested parties, creditorsand stockholders alike.183 The substance of these federal bankruptcy law fiduciaryduties 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.184 Thedebtor-in-possession has a duty of loyalty to “maximize the value of the estate,”185

refrain from self-dealing, and treat all parties fairly in “resolv[ing] the tension whichresults from the sometimes conflicting objectives of [the diverse] constituencies.”186

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 would 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.

182 See In re Lifeguard Industries, Inc., 37 B.R. 3, 17 (Bankr. S.D. Ohio 1983); In re Airlift Interna-tional, Inc., 18 B.R. 787, 789 (Bankr. S.D. Fla. 1982); In re Curlew Valley Associates, 14 B.R. 506, 510n.6 (Bankr. D. Utah 1981).

183 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).

184 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).

185 Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 352 (1985).186 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).

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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.187 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’sassets. 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.188 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.

187 8 Del. C. §§278, 279.188 8 Del. C. §§279, 291.

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


THINGS TO REMEMBER WHEN MANAGING A BUSINESS ON THE VERGE OFINSOLVENCY

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 boarddoes 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 madefor the purpose of obtaining legal advice.189 The essence of the privilege is thatcommunications between a lawyer and his or her client are not subject to discovery inlitigation, 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.”190 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 [or her] to give sound informedadvice.”191 Attorney-client privilege appliesto both oral and written confidentialcommunications provided for the purpose oflegal advice, either originating from the clientor from the lawyer in response to a client’sinquiries.192 However, privilege protects onlycommunications, not the underlying facts communicated.193 In addition, attorney-clientprivilege is generally inapplicable to the information the attorney receives fromindependent non-client sources.

There are exceptions to the attorney-client privilege that result in otherwise priv-ileged communications losing their privileged status. For example, in the context of aderivative stockholder action, a claim of attorney-client privilege can also be defeatedupon a showing of “good cause,” as described below.194 The attorney-client privilege

189 8 JOHN H. WIGMORE, EVIDENCE §2290 (John T. McNaughton rev. ed., 1961).190 Upjohn v. United States, 449 U.S. 383, 389 (1981).191 Id. at 390.192 Id. at 389.193 Id. at 395.194 Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970).

The privilege protects only thecommunications between the clientand the lawyer, and not the under-lying facts.

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can be waived either intentionally or by inadvertent disclosure of privilegedinformation. Further, in certain limited situations, the attorney-client privilege cannotbe asserted, such as to protect communications that further an ongoing crime or fraud,known as the crime-fraud exception.

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;

• When the communications relate to thepurpose of receiving legal advice;

• When the communications are made inconfidence by the client;

• When the communications are, at theclient’s insistence, permanently pro-tected from disclosure by the client orby the legal advisor; and

• When the protection is not waived.195

195 8 JOHN H. WIGMORE, EVIDENCE §2292 (John T. McNaughton rev. ed., 1961).

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


Attorney-client privilege in the corporate context exists but can be difficult todefine. When a lawyer is representing a corporation, the lawyer’s professional duties

are owed to an entity, rather than to any officer, director,employee, stockholder or other constituent of the corporation.A lawyer representing a corporation must communicate with,and receive direction from, the client through its officers,directors and employees.196 Accordingly, “[a]n otherwise priv-ileged communication by a lawyer to a corporate agent doesnot lose its protected status simply because the agent thenconveys the attorney’s opinion to a corporate committeecharged with acting on such issues.”197 Over time, the state andfederal courts have developed the following three differentmethods to determine whether certain communications areconsidered privileged in the corporate context:

• 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.198 As noted in the discussion of theUpjohn test below, this test has beencriticized by Federal courts as too nar-row199 and inadequate.200

• 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.201

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

197 Shriver v. Baskin-Robbins Ice Cream Co., 145 F.R.D. 112, 114 (D. Colo. 1992).198 Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D. Pa. 1962).199 Upjohn, 449 U.S. at 392.200 Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 491 (7th Cir. 1970).201 Id.; Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977).

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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 privilege maybe limited and may notextend to all employees.


• 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 factors202:

O whether the communications are made by employees to corporatecounsel 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 whether the information was available from upper-echelon management.203

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 counseldistributed confidential questionnaires to managersseeking information regarding the payments and inter-viewed corporate personnel. The corporation thenshared some of the information with the SEC. The

Internal Revenue Service later commenced its own investigation and issued a sum-mons requiring production of all files relating to the corporation’s internal inves-tigation, specifically including the questionnaires. The corporation claimed that theattorney-client privilege applied to the files from the internal investigation. The Appel-late Court applied the control-group test and held that privilege did not apply to

202 Upjohn, 449 U.S. at 396-9.203 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 the employee’s employment; (4) with an attorney who is authorizedby the management to inquire into the subject; and (5) when the attorney is seeking information to assisthim or her in either (a) evaluating whether the employee’s conduct is binding on the corporation;(b) assessing the legal consequences of the employee’s conduct; or (c) preparing legal responses to actionsof others regarding that conduct. Id. at 403.

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


communications with middle management employees who could not direct the corpo-ration’s response to the legal advice received. However, the Supreme Court reversed,finding the control-group test too limited, and held that the communications by thecorporation’s employees to counsel were covered by the attorney-client privilegeinsofar as the responses to the questionnaires and any notes reflecting responses tointerview questions were concerned.204

Although the Upjohn test is now the prevailing test used to evaluate when theattorney-client privilege applies in the corporate context in federal courts and manystate courts, some state courts still use variations of both the control-group and subjectmatter tests.

INVOKING AND WAIVING PRIVILEGE

The corporation’s attorney-client priv-ilege belongs to the corporation, thus thepower to invoke or waive the privilege lieswith the corporation’s management orauthorized agents. An individual cannot pre-vent disclosure of communications betweenhimself and the corporation’s counsel if thecorporation has waived privilege.205 Further, communications involving personal orindividual concerns of a corporate agent often are not entitled to the privilege.206 Incertain circumstances, if an employee of a corporation seeks legal advice from thecorporation’s counsel for himself or if that corporate counsel acts as a joint attorneyand dual representation may exist, the employee may be able to invoke the privilege.207

However, as illustrated by the Ninth Circuit’s decision in United States v. Ruehle,employees must be made aware that the corporation controls the attorney-client priv-ilege and the privilege may not protect employee communications made in the courseof an investigation from disclosure to third parties, including the government. Thecorporation has discretion to waive the privilege or otherwise disclose informationwithout input from individual employees, unless the individual employees retain

204 Id. at 383-384.205 Diversified Indus., Inc. v. Meredith, 572 F.2d at 611 n.5.206 Horton, 61 BUS. LAW. at 112.207 Id.

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Disclosing confidential and priv-ileged communications toindividuals outside the corpo-ration, such as the corporation’saccountants, may result in lossof the privilege.


independent legal counsel at the outset of the investigation to protect their individualinterests, or clearly seek dual representation by the corporation’s attorneys in a waythat maintains their individual privilege.208

An officer or agent acting within the scope of his or her authority also has thepower, advertently or inadvertently, to waive the attorney-client privilege. Usually, ifcommunications are disclosed to third parties, not for the purpose of assisting theattorney in rendering legal advice, the privilege is lost.209 However, under the jointdefense theory, in the context of an internal corporate investigation, disclosure by in-house counsel of privileged communications to present and former employees or otherco-defendants and their attorneys does not result in the loss of the confidentiality pro-tections of the attorney-client privilege.210

Effectively, the joint defense theory is meant tosupport the “advantages of, and even, thenecessity for, an exchange or pooling ofinformation between attorneys representingparties sharing such a common interest in liti-gation, actual or prospective.”211 Additionally,the Delaware Court of Chancery has held that Delaware law approves the privilege’sapplication to attorney-client communications where an investment banker is present,especially in the context of a corporate transaction.212 The common interest privilegealso can be extended to communications with auditors.213

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.214 The new managers or trustees may assert orwaive the privilege, even as to communications made by former directors and officers.215

208 United States v. Ruehle, 583 F.3d 600 (9th Cir. 2009).209 Thomas R. Mulroy & Eric J. Muñoz, The Internal Corporate Investigation, 1 DEPAUL BUS. &

COM. L.J. 49, 61-62 (2002); but see 3Com Corporation v. Diamond Holdings, Inc., C.A. No 3933 (Del.Ct. Ch. May 31, 2010).

210 Id.211 Id. at 62. See also Transmirra Prods. Corp. v. Monsanto Chem. Co., 26 F.R.D. 572, 579 (S.D.N.Y. 1960).212 3Com Corporation, C.A. No 3933.213 See, e.g., Sherman v. Ryan, 911 N.E.2d 378, 400-02 (Ill. App. Ct. 2009).214 Commodity Futures Trading Comm’n, 471 U.S. at 349.215 Id.

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Although the attorney-clientprivilege belongs to the corpo-ration, it can be waived, eveninadvertently, by an officer ordirector acting within the scopeof his or her duties.


Similarly, the power to assert and waive a subsidiary’s privilege passes to new owners;once control of the subsidiary passes, the former parent corporation can no longer preventthe subsidiary from waiving privilege.216

In-House Counsel

There have been additional concerns regarding the applicability of attorney-clientprivilege to communications between the corporation and in-house counsel. Generally,internal communications between in-house counseland corporate employees may be covered by attorney-client privilege if the communications concern matterswithin the scope of the employee’s corporate dutiesand the employees are sufficiently aware that questionsposed to them by in-house counsel are for the purposeof the corporation obtaining legal advice.217 In-housecounsel typically communicate with a broader range of corporate agents than outsidecounsel, including agents who are involved in the daily implementation of corporatepolicies and are more likely to be aware of issues and problems that may arise thanupper-level management. Attorney-client privilege works to promote free communica-tion between employees and in-house counsel in the corporate context; without suchprotection, internal counsel could face difficulty in assisting the corporation withresolving and remedying legal matters.218

EXAMPLES OF WAIVER

Inadvertent Waiver

An inadvertent waiver often 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.219 However, mostcourts conclude that such inadvertent and mistaken disclosure of information does notresult in waiver if the company took reasonable precautions to prevent disclosure andpromptly took reasonable steps to rectify such error.220 Other courts hold that becausea client is the only one who can waive the privilege, the accidental and inadvertent

216 Id.217 Upjohn, 449 U.S. at 403.218 Horton, 61 BUS. LAW. at 128-29.219 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1:23 (2007).220 Id.; Fed. R. Evid. 502(b).

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


disclosure of confidential information alone is insufficient to constitute a waiver.221

Federal rules of evidence and most state ethics rules require that when an attorneyreceives materials that relate to another attorney’s representation of his or her clientand knows or reasonably should know the materials were sent inadvertently, that per-son should promptly notify the other party of such disclosure so he or she can takeprotective action.222 In the event a document is inadvertently produced, the lawyer canmove for return of the document and that it be banned from use in the litigation inorder to maintain privilege.223

Federal Rule of Civil Procedure 26(b)(5)(B) further allows a producing party tonotify the receiving party of information produced in discovery that is subject to aclaim of privilege or of protection as trial-preparation material.224 On receipt of thenotice, the receiving party “must promptly return, sequester, or destroy the specifiedinformation and any copies it has; must not use or disclose the information until theclaim is resolved; must take reasonable steps to retrieve the information if the partydisclosed it before being notified; and may promptly present the information to thecourt under seal for a determination of the claim.”225

Deliberate Waiver

Occasionally, a corporation may decide deliberately to disclose a confidentialcommunication 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 mergeror filing a registration statement with the SEC.226 In these circumstances, most courtswill find that the disclosure waives privilege.227

Selective Waiver

Some courts hold that the doctrine of selective waiver works to preserve attorney-client privilege and work product protection against third parties on certain privileged

221 Id.222 Id.223 Id.226 F.C. Cycles International, Inc. v. Fila Sport, S.p.A., 184 F.R.D. 64, 73-74 (D. Md. 1998).227 United States v. Billmyer, 57 F.3d 31, 36-37 (1st Cir. 1995).

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documents or materials that have been previously disclosed to a government agency.228

Selective waiver was recognized in Diversified v. Meredith when the court assertedthat the right to disclose investigative material to a federal agency should result in thelimited waiver of the attorney-client privilege for that purpose.229 However, selectivewaiver is reviewed by courts on a case-by-case basis. Unlike in Diversified, manycourts have refused to recognize selective waiver of attorney-client privilege. Forexample, in 2006 the court in In re Qwest Communications International Inc. Secu-rities Litigation230 rejected Qwest’s assertion that thousands of documents in a classaction litigation were protected by the attorney-client privilege where it had previouslyproduced such documents to the SEC and the Department of Justice under con-fidentiality agreements that provided for selective waiver during an investigation.

Crime-Fraud Exception

Attorney-client privilege does not apply to communications by a client with his orher lawyer that further ongoing criminal activities. This is known as the crime-fraudexception. The crime-fraud exception attempts to protect legitimate inquiries for legal

advice, without permitting clients to use their attorneys asknowing or unknowing participants in ongoing criminalactivity. Most courts follow a two-pronged test to over-come the privilege, including:

• A prima facie showing that the client was engaged in“wrongful conduct” when he or she sought advice ofcounsel, that he or she was planning such conductwhen seeking the advice of counsel, or that he or shecommitted a crime or fraud subsequent to receivingthe 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.231

228 David R. Wolfe, “The Future of Selective Waiver of Attorney-Client Privilege and Work-ProductProtection 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., 572 F.2d at 611.

229 Diversified Indus., Inc., 572 F.2d at 611.230 450 F.3d 1179 (10th Cir. 2006).231 RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS §82.

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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.


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 the information be published or distributed toothers, the privilege will not apply.232

Maintaining Confidentiality

Most commonly, concerns regarding theconfidentiality of corporate attorney-clientcommunications emerge following theinadvertent disclosure of privilegedinformation by the corporation, such as indiscovery during litigation. A corporation canbe 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.233 Courts also havedetermined that a person may relay a confidential communication through or in thepresence of a third person without breaching its confidentiality only “if the [third]person’s participation is reasonably necessary to facilitate the client’s communicationwith a lawyer or another privileged person and if the client reasonably believes that theperson will hold the communication in confidence.”234

232 In re Grand Jury Proceedings, 727 F.2d 1352, 1356 (4th Cir. 1984).233 Scott Paper Co. v. United States, 943 F. Supp. 489, 499 (1996); see also 1 JOHN K. VILLA,

CORPORATE COUNSEL GUIDELINES §1:12 (2007).234 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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The attorney-client privilege isonly intended to protect dis-closure of confidentialinformation. If the informationis not maintained in confidence,the privilege will be lost as tothat information.


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 theirclients. The chief difference between the professional duty of confidentiality and the

evidentiary attorney-client privilege is that the duty ofconfidentiality applies to virtually all informationprovided to a lawyer concerning a client, and prohibitsvirtually all disclosures, whereas the attorney-clientprivilege only applies the question of whethercommunications between a lawyer and his or her cli-ent are subject to compelled disclosure in litigation or

a regulatory proceeding discovery in litigation.235 Privilege exists to protect specifictypes of communications between a client seeking legal advice and the lawyer fromwhom such advice is sought.236

A lawyer’s ethical obligation pertains to the information relating to the representa-tion, whether disclosed by the client or brought to the lawyer’s attention from anothersource.237 Disclosures contrary to the ethical obligation of confidentiality may be madeonly in those limited circumstances permitted under relevant ethical rules (or in com-pliance with other laws) or with the informed consent of the client.238 In general, theprofessional duty of confidentiality remains a central part of the lawyer’s ethicalobligations, and continues to encompass far more, and to be more broadly applicable,than the attorney-client privilege.239

235 Horton, 61 BUS. LAW. at 101.236 Id.237 Id.238 Id.239 Id. at 102.

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As a fiduciary, a lawyer’sobligation to maintain theconfidentiality of a client’sinformation is much broaderthan the attorney-clientprivilege.


Work Product Doctrine

Similar to the doctrine of attorney-client privilege, the work product doctrine protectsthe confidentiality of certain materials related to the legal representation of a client. Thepurpose behind the work product doctrine is to “preserve a zone of privacy in which alawyer can prepare and develop legal theories and strategy ‘with an eye towardlitigation,’ free from unnecessary intrusion by his adversaries.”240 Federal Rule of CivilProcedure 26(b)(3), codifying the work product doctrine as it was set forth in Hickman v.Taylor,241 outlines the elements of the work product doctrine for federal courts as follows:

“[A] party may obtain discovery of documents and tangible things . . . prepared in antici-pation of litigation or for trial by or for another party or by or for that other party’s

representative only upon a showing that theparty seeking discovery has substantial needof the materials in the preparation of the par-ty’s case and that the party is unable withoutundue 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.”242

Recently, the Court of Appeals for the District of Columbia expanded the pro-tections afforded by the work product doctrine, holding that (i) a document preparedby an outside auditor “because of” the prospect of litigation was protected by the workproduct doctrine, and (ii) there was no waiver of those protections when the companyshared certain work product with the outside auditor.243 The court reasoned that thecompany had not disclosed the work-product to an adversary or a conduit to an adver-sary since the outside auditor was not a potential adversary in the dispute at questionand the outside auditor had a duty of confidentiality to the company.

240 United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998).241 329 U.S. 495 (1947).242 Fed. R. Civ. P. 26(b)(3).243 United States v. Deloitte LLP, 610 F.3d 129 (D.C. Cir. 2010) (Although the court found that the

work product doctrine had not been waived, the court noted that such voluntary disclosure did waive theattorney-client privilege).

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.

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PRIVILEGE IN DERIVATIVE SUITS AND CLASS ACTIONS

A derivative suit is a legal action brought by a stockholder or former stockholderpurportedly in the name of the corporation and against one or more of its officers ordirectors seeking a recovery on behalf of theinjured corporation for wrongful conduct.

The purpose of the derivative action is toenforce a corporate right that the corporationhas failed or refused to assert.244

By contrast, a class action suit may be broughtagainst the corporation on behalf of current orformer shareholders (as well as current orformer officers or directors) to remedy harminflicted directly upon shareholders.

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.245 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.”246

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, including:

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

244 1 R. FRANKLIN BALOTTI & JESSE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS AND

BUSINESS ORGANIZATIONS §13.10 P. 13-20.245 Garner, 430 F.2d at 1103.246 Id. at 1100.

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 officers or directors.

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.

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• 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 its availability 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 composed of advice concerning the litigationitself;

• 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.247

In general, Garner holds that, in a derivative action, shareholders can access priv-ileged corporate communications, so long as there is “good cause” to waive theattorney-client privilege and disclose the information.248 Even though the Garner testis flexible, there are generally accepted limitations to the rule, including, among otherthings, privileged communications that result in remedial measures or those madeduring the course of the derivative suit.249 Garner also does not apply to claims ofwork product because Garner is premised on the idea of mutuality of interest betweenmanagement and stockholders, “once there is sufficient anticipation of litigation totrigger the work product immunity,” this mutuality is destroyed.250

247 Id. at 1104.248 Ward v. Succession of Freeman, 854 F.2d 780, 784 (5th Cir. 1988).249 1 JOHN K. VILLA, CORPORATE COUNSEL GUIDELINES §1.27 (2007).250 Sherman v. Ryan, 392 Ill. App. 3d 712 (Ill. App. Ct. 2009).

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PRIVILEGE IN CORPORATE INVESTIGATIONS

Government Investigations

When a corporation is being investigated for alleged criminal or fraudulent activ-ity, a board often will announce an intention to cooperate fully with the inves-tigation.251 In past years, the Department of Justice evaluated cooperation based on thecorporation’s willingness to waive attorney-client privilege and work product pro-tections. These positions were embodied in Department of Justice guidance to prose-cutors, commonly referred to as the Holder Memorandum, the ThompsonMemorandum and the McNulty Memorandum. However, as a result of pressure from

Congress, the Department of Justiceannounced on August 28, 2008 that it hadsignificantly changed its policies. Under thenew policies, cooperation is measured onwhether a corporation voluntarily disclosesrelevant facts as opposed to whether it agrees

to waive its privileges. Discussed below are the prior Department of Justice memo-randums (each named after the Deputy Attorney General who issued them) as well asDepartment of Justice announced guidelines and the Congressional response.

251 Id.

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

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Holder Memorandum252

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 thecorporation’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.”253 Adhering to the suggestionsof the Holder Memorandum results in the corporation’s effective waiver of privilegesthat may otherwise be available in a potential action, leaving the corporation vulner-able.

Thompson Memorandum254

In January 2003, Deputy Attorney General Larry D. Thompson issued a revisedstatement emphasizing changes to the ways in which the Department of Justice wouldassess the authenticity of a corporation’s cooperation.255 “Too often business orga-nizations, while purporting to cooperate with a Department investigation, in fact takesteps to impede the quick and effective exposure of the complete scope of wrongdoingunder investigation.”256 Like the Holder Memorandum, the Thompson Memorandumurged voluntary disclosure, identification of culpable corporate agents, and waiver ofapplicable privileges.257

252 Memorandum from Eric H. Holder, Deputy Attorney General, to Heads of Department ComponentHeads and United States Attorneys (June 16, 1999), http://www.abanet.org/poladv/priorities/privilegewaiver/ 1999jun16_privwaiv_dojholder.pdf.

253 Id.254 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.

255 Horton, 61 BUS. LAW. at 116.256 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.

257 Id.

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McNulty Memorandum258

In December 2006, Deputy Attorney General Paul J. McNulty announced a for-mal procedure for prosecutors to follow when seeking waiver of the attorney-clientand work-product protections. The McNulty Memorandum revised and superseded theHolder and Thompson Memoranda. Under the McNulty guidelines, before askingcorporations 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.259

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 from theDepartment of Justice, though this was unnecessary if the corporation voluntarilyoffered privileged documents.

The McNulty Memorandum was widely criticized as being coercive and unfair.In particular, it has been suggested that “the environment created by prosecutorialpressure for early waivers – whether or not such pressure is ‘fair’ in a philosophicalsense – has certainly contributed to the increasing perception that the attorney-clientprivilege has become, as a practical matter, irrelevant in a significant corporateinvestigation.”260 Further, the “slippery slope toward diminution or even elimination ofthe corporate attorney-client privilege insofar as it relates to governmental inves-tigations and prosecutions may well have a chilling effect on

258 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.

259 Id.260 Horton, 61 BUS. LAW. at 119.

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communications between corporate client representatives and corporate lawyers,which is likely to lead in turn to less effective lawyering in the corporate and transac-tional context and diminished legal compliance by corporations.”261

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.262

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. On August 28, 2008, the Department of Justice, in the FilipMemorandum, announced significant changes to its policy regarding application of theattorney-client privilege in government investigations as follows:

• First, cooperation with a government investigation would no longer bemeasured on whether a corporation chooses to waive attorney-client priv-ilege – rather, it would depend on whether the corporation has timely dis-closed relevant facts;

• Second, federal prosecutors would no longer demand privileged attorney-client communication or attorney work product;

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

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

261 Id. at 126.262 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 PressConference Announcing Revisions to Corporate Charging Guidelines, August 28, 2008.

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• Fifth, the Department of Justice would not evaluate cooperation based on acompany’s disciplinary action against its employees.263

The Seaboard Report264

In October 2001, in response to an enforcement action against an employee of asubsidiary of the Seaboard Corporation, the SEC provided criteria to evaluate theindependent efforts and level of cooperation exhibited by companies charged withsecurities law violations (the “Seaboard Report”).265 Specifically, the SEC emphasizedthat it would consider whether public companies hired outside counsel to conductinternal investigations and whether the company had ever previously engaged suchoutside counsel.266 Further, in the Seaboard Report, the SEC clarified its position thatdisclosure of privileged information, pursuant to a confidentiality agreement, to theSEC in the course of an investigation should not necessarily waive the attorney-clientprivilege as to third parties although some courts have not agreed with this view.267

Congressional Investigations

The Constitution grants Congress an implied power of inquiry to inform itself as itmakes laws and oversees their execution, and Congress may enforce its power throughsubpoenas and contempt proceedings.268 A congressional investigation is usually initiatedby the U.S. Senate or House of Representatives through standing committees and sub-committees or through committees authorized to investigate specific matters.269

A congressional investigation resembles a trial more than a routine oversighthearing.270 Although corporations subject to congressional investigations have theright to invoke constitutional privileges during such an investigation, attorney-clientprivilege and the work product doctrine are not guaranteed by the Constitution and arenot required to be recognized by Congress.271 However, in practice, Congress some-times accommodates a corporation’s legitimate assertion of attorney-client privilege.272

As a result, corporations and attorneys must decide whether to disclose privilegedcommunications and documents in response to committee requests or instead invokeprivilege at the risk of having it rejected.

263 Id.264 Securities Exchange Act Release No. 44969, October 23, 2001.265 Id.266 Id.267 Id.; Brief of SEC as Amicus Curiae, McKesson HBOC, Inc., No. 99-C-7980-3 (Ga. Ct. App. Filed

May 13, 2001); see also 450 F.3d 1179 (10th Cir. 2006).

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Internal Investigations

A corporation may initiate an internal investigation in response to a stockholderdemand or lawsuit, government agency investigation or subpoena; or as a result of either acomplaint or grievance from an employee or group of employees.273 Regardless ofwhether the investigation begins from inside or outside of the corporation, the corporationhas a significant interest in protecting the confidentiality of counsel’s analysis in the inves-tigation.274 To maintain the attorney-client privilege, corporate counsel should alwaysconsider, regardless of the nature of their work, that their participation in the investigationmust be seen chiefly as a provider of legal advice to the corporation. Otherwise, there is arisk that the attorney-client privilege will not apply.275 Corporate counsel is in a muchstronger position to assert privilege as to communications and other investigative materialwhich, although representing factual and non-legal information, has as its main purposethe rendering of legal advice.276 Finally, the documentation by counsel that the particularcommunications at issue were made in order to obtain legal advice increases chances ofmaintaining privilege. In addition, investigative material that is the product of an attorney-client relationship should be protected; this is supported by the Upjohn opinion.277

CONCLUSION

To a surprising degree, whether a corporation’s communications with its lawyers areprotected from disclosure remains subject to a shifting amalgam of state and federal statutes,legal theories, and rules. For example, Section 307 of the Sarbanes-Oxley Act of 2002requires the SEC to issue rules setting forth minimum standards for professional conduct ofattorneys appearing and practicing before the SEC, including such rules requiring attorneysto “report-up” within the organization any evidence of a material violation of securities lawor fiduciary duty (or similar duty) by an issuer or any agent thereof.278 This type of rule-making demonstrates the increased pressures placed on the corporate attorney-client priv-ilege.279 It is important for corporate counsel, directors, officers and other employees to beinformed of these types of considerations so that the corporation’s counselors can protect itsconfidences in a manner that is compliant with all pertinent rules and regulations.

273 Thomas R. Mulroy & Eric J. Munoz, The Internal Corporate Investigation, 1 DEPAUL BUS. & COM.L.J. 49 (2002).

274 Id. at 49.275 Id. at 58.276 Id.277 Id.278 15 U.S.C.S. §7245 (2002).279 Horton, 61 BUS. LAW. at 115.

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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 or available in all circumstances (e.g., for breaches ofthe fiduciary duty of loyalty where the director or officer acted in bad faith orinsolvency of the company), it is permitted in a wide variety of circumstances andgenerally provides officers and directors with the most financial protection. In addi-tion, in certain instances, indemnification is mandatory under the DGCL.

For those situations in which indemnification isnot available, D&O insurance can provide another lineof financial protection. Companies should carefullyevaluate their indemnification and D&O insuranceprograms on a regular basis, and revise and updatethem when necessary to reflect the changing needs andcircumstances of the corporation, the law, and itsdirectors and officers.

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 themost capable and responsible persons to serve in corporate management.280 A corpo-ration generally has statutory authority to indemnify any person who was or is a partyto any direct legal proceeding (an action brought against the person by a third party)by reason of the fact that the person is or was a director, officer, employee or agent ofthe corporation. The corporation can indemnify a person for reasonably incurred

280 Merritt-Chapman & Scott Corp. v. Wolfson, 264 A.2d 358, 360 (Del. Super. Ct. 1970).

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

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expenses, judgments, fines and amounts paid in settlement. The corporation can onlydo so, however, as long as the person acted in good faith and in a manner the personreasonably believed to be in the best interest of the corporation.

If a derivative action (an action on behalf of the company by a stockholder orcreditor) is brought against a director or officer, the company may only indemnify thatperson for expenses, such as attorney’s fees, in connection with defense of such actionand only if that person acted in good faith and in a manner that person believed to bein the company’s best interest. Unlike for a direct action, the company is not permittedto indemnify the director or officer for any judgment or settlement in a derivativeaction. (This is because, in a derivative action, the alleged harm is to the company, soany judgment or settlement would go to the company. If the company were then toindemnify the director or officer for the judgment or settlement, there would be no netrecovery to the company.)

Section 145 provides that in either a direct or derivative action, the corporationmust indemnify any person who successfully defends such action for expenses, such asattorney’s fees, reasonably incurred. If the person is not successful on the merits orsettles the action, the corporation may only indemnify him for those expenses upon adetermination by a neutral body that the person acted in good faith and in a manner hereasonably believed to be in the best interests of the company. Depending on whetherit is a direct or derivative case, the neutral body can be the court, the board of direc-tors, an independent legal counsel or the stockholders. The corporation may alsoindemnify a person for judgments, fines, or settlements in a direct case as long asapproved by the neutral body.

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. Inaddition, Section 145 allows corporations to advance such expenses (including attor-neys’ fees) to persons serving at the request of the corporation as directors, officers,employees or agents of another entity on such terms and conditions, if any, as thecorporation deems appropriate. The ability to advance expenses can be very importantbecause the costs of litigating a case, regardless of its merit or ultimate outcome, canbe prohibitively expensive. The Delaware Court of Chancery is vested with exclusivejurisdiction to hear and determine all actions for advancement of expenses orindemnification. Additionally, the Court of Chancery is permitted to summarily

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determine a corporation’s obligation to advance expenses (including attorneys’ fees),thus providing an avenue whereby a person seeking advancement of expenses canobtain a relatively speedy judicial determination of their request. The indemnificationand advancement of expenses provided by the DGCL and the corporation’s charter andbylaws will generally 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 andadministrators. Moreover, the right to indemnification or advancement of expensesunder a provision in the certificate of incorporation or the bylaws cannot be eliminatedor impaired by an amendment to such provision after the occurrence of the act oromission that is the subject of the action for which expense reimbursement is sought,unless the provision in effect at the time of the act or omission explicitly authorizessuch elimination or impairment.281

Additional Sources of Indemnification Rights

In addition to the mandatory indemnification provided by the DGCL, most corpo-rations provide for indemnification in their charters and bylaws to the maximum extent

allowed by Delaware law. In addition, many corpo-rations enter into specific indemnification agreementswith their directors and officers. Due to the significantrisks of stockholder lawsuits and other potentialliabilities that directors and officers face as a result oftheir roles within their corporations, the vast majorityof qualified director and officer candidates expect,and oftentimes will not serve without, robustindemnification and related rights.

Directors and officers should be familiar with the various provisions of the corpo-ration’s charter documents and their individual agreements with the corporation thataddress their indemnification rights. Those provisions and agreements should bereviewed by the corporation and its directors and officers (as well as legal counsel orother appropriate advisors) from time to time as circumstances merit to evaluate

281 See 8 Del. C. § 145(f) (reversing the rule announced in Schoon v. Troy Corp., 948 A.2d 1157 (Del.Ch. 2008), which permitted a corporation to eliminate the right to indemnification or advancement ofexpenses after a former director or officer has left office and before the former director or officer has beennamed in an action for which expense reimbursement is sought).

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Given the proliferation ofsuits against corporations,the vast majority ofqualified director andofficer candidates expectthat a corporation willprovide for robustindemnification rights.


whether the indemnification rights and obligations they contain continue to be appro-priate and adequate in light of the parties’ needs and circumstances.

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 toindemnify 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 or rescinded without stockholder action toamend the certificate of incorporation. Withoutsuch a provision or other contractual right toindemnification, the availability ofindemnification for directors and officerswould be at the discretion of the board.Whether a board would grant indemnificationunder particular circumstances may depend ona number of factors, and cannot be guaranteed.Broad indemnification provisions containedin a corporation’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 directors and officers to the full extent provided by Section 145.

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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.


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. Unless expressly permitted by the charter or bylaws,the right to indemnification or advancement of expenses provided in the bylaws cannotbe eliminated or impaired by a subsequent amendment to the bylaws after the act oromission relating to the indemnification or expense advancement has occurred; how-ever, the board of directors may amend or repeal such protections at any time beforethe occurrence of such act or omission.282

Contractual Indemnification Rights

Many corporations enter into indemnification agreements with directors and offi-cers that provide an additional layer of comfort beyond the statutory provisions andprovisions contained in the charter and bylaws. These agreements typically provide forindemnification and advancement of expenses to the fullest extent permitted by Dela-ware law. These direct contractual arrangements most commonly take the form of astand-alone indemnification agreement between the corporation and the individual, butcan sometimes be found in employment agreements and similar arrangements as well.Typically a corporation has a standard form of indemnification agreement. If the

corporation enters into indemnificationagreements with its directors andexecutive officers, it should considerseeking stockholder approval of thoseagreements in accordance with theinterested director transaction provi-sions of the DGCL to reduce the ability

of third parties to challenge their enforceability on that basis. Applicable listingrequirements of the New York Stock Exchange, NASDAQ and other stock exchangesfurther require that indemnification arrangements, as well as many other arrangementsbetween the corporation, its directors and officers and other related parties, beapproved or recommended for approval by the corporation’s audit committee oranother committee of independent directors. In the case of adoption of anindemnification agreement for the benefit of all the directors, none of the directors

282 8 Del. C. § 145(f).

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


may be considered disinterested and thus securing the ratification of stockholders ofsuch arrangements is desirable.

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. This is so even ifthe indemnification provisions of the corporation’s certificate of incorporation orbylaws are subsequently modified by actions of the corporation’s board of directors orstockholders in a manner adverse to the corporation’s directors and officers.Indemnification agreements generally include very specific procedural mechanisms(regarding advancement of defense costs, burden of proof, etc.) and other provisions(e.g., imposing on the corporation an obligation to maintain directors’ and officers’insurance on behalf of the indemnitee) that provide added comfort to the affectedindividual.

SEC Position on Indemnification for Securities Law Violations

The SEC maintains a long-standing position that the indemnification of directorsand officers of a corporation for liabilities arising under the Securities Act of 1933 (the“Securities Act”) is against public policy as expressed in the Securities Act and istherefore unenforceable. While not universally accepted by courts throughout thecountry, some courts have affirmed the SEC’s view.

As a result, directors and officers should not assume that their indemnificationrights for claims brought under the Securities Act will be upheld if challenged by theSEC, even if Delaware law would otherwise permit indemnification.

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Contractual agreements withdirectors and officers providingfor indemnification rights gen-erally provide the highest levelof comfort for the directors andofficers because they cannot bemodified without their consent.


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, wasor will be a director, officer, employee or agent of thecorporation or who serves in certain capacities withanother entity at the request of the corporation. Theunderlying public policy stems from the fact that, asdiscussed above, a corporation is not legally permittedto indemnify 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 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.

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


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 (at least 30 to 60 days generally is necessary)

and effort in seeking competing proposalsfrom reputable insurers and carefully review-ing and negotiating the terms and conditionsof the 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 a goodpolicy 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 covered. It is important to remember that employeesof an insurance company’s claims department are trained to read the policy as nar-rowly as reasonably possible. Corporations can minimize the risk of having coveragedenied by negotiating carefully crafted 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 policywith some foresight and to negotiate coverage of claims that, while they may seemunlikely at the time, may come to pass in the future. For example, a corporation that isfinancially sound at the time it purchases its D&O policy should consider the policy’sbankruptcy exclusions despite the fact that bankruptcy is unlikely at the time. A corpo-ration that has to reopen negotiations with its insurance carrier after its circumstanceshave worsened may find that its risk profile has changed such that the expandedcoverage is simply unavailable or prohibitively expensive.

Furthermore, a D&O policy should be reviewed by the corporation at least annu-ally to determine whether the coverage is sufficient (in both its terms and coveragelimits) under the corporation’s present circumstances, as well as in light of foreseeablecircumstances in which the corporation may find itself. Directors and officers shouldpersonally familiarize themselves with their corporation’s D&O insurance programand regularly review that program to determine whether changes are merited.

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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.


While public companies should considerD&O insurance to be indispensable, privatecompanies should consider purchasing D&Oinsurance as well, particularly if they areengaged in mergers and acquisitions or capitalraising through securities offerings. These activities can expose their directors andofficers to substantial litigation risks from acquirers, minority stockholders and secu-rities purchasers. Most D&O carriers offer policies geared specifically to privatecompanies that have lower coverage limits and lower retentions (deductibles). Theydo, 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 type of claims covered by thepolicy, and otherwise increase the scope or coverage of the policy in a way that isbeneficial to the insureds in 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 sharedbetween the corporation and all insured directors and officers, and are subject to theretention applicable to the policy. Thus, each insured should be aware that claimsmade by other insureds could exhaust a policy before their claim arises and therebyleave 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 and

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


judgments, 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 or thecorporation is unable to indemnify due to the insolvency of the corporation or theclaim being made derivatively on behalf of the corporation).

Side B Coverage

Side B coverage generally provides reimbursement to the corporation when itactually indemnifies an applicable director or officer in connection with a claim. Dueto the fact that most claims against directors and officers are indemnifiable, Side Bcoverage is the most commonly invoked portion of a D&O policy.

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, so these policies should be carefullyscrutinized as well. Because stand-alone Side A DIC coverage can only be used whenthe director’s or officer’s two primary sources of recourse – indemnification from thecorporation and the primary D&O policy – are unavailable, some companies maydetermine that it is not worth the additional cost of the coverage. Additionally, thebenefits of stand-alone Side A DIC coverage can be further reduced if the Side Acoverage in the primary D&O policy has the added reliability of being non-rescindable.

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


Employment Practices Liability Insurance

In addition to and in connection with a D&O policy, many corporations are pur-chasing 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.Other “hammer clauses” permit a carrier to recommend alternative dispute resolutionfor the claim.

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 financial

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


condition 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.

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 when a claimis made, the policy will not cover the claim if its underlying events and circumstancesoccurred on or before a designated date in the past, which is typically some period ofyears 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 common

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parlance 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 claims. Companies are sometimessuccessful in negotiating language providing that claims can be submitted any time upto the policy expiration date (or in some cases, after the expiration date.)

Tail Policies

Under certain circumstances, a corporation may purchase a “tail” insurance policy toextend the coverage time period for claims arising out of events that occurred while theoriginal D&O policy was in effect, despite the fact that the claims themselves arise after-wards. For example, D&O policies insure against claims made prior to the effective date ofa merger or other acquisition, but if the corporation consummates a merger or is otherwiseacquired, it may need to obtain a tail insurance policy to cover itself and the directors andofficers against wrongful acts that occurred prior to the completion of the merger oracquisition. Some D&O policies have automatic tail coverage available at the insured’soption in the event of a merger or acquisition.

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 therefore have coverageunder the acquiring corporation’s D&Opolicy. Directors and officers of a targetcorporation engaged in acquisition nego-tiations should consider who will bearthe cost of a necessary tail policy, andshould consult their D&O carrier well inadvance of the transaction closing toensure that there is no gap in coverage.Directors and officers also should bemindful of situations where their D&O policy will lapse or otherwise terminate. If a

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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 the company shouldallot sufficient time and funds totimely acquire such a policy.


new, replacement D&O policy will not be in place at the time of termination of the oldpolicy, they should carefully consider whether a tail policy is appropriate and, if so,take necessary measures to ensure that one 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 reevaluate carefully their changing D&O insurance needs and cir-cumstances at least a couple of months before the expiration of their current policy sothat they have sufficient time to negotiate new or revised terms with their current car-rier, or to 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 generally are not 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 specificlanguage 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

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(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 could not beexhausted by the corporation.

Severability Issues

D&O insurance policies are issued by insurers based on their evaluation of anapplication submitted by the person or entity seeking insurance. Applications for D&Oinsurance generally are 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 mem-bers of its board and management team, applications by public companies generallyrequire the corporation to attach its financial statements and certain SEC filings,thereby including them in the information the insurer is entitled to consider whenreviewing the application. Furthermore, while a broad group of directors and officersare generally beneficiaries under D&O insurance policies, the applications typicallyare submitted and signed by one or two of the corporation’s top management members(generally the chief executive officer and chief financial officer).

As with other forms of insurance, misstatements or omissions in the corporation’sapplication, including in any SEC filings or other documents the corporation isrequired to attach to, or incorporate into, the application, can form the basis for theinsurer to seek to rescind the policy and void the coverage. For example, consider acorporation and its directors and officers that are being sued by stockholders whoallege that the corporation’s publicly filed financial statements or other SEC filingscontained material misstatements or omissions that caused the stockholders to lose allor a significant portion of their investment when the corporation’s stock price plum-meted after a recent release of negative financial results. If the financial statements andSEC filings that are the subject of the plaintiffs’ lawsuit were also submitted as part ofthe corporation’s application for D&O insurance, the directors and officers may face asituation where their D&O coverage is void based on the very set of factual circum-stances 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 provide

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the 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.

The risk of material misstatements and omissions in the corporation’s application,and the resulting possibility that the policy would be rescinded and its coveragevoided, can be mitigated by the inclusion of a strong severability clause. If a broadseverability clause cannot be negotiated into the policy, a severability clause appli-cable to the misconduct exclusion can have the same prophylactic effect. Good sever-ability clauses generally provide that, in the event that the insurance applicationcontained misstatements or omissions or particular insureds are guilty of misconduct,the policy is only rescinded or coverage denied as to the insureds that had knowledgeof the misstatements and omissions in the application or committed or were aware ofthe bad acts.

It is also sometimes possible to avoid an application altogether, or to submit anabbreviated application, if the corporation simply is renewing its D&O policy with itscurrent carrier. Companies generally should seek to minimize the amount ofinformation required to be included in or appended to the application in order toreduce the risk of inadvertent misstatements or omissions.

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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 insuredpersons (i.e., one of the corporation’s current or former officers or directors) acting asor working in concert with the person making the claim. The rationale of the insuredvs. insured exclusion is relatively clear and non-controversial – the insurer wants toavoid being required to, and few companies would argue that the insurer should haveto, cover a claim where one insured is suing another insured (or the corporation) in acollusive 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. Furthermore, a broad definition of whoconstitutes an “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, if employees are insureds under thepolicy and if an employee provides assistance to the named plaintiffs by supplyinginformation or otherwise, the insurer may invoke the insured vs. insured exclusion todeny coverage. Issues can also arise in connection with claims in merger and acquis-ition, whistleblower and bankruptcy contexts. As a result, it is very important toclosely scrutinize the language of the insured vs. insured exclusion in a corporation’sD&O policy, and to seek to narrow the applicability of the exclusion to the extentpossible.

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 as

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to 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 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 cost hun-dreds of thousands of dollars or more to defend and can take years before a final reso-lution is reached. Essentially, in addition to paying its own defense costs, the corporationwould be required to advance all defense costs to its officers and directors, and may haveto wait an extended period of time to be reimbursed by the insurer. As a result, insuredsshould seek to negotiate a “pay as you go” clause in their D&O policy, such that theinsurer is required to pay defense costs as they are incurred, generally on a monthly orquarterly basis. For public companies, “pay as you go” clauses take on added sig-nificance due to prohibitions contained in the Sarbanes-Oxley Act of 2002 againstcorporate loans to directors and officers, because in some situations, the advancement oflegal expenses to directors and officers could be construed as prohibited loans.

Bankruptcy Issues

Bankruptcy can have significant adverse effects on coverage available under aD&O policy. For example, bankruptcy courts have held, although not frequently, that aD&O policy is an asset of the bankruptcy estate and should therefore be available to paycreditors’ claims against the bankrupt corporation. 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 directorsbefore they will do so. Such an order can, unfortunately, sometimes take a significantamount of time to obtain. One way to address this situation is to ensure that the D&Opolicy contains an appropriate order of payments provision, as described above, thatprovides that the directors and officers take priority over the corporation with respect topayments under the policy. This helps support an argument, if necessary, that the corpo-ration’s rights in the D&O policy are subordinate to the rights of the directors and offi-cers, and that the policy is therefore not an asset that must be used to satisfy the claimsof the corporation’s creditors in bankruptcy. An alternative is to negotiate a provisionproviding that the company (i) waive any automatic stay or injunction that may applyand (ii) agree not to oppose any efforts by the insurer to pay an insured person.

In addition, if a bankruptcy trustee chooses to sue the bankrupt corporation’sformer directors and officers, the insurer may seek to assert the insured vs. insuredexclusion discussed above to deny coverage on the theory that the trustee is asserting

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the rights of one insured (the corporation) against other insureds. Many D&Oinsurance carriers offer policies that expressly provide coverage in this type of sit-uation, but the particular language should be scrutinized closely to ensure that it issufficiently broad.

Directors and officers of a corporation that is contemplating bankruptcy shouldreview carefully 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, and may not be available.

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 scrutinizedcarefully, and negotiated if necessary, beforepurchasing the D&O policy. For example,there are generally provisions specifying theapplicable venue and forum in the event of adispute under the policy. If resolving a dis-pute in the insurer’s preferred locale wouldpresent significant burdens for insureds located long distances from that place(including the costs of paying for travel and other expenses of witnesses and expertsrequired to attend the proceedings), the corporation should seek to negotiate a moreconvenient venue and forum. Sometimes the boilerplate provisions also require arbi-tration of disputes before arbitrators with insurance expertise (read: people who willlikely have ties to the insurance industry). Furthermore, most D&O policies requirethat disputes be resolved under New York law, which is generally more favorable toinsurers. The corporation’s ability to negotiate these and other boilerplate provisions ofthe policy will be, as with any other provisions, significantly dependent on the marketfor D&O insurance at the time of purchase.

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


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 and 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 time by which notice must begiven of claims arising out of events that occurred while the D&Opolicy 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 severability defi-nition 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 vs. Insured: This term refers to the fact that the insurer willtypically not cover claims where there is one or more insureds actingas, or working 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 that theproceeds of D&O insurance are an asset of the estate the companyshould ensure that the order of payment specifies that directors andofficers take priority over the company. If not, creditors can use thepolicy to relieve the company’s debts, leaving nothing to cover theclaims against directors and officers.

• Venue and Choice of Forum: Venue and choice of forum refer to wherea claim is to be adjudicated. A company would be wise to requireclaims be defended in close proximity to their headquarters to avoidpaying for travel 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 in part to avoid such liability.

Stockholder liability for actions of a properly functioning corporation are rare,and are premised on the “piercing the corporate veil” theory. In general, liability forthe acts of the corporation under a piercing the corporate veil theory involves a fla-grant disregard and disrespect for the corporate entity and its formalities, or the pres-ence of fraud. Classic examples are co-mingling of assets and failure to obtain anycorporate approvals. Although piercingclaims are brought most frequently againstparent corporations of wholly owned sub-sidiaries, individual stockholders (such assole or majority stockholders) are alsosometimes sued 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 stockholders personally liable for any damages sustainedby the plaintiff. A Delaware court will uphold this request if it would be inequitable orunfair not to do so. “[P]ersuading a Delaware court to disregard the corporate entity isa difficult task,”283 and therefore corporate veil piercing is rarely successful.

Interpretations of the theory of piercing the corporate veil vary among the 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;

283 Harco Nat’l Ins. Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *10 (Del. Ch.Sept. 19, 1989).

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When the corporate existence isflagrantly disregarded or abused,it is possible that the parentcorporation or substantial stock-holders of a corporation may befound to be liable for the actions ofthe corporation under a theoryreferred to as “piercing the corpo-rate veil.”


others have referred to an agency relationship between the two corporations; while stillothers have referred to ‘piercing the corporate veil.’”284 This chapter introduces theprimary bases on which courts have relied to disregard the corporate form under Dela-ware law, including fraud, instrumentality, alter ego, estoppel and agency.

FRAUD

Delaware courts have stated that “[f]raud has traditionally been a sufficient rea-son to pierce the corporate veil.”285 Other related reasons for piercing the corporateveil include “contravention of law or contract,” “public wrong,” and similar

injustices.286 In Gadsden v. HomePreservation Company, Inc.,287 theplaintiff sued the defendant corpo-ration for failure to perform homerepairs pursuant to a contract. Theplaintiff obtained a judgment, butwas unable to enforce it because 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 defendant] con-stituted a fraud, contravention of

contract, and a public wrong” and found the sole stockholder liable for the judg-ment.288 Several factors supported the court’s decision in the Gadsden case, includingthe following facts:

• The defendant corporation had no funds in its bank account, and any moneythat was placed there was quickly withdrawn by the stockholder;

284 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 839 (D. Del. 1978).285 Harco Nat’l Ins., 1989 Del. Ch. LEXIS at *10.286 Id.287 Gadsden v. Home Preservation Co., Inc., No. 18888, 2004 Del. Ch. LEXIS 14, at *1 (Del. Ch.

Feb. 20, 2004).288 Id. at *18.

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

• The corporation held no money in itsbank accounts;

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

• 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.


• The corporation had no assets – all tools and equipment used to performhome repairs by the defendant corporation were owned by the stockholder.Nonetheless, the corporation continued to fraudulently guarantee its repairsfor 10- and 20-year periods; and

• The plaintiff was a homeowner rather than a more sophisticated and knowl-edgeable creditor.289

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.”290

INSTRUMENTALITY

Alleging that a corporation is a “mereinstrumentality” of an individual stockholderor a parent corporation is another way plain-tiffs may attempt to hold stockholders liablefor a corporation’s wrongs. This theory applieswhere the controlling stockholder or parentcompany has ignored the separate identity ofits subsidiary.291 Although it does not require ashowing of fraud, some courts have required a showing of unfairness or injustice.292

Two cases illustrate 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.293 In an attempt to replace the trust, the defendant, rather than thetrustee corporation, entered into an agreement with the employee to make anoutright gift of the shares.

289 Id. at *16.290 Id. at *18.291 Walsh v. Hotel Corp. of Am., 231 A.2d 458, 461 (Del. 1967).292 Harper v. Del. Valley Broadcasters, Inc., 743 F. Supp. 1076, 1086 (D. Del. 1990) (citing Harco

Nat’l Ins., 1989 Del. Ch. holding that an “overall element of injustice or unfairness must always be pres-ent” before Delaware courts will disregard separate legal entities in equity).

293 Equitable Trust Co. v. Gallagher, 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.


The actual shares were never transferred, and after the employee’s death thedefendant refused to give the shares to the trust’s executor, arguing that thegift was not an enforceable promise. The court disregarded the existence ofthe trustee corporation, on the grounds that: (i) the defendant or hisimmediate relatives owned virtually all of the stock of the corporation,(ii) the defendant “personally dominated the corporation in all itsoperations,” and (iii) the defendant admitted that he “regarded himself as thecorporation.”294 In evaluating the enforceability of the promise, the courtfound that it did not matter that the offer was made by the defendant ratherthan the trustee corporation because the corporation was a mereinstrumentality of the defendant.

• In Walsh v. Hotel Corp. of America, the plaintiff was injured while staying ata motel operated by the subsidiary and sued the defendant parent corpo-ration. The court allowed the plaintiff to amend her complaint to assert thatthe defendant was liable for the acts of its wholly owned subsidiary.295 Giventhat the defendant’s name was the only one displayed in the lobby and on themotel’s stationery, and that the defendant was listed as the operator of themotel in a reputable financial handbook, the court held that these facts“furnished reasonable grounds to suggest that the defendant, as the solestockholder of its subsidiary, may have disregarded the separate existence ofthat subsidiary.”296 The court permitted the amendment and allowed addi-tional discovery in support of the instrumentality theory of liability.

ALTER EGO THEORY

The alter ego theory of liability is sometimes treated as synonymous with theinstrumentality theory,297 and has been described as a close relative of the veil-piercingtheory.298 Under the alter ego theory, where a corporation is merely a shell or façadefor its dominant stockholders, the stockholders may be liable for the corporation’swrongs. Before a court will ignore the corporate form and hold stockholders liable onthis ground, it will consider the following factors:

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

294 Id. at 493-94.295 Walsh, 231 A.2d at 461.296 Id.297 Id.298 Harper v. Del. Valley Broadcasters, Inc., 743 F. Supp. 1076, 1085 (D. Del. 1990).

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• Whether the corporation was solvent;

• Whether dividends were paid;

• Whether corporate records were kept;

• Whether directors and officers functioned properly;

• 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.299

The above list is not exhaustive. “No single factor could justify a decision to dis-regard the corporate entity, but. . . an overall element of injustice or unfairness mustalways be present as well.”300 This “element of injustice” does not need to equate to afinding of fraud, but without it, a plaintiff cannot successfully assert the alter ego theory.

Harper v. Delaware Valley Broadcasters, Inc.provides an example of a court’s analysis under thealter ego theory.301 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 Harper court focused its

299 Harco Nat’l Ins. Co. v. Green Farms, Inc., No. 1131, 1989 Del. Ch. LEXIS 114, at *11-12 (Del. Ch.Sept. 19, 1989) (quoting U.S. v. Golden Acres, Inc., 702 F. Supp. 1097, 1104 (D. Del. 1988)).

300 Harper v. Del. Valley Broadcasters, 743 F. Supp. at 1086 (citing Harco Nat’l Ins., 1989 Del. Ch.LEXIS 114, at *11-12).

301 Harper v. Del. Valley Broadcasters, 743 F. Supp. 1076 (D. Del. 1990).

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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.


attention on the sophistication of the plaintiff. Here, the plaintiff was a stockholder anddirector of the defendant and was aware of the relationship between the partnershipand the defendant. Beyond the loss of compensation, no other injustice had beenalleged, and the court refused to ignore the separate legal existence of the defendant.302

ESTOPPEL

Equitable estoppel is another theory that courts have relied upon in finding astockholder liable for the acts of a corporation. Under this theory, a parent company orcontrolling stockholder may be liable when: (i) it has by its conduct led a third party tobelieve that the parent or controlling stockholder would be responsible for the obliga-tions of the subsidiary or controlled company, and (ii) the third party has changed itsposition in detrimental reliance on that belief.

For example, in Mabon, Nugent & Co. v. Texas American Energy Corp.,303 thecourt held the plaintiff debenture holders had alleged facts sufficient to support a claimthat the parent company of the debenture issuer could be held liable for payment of thedebentures on a theory of equitable estoppel.304 The court held the plaintiffs had estab-lished detrimental reliance by alleging that they had purchased and held the debenturesof the subsidiary company in reliance on the belief that the parent had assumed thesubsidiary’s obligations under the debenture, based on the following alleged facts:

• Following a reorganization of the subsidiary, the consolidated financialstatements of the parent and subsidiary companies were identical;

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

• 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.305

302 Id. at 1086.303 Mabon, Nugent & Co. v. Texas American Energy Corp., No. 8578, 1988 Del. Ch. LEXIS 11, at *1

(Del. Ch. Jan. 27, 1988).304 Id. at *11 (quoting Wilson v. Am. Ins. Co., 209 A.2d 902, 904 (Del. 1965)).305 Id. at *10-11.

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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 subsidiary forthe parent’s benefit, such that the subsidiary is acting as an agent of the parent, thenthe parent may be found liable for the acts of the subsidiary. A showing that the parentand subsidiary share the following may support a finding that the parent controls thesubsidiary as an agent:

• Stock ownership;

• Directors and officers;

• Financing arrangements;

• Responsibility for day-to-day operations;

• Arrangements for payment of salaries and expenses; or

• Origin of the subsidiary’s business and assets.306

All of these factors (and others) may be considered; no one factor alone is suffi-cient to prove that an agency relationship exists. The fact that a parent holds out to the

public that a subsidiary is a department of its ownbusiness can increase the parent’s liability exposure forthe subsidiary’s acts.307

Importantly, some courts have held that holding aparent company liable for the acts of the subsidiaryunder an agency theory does not require a showing offraud or other inequity, as would be required for ashowing of liability under a theory of corporate veil

piercing.308 However, demonstrating that a subsidiary is an agent of a parent is a diffi-cult burden for a plaintiff. For example, in Japan Petroleum Co. (Nigeria) Ltd. v.Ashland Oil, Inc., the court held that a subsidiary was not the agent of a parent com-pany even though the companies had joint operations, shared common directors and

306 Japan Petroleum Co. (Nigeria) Ltd. v. Ashland Oil, Inc., 456 F. Supp. 831, 841 (D. Del. 1978).307 Id.308 Id. at 840.

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

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officers, and the parent exerted control over the subsidiary’s finances.309 The courtheld that notwithstanding these “close ties,” the two companies had “many of theindicia of separate corporate existence,” such as separate bank accounts and separatecontractual rights and obligations, and the evidence established that the parent lackedtotal control over the subsidiary.310 The Third Circuit later indicated, however, that thedistrict court in Japan Petroleum Co. may have demanded too much of plaintiffs byrequiring a showing of “total” control, which is “not a prerequisite” to finding anagency relationship under general principles of agency.311

VEIL PIERCING IN THE CONTEXT OF FIDUCIARY DUTY BREACH

The foregoing discussion focused on the circumstances in which a stockholder,who may or may not be a director, could be found liable for the actions of a corpo-ration. The concept of piercing the corporate veil can also surface in director liabilitycases. For example, in Grace Brothers, Ltd. v. UniHolding Corp.,312 a court rejectedclaims by defendant directors that they could not be liable for breach of fiduciary dutyin their capacity as directors of the parent in connection with acts of a subsidiary. Thecourt held that “[d]irectors of a parent board can breach their duty of loyalty if theypurposely cause – or knowingly fail to make efforts to stop – action by a wholly-owned subsidiary that is adverse to the interests of the parent corporation and itsstockholders.”313 In reaching this decision, the court noted that one director was thechairperson of the subsidiary and that all directors knew about the subsidiary’s chal-lenged transaction and could have acted to cause the subsidiary to avoid the action.314

While Grace Brothers is not a traditional corporate veil piercing case, it demonstrateshow the doctrine may play a role in director liability cases and sets forth theresponsibilities directors have with regard to their subsidiary corporations.

309 Id. at 840-45.310 Id.311 Phoenix Canada Oil Co. v. Texaco, Inc., 842 F.2d 1466, 1477-78 (3d Cir. 1988).312 No. 17617, 2000 Del. Ch. LEXIS 101, at *1 (Del. Ch. July 12, 2000).313 Id. at *4.314 Id at *35-*45.

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CHAPTER 10

NONPROFIT ORGANIZATIONS

INTRODUCTION

This chapter highlights the major differences between the fiduciary duties andother responsibilities of corporate directors and officers of nonprofit organizations andtheir counterparts in for-profit corporations. This chapter is not a comprehensive guidefor directors and officers of nonprofit organizations. It is incumbent on the directorsand officers of nonprofit organizations to familiarize themselves with the nuances ofthe nonprofit sections of the corporations code of their particular state of incorporation,particularly because state laws governing nonprofit organizations are not uniformlysubject to influence by Delaware law to the same extent as the laws governing for-profit corporations.

MANAGING THE BUSINESS AND THE ROLES OF DIRECTORS AND OFFICERS

Generally, directors and officers of a nonprofit organization are responsible fordirecting the corporation’s activities in a manner that is consistent with its purpose, bycontrast to the responsibility of a board of a for-profit corporation to maximize share-holder value. The organizational structure of a non-profit organization is typically thesame as a for-profit entity; the board of directors, which may also be called the boardof trustees, is responsible for the management of the organization’s business andaffairs, but acts in a supervisory role and delegates the details of the day-to-day man-agement of the organization to the officers of the corporation. Similar to a for-profitorganization, a nonprofit organization may have a chief executive officer or president(who may also be referred to as an executive director), secretary, treasurer and suchother officers as may be determined by the board of directors or as may be required bythe laws of the state in which the nonprofit is organized. Typically, the officers areagents of the corporation in the strict legal sense and as such have the powerindividually to bind the corporation, while the directors can only act as a group.Nevertheless, directors are clearly fiduciaries of the corporation and have ultimatepower and authority over the corporation through their ability to hire, supervise andreplace the officers.

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FIDUCIARY DUTIES

The fiduciary duties of corporate directors and officers of nonprofit organizationsgenerally are similar to those of their counterparts in for-profit corporations, but varyby state and also depending on the type of non-profit entity. For centuries, trustees ofcharitable trusts have been deemed to have the same obligation toward the assets of thetrust as towards their own, personal resources. This responsibility, the duty of care, isto act prudently when managing the nonprofit organization’s income and assets. Moststates impose the standards of fiduciary responsibility (including the duty of care, dutyof loyalty and other duties summarized in Chapter 2) on directors of nonprofit orga-nizations, whether or not the organizations are trusts and whether or not they are chari-table.

Similarities between the fiduciary duties of directors and officers of nonprofit andfor-profit corporations notwithstanding, fiduciary law does not assure accountability innonprofit organizations because of the absence of rigorous enforcement by regulators(e.g., state attorneys general) and constituents. For example, in the for-profit context,shareholders enforce director accountability by bringing derivative lawsuits against thecorporation in the event of a breach of fiduciary duty in order to protect their economicinvestment. Because nonprofit organizations do not have shareholders, this account-ability mechanism is less likely to have the same force. However, the IRS and stateattorneys general have authority to supervise activities of non-profits. The IRS canimpose penalties on directors or officers of non-profits that receive excess compensa-tion and can revoke a non-profit’s tax-exempt status if it engages in unreasonableactivities. Further, state attorneys general also may investigate non-profits and bringactions against non-profits and their directors and officers on behalf of the public.

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Because of a lack of enforcement, watchdog agencies have assumed a role inmonitoring and publicizing the activities of nonprofit entities. Generally, these watch-dog agencies (i) write standards to which charitable organizations are expected toadhere; (ii) enforce standards by rating entities in adherence to standards; and(iii) distribute ratings and other reports to the general public. The Standards for CharityAccountability issued by the Better Business Bureau Wise Giving Alliance serve as aleading example of watchdog agency standards.315

The Standards for Charity Accountability enumerate twenty standards across fourcategories of accountability: (i) governance and oversight; (ii) measurement of effec-tiveness; (iii) finances; and (iv) fundraising and informational materials. While volun-tary standards such as those put forth by the Better Business Bureau Wise GivingAlliance go beyond the requirements of local, state and federal laws and regulations,some of these rules may take on the force of law as federal and state governmentsevolve best practices guidelines for nonprofit organizations in the future.

THE USE OF COMMITTEES

As in the for-profit context, the bylaws of a nonprofit organization may authorize,or the board may establish by resolution, committees that are given the authority to acton behalf of the board. For many nonprofit organizations, the only committee possess-ing the authority to take action that will bind the corporation when the board of direc-tors is not in session is the executive committee. The bylaws may also provide forcommittees that do not exercise the authority of the board, whose members are notvoting directors. Because of the typical nonprofit organization’s dependency on volun-teer time and services to accomplish essential tasks, the use of committees is essential.

Certain states, such as California, require that nonprofit organizations organizedfor charitable purposes that receive or accrue gross revenue of at least $2 million inany fiscal year have an audit committee, which may not include any officers or othermembers of the organization’s staff. The audit committee must be separate from anyfinance committee also established by the board. Audit committee members must not

315 Better BUSINESS BUREAU WISE GIVING ALLIANCE, STANDARDS FOR CHARITY ACCOUNTABILITY

(2003), http://give.org/for-charities/How-We-Accredit-Charities/. These standards are intended to apply topublicly soliciting organizations that are tax exempt under section 501(c)(3) of the Internal Revenue Codeand to other organizations soliciting charitable donations. These standards are not intended to apply toprivate foundations that do not solicit contributions from the public.

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be compensated for service on the committee and may not have a material financialinterest in any entity doing business with the corporation.316

ATTORNEY-CLIENT PRIVILEGE IN A NONPROFIT CONTEXT

For communications to be protected under attorney-client privilege, thecommunication must be made in confidence between a lawyer and a client, both actingin their respective capacities. There is no difference in the applicability of the attorney-client privilege in a for-profit or nonprofit context. For more detailed informationregarding attorney-client privilege, please refer to Chapter 7.

INDEMNIFICATION AND INSURANCE

To protect directors and officers from personal liability for acts or omissionsmade while serving in their official capacities, a nonprofit organization may indemnifyor provide insurance for directors and officers, as described below. Many states havestatutes permitting and in some instances requiring a non-profit entity to indemnify itsofficers and directors.317 However, to provide clear and comprehensiveindemnification rights, a nonprofit organization should provide in its articles or bylawsthat it will pay the judgments and related expenses incurred by directors and officerswhen those expenses are the result of an act or omission by the director or officerwhile acting in the service of the organization. Indemnification cannot extend tocriminal acts and may not cover certain willful acts that violate civil law.

To protect directors and officers, a nonprofit organization should consider pur-chasing directors’ and officers’ liability insurance (“D&O Insurance”), so that theresources of the insurer will be available to provide protection to the directors andofficers if the insured does not have sufficient resources. It is worth noting that D&OInsurance will not cover violations of criminal law. Further, D&O Insurance typicallyexcludes an extensive list of civil law transgressions that may include offenses such aslibel and slander, employee discrimination, and antitrust activities – the most prevalenttypes of liability in the nonprofit context. The exclusions to D&O Insurance coverageshould be carefully reviewed before concluding that the policy offers the necessarycoverage to directors and officers of a nonprofit organization.

316 Cal. Gov’t Code §12586(e)(2).317 See 8 Del. C. §102 and §145; see also Cal. Corps. Code §§5238(d), 72376 and 9246(d).

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Please refer to Chapter 8 for a more detailed discussion of indemnification andinsurance of directors and officers.

PERSONAL LIABILITY

Because the law recognizes corporations as separate legal entities, the corporateform often serves as a shield against a director’s or officer’s liability. It is unusual fordirectors or officers to be found personally liable for an act or omission done whileserving a nonprofit corporation, particularly where the transaction or other behavior isoutside the realm of investment decisions. Of course, directors or officers of a non-profit corporation are not completely immune. Personal liability may result when adirector or officer of a nonprofit corporation (i) breaches standards of fiduciaryresponsibility; (ii) violates civil rights law; or (iii) breaches defamation, antitrust orfundraising regulation law. Further, personal liability may attach where a director’s orofficer’s conduct is wrongful and willful, continuous, or not based on reasonable care.

In limited circumstances, certain volunteer directors and officers of nonprofitorganizations may be protected from liability under the federal Volunteer ProtectionAct if the volunteer (i) performs services; (ii) volunteers for a nonprofit organization orgovernmental entity; and (iii) either (a) receives no compensation (reasonablereimbursement for expenses is allowed) or (b) does not receive anything of value inlieu of compensation in excess of $500 per year.318 Under the Act, a volunteer of anonprofit organization or governmental entity is not liable for economic harm causedby an act or omission made while carrying out responsibilities on behalf of the orga-nization, so long as the volunteer is properly authorized and licensed, if such author-ization is needed.319 However, if the harm was caused by willful or criminalmisconduct, gross negligence, reckless misconduct or a conscious, flagrant indif-ference to the rights or safety of the harmed individual, or if the harm was caused bythe volunteer operating a motor vehicle, vessel, aircraft or any vehicle for which alicense or insurance is required, the Act will not shield the volunteer from liability.320

318 42 U.S.C.S. §14505(6).319 42 U.S.C.S. §14503-4.320 42 U.S.C.S. §14503(a)(3) and (4).

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A major benefit of federal volunteer protections, such as those available under theVolunteer Protection Act, is the encouragement of a comprehensive and consistentapproach to volunteer immunity, resulting in similar treatment of volunteers serving indifferent states. While the Volunteer Protection Act fills in gaps created by divergentand wide-ranging differences in current state volunteer immunity laws, volunteerdirectors and officers of nonprofit organizations are already protected in many states.Several states have enacted immunity laws that protect volunteer directors and officersof nonprofit organizations from assertion of civil law violations. For example, Cal-ifornia state law provides that a volunteer director or executive officer of a nonprofitcorporation is not liable for monetary damages to a third party if the act or omissionwas done in good faith and within the scope of duty.321

321 Cal. Gov’t Code §5239 (with exceptions for reckless, wanton, gross, or intentional negligence andwith a requirement of liability insurance policy coverage).

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Fiduciary Duties and Other Responsibilities

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