THE ILLUSORY DELAWARE DIRECTOR LIABILITY LIMITATION STATUTE
In response to the perceived D&O liability and insurance crisis in the mid to late 1980's, approximately 45 states amended their corporation statutes beginning in 1986 in an attempt to limit the liability of directors (and in some instances officers). Although these statutes received considerable publicity when enacted, only a handful of courts have considered and interpreted the statutes over the last seven years. That fact alone strongly indicates the ineffectiveness of the statutes since plaintiffs can typically plead their claims to clearly fit within the numerous exceptions in the statutes, thereby avoiding both the liability limitation and judicial scrutiny of the statutes.
Many to these director liability limitation statutes follow almost verbatim § 102(b)(7) of the Delaware General Corporation Law, which was enacted effective July 1, 1986. The Delaware Supreme Court recently confirmed that the Delaware provision (and thus many other similar provisions in other states) provides little protection to directors. In Zim v. VLI Corporation, 621 A.2d 773 (March 8, 1993), the directors of a Delaware corporation which was the target of a friendly tender offer/merger were sued for breach of their fiduciary duty of candor and equitable fraud based on the defendants' alleged failure to disclose to shareholders the primary reason for renegotiating the terms of the transaction.
The Delaware Supreme Court ruled that the director liability limitation afforded by § 102(b)(7), Delaware General Corporation Law, and VLI's certificate of incorporation provision enacted thereunder did not insulate the VLI directors from liability. The court found that the directors' duty of candor to disclose to shareholders all material facts bearing upon a merger vote arises under both the fiduciary duties of care and loyalty owed by directors to shareholders. Because § 102(b)(7) expressly excepts from its protection, among other things, claims for breach of the directors' duty of loyalty, the court ruled that the statute was inapplicable to duty of candor type claims.
Equally important, the court reversed the Chancery Court's conclusion, after a four-day trial, that the defendants' disclosures to shareholders were not misleading. The Chancery Court examined whether the directors disclosed the predominant factors in their subjective decision to accept the takeover proposal. The Supreme Court instead adopted an objective test:
The focus is on what a reasonable investor would consider important in tendering his stock, not what a director considers important. In determining what information is to be provided to the shareholders, a director should not be controlled by his or her own subjective views to the exclusion of an objective analysis of what the investor might consider relevant.
Because the lower court considered only the VLI directors' subjective views and motivations, without addressing what a reasonable stockholder would consider important, the case was remanded for retrial.
This new Delaware Supreme Court case contains at least two important lessons for directors. First, Delaware § 102(b)(7), and similar statutes in other states, affords little real protection to directors. Since a director's duty of candor is based in part upon the duty of loyalty, the protective statute is inapplicable in virtually all state law disclosure claims. When this ruling is considered in light of the numerous other exception to § 102(b)(7), including claims under any federal statute, the ease by which plaintiffs can plead around the liability limitation provision becomes clear.
Second, the case increases the plaintiffs' forum selection options. Disclosure claims against directors and officers are typically asserted under §10(b) of the Securities Exchange Act of 1934. Those claims must be maintained in federal court. A disclosure claim based upon state law, though, can be maintained in state court which, depending upon the jurisdiction, may be viewed by plaintiffs as a more attractive forum. By endorsing state law D&O disclosure claims, the Delaware Supreme Court has given to plaintiffs yet another potentially important arrow in their already full quiver of weapons available against directors and officers.
SECURITIES LITIGATION LOSS PREVENTION
As has been discussed in previous issues of The ACE Report, the single greatest exposure for directors and officers of public companies is under the federal securities laws. Whenever the investing public is surprised by company disclosures, thus resulting in a material upward or downward movement in the company's stock price, litigation will likely be filed alleging that the company and the responsible D&Os improperly delayed disclosure of that surprising information. Investors who traded in the company's stock during the period the information was allegedly with-held will claim they were damaged to the extent the stock price when they traded was different than what the stock price would have been if timely disclosure of the information had been made.
Although D&O securities litigation typically arises out of the surprising disclosure by the company of negative news, the surprising disclosure of good news can also generate claims by shareholders who sold their shares shortly before disclosure of the good news and the resulting stock price increase. In essence, this litigation usually arises whenever the investment community is surprised by the disclosure of either good or bad information or when the expectations of the investment community differs from the company's actual condition or performance.
Given the broad scope of the U.S. federal securities laws and the sophistication of the professional plaintiffs' bar, D&Os cannot avoid securities litigation altogether. However, a well conceived and fully implemented securities law loss prevention program can reduce the likelihood and severity of such litigation.
The goad of the federal securities law, and thus the goal of a securities law loss prevention program, is the full, accurate and timely disclosure of material information. The following summarizes some of the loss prevention concepts in this area:
Coordinated Team Approach. No one person or department can fully satisfy the securities law disclosure requirements. Rather, an integrated team of outside professionals and representatives from various segments of the company must work together, with each having clearly defined and understood responsibilities regarding when, how and who identifies and discloses material information. Inadequate internal communications invariably lead to inadequate disclosures to the investing public.
Delegation of Responsibility. Although many aspects of the disclosure process are typically delegated to lower management or outside professionals, senior management and, where appropriate directors, should personally review all important securities law filings and disclosure statements and assure themselves that the company has taken reasonable steps to disclose accurately and completely all relevant material information. Since senior management and the directors will be the defendants, they should be personally able to defend the challenged disclosure.
Detailed Disclosures. The more specific and detailed a disclosure, the more likely it will satisfy investors and the courts. Vague or veiled references to negative information invites false expectations by investors and therefore serves little benefit.
Exaggerated Disclosures. Disclosure of good news should not be overly touted and disclosure of negative news should not be down played. The company should resist the temptation to maintain or overly increase investor confidence at the risk of issuing misleading disclosures. Restraint in disclosing good news and openness in disclosing negative news builds long-term credibility and helps prevent unreasonable expectations.
Company Spokespersons. Disclosures should be communicated through a relatively small number clearly identified company spokespersons, who are experienced and schooled in disclosure and investor relations issues. The more people talking on behalf of a company, the greater the chance for inconsistent or inaccurate company disclosures. Similarly, the chain of command for approval of written or oral disclosures should be well defined and relatively short so that decisions can be made quickly if necessary.
Listen to Internal Skeptics. The disclosure decision-makers should not casually ignore skeptics within the company who warn management of actual or potential problems. Their warnings may be correct. If a culture exists in which people are writing memos designed to cover themselves because management refuses to listen, potential "smoking gums" are created for discovery in the litigation.
Coordinate Insider Trading. If insiders trade in the company's stock shortly before the announcement of surprising news, the plaintiffs' case is greatly enhanced and the chance of a court dismissing that case is greatly reduced. The company's insider trading program should include input from the company's investor relations personnel and others involved with disclosure decisions to assure that a surprising disclosure is not imminent.
Securities Analysts Communications. Meetings with or other oral disclosures to stock analysts should be carefully prepared and rehearsed. Inconsistent or selective disclosure should be avoided.
Documentation of Oral Disclosures. It is much more difficult to defend a securities claim based upon alleged oral communications to analysts, reporters or others since, unlike claims based upon written disclosures, significant fact issues exist as to exactly what was or was not orally disclosed. This evidentiary concern is minimized of the oral disclosures are documented by maintaining a copy of the speech or outline used for a presentation or preparing a memorandum summarizing the disclosure soon after the fact.
Avoid Leaks. A company should make every reasonable effort to assure that no one in the company is leaking material information to his or her favorite stock analyst or other outsiders. No disclosure should be made until the appropriate decision-makers approve the disclosure. Once internally approved, the information should be expeditiously and consistently disclosed to the entire market, not just to selective segments of the market.
Analysts' Reports. Companies should be reluctant to review and comment on analysts' reports before those reports are released to the public. Pre-release review of analysts' reports is risky and fraught with danger since such reports may become tantamount to disclosure by the company.
Monitor Investment Expectations. A company's disclosures should be based, in part, upon the current expectations of investors. If the company detects that those expectations are diverging from reality, appropriate corrective disclosure may be appropriate even if such disclosure is not otherwise required.
U.S. SUPREME COURT RECOGNIZES CONTRIBUTION CLAIM
On June 1, 1993, the U.S. Supreme Court ruled the defendants in a Section 10(b) securities law claim have a right of contribution against nondefendants who participated in or contributed to the securities law violations. Musick, Peeler & Garrett v. Employers Insurance of Wausau, 1993 U.S. LEXIS 3743 (June 1, 1993). In that case, Cousins Home Furnishings, Inc. and various of its officers and directors were sued for securities law violations arising out of the company's public offering of stock. The named defendants settled the litigation for $13.5 million, of which $13 million as paid by the D&O insurers for the company. Those insurers then commenced a subrogation claim against the company's attorneys and accountants involved in the public offering, seeking contribution based upon the professional's allegedly joint responsibility for the securities violations.
Not suprisingly, in its June 1 opinion the U.S. Supreme Court recognized that the D&O defendants, and thus the D&O insurers, have a right to seek contribution as a matter of federal law against persons not named in the original lawsuit who allegedly share responsibility for the securities law violations. In essence, the Court permitted the defendants in a Section 10(b) claim to spread the cost of that litigation among not only the defendants which were selected by plaintiffs, but also other potentially culpable wrongdoers who for whatever reason were omitted from the original lawsuit.
At first blush, the opinion appears to be a major victory for D&Os and their insurers since it permits the distribution of liability in securities law claims among not just the named defendants, but other third parties including the company's professional advisors. In reality, though, the opinion will likely be of only marginal benefit to individual D&Os and their insurers, although it may be of greater benefit to the defendant company.
In most instances, professional advisors who are not originally named as defendants refuse to voluntarily participate in a settlement. Instead, those professionals typically force the original defendants to file and prosecute a third party claim for contribution against the professionals. That litigation can be extremely expensive, time consuming and distracting from the company and its management. For tactical reasons that third party claim is usually not brought during the pendency of the original action, but is postponed until after the defendants have settled with the plaintiff and identified the loss for which they seek contribution. Except in the most unusual cases, the company typically decides following settlement of the original lawsuit that the time, expense, distraction and publicity associated with a subsequent claim for contribution against its professionals outweighs the potential economic recovery from those professionals. This is particularly true where a large portion of the original settlement is funded by the D&O insurer, not the company.
The D&O insurer is also frequently reluctant to prosecute this claim for contribution. In addition to the large expense associated with the lawsuit, the D&O insurer faces significant uncertainties and practical difficulties. As a stranger to the underlying transaction, the D&O insurer will not know the full strengths and weaknesses of the contribution claim until substantial discovery in the subrogation proceeding occurs. After a substantial investment in the proceeding, the D&O insurer may for the first time identify major weaknesses in the contribution claim. More importantly, in this type of complex litigation, the full attention, support and cooperation of the directors and officers who relied upon and dealt with the professional advisor defendants is critical yet unlikely to be available since those directors and officers have no financial or other incentive to assist the D&O insurer (notwithstanding their obligation under the policy to cooperate with the insurer).
For these and other reasons, D&O insurers where possible seek to avoid the payment of loss attributable to the professional advisors or other noninsureds. Since those professional advisors are in most instances agents of the corporation, not the defendant directors and officers, D&O insurers typically take the position that the company, not the D&Os or their insurer, should advance any settlement funds attributable to the professional advisor's exposure. In that circumstance, the company, not the D&O insurer, would bear the burden of prosecuting any contribution claim against the professional advisors.
Although the recent U.S. Supreme Court decision will probably not result in a significant increase in third party contribution litigation under Section 10(b), it will likely result in greater pressure by a defendant company, its directors and officers and its D&O insurer on the professional advisors to contribute to the settlement of securities litigation. If a contribution claim is litigated, though, the company rather than the D&O insurer will be the likely claimant.