The Delaware Limited Liability Company Act provides:

(b) It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.

Del. Code Ann. tit. 6, §18-1101. 

With regard to fiduciary duties, the DLLCA allows for complete waiver. See, e.g., Gerber v. Enter. Prods. Holdings, LLC, 2012 WL 34442, at *13 (Del. Ch. Jan. 6, 2012) ("Alternate entity legislation reflects the Legislature's decision to allow such ventures to be governed without the traditional fiduciary duties, if that is what the ... governing document provides for, and allows conduct that, in a different context, would be sanctioned.").

But what if the participants in an LLC are silent about fiduciary duties? Should the courts impose fiduciary duties, even though the DLLCA does not expressly provide for them? 

In 2009 Chief Justice Myron Steele of the Delaware Supreme Court wrote a law review article arguing "that default fiduciary duties violate the strong policy favoring freedom of contract enunciated by Delaware's legislature" and that "the costs of default fiduciary duties outweigh the minimal benefits that they provide." Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221, 223-224 (2009). This prompted Larry Hamermesh to organize an online symposium on the topic of Default Fiduciary Duties in LLCs and LPs over at the The Institute of Delaware Corporate & Business Law.

In Auriga Capital Corp. v. Gatz Properties, LLC, Chancellor Strine confronts the issue of default fiduciary duties in a manager-managed LLC and reaches a different conclusion than Chief Justice Steele’s. Chancellor Strine's composed a section of the opinion under the heading "Default Fiduciary Duties Do Exist in the LLC Context," analogizing to fiduciary law in the corporate context. The text and history of the DLLCA provide some important clues, but Strine's analysis also depends heavily on the structure of the relationship between an LLC's manager and the LLC's members:

The manager of an LLC –- which is in plain words a limited liability “company” having many of the features of a corporation –- easily fits the definition of a fiduciary. The manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC. Rather, the manager is vested with discretionary power to manage the business of the LLC.

While Professor Ann Conaway objects to Chancellor Strine's opinion on several grounds, I think Chancellor Strine is on solid ground. Professor Conaway purports to identify several "errors" in the opinion, none of which seems like an error to me, though, admittedly, each involves a contestable interpretation of the DLLCA. Facing uncertainty in the governing statute, Chancellor Strine analyzes the structure of the LLC and interprets the statute accordingly. He is taking the approach I advocated in The Critical Resource Theory of Fiduciary Duty:

The theory proposed here is animated by the view that fiduciary relationships form when one party (the "fiduciary") acts on behalf of another party (the "beneficiary") while exercising discretion with respect to a critical resource belonging to the beneficiary. The italicized typeface highlights the three core requirements of a fiduciary relationship. Each requirement plays an important role in distinguishing fiduciary from nonfiduciary relationships. When combined, these requirements show how the duty of loyalty that is the essence of fiduciary duty protects beneficiaries against opportunistic behavior by fiduciaries.

Note the last sentence of the passage from Chancellor Strine's opinion, quoted above (taking some liberty to imply the beneficiary): "the manager is vested with discretionary power to manage the business of the LLC [on behalf of the members]." Fiduciary duties serve a useful function in contexts like these. Participants in a Delaware LLC are permitted to waive the duties, but when they don't, courts should assume they apply ... just as they have done in similar relationships for hundreds of years.

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Law schools are under attack. Depending upon the source, between 20-50% of corporate counsel won’t pay for junior associate work at big firms. Practicing lawyers, academics, law students and members of the general public have weighed in publicly and vehemently about the perceived failure of America’s law schools to prepare students for the real world.

Admittedly, before I joined academia a few months ago, I held some of the same views about lack of preparedness. Having worked with law students and new graduates as outside and in house counsel, I was often unimpressed with the level of skills of these well-meaning, very bright new graduates. I didn’t expect them to know the details of every law, but I did want them to know how to research effectively, write clearly, and be able to influence the clients and me.  The first two requirements aren’t too much to expect, and schools have greatly improved here.  But many young attorneys still leave school without the ability to balance different points of view, articulate a position in plain English, and influence others.

To be fair, unlike MBAs, most law students don’t have a lot of work experience, and generally, very little experience in a legal environment before they graduate.  Assuming they know the substantive area of the law, they don’t have any context as to what may be relevant to their clients. 

How can law schools help?

First, regardless of the area in which a student believes s/he wants to specialize, schools should require them to take business associations, tax, and a basic finance or accounting course.  No lawyer can be effective without understanding business, whether s/he wants to focus on mom and pop clients, estate planning, family law, nonprofit, government or corporate law. More important, students have no idea where they will end up after graduation or ten years later.  Trying to learn finance when they already have a job wastes the graduate’s and the employer’s time.

Of course, many law schools already require tax and business organizations courses, but how many of those schools also show students an actual proxy statement or simulate a shareholder’s meeting to provide some real world flavor? Do students really understand what it means to be a fiducuiary?

Second and on a related point, in the core courses, students may not need to draft interrogatories in a basic civil procedure course, but they should at least read a complaint and a motion for summary judgment, and perhaps spend some time making the arguments to their brethren in the classroom on a current case on a docket. No one can learn effectively by simply reading appellate cases. Why not have  students redraft contract clauses? When I co-taught professional responsibility this semester, students simulated client conversations, examined do-it-yourself legal service websites for violations of state law, and wrote client letters so that the work came alive.

When possible, schools should also re-evaluate their core requirements to see if they can add more clinicals (which are admittedly expensive) or labs for negotiation, client consultation or transactional drafting (like my employer UMKC offers). I’m not convinced that law school needs to last for three years, but I am convinced that more of the time needs to be spent marrying the doctrinal and theoretical work to practical skills into the current curriculum.

Third, schools can look to their communities. In addition to using adjuncts to bring practical experience to the classroom, schools, the public and private sector should develop partnerships where students can intern more frequently and easily for school credit in the area of their choice, including nonprofit work, local government, criminal law, in house work and of course, firm work of all sizes.  Current Department of Labor rules unnecessarily complicate internship processes and those rules should change.

This broader range of opportunities will provide students with practical experience, a more realistic idea of the market, and will also help address access to justice issues affecting underserved communities, for example by allowing supervised students to draft by-laws for a 501(c)(3). I’ll leave the discussion of high student loans, misleading career statistics from law schools and the oversupply of lawyers to others who have spoken on these hot topics issues recently.

Fourth, law schools should integrate the cataclysmic changes that the legal profession is undergoing into as many classes as they can. Law professors actually need to learn this as well.  How are we preparing students for the commoditization of legal services through the rise of technology, the calls for de-regulation, outsourcing, and the emerging competition from global firms who can integrate legal and other professional services in ways that the US won’t currently allow?

Finally and most important, what are we teaching students about managing and appreciating risk? While this may not be relevant in every class, it can certainly be part of the discussions in many. Perhaps students will learn more from using a combination of reading law school cases and using the business school case method.

If students don’t understand how to recognize, measure, monitor and mitigate risk, how will they advise their clients? If they plan to work in house, as I did, they serve an additional gatekeeper role and increasingly face SEC investigations and jail terms.  As more general counsels start hiring people directly from law schools, junior lawyers will face these complexities even earlier in their careers. Even if they counsel external clients, understanding risk appetite is essential in an increasingly complex, litigious and regulated world.

When I teach my course on corporate governance, compliance and social responsibility next spring, my students will look at SEC comment letters, critically scrutinize corporate social responsibility reports, read blogs, draft board minutes, dissect legislation, compare international developments and role play as regulators, legislators, board members, labor organizations, NGOs and executives to understand all perspectives and practice influencing each other. Learning what Sarbanes-Oxley or Dodd-Frank says without understanding what it means in practice is useless.

The good news is that more schools are starting to look at those kinds of issues. The Carnegie Model of legal education “supports courses and curricula that integrate three sets of values or ‘apprenticeships’: knowledge, practice and professionalism.” Educating Tomorrow’s Lawyers is a growing consortium of law schools which recommends “an integrated, three-part curriculum: (1) the teaching of legal doctrine and analysis, which provides the basis for professional growth; (2) introduction to the several facets of practice included under the rubric of lawyering, leading to acting with responsibility for clients; and (3) exploration and assumption of the identity, values and dispositions consonant with the fundamental purposes of the legal profession.”  The University of Miami’s innovative LawWithoutWalls program brings students, academics, entrepreneurs and practitioners from around the world together to examine the fundamental shifts in legal practice and education and develop viable solutions.

The problems facing the legal profession are huge, but not insurmountable. The question is whether more law schools and professors are able to leave their comfort zones, law students are able to think more globally and long term, and the popular press and public are willing to credit those who are already moving in the right direction.  I’m no expert, but as a former consumer of these legal services, I’m ready to do my part.

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As David notes, one of the fallouts of a negative say on pay vote have been shareholder lawsuits.  The lawsuits allege, among other things, that the negative say on pay vote is an indication not only that the board breached its duty of loyalty, but also that the board should not be given the presumption of the business judgment rule for demand futility purposes--and hence that such suits should be allowed to survive a motion to dismiss.  This semester I am writing an article on the feasibility of these say on pay lawsuits, and hence I was surprised when earlier last week a U.S. District Court in Ohio allowed shareholders say on pay lawsuit against Cincinnati Bell to survive a motion to dismiss in an order that relied on the negative say on pay vote.

Shareholders brought suit against the directors of Cincinnati Bell after 66% of shareholders voted against the 2010 executive compensation at its May 2011 annual meeting.  The order framed the issue in this way, "This civil lawsuit presents the question, among others, whether a shareholder of a public company may sue its directors for breach of the duty of loyalty when the directors grant $4 million dollars in bonuses, on top of $4.5 million dollars in salary and other compensation, to the chief executive officer in the same year the company incurs a $61.3 million dollar decline in net income, a drop in earnings per share from $0.37 to $0.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8% annual shareholder return."  To be sure, with such a framing it seemed pretty clear where the court was headed. . .

In its order, the court stated that shareholders' allegations "raise a plausible claim that the multi-million dollar bonuses approved by the directors in a time of the company's declining financial performance violated Cincinnati Bell's pay-for-performance policy and were not in the best interest of Cincinnati Bell's shareholders.  In so stating, the court specifically noted shareholders' assertions that the negative say on pay vote provides "direct and probative" evidence that the compensation awards were not in the best interests of the shareholders.  This finding is of course precisely what shareholders hoped to achieve with say on pay litigation.  Indeed, each of the lawsuits makes a similar claim that the say on pay vote reflects shareholders' independent assessment that the challenged compensation awards were not in their best interests, and as a result, such negative votes should be used to rebut any presumption that directors' action ofapproving executive compensation awards were in the shareholders' best interests.  Moreover, the suits often rely on corporate disclosure in their proxy statement and other public documents that expresses a commitment to pay for performance to demonstrate that the challenged award conflicts with the company's own pay policies.  The Cincinnati Bell order suggest that relying on corporate disclosure in this way is effective.  In that regard, it also may prompt corporations to alter their disclosure to avoid such reliance.

Importantly for purposes of shareholders being able to get their day in court, the order agrees with shareholders' contention that they were excused from making any presuit demand.  In the court's view, the fact that directors had approved the compensation award, recommended that shareholders approve the award, and suffered a negative shareholder vote, demonstrated that demand would be futile on such directors.    This is interesting.  On the one hand, you can imagine directors contending that they only did what federal law now requires them to do.  Moreover, Dodd-Frank has a provision specifically stating that the say on pay vote is advisory and should not be construed as overruling directors' decisions, or changing or adding additional fiduciary duties for directors, and many commentators have argued that such a provision indicates that say on pay votes should not be used to somehow alter the law in this area, including the law with respect to demand rules.  On the other hand, some commentators have noted that Dodd-Frank does not prevent such votes from being used to support a finding of a fiduciary duty breach.  The Cincinnati Bell court cites this latter commentary.

Of course, just because a suit survives a motion to dismiss does not mean that shareholders will win at trial (see e.g., Disney!).  Then too, Cincinnati Bell is an Ohio corporation--though the court did cite Delaware law in its demand futility discussion.  However, a decision like this certainly prolongs these say on pay lawsuits.  Such a decision also suggests that these say on pay votes may impact, and even change, fiduciary duty law regarding compensation.

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The American Law Institute is creating a Restatement Third, Employment Law. Chapter 8 of Tentative Draft No. 4, which was discussed today at the Annual Meeting, is entitled "Employee Obligations and Restrictive Covenants." Within that chapter is a section entitled "Employee Duty of Loyalty." This is the core obligation:

Employees owe a duty of loyalty to their employer in matters related to the employment relationship.

This is an uncontroversial (re)statement of the black-letter law, but some members of the ALI challenged the use of the word "loyalty." As noted by several of the ALI bloggers, some members want the ALI to omit references to "loyalty" because it implies that the relationship between employers and employers is reciprocal. These members prefer the term "mandatory obligation," which (to them) connotes that employment is a one-way street.

Although Reporter Samuel Estreicher did not grant the point, he repeatedly invoked the need to "delimit" the concept of loyalty and suggested that the "duty of loyalty" in the ALI's Restatement of the Law Third, Agency was ill-defined. These comments suggest the possibility of some future work to be done rationalizing the duty of loyalty in the two Restatements.

Count me as a fan of the duty of loyalty and as an opponent of attempts to delimit that duty. Such attempts, which surface regularly in the law of business associations, run at cross purposes with the value of the duty as a standard of last resort. Self-interested behavior may be constrained by statute or by contract, but the issue in cases involving the duty of loyalty is whether self-interest was checked in the absence of a specific rule. If courts (or Restatement drafters) are too precise with the boundaries of the duty, they provide bad men with a roadmap for opportunistic behavior. As I have written many times on this blog, ambiguity is our friend in this area.

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Is it Dodd-Frank?  Probably, on the federal level, but this has been a year of plenty of action.  The SEC did its proxy reform concept release.  And in enforcement, the post-Galleon spread of wiretaps looks to make next year a big year for prosecutions - so far we just have Don Chu, which threatens uber hedge fund SAC.  The enforcement case of the year this year must be the Goldman Sachs ABACUS deal settlement.  Here's Adam Levitin on it.

I don't keep up with Delaware like my compadres on the blog, but as Gordon has noted, Airgas might be an important case, and, indeed, it has spawned a few opinions.

I don't think the US Supreme Court did a lot of corporate law this year, with business patents and PCAOB decisions that could have gone far resolving very little.  But the Morrison case, presuming that the securities laws do not apply extraterritorially (and arguably not reversed by a sort of clumsy effort in Dodd-Frank to reverse it), could be pretty big, here's Richard Painter on both issues.  And until the honest services statute is revised, Skilling was good news for corporate executives, here's Christine on the case.

On international deals, the killing of BHP's bid for Potash by the Canadian government may a harbinger of protectionism as an M&A defense, so I say it's pretty notable.  Here's Steve Davidoff on one aspect of the affair.

And in international regulation, Basel III's continuing development gets my nod.  The Basel Committee just met, plans to promulgate the text of Basel III by the end of the year, and has concluded, as US regulators like Sheila Bair have been urging, that systemically significant "banks should have loss-absorbing capacity beyond the Basel III standards ... work on this topic continues in the Committee and the Financial Stability Board (FSB)."

What have we missed?

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Boston University is sponsoring a fiduciary law conference on October 29, 2010 in honor of Tamar Frankel. Great lineup. The papers will be published in the Boston University Law Review. 

If you are interested, note the following: "All are welcome to attend. There is no registration fee, but if you plan to attend, please RSVP to Andrea Larsen, alarsen@bu.edu. If you have academic questions about the program, please contact Professor Kenneth W. Simons, ksimons@bu.edu."

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Jack Coffee, Larry Ribstein, and J.W. Verret testified before the Senate Judiciary Subcommittee on Crime and Drugs today in a hearing titled "Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?" Start watching here at about 59:00.

Jack makes the case for fiduciary duties for broker-dealers and warns against "Chicken Littles" who might scream that the imposition of fiduciary duties in this context would cause the sky to fall. Right on cue, J.W. follows with an argument that the hindsight bias inherent in fiduciary duty litigation would bring securities markets to a standstill. Larry bats cleanup with an indictment of fiduciary duty in the criminal context (pun intended) on the ground that fiduciary standards are too "amorphous," and he scored a point here by citing the Supreme Court's recent decision in Jones v. Harris as an example of the difficulty of defining fiduciary obligation.

The exchange between Jack and Larry on the vagueness point after the prepared statements is the best part of the hearing. (Start at about 1:26.) In the end, I am inclined to side with Larry on this one, especially when the issue turns to criminal penalties for breach of fiduciary duty. Fiduciary duty is the wrong tool to deal with the problems in securities markets.

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Now that I’ve taught my last class for the semester, I thought I’d jot a few posts with reflections on teaching from the semester before I turn attention to grading and then writing.

Watching the SEC’s Goldman suit, the Senate hearings, and the financial reform legislation unfold has left me convinced that we business association teachers should consider teaching agency and partnership in the basic course (if we don’t already do so). Why? It is not just that many actual business entities are the “uncorporations” that Larry Ribstein writes about and not the “inc.s” in many law school class rooms. Consider the following two problems identified in the Goldman hearings or with respect to the financial crisis:

• Conflicts of interest (by Wall Street firms, rating agencies, mortgage brokers, mortgage originators etc.); and

• Lack of disclosure (to mortgage borrowers, investors in asset-backed securities etc.).

Of course there are lots of other potential areas of concern – like financial institution “safety and soundness,” but the two problems above are essentially about agency costs. As are two of the proposed remedies being discussed:

• Fiduciary duties (for mortgage brokers, or registered broker-dealers); and

• Greater disclosure.

We can have a discussion about whether these are the most important problems and the most pressing reforms in the wake of the crisis, but they are front–and-center in the current debate. To frame the basic tradeoffs involved, there are two analytical approaches and two approaches to teaching students. The first is to start deep in the weeds of specialized areas of securities and financial regulation. The second is to start with basic building blocks.

The place to go for those building blocks is agency and partnership law. It is funny how much of the public debate on the Goldman suit resembles debates in those chestnut fiduciary duty cases from a Business Associations case book. Could “sophisticated investors” protect themselves against conflicts of interest with greater diligence or harder negotiations on price? Or do they need (or would it be more efficient to give them) the protection afforded by fiduciary duties? And when we talk about fiduciary duties, even the basic Business Associations course should help students see that those duties could vary quite a bit from one context or form of business entity or state to another.

Perhaps it is just my own learning style, but if I had to take a Business Association class again, I’d prefer to start learning the basic concepts that Corporations borrows from Agency and Partnership rather than being parachuted into the world of staggered boards and poison pills. Don’t kids learn basketball by practicing lay-ups before moving to dunks?

We’ll see how I feel in the fall when I teach my first purely Corporations class.

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You may remember this story from last spring….

On a crisp Saturday morning in the spring of 2009, a somber group of citizens from the Connecticut towns of Bridgeport and Hartford boarded a tour bus.  The tour route did not pass through the lovely Hollywood Hills homes of Oscar-winning actors perched high above the sprawling city of Los Angeles, nor did the tour route pass through Manhattan’s historic and affluent upper east side to visit the brownstone where Carrie Bradshaw lived or the cupcake shop that she visited in a popular television series titled “Sex in the City.” Upon having loaded its passengers, the bus, flanked by national and international media – more journalists in fact than tour participants – took the road to Fairfield County, Connecticut to tour the homes of executives who work for the American International Group, Inc., a mammoth international insurance company with significant financial services operations in more than 130 countries. The bus tour group, organized by Connecticut Working Families, a coalition of community organizations, labor unions and neighborhood activists that lobby to impact issues important to working and middle class families, considered themselves emissaries of a nation frustrated by an economic crisis. As anticipation of a confrontation between the tour participants and the executives and their families grew, AIG executives like David Poling, recipient of a $6.4 million award, began renouncing their bonuses and enhancing their home security devices.

Sharpen your pitch forks and light the torches. Bonus distributions to executives at bailed-out firms made Americans mad. Moreover, the discovery of the role of credit defaults swaps in the crisis has fueled the rage. Justifiable national frustration suggests that federal rules may soon override state court precedent and legislation that protect directors from liability or at least big bonuses will be more closely watched and possibly denied by the exec comp czar. Possibly. Mark Roe has persuasively argued that the real competition in corporate law is not among the states but between the federal government and Delaware. An interpretation of fiduciary duty that excuses corporate management’s failed efforts to oversee enterprise risk management may offer further evidence to support Roe’s theory.

We have seen a flurry of activity to introduce federal oversight of executive compensation packages for companies that are recipients of the federal dole. (See David Zarig's post here.) In her November 1^st blog on Jones v. Harris (here), Michelle Harner offered interesting insight into the issues of interestedness and independence in the context of fee structures. I see an easy application of these arguments in the context of executive compensation and parallels in arguments about effective enterprise risk management.

The consequences of a systemically significant institution’s failure to execute risk management policies with care reverberate through many constituencies. Ever increasing numbers of Americans own a broader array of stocks, even if only through mutual funds or retirement funds. In the absence of action on the part of the Delaware legislature or courts, the federal government might easily commandeer the regulatory stage.Federal preemption in the area of executive compensation may pave the road for preemption in other areas of governance, such as risk management. The poster child for this proposition: AIG. My prediction that we may see federal intervention into corporate governance on risk management is based on the brewing national debate on independence and interestedness.

The audit committee and independence standards and other corporate governance reforms adopted as part of SOX offer examples of ghosts from Christmases past. But additional intervention is appearing on the horizons. Congressional proposals for corporate-last-wills-in-testament, a requirements that companies explain in advance their policy for dealing with potential insolvency, present another example of the Feds pending foray into the corporate governance sphere. This funeral legislation, as it has been described, requires firms to state how they would unwind their businesses and gives the Treasury authority over initiating the unwinding of certain systemically significant institutions. Even lower federal courts seem to “want in” on the movement for a broader interpretation of directors’ fiduciary duties, as illustrated by Judge Rakoff’s rejection of the SEC v. Bank of America/ Merrill Lynch settlement negotiation. With all of the frustration we are left to wonder about future interpretations of directors fiduciary duties. 

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With all the investors in distress news in today's Times, I'm just glad that we're somewhat close to Thanksgiving.  This Madoff motion by the investors who think their losses ought to include some of the scheme's paper profits is pretty cheeky, and completely antithetical to the way the trustee has been doing things.  It could also, it seems to me, put the SIPC - the securities industry FDIC - on the hook for the whole fictional $50 billion originally thrown around with regard to the affair, it seems to me.  For that reason alone, it seems like a stretch, but one increasingly thinks knowledge of bankruptcy and its cognates would be of real assistance these days.  Also in distress - Raj Rajaratnam's defense, ably analyzed by Peter Henning here.

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Utah is awash in fruit juice. Tahitian Noni. Xango. MonaVie. Synaura.

But the spotlight today is on Zrii:

Zrii is a Sanskrit word that means light, luster, splendor and prosperity. As a company, as a brand and as a product, Zrii was born iconic. Bill Farley, one of the true icons of American business, realized that his years of experience and wealth of connections had prepared him to embark on an incredible journey. And that journey is Zrii.

That's just a sampling of what you get on these websites. You cannot really appreciate this industry without at least visiting some of the websites. Watch the video at Zrii ... "Deepak Chopra! Deepak Chopra! Deepak Chopra!"

But I digress. The reason I am writing about Zrii is that the Delaware Court of Chancery (VC Parsons) just issued an opinion involving the company. (Thanks, Francis!) The facts are full of intrigue revolving around an attempted coup: a covert conclave, computer sabotage, an employee walkout.

The coup was directed at Zrii founder and CEO, William Farley. Like the other companies listed above, Zrii is a multi-level marketing (MLM) business, and the main participants in the attempted coup were either officers of the company or high-level distributors. The distributors had all signed contracts in which they agreed not to solicit other Zrii distributors for six months after ending a distributor relationship with Zrii.

By the way, here is a description of one of the defendants, just so you know what we are dealing with:

Jason Domingo is a resident of California. Domingo, called the “Master Distributor,” was the senior-most Zrii [Independent Executive or "IE"] and a Ten Star IE, the highest level attainable by an IE. As the Master Distributor, Defendant Domingo’s downline [the people below him in the pyramid of distributors] included every IE and every customer of the entire company – somewhere around 70,000 people, by Domingo’s estimate. In this capacity in 2008, his first full year with Zrii, Domingo earned approximately $600,000.

Well, the coup didn't work, so the insurgents left Zrii for LifeVantage, another MLM company that sells anti-aging products. Then they proceeded to tell other Zrii distributors to follow them.

The case was before Chancery on a preliminary injunction motion, and the issues revolved around a claim of civil conspiracy, which would be governed by Utah law, though one of the elements of the claim was "one or more unlawful, overt acts," and the plaintiffs wanted to satisfy this element by reference to, among other things, a breach of fiduciary duty.

Is there any doubt that the defendants breached their duties to Zrii? Not really.

But they did it with such a flair! It's unusual to see such shamelessness and lack of nuance outside the movie theater.

Oh, and they (probably) breached their non-solicitation agreements, too.

Motion granted. The remedy? A three-month injunction.

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In an August 2007 press release, Marsh warned “the financial services sector, including insurance companies, hedge funds, banks and ratings agencies, that they may be exposed to greater directors’ and officers’ liability (D&O) and errors and omissions (E&O) liability claims in the wake of the current subprime mortgage crisis.”  Despite speculation about a domino effect, the cost of D&O liability insurance for other sectors, which dropped significantly in early 2007, has continued to decline.  A recent article suggests that this pricing trend may continue because the litigation/liability impact of the subprime mortgage crisis generally has been localized and somewhat contained.  As more companies begin to feel the pinch of the credit crunch and investors tally up their losses, however, litigation against directors and officers of companies outside of the financial sector is likely to increase.

Nevertheless, increased litigation does not necessarily mean increased board liability.  In fact, to the extent that a board’s conduct is simply negligent or even grossly negligent, the board likely will be protected under an exculpation clause in the company’s charter.  Moreover, even if a board’s conduct is allegedly outside the scope of exculpation, the litigation likely will settle before the plaintiff’s case proves too much and places the alleged damages outside of the company’s indemnification or D&O liability insurance policies.  As suggested by the findings of a recent empirical study of securities class actions conducted by Tom Baker and Sean Griffith, the amount and structure of D&O policies influence and encourage settlements before trials on the merits in many cases.  This settlement strategy of course makes sense in light of “final adjudication” and “in fact” triggers included in most bad actor and similar exclusions in D&O policies.

Settlement before adjudication on the merits perhaps helps corporate officers, who are not protected by exculpation clauses and may not be protected by the business judgment rule, sleep at night.  Likewise, it may render meaningless the increasing case law discussion of whether a board’s alleged disregard of its duties constitutes gross negligence or bad faith, at least from a board liability perspective.

The Delaware Court of Chancery in Ryan v. Lyondell Chemical and the Delaware Bankruptcy Court in Bridgeport Holdings Inc. Liquidating Trust v. Boyer, 388 B.R. 548, recently indicated that a board’s lack of significant engagement in a sale process could constitute bad faith.  (Both decisions were decided at the pre-trial motion stage; see Gordon Smith’s September post on Ryan for a thoughtful discussion of what such a decision really means for boards.)  Shortly after those decisions, the Delaware Court of Chancery again addressed the issue of bad faith and determined that allowing an interested officer to manage a division sale or approving a naked no-vote termination fee was at best an act of gross negligence and not bad faith.  (See McPadden v. Sidhu and In re Lear Corp. Shareholder Litigation, respectively.)  In each case, the court’s focus on the gross negligence versus bad faith distinction hearkens back to the Delaware Supreme Court’s statement in Stone v. Ritter that “[w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”

I raise this recent quartet of cases because the issue of gross negligence versus bad faith could play an important role in litigation arising out of the current economic crisis.  Although, as suggested above, the distinction may not ultimately subject the board to personal liability, it could impact the future cost of D&O liability insurance.  A corporate defendant’s ability to dismiss litigation against its board because of an existing exculpation clause eliminates any related claim under the company’s D&O policy and arguably helps contain premium costs.  Moreover, if cases continue to settle prior to adjudication on the merits, which I suspect they will, dismissal of the litigation at the motion to dismiss or summary judgment stage may be the only means to avoid payments under D&O policies.

If a board authorized investments in mortgage-backed securities, collateralized debt obligations, collateralized loan obligations or similar investment vehicles without understanding the structure of, or risk inherent in, those vehicles, has the board committed a conscious disregard of its known duties?  Likewise, does such a violation exist if a board of an insolvent company knowingly authorized a high-risk investment strategy without considering creditors’ interests?  It will be interesting to see how courts resolve those and similar issues and how the insurance industry responds.

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I first want to thank Lisa Fairfax and Gordon Smith for the invitation to guest blog on The Conglomerate.  I am a long-time reader but first-time blogger, so this is an exciting opportunity for me.  I am a relative newcomer to the academy, having spent almost eleven years in private practice, most recently as a Partner in the Business Restructuring and Reorganization Practice Group at Jones Day.  I have been teaching at the University of Nebraska College of Law since 2006.

My interests and scholarship focus on issues at the intersection of corporate and insolvency law.  During the next two weeks, I hope to explore some of these issues with you, many of which are implicated by the current economic crisis in the United States.  For example, I have spent much time (too much if you ask my family) during the past several months considering a board’s duty with respect to investment decisions and enterprise risk management; the utility of credit default swaps and similar derivative instruments; the impact of investments by hedge funds and private equity firms on distressed companies; and the ability of federal bankruptcy law to address the current economic crisis.

Let me start with a board’s fiduciary duties.  As Gordon Smith discussed in a recent post, the likelihood of a board being held liable for excessive risk-taking in investment decisions is highly unlikely, at least under existing applications of the business judgment rule.  And perhaps this result is correct and in the best interests of the corporation.  After all, boards are not guarantors of corporate success, and their informed, good faith corporate decisions should receive protection under the law.

But if a corporation is insolvent, which arguably many of those caught up in the current economic crisis were at the time of at least some investment decisions, does this fact change the analysis?  Should it?  In the North American Catholic case, the Delaware Supreme Court suggested in dicta that a board’s fiduciary duty runs to shareholders when the corporation is solvent or nearly-solvent (i.e., in the zone of insolvency) and to creditors when the corporation is insolvent.  For insightful and thought-provoking discussions of whether a board’s duties should shift to creditors, see Henry Hu’s and Jay Westbrook’s 2007 article proposing no shift in duties and Doug Baird’s and Todd Henderson’s 2008 article suggesting a contractarian solution.

The business judgment rule rests, in part, on good faith and an absence of conflicts of interest.  In the insolvency context, however, these basic assumptions cannot be taken for granted.  For example, a board of an insolvent corporation that gives undue weight to equity value in its assessment of investment opportunities arguably is acting in bad faith or, at a minimum, with reckless disregard of its duties.  This analysis may turn on considerations similar to those discussed by the courts in the Central Ice Cream and Credit Lyonnais Bank, 1991 Del. Ch. LEXIS 215, cases.

Similarly, conflicts of interest may arise in unexpected ways for directors of insolvent corporations.  For example, directors serving on the boards of both a parent corporation and its wholly-owned subsidiary generally do not have disqualifying conflicts of interest because the interests of the parent, as the sole shareholder, and the subsidiary are aligned.  Nevertheless, when the subsidiary is insolvent, common directors may have a conflict of interest because their primary duties now run to the corporations’ creditors.  The district court in ASARCO LLC v. Americas Mining Corp., 2008 U.S. Dist. LEXIS 71269, recently noted that “the directors of an insolvent wholly owned subsidiary have divided loyalties (between the parent, their corporation (the subsidiary), and the subsidiary’s creditors) and ‘when faced with such divided loyalties, directors have the burden of establishing the entire fairness of the transaction.’”

Directors also may face enhanced conflict-of-interest scrutiny in the approval of compensation, bonuses and other allegedly self-interested transactions when the corporation is insolvent and those transactions potentially constitute fraudulent conveyances under state or federal bankruptcy law.  The boards of AIG and Lehman Brothers currently are under the microscope with respect to those issues.

Consequently, boards of insolvent corporations that fail to consider investment risks in light of creditors’ interests, whether because of bad faith, ignorance or unrecognized conflicts, may do so at their own peril.  In the current environment, boards of insolvent corporations may have a very difficult time showing that their investment decisions satisfy the entire fairness test.  In fact, boards likely will try to defend the numerous breach of fiduciary duty actions bound to be filed both in and outside of bankruptcy first on solvency grounds.  A board’s ability to show that the corporation was not insolvent in fact at the time of the decision may allow the board to claim that its duties flowed to shareholders and that its conduct is protected by the business judgment rule.  Although corporate stakeholders likely will not benefit from that approach, lawyers, financial advisers and valuation experts certainly will.

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The automakers want a federal bailout, and the WSJ has a story on the currently ineligible bank-like institutions (private banks, most notably) hoping to get their bit of the $250 billion.  A sign that things really are bad?  John Carney suggests otherwise:

When thousands of otherwise healthy banks are lining up for the funds, willing to give up equity stakes and pay dividends to the government, we know that the price extracted for the bailout bucks is too small.  Healthy banks wouldn’t be eager to get on the gravy train if it was priced correctly.

We've noted that if there are downsides to this money, Treasury hasn't gotten around to enacting them very carefully, and as the injections go forward, it's going to be difficult to put onerous new conditions in place - that would look like, and might even be, the sort of retroactive administrative regulations disfavored by the courts.

We may, in short, be seeing a real shift in regulatory philosophy here, from punishing bailouts of financial institutions to pleasureable ones (for them, at least).

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Over at the Race to the Bottom, Harry Gerla has had several posts on the failed Caremark revolution.  The premise is that the famous 1995 Delaware Chancery Court case has had little impact because its standards for liability are so lax that it is extremely difficult for plaintiffs to succeed in a Caremark claim.  I agree in part--it is indeed very hard to succeed with a Caremark claim.

I do not think it follows, though, that Caremark has failed to have a significant impact.  I suspect that Caremark was designed to be part of a breed of Delaware case that strives to give guidance and change norms, and hence behavior, without actually holding anyone legally liable for bad behavior.  In a later post I will try to explain why I think this is a sensible strategy in some categories of cases, including Caremark--Claire Hill and I have started to set out our explanation in a recent article.  If we are right that Caremark belongs to this genre of cases (and we are far from alone in that belief), then it is no strike against Caremark to point out that few plaintiffs have succeeded with a Caremark claim.  The real question is whether the case has succeeded in changing norms and behavior.  My own highly sketchy sense is that it has.  Backing up that claim empirically is hard, but that's where the real question lies.

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