Archive for the ‘Governance’ Category

In Quadrant Structured Products v. Vertin et al, the Delaware Court of Chancery held in an opinion issued October 1, 2014, and again confirmed in relevant part on October 28, 2014, that lenders do not have direct claims against directors of a company for breach of fiduciary duty, and the directors do not owe fiduciary duties to the company’s lenders, but if a company is in the zone of insolvency, lenders do have the right to bring a derivative claim, just as a shareholder would under normal circumstances.


When a company is in financial difficulty, its shareholders and lenders often find themselves at odds. This is particularly true when the company has been through several rounds of financing, because holders of preferred stock have first right to the company’s assets in a liquidation, and even though they are shareholders, they are also pseudo-creditors. During the last recession, lender’s lawyers creatively asserted claims against company directors, first claiming that when a company was broke or nearly broke (in the “zone of insolvency”), the directors owed fiduciary duties to the lenders. When that didn’t work, they claimed that directors breached their fiduciary duties to the company by making risky business decisions that put a troubled company deeper in debt. These came to be known as the “zone of insolvency” claims.

Because a large percentage of U.S. companies are incorporated in Delaware, and many other states follow Delaware law on matters of corporate governance and fiduciary duties, Delaware courts addressed these arguments frequently from 2004 through 2010.

Company Directors or Mangers do NOT Owe Fiduciary Duties to Lenders

First, Delaware courts made it clear that directors (corporations), managers (LLCs), and general partners (partnerships) owe fiduciary duties to the entity, not to its owners, and not to its creditors. Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 792 (Del. Ch. 2004); North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). It has long been law that shareholders cannot sue directors for breach of fiduciary duty, because fiduciary duties are owed to the company, not to individual shareholders. Instead, they must bring a “derivative” action – a law suit against the company, to cause the company to sue its directors. When lenders tried to sue directors for breach of fiduciary duty, Delaware courts turned them away also – in Gheewalla the court held: “The directors of Delaware corporations have the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners,” and denied creditors the right to sue directors for breach of fiduciary duty. However, the court also held that once a company is broke, its creditors also have the right to bring a derivative suit for breach of fiduciary duty – like shareholders, lenders can sue the company to cause the company to sue its directors for breach of fiduciary duties.

Insolvency Does Not Expand the Usual Fiduciary Duties

Based on the decisions in Production Resources and Gheewalla, lenders next brought derivative claims asserting that if a company is in financial trouble (in the zone of insolvency), the directors have a duty to manage the company for the benefit of its creditors, and not make risky decisions that could lead to the company going broke, or “deepening its insolvency.” The argument goes like this: When a company is in trouble, the directors often take big risks, entering into questionable deals that, if successful will save the company, but have a high risk of failure. A risky deal that destroys the company leaves little for the creditors, but if the directors instead act to preserve the remaining assets for the creditors, they will at least get some if not all of their money back. If a company has significant debt, shareholders of troubled companies support taking bet-the-company risk – they have already lost their investment to the lenders, who get first pick. Thus, they have nothing to lose.

Delaware courts do not support the lenders argument that fiduciary duties shift to benefit the lenders: “…if a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Gheewalla, 930 A.2d at 101, See also Trenwick American Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 202-203 (Del. Ch. 2006) affd., 931 A.2d 438 (Del. Supr. 14 Aug 2007). The business judgment rule, as developed and refined over the years, particularly in Delaware, encourages risk and protects directors from risky decisions that do not work out, so long as they are taken properly and fairly.

Quandrant Structured Products v. Vertin

The Delaware Court of Chancery addressed this issue again recently. In Quadrant Structured Products v. Vertin et al, Athilon Capital, a company that sells credit protection to large financial institutions, guaranteed credit default swaps on collateralized debt obligations sold by its wholly-owned subsidiary. During the 2008 financial crisis, Athilon was deep into the zone of insolvency. Another company, EBF, bought all of the Athilon’s Junior Subordinated Notes and all of its equity, gaining control over Athilon. Thereafter, Quadrant Structured Product bought Athilon’s Senior Subordinated Notes.

EBF, now in control of Athilon, but in a junior security position, decided (1) not to exercise its right to defer interest payments to itself on the junior notes, (2) to pay above-market service and licensing fees to its own affiliate, and (3) to adopt a new, riskier business strategy instead of dissolving Athilon, which would have benefited other creditors like Quadrant. Since EBF’s notes were junior to Quadrant’s notes, EBF would get nothing in a liquidation, but could benefit if the risky strategy worked – they already had nothing, so all of the risk of EBF’s strategy fell on Quadrant. In short, a junior lender was able to improve its position over a senior lender by taking over the company and making decisions to its benefit. Quadrant, the senior creditor, sued the new directors, claiming that since the company was in the zone of insolvency, the directors breached their fiduciary duties by not making business decisions to benefit the senior lenders.

The Delaware court held that the directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy was allowed under the “business judgment rule,” even though Quadrant and other senior creditors bore the full risk if the strategy failed. Vice Chancellor Laster held: “In the case of an insolvent corporation, board decisions that appear rationally designed to increase the value of the firm as a whole will be reviewed under the business judgment rule, without speculation as to whether those decisions might benefit some residual claimants more than others.”

The ruling makes it clear that, at least in Delaware, even though creditors gain the rights of shareholders to bring a derivative action when a company is in the zone of insolvency, that right does not include a shift of fiduciary duty from the company to the creditors. The directors’ duty remains to the company, and decisions normally protected by the business judgment rule do not lose that protection just because a company is going broke.

It should also be noted that the Delaware court remained consistent by holding that the directors’ decisions not to defer interest on the notes held by the junior creditor, and to pay above-market fees to an affiliate of the junior creditor, were conflicting interest transactions subject to entire fairness review, and not purely protected by the business judgment rule. That portion of the decision would have been the same without a “zone of insolvency” situation, and those claims were not dismissed


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In a December 19, 2014 ruling the Delaware Supreme Court confirmed that the “market-check” requirement from the original Revlon decision, and the subsequent QVC decision, do not require a board to run a mandatory auction as part of every change of control transaction. There are other options the board may use to satisfy its Revlon duties in a change of control of transaction, such as a  post-signing market check, so long as there are no material barriers against the emergence of a superior proposal and the company’s stockholders are provided with a non-coercive, fully informed shareholder vote. In the ruling, C&J Energy Services, Inc. et al v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, the court held “Revlon does not require a board to set aside its own view of what is best for the corporation’s stockholders and run an auction whenever the board approves a change of control transaction.”  The ruling is discussed in detail on The Harvard Law School Forum on Corporate Governance and Financial Regulation: Delaware Court Reverses Preliminary Injunction Requiring Go-Shop.

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A Massachusetts appellate court recently pierced the liability veil of a single-member limited liability company because of its failure to keep “corporate records.” According to the LLC Law Monitor, in Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014) the Massachusetts Appellate Division, pierced the limited liability veil of a single-member LLC based on only one factor: the LLC’s failure to maintain business records.

Background – Piercing the Corporate Veil

Shareholders and other equity owners of corporations, as a general rule, will not be personally liable for the debts and other liabilities of the corporation. If a corporation owes a creditor money, the creditor cannot seek payment from the shareholders’ personal assets, even when the corporation is owned by only one or two people, because corporations have “limited liability.” This is commonly called the “corporate veil,” or the “liability veil.” Limited liability extends by law to other statutory entities, such as limited liability companies (LLCs), and limited partnerships.

However, under certain circumstance the courts may “pierce the corporate veil” to hold one or more shareholders (corporation), members (LLC) or limited partners personally liable for the debts of the company or partnership. The court may take this action when justice requires, but in doing so, normally considers a number of factors to determine if the company has maintained its separate identity. In Colorado, the factors are:

• whether a corporation is operated as a separate entity;

• commingling of funds and other assets between the company and its owners;

• failure to maintain adequate corporate records or minutes;

• the nature of the corporation’s ownership and control;

• absence of corporate assets and undercapitalization;

• use of a corporation as a mere shell, instrumentality, or conduit of an individual or another corporation;

• disregard of legal formalities and the failure to maintain an arms-length relationship among related entities; and

• diversion of the corporation’s funds or assets to non-corporate uses.[1]

The Massachusetts Case

In the Kosanovich case Milan Kosanovich purchased a condominium from 80 Worcester Street Associates, LLC (WSA), which was owned by Jeffrey Feuerman. WSA agreed to repair any defects in the condominium for up to one year after closing.

During the following year Kosanovich complained of defects, and Feuerman repaired some but not all of the problems. Kosanovich sued WSA and Feuerman for breach of contract, breach of an implied warranty of habitability, and violations of the Massachusetts Consumer Protection Act. At trial the judge ruled in favor of Kosanovich and awarded him $9,000 in damages. The judge also pierced WSA’s veil and found Feuerman personally liable for the damages award.

On appeal the appellate court examined the factors applicable to “piercing the corporate veil” (Massachusetts applies 12-factors, which are similar to the 8-factor test under Colorado law).

Feuerman ran WSA out of his house and his car and he had no bookkeeping records, tax records or returns, checkbook, or records of payments to subcontractors. The Massachusetts appellate court held that was enough to pierce the veil, saying that “Feuerman’s failure to maintain or produce records hindered the court’s ability to establish the twelve factors, including intermingling of assets, thin capitalization, and insolvency…. Feuerman’s failure to maintain business records coupled with his sole ownership and pervasive control of WSA supported the [trial] judge’s decision to pierce the corporate veil.”

Lawyers have an old saying that “bad facts make bad law,” and veil piercing cases often provide facts that cause courts to stretch the law to find liability when justice requires. The Kosanovich case likely fits that model, since undoubtedly Feuerman took all the money out of his company, and didn’t do the promised work, leaving no funds to pay the judgment.

However, the Colorado Limited Liability Company Act contains one key provision that may lead to a different outcome were the Kosanovich case brought in Colorado:

§ 7-80-107. Application of corporation case law to set aside limited liability
(1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.

(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.

There is no similar language in the Massachusetts Limited Liability Company Act, and so a Colorado court could not hold that the failure to maintain business records by itself was a reason to pierce the corporate veil. Nevertheless, even in Colorado, the failure to maintain company records remains a factor that, when combined with one or more other factors showing the company is a mere alter-ego for the owner, will support imposing liability on the owner(s) if justice requires it. In fact, in a 2009 Colorado case, McCallum Family L.L.C. v Winger, 221 P.3d 69 (Colo. App. 2009), the court pierced the liability veil to impose personal liability on a person who was not an owner, director, or officer, but who was a mere employee. In that case, even though Marc Winger was not an owner, director, or officer of the company, the court found that he “managed the entire business” and routinely used company funds to pay his personal bills, and his wife was a director, a 50% shareholder, and president, and his mother was a director, a 50% shareholder, vice president, and secretary. Thus, the court held that the company was his alter ego and that he would be liable for the debts of the company.

Colorado appellate courts have resolved claims under the alter ego doctrine 21 times. In those cases, the corporate veil has been pierced nine times and maintained 12 times; Federal courts applying Colorado law have pierced the veil in seven of 22 cases.[2]

While the Kosanovich case may have not been decided on the same grounds by a Colorado court, a Colorado court could well reach the same result on other grounds; these cases serve as a valuable reminder that the relatively simple requirement of keeping separate company books and records, have annual meetings (at least on paper), and observing basic corporate and governance formalities, remains important to preserving the limited liability that business owners expect when they chose the corporate or LLC form to do business.

[1] Cherry Creek Card & Party Shop, Inc. v. Hallmark Marketing Corp., 176 F.Supp.2d 1091 (D.Colo.,2001); See 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Kathy Stricklan Krendl.

[2] 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Cathy Stricklan Krendl

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The Securities and Exchange Commission announced today that companies can use social media outlets like Facebook and Twitter to make news announcement in compliance with Regulation FD (Fair Disclosure), if investors have previously been told which social media the company will be using, and who’s feed to monitor. Regulation FD requires companies to distribute important news in a manner designed to get that information out to the general public, so that all investors have the ability to get important news at the same time. Today the SEC confirmed that social media can meet that requirement, if certain conditions are met.

The SEC commenced an investigation last year after Netflix CEO Reed Hastings posted on his personal Facebook page on July 3, 2012 that Netflix’s monthly online viewing for June 2012 had exceeded one billion hours for the first time. Netflix did not report that information to investors through a press release or Form 8-K filing, and a Netflix press release later that day did not include the information. The announcement represented a nearly 50% increase in streaming hours from Netflix’s January 25, 2012 report, and was clearly important news to the market. Hastings and Netflix had not previously used Facebook to announce company metrics, and they had never told investors to watch Hastings’ personal Facebook page for Netflix news. Netflix’s stock price increased from $70.45 at the time of the post, to $81.72 at the close of the following trading day.

According to the SEC press release: “The SEC did not initiate an enforcement action or allege wrongdoing by Hastings or Netflix. Recognizing that there has been market uncertainty about the application of Regulation FD to social media, the SEC issued the report of investigation pursuant to Section 21(a) of the Securities Exchange Act of 1934.”

The SEC’s report of investigation, available here, confirms that Regulation FD applies to social media used by public companies the same way it applies to company websites. As a result, reporting issuers cannot use social media as the sole method to report material, non-public information, unless the issuer has previously notified investors and the public to look to a specific site, page or feed for that type of information. Failure to comply could constitute selective disclosure and a violation of Regulation FD.

In particular, the report of investigation notes that the personal social media site of an individual corporate officer would not ordinarily be assumed to be a method  “reasonably designed to provide broad, non-exclusionary distribution of the information to the public” as required by Regulation FD, even if the officer is a business celebrity and has a large number of subscribers, friends or contacts.  “Personal social media sites of individuals employed by a public company would not ordinarily be assumed to be channels through which the company would disclose material corporate information”, and may not be used for that purpose unless the public is given advance notice that the site may be used to distribute company information.



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In my last post I commented on the Harvard Shareholder Rights program’s misguided effort to eradicate classified boards of directors. Today, theRacetotheBottom commented on a paper by Margaret Blair, “Corporate Law and the Team Production Problem“, challenging the dominate scholarly view over the last few decades that the sole purpose of a corporation is to maximize value for its shareholders. According to Blair: “Prominent advocates of shareholder primacy such as Michael Jensen, Jack Welch, and Harvard’s Lucian Bebchuk have backed away from the idea that maximizing share value has the effect of maximizing the total social value of the firm…”. Perhaps the old fashioned idea that employees of business entities aren’t merely serf’s working solely for the shareholders, and the communities where corporations reside aren’t merely hosts for corporations to leech until they are sold or liquidated, is becoming popular again.

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The Harvard Law School Shareholders Rights Project recently issued joint press releases with five institutional investors announcing the submission during the 2012 proxy season of proposals to more than 80 S&P 500 companies with staggered boards, urging that their boards be declassified, according to an article by Martin Lipton and Theodore Mirvis posted on the Harvard law School Forum on Corporate Governance and Financial Regulation. This is interesting for a couple of reasons. First, it is unusual to see a disagreement of this nature aired out on two competing Harvard Law School public forums. Second, in my opinion, Martin Lipton and Theodore Mirvis are exactly right, and the Harvard Law School Shareholders Rights Project is dead wrong on the issue of declassified boards.

The Shareholder Rights Project is actively seeking to eliminate staggered or classified boards in favor of boards that are up for re-election and replacement annually. The arguments pro and con are not as simple as frequently represented. Classified boards make hostile takeovers more difficult, and promote board continuity, but can entrench boards and make them less responsive to shareholders, and the Harvard professors running the Shareholder Rights Project argue that they reduce the value received by shareholders in hostile takeovers.

In their article “Harvard’s Shareholder Rights Program is Wrong“, Lipton and Mirvis point out:

“There is no persuasive evidence that declassifying boards enhance stockholder value over the long-term, and it is our experience that the absence of a staggered board makes it significantly harder for a public company to fend off an inadequate, opportunistic takeover bid, and is harmful to companies that focus on long-term value creation. It is surprising that a major legal institution would countenance the formation of a clinical program to advance a narrow agenda that would exacerbate the short-term pressures under which American companies are forced to operate.”

Declassifying all public company boards to remedy unquantifiable complaints that some boards are unresponsive and some shareholders might have received more in a hostile takeover is like using a shotgun to kill a mosquito – on your own arm! Corporations do not exist solely to report increased quarterly earnings. Corporations and other business entities provide jobs, pay taxes (or at least pay money to people who pay taxes), support charities and make countless tangible and intangible contributions to the economy and society in general. They provide a limited liability platform for investors and inventors to research, develop and launch new ideas, technologies, and developments.

Eliminating classified boards turns directors into politicians, campaigning to be elected every year. In business as in politics, the more frequent the elections the more difficult it is to conceive and implement long term solutions and sustainable growth. Directors sometimes have to make difficult decisions. Good directors know their company and its industry, its market, its employees and the challenges, obstacles and opportunities the company faces. Most shareholders have very little or no insight into these things – what they know is the stock price and the dividends.  And with public corporations, who are the voters who elect directors? According to the Harvard Shareholder Rights Project, their project is representing “institutional investors”. Institutional investors are public pension funds like CalPERs, and include vulture capital funds, private equity funds and investment banks like Goldman Sachs and its clients. What do CalPERs, Goldman Sachs and other institutional investors want? Quarterly profits and quarterly growth, so they can show rapid and dramatic returns on their investments and pay out their investors at the end of their investment horizon – anywhere between two to seven years. Long term growth, jobs, sustainable tax bases, community development, charitable contributions, and other stakeholders are not their concern.

Eliminating classified boards is just another step in the elimination of small and individual investors from the stock market. The pressure to report quarterly earnings growth, quarter after quarter, contributed to the Enron, Qwest, Global Crossing and countless other financial reporting frauds in the last decade – none of those companies exist any longer, and their jobs, tax payments, lease payments, charitable contributions, and contributions to the economies of their communities are gone – but for a couple of years, shareholders who were smart enough to sell based on false quarterly earnings reports made out like bandits.

Now the Harvard Law School Shareholder Rights Project wants to institutionalize the annual election of directors by institutional shareholders, giving control of corporations to large investors whose main interest is short-term profit. Efforts to promote “shareholder rights” that provide incentives to directors to pay attention and not be careless or complacent should be applauded. Efforts to turn corporations into profit generators for institutional investors who have short-term investment horizons are dangerous. Corporations owe duties to their shareholders, but shareholders are not their only stakeholders. Long term sustainable growth serves the community and its taxpayers, and promotes the economic well-being of the country, as well as serving shareholders. Perhaps the students at the Harvard Law School Shareholder Rights Project are more interested in getting jobs on Wall Street after graduation, than they are in making positive changes in corporate governance.

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In an interesting case of first impression the Delaware Court of Chancery recently held that a company and its directors do not have a disclosure obligation, and do not owe other fiduciary duties, to a shareholder when exercising a right of first refusal.  A right of first refusal grants the holder the right to match any offer received by the seller.  In Latesco, L.P. v. Wayport, Inc., the company had a right of first refusal over some of the shares owned by one of its shareholders (a former insider).  The shareholder sought to sell some shares and got an offer from a third party.  The company exercised its right of first refusal and bought the shares, without disclosing confidential, inside information, that would have indicated the shares might be, or soon would be, worth more than the purchase price.

The Delaware court held that in these circumstances, the company and its directors do not owe a duty to the selling shareholder to disclose confidential information.  When exercising a right of first refusal, the company does not solicit the purchase or sale of shares, as they would do so if they were issuing new stock.  Instead, the shareholder gets an offer of purchase from a third party, notifies the company of the offer, and the company decides whether it wants to match the offer and purchase the shares.  No fiduciary duty is owed to the selling shareholder.

If the company solicits the purchase of shares from its shareholder, it would owe the same duties of disclosure as any selling or buying shareholder, and, in fact, in this case there is more to the story.  When the shareholder contacted the company with his notice of sale, the company asked if he would sell more shares to the company, shares that were not covered by the right of first refusal.  The  company did not disclose facts indicating that those shares might be worth more than the seller knew.  The court held that, for those extra shares not covered by the right of first refusal, “insiders should expect to observe the normal obligations of fiduciaries not to engage in transactions with stockholders while in the possession of material information” not known to the sellers.  The insiders could be liable for fraud and breach of fiduciary duties.

For a more detailed discussion of Latesco v Wayport, see this discussion by Francis G.X. Pileggi at the Delaware Corporate and Commercial Litigation Law blog.

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