Category: Corporate

THE THREE RULES OF NEGOTIATION.

These three rules of negotiation can mean the difference between your business’s success and failure.


To illustrate the power of these rules, we use the example of a simple negotiation between a small business without apparent leverage and a much larger business with immense leverage. These rules are also highly effective in transactions of much greater complexity and scope, in any industry, and with parties of differing size, interests, needs and challenges.

THE THREE RULES OF NEGOTIATION

Saul Winsten
The Winsten Group.Trusted Counsel LLC
www.thewinstengroup.com

Copyright 2018 Saul Winsten , all rights retained and reserved

These three rules of negotiation can mean the difference between your business’s success and failure.

Contracts are a means to establish and define commercial relationships, increase profitability and reduce risk. These three rules, when properly applied to contract negotiation, also can produce competitive advantage, enduring collaborative relationships, protection of intellectual property rights and business interests, and a wealth of other benefits for your organization.

To illustrate the power of these rules, we use the example of a simple negotiation between a small business without apparent leverage and a much larger business with immense leverage. These rules are also highly effective in transactions of much greater complexity and scope, in any industry, and with parties of differing size, interests, needs and challenges.

Rule One: Start with the End.

Wasn’t it Yogi Berra who said, “If you don’t know where you’re going, you’ll end up somewhere else?” He’s got something there.

Whether problem solving, negotiating a contract or resolving a dispute, you gain a decisive advantage when you begin your negotiation with the end in mind. Then build your strategy and action from there. Not taking the time up front to think through where you need to end up and how you will get there – making it up as you go along – is a mistake too often made.

Our client, a well-established EU-based business with a new USA subsidiary, designs and produces zero-defect, highly engineered products and is a Tier 1 supplier to large multinational manufacturers. It had just been selected by a much larger USA-based multinational Original Equipment Manufacturer (OEM) to negotiate a contract for production and supply of a component for the OEM’s engines. This OEM had earned a reputation for being tough on small suppliers. The OEM enjoyed its size, financial strength and market share, employing that clout in all negotiations. Our client knew that it would be difficult to obtain a profitable contract and retained us to assist in negotiations.

At the beginning of the process, we determined our client’s objectives, our end:
• to obtain a profitable exclusive contract for design and manufacture of highly engineered products in high volume,
• to protect our intellectual property and reduce our risk, and
• to establish and strengthen a new long-term, mutually beneficial relationship with this OEM and its affiliates.

Because our end was to build a productive long-term relationship, we approached negotiations as a collaborative problem-solving exercise, not an adversarial process with a single winner and a single loser. Every piece of correspondence, every interaction between the parties and negotiators, was intended to build trust and confidence.

Next, we identified and assessed our risks and opportunities, and strengths and weaknesses that might impact our ability to obtain the end we sought.

From there we identified our terms:
• what final terms we
needed, and why
• what terms we wanted
• how best to reach our end

Of course, need and want are very different things, not to be confused and never to be lost sight of. What we needed determined what our “walk away” points must be.

Here’s where Yogi comes in. If you don’t know what your objectives are and commit to them from the beginning, you will find yourself in negotiations being pushed or led back from one position to another. The end will be different from the one you hoped for.

Rule Two: Prepare. Prepare. Prepare.

Sun Tzu, the ancient Chinese military strategist and philosopher, said that the true master of the Art of War is one who wins the battle before it has started.

Likewise, the most successful negotiations are those for which careful research and planning begin well before the formal negotiations.

Before sitting down at the negotiating table, it is essential that you thoroughly know and understand the other party, its needs and its goals. Also learn as much as you can about its playbook, the persons with whom you will negotiate and the ultimate decision makers.

When you know yourself and you know your opponent – and apply that knowledge – you gain a significant advantage.

Back to our example:
Prior to our first meeting with the OEM leaders and negotiators, we learned all we could about the other party, its business, its product needs, its sources of competitive product supply, and its processes that might involve our product. Our USA president (an established and knowledgeable engineer), European executives (also established and knowledgeable engineers) and others in the company were in regular contact with the OEM’s engineers and procurement personnel. Through industry knowledge and contacts, we gained more information about the OEM’s negotiators and decision makers, their tactics and demands in similar negotiations, as well as how the OEM treated other suppliers and their intellectual property. And, of course, we carefully reviewed the OEM’s proposed procurement agreement.

When we sat down together, it was apparent the OEM hadn’t expended much effort to learn about us or develop a strategy for this contract. The OEM had bigger deals to think about and was confident that, with its strong leverage, we would accept its demands.

Based on our research, we anticipated that at the very end of negotiations – when we, the smaller party, would happily think the deal was done – the OEM would ask for more.

Because we knew what the OEM had demanded of other suppliers, we anticipated that we would be asked to warehouse our finished product at our sole expense, with payment by the OEM only after it took possession. This consignment arrangement would produce cost savings for the OEM, but it would burden us with additional costs and risk. We also knew the OEM had existing warehousing capacity and financial resources to easily handle its own storage of small components for just-in-time use.

We determined in advance that we would not accept this last-minute demand unless we were adequately compensated. We formulated a response consistent with our advantages (the OEM could not obtain a truly competitive product at this price on this timeline) and what the OEM viewed as our weakness (our size, and eagerness to enter this contract). In this case, we were going to try to turn a perceived weakness into an advantage.

Rule Three: Pay Attention and Seize Opportunity.

Sun Tzu instructed his generals to occupy the field of battle first. In doing so, they could secure the best ground from which to wait for the opposing army’s arrival, watch its moves, and quickly adapt to those moves to achieve victory.

When you apply the first two rules, you may have a better opportunity to occupy the field of battle first. You likely are prepared for engagement before and better than the other party. Thus, you can recognize and utilize favorable opportunities that arise. Some of these opportunities might be subtle, such as cues picked up by the behavior, body language and voice of the other parties.

Turning an opportunity to our advantage:
We arrived for formal negotiations at the OEM’s mammoth headquarters and were ushered into a large conference room dominated by a long, dark table. The OEM had already placed its negotiator, multiple procurement and engineering staff, other assistants, computers and paperwork at their end of the table. We were pointed to seats at the extreme other end. Clearly, the OEM was ready for its traditional adversarial negotiations.

We were prepared to change the dynamics.

We asked to move toward their end of the table, as it would be more conducive to discussion. They agreed. Throughout that day, we worked to create a dynamic of non-adversarial negotiations, of collaborative problem solving.

We already knew a great deal about what the OEM needed to meet its goals and schedules, its current product sourcing, and its supplier challenges. We knew our product capabilities and could calculate our design and production costs to a fraction of a cent. We also had a good idea of the performance, cost and availability of competitive products. With this knowledge, we were able to meet most of the OEM’s demands on terms that also benefitted us, or propose others that were acceptable to us. Our own demands fit the OEM’s budget and were for the most part easily accommodated. Protection of our intellectual property, particularly trade secret information, was crucial for us, and we pressed our requirements until the OEM agreed.

By the end of the second day, the OEM seemed satisfied with the results of negotiations. It now had a reliable supplier of a superior, highly engineered component, in desired volume, at desired cost, with a production and delivery schedule that fit its needs. We, too, were satisfied that the negotiated contract achieved our desired end. It was a classic win-win.

As anticipated, the OEM’s general counsel made the consignment demand after all else had been agreed to. We were prepared. We did not directly reject it, nor we did accept it. Instead, we followed our prepared script. We repeated calmly and deliberately that our product was measurably superior to anything they could procure elsewhere, was at an acceptable price, and would be produced and delivered on a schedule that allowed them to fulfill their customer commitments We used our small size to our advantage, repeating that this new demand would place burdensome costs and risks on us.

Then we said nothing.

Now, you know we wanted that contract. We wanted it signed before we left the OEM’s headquarters. We did not want to risk losing this contract or this new client. In fact, our European chairman and USA president had decided in advance that if push came to shove, the consignment arrangement could be acceptable if we were appropriately compensated. The OEM of course did not know that.

The OEM’s general counsel waited for us to respond. When we did not, he cleared his throat, shifted slightly in his chair, rounded his shoulders a bit and looked down. His voice was softer and of a different pitch when he said, “Well, that’s our final offer.”

It just didn’t look or sound like a final, take-it-or-leave-it demand. It looked like an opportunity for us to seize.

Our company chairman was tired. He began to shift in his seat and was about to speak. He later confirmed that he was about to accept their demand. However, at the last second, he took the cue to wait. He said nothing.

The silence following the “final offer” could not have lasted more than a few seconds. Our chairman thought it seemed longer.

Then the OEM negotiator sighed. “Well, okay. No consignment,” he said.

We all shook hands.

Deal done.

It was the single most profitable agreement ever obtained by our multinational client in its long history.

Saul Winsten is General Counsel of The Winsten Group.Trusted Counsel, LLC a leading legal, strategic and corporate affairs firm. He has served as General Counsel, executive, and trusted outside counsel of US and multinational businesses, non-profit organizations, and strategic alliances. Saul has also served with distinction as a member and leader of Boards of Directors.

*The Three Rules article above was excerpted and adapted from speeches, workshops, and presentations provided to leaders, lawyers, Boards of Directors, senior executive groups, business groups, trade associations and others.

A FEW SIMPLE STEPS THAT DIRECTORS CAN TAKE TO MINIMIZE DIRECTOR LIABILITY

Directors of Public Companies should take these steps. Substantial Privately-Owned and Family-Owned and Managed Companies would do well to take them as well.

With a few simple steps, directors can reduce the burden of these lawsuits and protect themselves from the most common tactics utilized by stockholders’ attorneys.

Seven Tactics for Minimizing Director Litigation Headaches

Published by Craig Zieminski and Andrew Jackson Craig Zieminski, July 10, 2017

Law firms that specialize in suing directors will scrutinize nearly every major transaction, public offering, stock drop, restatement, and press release filed by public companies. For instance, according to Cornerstone Research, stockholders file lawsuits challenging the majority of public company transactions valued at more than $100 million, with an average of three lawsuits per transaction. An effective defense of these almost-inevitable lawsuits can begin long before they are filed. With a few simple steps, directors can reduce the burden of these lawsuits and protect themselves from the most common tactics utilized by stockholders’ attorneys.

1. Vet conflicts early and often. Perhaps the easiest way to avoid fiduciary duty liability is to avoid situations where you have conflicting interests in a transaction or other board decision. Due to various protections under Delaware law, directors are rarely held liable for poor or ill-informed decisions if the directors are not self-interested (unless they are grossly negligent), and articles of incorporation almost universally protect directors from monetary damages for such decisions. By contrast, Delaware fiduciary duty law imposes exacting standards for directors who participate in board decisions when they have a material self-interest in that decision. Thus, any major board initiative should begin with a full analysis of each director’s potential self-interests, and this analysis should be updated throughout the initiative. Of course, this analysis requires you to stay organized with your outside business interests (e.g., your employer’s customers, suppliers, and competitors) and personal financial situation (e.g., ownership interests). Recusing yourself can be the stitch in time that saves nine.

2. Treat all board communications formally. The documents that often cause the most trouble in litigation are informal e-mails between two directors. Even if e-mails contain nothing objectively negative regarding the board decision at issue, such e-mails can raise questions about the board’s deliberative process, especially if the issue raised in an e-mail was not discussed with the full board. A skilled plaintiff’s counsel can often interpret a casually written message in an unintended manner. In most instances, if a director raises any concern outside of a board meeting, the full board should resolve that concern and memorialize the process in a contemporaneous document (e.g., the minutes). If you have said anything in an e-mail that is inconsistent with your ultimate vote on an issue—even if you were just playing “devil’s advocate”—you should be prepared to square your communications with your vote. In other words, make sure your concerns are resolved through the deliberative process before making your decision.

3. Maximize efficiency in pressing circumstances. Perhaps underestimating how quickly and diligently directors and their advisors can work in exigent circumstances, plaintiffs’ attorneys often allege that board decisions were too rushed. For instance, in one of the more infamous Delaware fiduciary duty decisions, a financial advisor did not send any valuation materials to a board of directors until 9:42 p.m. on the night that the directors met to vote on a merger. The board met at 11 p.m. and approved the merger that night. Tight deadlines are often unavoidable, but directors can take steps to maximize the efficiency of the process. For instance, request early drafts of meeting materials, make your advisors work around-the-clock when necessary, and don’t wait until the board meeting to ask questions. At the end of the day, you need to be able to honestly state that you had enough time to fully consider any issues or concerns and come to a reasoned decision. Use your resources efficiently to get to that point.

4. Make your advisors an asset, not a liability. The quality and independence of a board’s advisors is a direct reflection on the quality and independence of the board’s process. This scrutiny begins when a board (or committee) selects its outside advisors. Stockholders may cry foul if directors simply accept management’s recommended advisor, especially if any member of management may have a self-interest in the relevant transaction.

To avoid these common allegations, interview multiple advisory firms, thoroughly inspect their potential conflicts, and negotiate for a fee structure that aligns the advisor’s incentivizes with the best interests of the stockholders. Stockholders also regularly allege that advisors are “deal cheerleaders” who bend their analysis to support the board’s wishes. To rebut these allegations, insist that your advisors objectively analyze the relevant issues, and ask them to obtain the board’s approval for any significant assumptions, methodology decisions, and other subjective portions of their analyses. To the extent possible, you should also resist your advisors’ efforts to load their work-product with disclaimers. Above all, carefully analyze your advisors’ work-product, ask questions, and do not rely on their opinions until you understand and approve of the efforts and reasoning underlying those opinions.

5. Ensure that the meeting minutes fully reflect the process. We cannot overstate the importance of minutes in litigation against directors. First, judges and juries typically place more weight on contemporaneous records of a board decision than after-the-fact testimony. Second, depositions often happen several months (if not years) after a challenged board decision, and minutes are an important tool for refreshing directors’ memories. Ask the board secretary to draft minutes promptly after a board meeting so that you can review them while the meeting is still fresh on your mind. When reviewing minutes, make sure that they accurately reflect a summary of the issues discussed, the specifics of any decisions reached, and a list of all attendees (plus mid-meeting arrivals and departures). Not every single statement made during a meeting can or should be part of the minutes, but it is important for the minutes to reflect every topic discussed at the meeting. Ask yourself: “If I’m questioned about this meeting at a deposition next year, will these minutes help me answer questions and show the court that we fulfilled our duties?”

6. Know the boundaries of the attorney-client privilege. The attorney-client privilege is not a guarantee that all correspondences with counsel are shielded from discovery. For instance, contrary to many directors’ (and attorneys’) beliefs, the attorney-client privilege does not protect every e-mail on which an attorney is copied. Rather, an e-mail is generally privileged only if the correspondence is sent in furtherance of requesting or providing legal advice. Parties in litigation are often required to redact the “legal advice” portion of e-mails and produce the remaining portions. Thus, an e-mail (or a portion of an e-mail) concerning purely business issues might not be shielded from production. Additionally, communications with certain persons that would ordinarily be privileged, including in-house and outside counsel, may not be privileged under certain circumstances. Further, even if a document is undisputedly privileged, litigants sometimes waive the attorney-client privilege for strategic reasons, such as when the board asserts that it made a challenged decision in reliance on advice from counsel. While it is vital to have open and honest communications with your counsel, it is also important to remember that those communications may be shown to an opposing party. If there is something you would not write down in a non-privileged e-mail, then consider calling your attorney instead of sending an e-mail.

7. Use a board-specific e-mail address. By exclusively using a non-personal e-mail address for board-related correspondences, you can significantly reduce the odds of personal e-mails (or e-mails concerning your other business endeavors) becoming subject to discovery. Too often, we see directors using their “day job” e-mail addresses for their directorial correspondences; this can lead to situations where your employer’s confidential information must be copied, reviewed by your outside counsel, or (worse yet) produced to the opposing party in litigation. The same holds true for personal e-mail addresses, which some directors use for their family’s bank statements and board-related e-mails. The best way to potentially avoid this situation is to proactively segregate board-related e-mails to a different e-mail account. Some companies create e-mail addresses for their directors. If yours does not, consider creating an e-mail account and conducting board-related business solely from that address.

Craig Zieminski and Andrew Jackson are litigation attorneys at Vinson & Elkins LLP. They specialize in representing companies and their directors in lawsuits alleging breaches of fiduciary duties, partnership agreement duties, merger agreements, and federal securities laws.

Director Liability And Protection. Developments, Strategies, Trends.

by Pepper Hamilton LLP

Directors and officers are exposed to potential liability from suits by the company, shareholders, and debt holders, among others. There are, however, a number of protections available to protect the assets of directors and officers.

Published in the December 2017 issue of INSIGHTS (Volume 31, Number 12). INSIGHTS is published monthly by Wolters Kluwer, 76 Ninth Avenue, New York, NY 10011. For article reprints, contact Wrights Media at 1.877.652.5295. Reprinted here with permission.

Being a corporate director or officer can be risky business, especially for those involved with public companies. Directors and officers (Ds&Os) are exposed to lawsuits by the company, corporate successors, shareholders, debt holders, employees, bankruptcy trustees and governments. The building blocks of asset protection for Ds&Os are outlined in this article, as well as basic securities and fiduciary liability principles, updates on relevant government enforcement policies under the Trump Administration, and implications for D&O liability insurance coverage.

As discussed here, private securities claims and derivative suits against public company directors and officers are on a powerful upswing, with an unprecedented number of new lawsuits filed in 2017. Meanwhile, under the Trump administration, there are signs of a possible easing of government enforcement actions as the Department of Justice and SEC review prior policies governing corporate cooperation credit and the pursuit of individuals responsible for corporate wrongdoing. In these changing and challenging times, it is important for directors, officers and companies to review their corporate articles, bylaws, contracts and insurance to assure that corporate commitments and policies for protecting Ds&Os fit the needs of the company for balance sheet protection, flexibility and the exercise of discretion, and also satisfy the needs of Ds&Os for reliable and adequate sources of indemnity and advancement.

Asset Protection Overview

Lawsuits and demands against Ds&Os often materialize as claims for alleged violations of securities laws or breaches of fiduciary duties owed to the company or its stockholders. Directors and officers have several potential layers of protection for out-of-pocket expenses and losses, including legal costs, settlements and even judgments.

Statutory Corporate Indemnity and Advancement

State corporations laws permit or require companies to indemnify directors, officers, and employees who are forced to incur costs to defend or protect themselves in lawsuits or proceedings involving their work. Delaware and California law require indemnification of directors and officers who succeed in defending themselves—in Delaware “on the merits or otherwise” and in California “on the merits.”1

Delaware and California law also permit (but do not require) indemnification for defense costs, judgments, fines and settlements incurred by directors, officers and employees who acted “in good faith and in a manner reasonably believed to be in and or not opposed to the best interests of the corporation” or, in a criminal matter, “had no reasonable cause to believe the conduct was unlawful.”2

These are known as the “minimum standards of conduct” for permissive corporate indemnification. A corporation is not legally permitted to indemnify an individual for expenses resulting from conduct that fails to meet these standards. Nor may a corporation indemnify an individual for a judgment of monetary liability to the corporation itself.

Rather than face a potential non-indemnifiable liability, cases against Ds&Os generally settle, if they are not dismissed on pre-trial motions. Corporate laws permit a corporation to advance legal expenses prior to any final determination of whether an individual met the minimum standards of conduct for indemnification. In Delaware and California, corporations may advance defense costs if the individual promises to repay the money if he or she is later found not to have met the minimum standards of conduct for indemnification.3

In order to attract high quality Ds&Os to serve, many companies commit to indemnification and advancement of their Ds&Os in the articles of incorporation or bylaws “to the greatest extent permitted by law.” This language effectively makes permissive indemnification and advancement mandatory.

Contractual Indemnity and Advancement

Directors and officers can strengthen their rights to corporate indemnity and advancement by requiring, as a condition of employment, that the company enter into a private contract stating the terms of its obligation to indemnify and advance.4 Then, if later changes in the articles, bylaws, ownership, key decision-makers or policies are disadvantageous to a director or officer, the company is bound by its contractual agreements to them. These private agreements usually contain presumptions, burdens of proof, timetables and other terms that favor individuals and generally continue in force after the employment relationship or directorship ends.

Exculpation

Many states also permit companies to limit the personal liability of directors (but not of officers) to the corporation and its stockholders with an “exculpation” provision in the articles of incorporation. These provisions excuse directors from personal monetary liability to the company and its shareholders for breach of the fiduciary duty of care. Corporate laws do not permit exculpation, however, for breach of the fiduciary duty of loyalty, bad faith, intentional misconduct, knowing violations of law, transactions resulting in an improper personal benefit, or improper payment of corporate dividends.5

Third-Party Insurance

The final layer of asset protection is D&O liability insurance purchased by the company to protect corporate assets and provide coverage for Ds&Os when the company cannot or will not indemnify them. D&O liability insurance is designed to pay losses (including legal fees) for defending against allegations of “wrongful acts,” such as violations of securities laws or breaches of fiduciary duty, that result in damages to the company, its stockholders or investors.

Most D&O liability policies contain multiple products in a single policy. A traditional “ABC” policy covers personal asset protection and corporate balance sheet protection. Side A covers directors and officers when the corporation cannot or will not indemnify them—such as when it is insolvent, chooses to withhold indemnity, or concludes that an individual failed to meet the minimum standards of conduct. Side B reimburses the corporation for indemnification paid to directors and officers. Side C covers the corporation when it is named in a securities action. Finally, excess Side A DIC (difference in conditions) coverage is dedicated coverage for directors and officers that is not “shared” with the corporation. Side A DIC provides coverage in excess of a tower of primary and excess policies and, among other attributes, “drops down” to replace an underlying insurer if it becomes insolvent.

Although D&O policies provide coverage for claims alleging “wrongful acts,” they exclude coverage for willful or intentional misconduct, which is uninsurable as a matter of law and public policy. That said, insurance can provide coverage for conduct that would not be indemnifiable by the corporation, such as non-exculpable failure of oversight or forms of “bad faith” that do not rise to the level of intentional misconduct. Corporate laws generally allow companies to buy D&O insurance for nonindemnifiable claims.6

Liability Standards—Securities Laws

Corporate directors and officers have potential exposure under both state and federal laws for securities law violations, which commonly are based on allegedly misleading disclosures to investors or illegal sales of securities. Liability for securities violations ranges from mere negligence to intentional wrongdoing. Federal law preempts state law in securities fraud class actions.7

Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) is the work horse most often invoked against directors and officers in private securities litigation. Federal courts have exclusive jurisdiction over Section 10(b) cases, and most federal circuit courts have concluded that “recklessness” satisfies the mental state required to prove liability—although the U.S. Supreme Court has never determined whether “reckless” conduct is sufficient.8

Federal securities fraud class action filings hit a record pace in 2017, with the most new case filings since enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA set up legal hurdles and protections for companies, directors and officers, designed to weed out meritless claims at the pleading stage, often filed on little more than accusations of prior disclosure fraud when disappointing news results in a stock price decline.9

Sections 11 and 12 of the Securities Act of 1933 (Securities Act) are invoked against Ds&Os less frequently than Section 10(b) because they apply in narrower circumstances.10 Section 11 is designed to redress material misstatements in a registration statement, and most often invoked following a public offering, when stockholders can trace their purchases to a particular registration statement. Section 12 is designed to redress the illegal sale of unregistered securities and material misstatements in prospectuses and other offering materials. Ds&Os can defend themselves against misrepresentation claims under Sections 11 and 12 by demonstrating their due diligence and that they “had no reasonable ground to believe and did not believe” that the challenged statements were untrue when made.11

In 2017, the United States Supreme Court took up an important issue in Cyan Inc. v. Beaver County Employees Retirement Fund,12 about whether state courts have jurisdiction over claims filed under the Securities Act. From the mid-1990’s until recently, plaintiffs brought Section 11 and Section 12 claims in federal court, where many of the PSLRA’s protections operate through the federal rules of civil procedure.13 However, federal courts in California parted company with other jurisdictions by holding that state courts retain jurisdiction over 1933 Act claims. If the Supreme Court agrees, then public companies—especially new companies following an IPO—will face the prospect of securities class actions in state courts that lack familiarity with the federal securities laws and are not obliged to enforce some of the procedural protections contemplated by the PSLRA—thus, increasing D&O liability risk.

Liability Standards—State Fiduciary Duties

The liability of directors and officers for breach of fiduciary duties owed to the corporation or its stockholders is governed by state law—usually the state of incorporation.14 In Delaware, gross negligence violates the fiduciary duty of care.15 In California, directors and officers are held to a standard of ordinary negligence, except that directors, unlike officers, have no liability if they act in good faith and in reasonable reliance on others.16

Duty of Care: The Business Judgment Rule

The first line of defense in a breach of fiduciary duty case is the business judgment rule (BJR). By statute or common law, depending on the state, the BJR immunizes directors for decisions made in good faith and on an informed business basis, even if those decisions result in losses to the company or its stockholders. In Delaware, it is unsettled whether the BJR protects both directors and officers; in California, it protects only directors.17

Many states, including Delaware and California, recognize a presumption that disinterested directors acted in good faith and on an informed basis, and put the burden on plaintiffs to rebut the presumption that the BJR applies to a given board decision.

Where the BJR applies, courts are expected to defer to a board’s decision about managing corporate affairs.18 Even if a board’s business judgment is “substantively wrong, or degrees of wrong extending through ‘stupid’ to ‘egregious’ or ‘irrational,’ ” no court should second-guess it and no director should have liability for it as long as “the process employed was either rational or employed in a good faith effort to advance corporate interests.”19

Business judgments that result in waste of corporate assets, however, are not recognized as valid and could expose directors to personal liability. However, “waste” is a transaction “so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”20

Duty of Loyalty and Good Faith

Directors are not entitled to corporate indemnification—nor exculpated from personal liability—for breaches of the duty of loyalty or bad faith. “Bad faith” and the absence of good faith are “two sides of the same coin.”21 Bad faith in its “most extreme form” involves “the conscious doing of a wrong because of [a] dishonest purpose,” or “intentionally fail[ing] to act in the face of a known duty to act, demonstrating a conscious disregard for [his or her] duties.”22 In order to win a money judgment against directors, plaintiffs must allege and prove a non-exculpable breach of the duty of loyalty or bad faith. Accordingly, plaintiffs often allege that directors “consciously disregarded” a duty to intervene in events that are harmful to the company or its stockholders, or that they approved or engaged in transactions for self-interested reasons, knowing that their actions were not in the best interests of the company or its stockholders.

A transaction is self-interested when a director stands on both sides of it or is influenced by someone whose interests are across the table from the corporation’s interests. It is important to note that Ds&Os engage in business transactions with their companies not infrequently. These transactions are not inherently wrongful. Rather, the transaction will be subject to heightened judicial scrutiny, and the burden rests on the self-interested director to prove that the transaction was “entirely fair” to the corporation.23 This heightened scrutiny and burden expose the director to the risk of a finding that the director obtained a personal benefit that he or she knew was opposed to the best interests of the corporation or its shareholders—i.e., non-exculpable, non-indemnifiable conduct.

Liability for Failure of Oversight Under Caremark

Directors also face non-exculpable, non-indemnifiable liability exposure for a failure of corporate oversight that amounts to breach of loyalty. Under the Delaware Court of Chancery’s Caremark decision, directors face liability for breach of loyalty when “a loss eventuates not from a [business] decision but, from unconsidered inaction.”24 Directors may be liable if they knew or should have known that violations of law were occurring within the corporation and yet failed to take steps to prevent or remedy the situation. Directors must assure themselves that “information and reporting systems” exist that are reasonably designed to provide timely and accurate information sufficient to allow them to make informed judgments “concerning both the corporation’s compliance with law and its business performance.”25 “[A] sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability.”26

Because liability under Caremark is based on bad faith amounting to breach of the duty of loyalty, the company cannot indemnify a culpable director or officer. This narrows the potential source of indemnity to D&O insurance. A company may indemnify and advance legal fees and settlement costs, however, before a final determination of liability—which naturally tends to drive failure of oversight cases to settlement.

Government Investigations Focusing on Individual Wrongdoing

The federal titans of securities law enforcement—the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC)—have policies that encourage aggressive pursuit of individuals, both as sources of information and targets of enforcement action. These policies have negative implications for D&O defense.

The DOJ Policy

In a September 2015 memorandum by then-Deputy Attorney General Sally Yates, the DOJ announced a policy to more aggressively pursue individuals.27 This announcement followed an uptick in the number of individuals charged under the Foreign Corrupt Practices Act (FCPA) and the False Claims Act. Statements out of the DOJ under the new administration have raised some uncertainty about whether the policy will continue in full force.

The Yates Memo gave federal prosecutors and investigators guidance on “key steps” to strengthen pursuit of individuals for corporate misconduct. In order to gain “any” credit for cooperation, companies must turn over “all relevant facts” relating to conduct of individuals responsible for corporate misconduct. Both civil and criminal enforcement attorneys are to focus on individuals at the inception of an investigation and share information with each other. Enforcement attorneys may not agree to a settlement that protects individuals or resolves a corporate case without a clear plan to resolve individual cases. Finally, civil attorneys must consider actions for monetary recovery against culpable individuals regardless of ability to pay.

While the impact of the Yates Memo is still playing out, some commentators have noted a counterintuitive drop in FCPA enforcement actions against individuals.28 In a speech at New York University Law School in October 2017, Deputy Attorney General Rosenstein stated that while the Yates Memo is “under review” and subject to change, the policy of focusing on individual accountability for corporation wrongdoing will continue under the current administration.29 On the other hand, in a November 17, 2017 press release, Attorney General Sessions may have been alluding to the Yates Memo in declaring an end to the DOJ “practice” of blurring regulations and “guidance,” stating that the DOJ “will proactively work to rescind existing guidance documents that go too far.”30

The Yates Memo policies of targeting individuals responsible for corporate wrongdoing presents challenges to the protective use of corporate indemnity and third-party insurance. The criteria for obtaining cooperation credit pit companies against directors and officers in positions of oversight. Those potentially in harm’s way will want separate legal counsel early in any internal or government investigation, for which they will look to the company for immediate advancement. Third-party insurance may not be available to defray the cost because coverage generally is triggered by a claim for money and often provides only limited coverage, if any, to cover an investigation.

This dynamic increases the importance of careful consideration of potential conflicts that may require separate counsel for various corporate actors, which can spiral into a full-employment-act for lawyers unless carefully managed. At the same time, companies seeking to curry favor with the government may wish to maximize flexibility to refuse advancement to individuals perceived by the DOJ as potential wrongdoers. Of course, there may be legal limitations on a corporation’s ability to refuse advancement.

The impact of the DOJ’s cooperation program tends to make government investigations more complex, extend over a longer period of time, and foster more tension between and among Ds&Os who are under scrutiny and boards of directors or committees that are leading internal investigations. If an investigation leads to self-reporting of a violation of law, or an enforcement action based on, for example, information provided by a whistleblower, it may take longer for companies to settle while individual culpability remains under consideration. To assess the adequacy of D&O defense and protection, companies should reevaluate their indemnification and advancement bylaws, as well as insurance coverage, retention limits, excess coverage, policy language and exclusions, and Side A coverage for individuals.

SEC Policy

The SEC’s policies of pursuing individuals responsible for corporate securities violations have been endorsed under the Trump administration and raise many of the same challenges discussed above. A more recent SEC policy of requiring companies and individuals to admit wrongdoing in some cases as a condition of settlement further negatively impacts the D&O safety nets of indemnity and insurance.

Pursuit of individuals. SEC initiatives launched in 2010 and 2011 encourage individuals to cooperate and report corporate wrongdoing. The 2010 “Enforcement Cooperation Initiative” offers deferred prosecution agreements and non-prosecution agreements in exchange for cooperation,31 while the 2011 Whistleblower Program, implemented pursuant to the Dodd Frank Wall Street Reform and Consumer Protection Act, provides life-changing bounty awards for tips leading to successful enforcement actions, including against compliance officers and other gatekeepers.32

These programs operate in tandem with the SEC’s longstanding policy of encouraging corporate cooperation with SEC enforcement through self-reporting, self-remediation, and punishing and turning over individuals responsible for corporate wrongdoing. The 2001 Seaboard Guidelines, published in an SEC report of investigation, articulate the framework by which the SEC evaluates corporate cooperation, including factors considered in determining whether, and to what extent, the SEC will grant leniency for cooperating.33

These programs appear to be here to stay under the Trump administration, although details may be tweaked. The Whistleblower Program has continued to generate large rewards. An October 2017 SEC report announced that the total awards under the program have reached $162 million to 47 whistleblowers.34 A co-director of the SEC’s Division of Enforcement recently confirmed that the Seaboard Guidelines also will remain in effect, while acknowledging that the SEC should be more specific about the exact benefits of cooperation and provide greater transparency about why cooperation credit is granted or denied.35

Admissions of wrongdoing. In June 2013, then-SEC Chair Mary Jo White announced a shift in policy to seek more admissions of wrongdoing in settlements—a departure from the SEC’s longstanding practice of permitting settling parties to “neither admit nor deny” wrongdoing. According to a March 2015 article in The New York Times, the SEC had generated admissions of culpability in at least 18 different cases involving 19 companies and 10 individuals. In 2017, however, a co-director of the SEC Enforcement Division stated that, while the SEC supports having companies and individuals that admit wrongdoing to other agencies make similar admissions to the SEC, the “harder piece” is deciding whether to continue a policy of departing from the SEC’s “neither admit nor deny” practice.

The SEC’s policies of pursuing individual wrongdoers and seeking corporate cooperation raise the same issues discussed above regarding the DOJ policies of targeting individuals—i.e., more requests for separate counsel, advancement and indemnification, longer investigations, heightened tension between internal investigators and the subjects of investigation, and greater importance of Side A D&O insurance coverage.

Further, an admission of wrongdoing in an SEC settlement limits the ability of a settling director or officer to access corporate indemnity if the admission is deemed to establish non-indemnifiable conduct. Insurance may not be available to fill the gap because coverage for SEC investigations (as opposed to money damages claims) often is not covered or is limited, and there is no coverage for intentional wrongdoing. Ds&Os who admit liability also risk inability to access corporate or insurance funds for defense in parallel or follow on securities litigation, derivative suits and criminal proceedings.

Corporate D&O Litigation

M&A Lawsuits

Until 2016, whenever a public company was sold, the selling company’s board invariably found itself on the receiving end of a class action lawsuit for breach of fiduciary duty to the selling stockholders. So-called “merger objection” lawsuits typically were filed by stockholders of the selling company claiming that the directors and officers breached their fiduciary duties in negotiating the merger price and terms, agreeing to a price that was too low, and approving deficient proxy disclosures. As of the end of 2014, a leading research firm reported that more than 90 percent of merger and acquisition (M&A) transactions above $100 million had ended up in litigation since 2009.36

Historically, most M&A cases were resolved by settlement before the merger closed based on the defendants’ agreement to make additional disclosures or minor adjustments in the deal terms, along with a negotiated fee to the plaintiff ’s attorneys, in exchange for a broad release of D&O liability. Those settlements, until recently, were routinely approved.37 In these early settlements, directors never face a real prospect of out-of-pocket liability exposure.

Recently, however, more M&A cases are being litigated as traditional class actions for money damages after the merger closes.38 This trend has serious liability implications for directors. In order to obtain a judgment for money damages, plaintiffs must prove non-exculpable conduct. This requires proof of self-dealing, bad faith or breach of the duty of loyalty—all of which expose directors to out-of-pocket, non-indemnifiable loss, leaving directors to rely on Side A insurance to fill a potential corporate indemnity gap. It is often unclear exactly what degree of wrongful conduct, however, may be insured.

Two factors are driving the trend toward post-closing merger class actions. First, the Delaware Court of Chancery has taken a stand against broad releases in exchange for “a peppercorn and a fee,” refusing to approve pre-closing nonmonetary settlements. In January 2016, the Court of Chancery embraced the mounting criticism of these settlements and rejected a disclosure-only settlement in In re Trulia Inc. Securities Litigation.39Trulia echoed the analysis in Acevedo v. Aerofl ex Holding Corp., where the Court of Chancery harshly criticized “disclosure-only” settlements stating that they “do not provide any identifiable much less quantifiable benefit to stockholders” and that “ubiquitous merger litigation is simply a deadweight loss.”40 The Court in Aeroflex gave the plaintiffs three choices: (1) declare the claims moot based on the enhanced disclosures and seek attorneys’ fees; (2) propose a settlement limiting release of the directors to Delaware fiduciary duty claims; or (3) litigate the case.41 None of those choices would provide the defendants with broad releases from personal liability.

Second, the trend toward post-closing merger class action cases is fueled by the high potential dollar recovery. Plaintiffs now are filing many of these cases in federal court (to avoid Delaware).42 Although the cases are subject to a high dismissal rate, the rewards of surviving a motion to dismiss are potentially considerable. But again, in order to win a judgment against corporate directors, plaintiffs must establish non-exculpable liability—such as breach of loyalty—which is not indemnifiable by the company. Individual defendants, who usually have parted ways with the company under new ownership, are highly motivated to encourage a class-wide settlement with insurance dollars rather than face risk of personal liability at trial, even on weak or patently unmeritorious claims.

Derivative Suits

Derivative suits against corporate officers and directors historically have presented a low risk of liability for Ds&Os and low returns for plaintiff’s firms. Generally, cases are filed in the wake of securities class actions and settled for minor prophylactic measures, such as corporate governance improvements, and a relatively small fee award. Recently, however, derivative suits have gained traction after high-profile cases resulted in large settlements, including $275 million for Activision Blizzard (2014), $139 million for News Corp. (2013), $137.5 million for Freeport-McMoRan (2015), and $62.5 million for Bank of America Merrill Lynch (2012), among others.43

Stockholders seeking to sue on behalf of a company must establish their standing to assert the company’s claims, which normally are controlled by the board. Stockholders must first make a demand on the board to bring the desired action, or else establish that demand would be futile because a majority of the directors are too conflicted to exercise valid business judgment on a demand.44 In response to a demand, the board must investigate and make a business decision about whether it is in the best interest of the company to take the action demanded. If the demand is refused, courts should defer to the board’s business judgment and dismiss the case without considering the underlying merits of the claims.45

While the odds that plaintiffs will get past the pleading stage in a derivative suit are low, the potential payoff is high, as the settlements cited above suggest. As in the merger litigation context, plaintiffs must prove that defendant directors engaged in nonexculpable wrongdoing (bad faith, breach of loyalty), which generally cannot be indemnified by the company. Further, companies cannot indemnify directors and officers for a judgment of monetary liability in favor of the company, regardless of the theory. Thus, defendants face theoretical out-of-pocket liability in derivative suits. The primary defense strategy is to obtain dismissal based on plaintiffs’ lack of standing, regardless of the underlying merits of the claim. All equal, a settlement funded by D&O insurance is preferable to trial.

Plaintiffs have gained leverage in derivative suits based on recent Delaware decisions that allow more expansive pre-suit stockholder access to “books and records,” enabling plaintiffs to investigate D&O wrongdoing and file better complaints.46 Delaware courts have long encouraged stockholders to use Section 220 of the Delaware General Corporate Law to obtain nonpublic books and records before bringing derivative actions.47 To obtain corporate records, a would-be stockholder plaintiff need only show a “credible basis from which fiduciary misconduct could be inferred.”48

In 2014, the Delaware Supreme Court upheld a Court of Chancery decision enforcing a “books and records” demand by Wal-Mart stockholders to investigate an ongoing Wal-Mart internal investigation of alleged FCPA violations in Mexico. The court required Wal-Mart to comply with demands to search back-up tapes and to produce lower-level officer documents that were never seen by the board and certain privileged attorney-client communications.49 With such extensive information, plaintiffs in theory are better able to craft derivative complaints that stand a chance of survival at the pleading stage.

Coverage and Indemnity Implications

D&O coverage typically is triggered by a demand for money—not by a demand for corporate “books and records” or a demand that a board of directors investigate and bring suit on behalf of a company. Yet, these demands are serious precursors to derivative litigation against D&O defendants. Some D&O policies provide limited coverage to defray corporate costs of the board’s investigation in response to a demand. But this is only part of the cost. Individual Ds&Os who are questioned in the board investigation may seek separate counsel and request corporate advancement and indemnification. If the derivative suit were to result in a judgment in favor of the company, the culpable Ds&Os could not look to the company to defray the cost, and would need to call upon Side A insurance coverage.

Conclusion

If you are a director or officer of a public company, or considering a board position with a public company, it is a good idea to invest in a legal checkup on the company’s indemnification and advancement articles, bylaws, policies and agreements, and a review of its D&O liability coverage.

Endnotes

1 Del. Gen. Corp. Law § 145(c) (emphasis added); Cal. Corp. Code § 317(d) (emphasis added); Cal. Lab. Code § 2802 (mandating indemnification of employees for expenses incurred in the discharge of lawful duties).

2 Del. Gen. Corp. Law §§ 145(a) and (b); Cal. Corp. Code § 317(b).

3 Del. Gen. Corp. Law § 145(e); Cal. Corp. Code § 317(f).

4 Del. Gen. Corp. Law § 145(f); Cal. Corp. Code §§ 317(g) and (i).

5 Del. Gen. Corp. Law § 102(b)(7); Cal. Corp. Code § 204.

6 Del. Gen. Corp. Law § 145(g); Cal. Corp. Code 317(i).

7 The 1995 Private Securities Litigation Reform Act preempted state securities laws in class actions alleging securities fraud. 15 U.S.C. § 78u-4.

8 Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).

9 Cornerstone Research, Securities Class Action Filings, 2017 Midyear Assessment, available at https://www.cornerstone.com.

10 Section 11, 15 U.S.C. § 77k; Section 12, 15 U.S.C. § 77l.

11 Section 11(b)(1); 15 U.S.C. § 77k(b)(1); Section 12(a)(2), 15 U.S.C. § 77l(a)(2).

12 Cyan, Inc. v. Beaver County Employees Retirement Fund, Case No. 15-1439.

13 The Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227, was designed to preempt state jurisdiction over securities fraud class actions, and was widely understood to apply to claims under the Securities Act of 1933, superseding federal law conferring concurrent state and federal jurisdiction. Compare 15 U.S.C. § 77v with 15 U.S.C. §77(p) (SLUSA).

14 Under the “internal affairs doctrine,” the law of the state of incorporation governs the rights and duties among corporate constituencies. Edgar v. MITE Corp., 457 U.S. 624, 645 (1982). By statute, California law regulates director conduct and other internal affairs of companies that merely do business in the state. Cal. Corp. Code § 2115.

15 Gantler v. Stevens, 965 A.2d 695, 708-09 (Del. 2009).

16 Cal. Corp. Code § 309 (the standard of care is ordinary negligence – action “with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”). Directors, however, are immune from liability if they act in good faith and in reasonable reliance on others, which is tantamount to a gross negligence standard. Katz v. Chevron Corp., 22 Cal. App. 4th 1352, 1366 (1994).

17 FDIC v. Perry, No. CV 11-5561 ODW (MRWx) (C.D. Cal. Dec. 13, 2011); Gaillard v. Naomasa Co., 208 Cal. App.3d 1250, 1264 (1989).

18 Cal. Corp. Code § 309; Lee v. Insurance Exch., 50 Cal. App. 4th 694 (1996); Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

19 In re Caremark Int’l Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996) (emphasis in original).

20 In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 74 (Del. 2006); see also In re Walt Disney Co. Derivative Litigation, 907 A.2d 693, 749 (Del. Ch. 2005) (“waste is very rarely found in Delaware courts … . committing waste is an act of bad faith”).

21 In re Dole Food Co. Stockholder Litig., 2015 Del. Ch. LEXIS 223, at *129 (Aug. 27, 2015).

22 Id. at *129-30 (quoting McGowan v. Ferro, 859 A.2d 1012, 1036 (Del. Ch. 2004)).

23 See Guth v. Loft, 5 A.2d 503, 510 (Del. Ch. 1939).

24 In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967-968 (Del. Ch. 1996); see also Stone v. Ritter, 911 A.2d 362, 365 (Del. 2006) (confirming that “Caremark articulates the necessary conditions for assessing director oversight liability”).

25 Caremark, 698 A.2d at 970.

26 Id. at 971.

27 Sally Quillian Yates, Individual Accountability for Corporate Wrongdoing, Dep’t of Justice, available at http://www.justice.gov/dag/file/769036/download.

28 Sharon Oded, “Yates Memo – Time for Reassessment?,” Compliance and Enforcement, available at https://wp.nyu.edu/compliance_enforcement/2017/04/20/yates-memo-time-for-reassessment/#_edn4.

29 Kevin LaCroix, “Deputy AG Emphasizes Continued Individual Accountability for Corporate Misconduct,” D&O Diary blog, October 31, 2017 available at https://www.dandodiary.com/2017/10/articles/director-andofficer-liability/deputy-ag-emphasizes-continuedindividual-accountability-corporate-misconduct/.

30 Attorney General Jeff Sessions Ends the Department’s Practice of Regulation by Guidance, press release (Nov. 17, 2017), available at https://www.justice.gov.

31 SEC Spotlight, “Enforcement Cooperation Program,” available at https://www.sec.gov/spotlight/enforcementcooperation-initiative.shtml.

32 The SEC’s website announces huge awards. https://www.sec.gov/spotlight/whistleblower-awards. See https://www.sec.gov/spotlight/dodd-frank/whistleblower.shtml (background of the Whistleblower program).

33 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, https://www.sec.gov/litigation/investreport/34-4969.htm.

34 SEC Press Release, October 12, 2017, available at https://www.sec.gov/news/press-release/2017-195.

35 Andrew Ramonas, “SEC Should Clarify Path to Cooperation Perks in Cases: Official,” Bloomberg BNA, Oct. 26, 2017, available at https://www.bna.com/sec-clarify-path-n73014471401/.

36 Cornerstone Research, Shareholder Litigation Involving Acquisitions of Public Companies, Review of 2014 M&A Litigation, at 1, available at https://www.cornerstone.com [“2014 M&A Litigation”].

37 Acevedo v. Aeroflex Holding Corp., C.A. No. 7930-VCL, transcript of settlement hearing at 63-65, July 8, 2015 (Laster, V.C.) (quoting Solomon v. Pathé Communications Corp., 1995 Del. Ch. LEXIS 46, C.A. No. 12,563 (Del. Ch. Apr. 21, 1995) (Allen, C.)).

38 2014 M&A Litigation, supra note 37, at 1.

39 In re Truvia Inc. Sec. Lit., 129 A.3d 884 (2016).

40 Acevedo v. Aeroflex Holding Corp., No. 7930-CVL, at 63-65 (transcript of settlement hearing).

41 Id. at 74-76.

42 Cornerstone Research, Securities Class Action Filings, 2016 Year in Review, at 11-12, available at https://www.cornerstone.com.

43 See Kevin LaCroix, Largest Derivative Lawsuit Settlements, D&O Diary blog, Dec. 5, 2014, available at http://www.dandodiary.com/2014/12/articles/shareholdersderivative-litigation/largest-derivative-lawsuitsettlements.

44 See Aronson v. Lewis, 473 A.2d 805, 818 (Del. 1984) (holding that a stockholder may pursue a derivative suit in the absence of a pre-suit demand on the corporation’s board of directors only if the stockholder’s complaint contains allegations of fact sufficient to create a reasonable doubt (1) that the directors are disinterested and independent or (2) that the challenged transaction was otherwise the product of valid business judgment).

45 See, e.g., Cuker v. Mikalauskas, 692 A.2d 1042, 1045 (Pa. 1997) (the BJR permits the board of directors of a Pennsylvania corporation to reject a demand or terminate a derivative suit brought by the corporation’s stockholders); Zapata Corp. v. Maldonado, 430 A.2d 779, 788 (Del. 1981) (describing standard and proceedings in Delaware for dismissal of derivative claims based on the business judgment of an independent committee).

46 For example, the court in King v. VeriFone Holdings, Inc., 12 A.3d 1140 (Del. 2011), enforced an inspection demand under Delaware General Corporate Law section 220 in order to enable stockholders to take discovery and file a better derivative complaint after the first was dismissed for failure to plead that a pre-suit demand on the board would have been futile.

47 VeriFone Holdings, 12 A.3d at 1150 n.64 (citing cases).

48 Polygon Global Opportunities Master Fund v. W. Corp., 2006 Del. Ch. LEXIS 179 (Oct. 12, 2006).

49 Walmart v. IBEW, No. 13-614 (Del. July 23, 2014).

Businesses And Boards-Curing A “Defective Corporate Act” Under Delaware Law

The Exposure
Under the Delaware General Corporation Law (the “DGCL”) otherwise permissible corporate acts that do not satisfy the consent and other procedural requirements of the DGCL, the corporation’s organizational documents or any other agreement to which the corporation is a party, are deemed to be “defective corporate acts” and are generally held to be void and of no legal force and effect.[i]

In sum, founders and their Boards should, at minimum, undertake the below listed procedural steps* in order to ensure that otherwise defective corporate acts are cured and ratified in the manner prescribed by the DGCL.

WRITTEN BY:

Fox Rothschild LLP

The Problem
As every founder knows, starting and scaling a company is an extremely difficult and multi-faceted undertaking. In addition to the primary goals of developing a viable product, finding (and in some cases building from scratch) a robust market, and raising the capital necessary to sustain and scale their business and operations, founders and their core teams also grapple with the day-to-day management and operations of a growing enterprise, whether that be personnel issues, forecasting cash needs and burn rates or tackling the legal and regulatory hurdles that often go hand-in-hand with the creation of disruptive technologies. Unfortunately, given the size and complexity of the average founder’s workload, it is no surprise that emerging companies of all sizes occasionally neglect to heed the advice of their attorneys and ensure that any and all corporate actions taken by the company and its officers are properly authorized and, if necessary, approved by the company’s Board and stockholders.

The Exposure
Under the Delaware General Corporation Law (the “DGCL”) otherwise permissible corporate acts that do not satisfy the consent and other procedural requirements of the DGCL, the corporation’s organizational documents or any other agreement to which the corporation is a party, are deemed to be “defective corporate acts” and are generally held to be void and of no legal force and effect.[i] The pre-2014 historical body of Delaware case law held such corporate acts, taken without “scrupulous adherence to the statutory formalities” of the DGCL, to be acts undertaken “without the authority of law” and therefore necessarily void.[ii] Prior to the enactment of Sections 204 and 205 of the DGCL, the relevant line of Delaware case law held that corporate acts, transactions and equity issuances that were void or voidable as a result of the corporation’s failure to comply with the procedural requirements of the DGCL and the corporation’s governing documents could not be retroactively ratified or validated by either (i) unilateral acts of the Corporation intended to cure the procedural misstep or (i) on equitable grounds in the context of litigation or a formal petition for relief to the Court of Chancery.[iii] In short, there was no legally recognized cure for such defective actions and the company was left forever exposed to future claims by disgruntled shareholders, which could ultimately jeopardize future financings, exits and ultimately the very existence of the company.

The Statutory Cure
Luckily, for those founders who make the potentially serious misstep of failing to obtain the required consents and approvals before taking a particular action (e.g. issuing options to employees or executing a convertible note or SAFE without the prior consent of the Board), in 2014 Delaware enacted Sections 204 and 205 of the DGCL, which served to clarify the state of the law in Delaware and fill a perceived gap in the DGCL by providing new mechanisms for a corporation to unilaterally ratify defective corporate acts or otherwise seek relief from the Court of Chancery.[iv]

While both Section 204 and 205 were intended to remedy the same underlying issue and provide a clear process for ratifying or validating a defective corporate act, the mechanics set forth in the respective sections take disparate routes to arrive at the intended result:

Section 205 provides a pathway for ratification that runs through the courts, allowing a corporation, on an ex parte basis, to request that the court determine the validity of any corporate act.
Section 204, on the other hand, is considered a “self-help statute” in the sense that the procedural mechanic provided for in the statute allows a company to ratify the previously defective act unilaterally, without the time and expense involved with petitioning the court for validation of the corporate act in question.
In the case of early stage companies, the expenditure of the heavy costs and valuable time associated with seeking validation in the Court of Chancery render Section 205 a less than ideal tool for curing defective acts. This post focuses on Section 204, which provides a far less onerous mechanic for ratifying defective corporate acts, allowing a corporation to cure past errors “without disproportionately disruptive consequences.”[v]

Section 204 in Practice
Section 204 provides a company with a procedure to remedy otherwise be void or voidable corporate acts, providing that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided in [Section 204].”[vi] Pursuant to Section 204, a corporation’s Board may retroactively ratify defective corporate acts by adopting written resolutions setting forth:

the specific defective corporate act(s) to be ratified;
the date on which such act(s) occurred;
the underlying facts that render the act(s) in question defective (e.g., failure to obtain the authorization of the Board or inadequate number of authorized shares); and
that the Board has approved the ratification of the defective corporate act(s).
Additionally, if a vote of one or more classes of stockholders was initially required to authorize the defective act at the time such act was taken (e.g., the approval of a majority of the Series A preferred stockholders in the case of an act that falls within the purview of the Series A protective provisions), then ratifying resolutions of the relevant class of stockholders is also required in order to cure the prior defect in the corporate act.

In sum, founders and their Boards should, at minimum, undertake the below listed procedural steps* in order to ensure that otherwise defective corporate acts are cured and ratified in the manner prescribed by the DGCL.

A resolution by the Board that states (i) the defective corporate act to be ratified, (ii) the date of the defective act, (iii) if shares or other equity is involved, the number, class and date of the equity issuance, (iv) the reason for the defect, and (v) the approval and ratification by the Board of the defective corporate act.
Approval of the stockholders or a particular class of stockholders (in form of a written consent) if such an approval was required at the time of the defective corporate act.
Proper notice of the ratification sent to all stockholders (including stock that may have been invalidly issued). The notice must include a copy of the ratifying resolution/consent and an explanation that any claim that the ratification in question is not effective must be brought before the Court of Chancery no later than 120 days from the effective date of the ratification.
In certain circumstances, the filing of a “Certificate of Validation” with the Delaware Department of State to cure the defective corporate act being ratified (e.g., if shares were issued without filing the necessary Certificate of Amendment to increase the authorized shares of a corporation).
*This list should not be considered all-inclusive. Each situation is unique and further actions may be required depending on the underlying facts and the cause of the defect in question.

Takeaways
The potential adverse impact of an uncured defective corporate act cannot be understated. For an early stage company seeking to raise capital from venture investors or other outside parties (or eventually exit through an acquisition), the risks associated with such defective acts are particularly acute. As a practical example, a corporation’s failure to observe the proper procedures in the election of a director can result in the invalidation of such election. In the event of such a defective election, actions taken by, or with the approval of, the improperly elected Board may be void or voidable. This or other defective corporate acts may result in the corporation being in breach of representations and warranties in any number of contracts, including stock purchase agreements executed as part of a financing round or M&A transaction.

Generally speaking, relatively extensive due diligence is typically the first step in all venture financings and other major corporate transactions. As part of this process, counsel for the investor or acquiror will undoubtedly review all material actions of the company along with the corresponding Board and stockholder consents as a means of “tying out” the company’s cap table. Any defective corporate act that was not later ratified by the company in accordance with Section 204 or 205 will at best need to be ratified or validated in advance of the closing of the transaction, and at worst may result in either (i) a reduction in the company’s valuation due to the perceived risk that past actions are ultimately void or unenforceable, or (ii) in extreme situations, the abandonment or termination of the transaction.

In an ideal world, companies of all sizes would always observe the proper procedures in authorizing corporate acts and ensuring that all other necessary steps had been taken to ensure the validity of such actions. Unfortunately, in the fast-paced and often frenzied world of a startup, certain “housekeeping” items occasionally fall by the wayside. Upon the discovery of a defective corporate act by a company or its counsel, it is vital that the proper ratification procedures be undertaken in order to ensure that any and all past actions that could potentially be rendered defective are rectified and ratified in accordance with Section 204 (or in some cases Section 205) of the DGCL.

[i] A “defective corporate act” includes any corporate act or transaction that was within the power granted to a corporation by the DGCL but was thereafter determined to have been void or voidable for failure to comply with the applicable provisions of the DGCL, the corporation’s governing documents, or any plan or agreement to which the corporation is a party. See 8 Del. C. § 204(h)(1); See also, e.g., Blades v. Wisehart, C.A. No. 5317-VCS, at 8 (Del. Ch. Nov. 17, 2010) (holding that “scrupulous adherence to statutory formalities when a board takes actions changing a corporation’s capital structure”); STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991) (“Stock issued without authority of law is void and a nullity.”).

[ii] See, e.g., Blades v. Wisehart, C.A. No. 5317-VCS, at 8 (Del. Ch. Nov. 17, 2010) (holding that “scrupulous adherence to statutory formalities when a board takes actions changing a corporation’s capital structure”); STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991) (“Stock issued without authority of law is void and a nullity.”).

[iii] Id.

[iv] See H.B. 127, 147th Gen. Assemb., Reg. Sess. (Del. 2013): “Section 204 is intended to overturn the holdings in case law . . . that corporate acts or transactions and stock found to be “void” due to a failure to comply with the applicable provisions of the General Corporation Law or the corporation’s organizational documents may not be ratified or otherwise validated on equitable grounds.”

[v] In re Numoda Corp. S’holders Litig., Consol. C.A. No. 9163-VCN, 2015 WL 402265, at 8 (Del. Ch. Jan. 30, 2015).

[vi] 8 Del. C. § 204(a).

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