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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Urban Decay is a wonderful case about the obligations of founders to each other at the earliest stages of a company's existence. Facebook's founder, Mark Zuckerberg, is enmeshed in a lawsuit with some former friends from Harvard (Cameron Winklevoss, Tyler Winklevoss, and Divya Narendra), who founded a company called ConnectU. This case is scheduled for a hearing next week, and it could turn out to be the next Urban Decay.

According to a complaint filed in the Federal District Court for the District of Massachusetts, the ConnectU founders "engaged Mark Zuckerberg to complete the computer program software and database definitions" for a social networking site. Zuckerberg was given access to ConnectU's code, as it stood in late 2003. The ConnectU founders now claim that Zuckerberg misappropriated trade secrets, infringed on copyrights, breached a contract, breached an implied covenant of good faith and fair dealing, breached fiduciary duties, and committed fraud -- among other things -- in the founding of Facebook.

The plaintiffs did not allege the formation of a partnership (the successful claim in Urban Decay), despite these allegations in the complaint:

Divya Narendra asked Zuckerberg if he would like to be part of a website that Narendra and his team were developing.

Zuckerberg agreed to be a member of the harvardconnection.com website development team ..., to develop the [code], and to help launch, promote, and operate the site and business, in exchange for a beneficial interest in the website, including a monetary interest in any revenue or other proceeds or benefits from the website....

Had the plaintiffs been aiming at partnership formation, they would have benefited from an agreement to share profits, not revenues. Under the facts pleaded, it's not clear whether Zuckerberg would be a partner, but that looks like an agency agreement (which gives rise to fiduciary obligations).

The plaintiffs also failed to rely on the opportunity doctrine (perhaps because they had not formed a business entity?), but the complaint alleges that Facebook's launch "usurped [a] valuable business opportunity."

As it stands, the case is procedurally muddled. In a memorandum supporting Zuckerberg's motion to dismiss, Zuckerberg's lawyers offer arguments based on statutes of limitations and pleading requirements, and they contend that ConnectU does not own the claims because the company was not founded until later. (ConnectU addresses most of these issues in a prior filing.) If ConnectU can overcome these initial hurdles, we could have an interesting case on our hands.

Thanks to Valleywag for flagging the lawsuit and providing a gallery of wannabe Facebook founders.

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On Friday, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court cleared up some confusion about directors' fiduciary duties in distressed firms.  The most important thing to know about the case is that the court cited me in passing (JK), as well as fellow corporate law bloggers Steve Bainbridge and Larry Ribstein.      

In its principal holding, the court held that for a firm in the zone of insolvency (ZOI), its creditors have no direct breach of fiduciary duty claims against the firm's directors. 

Perhaps more interesting, language in the opinion also casts serious doubt about whether creditors can even bring ZOI derivative claims:

When 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.  (Emphasis supplied).

By contrast, discussing actually insolvent firms later in the opinion, the court confirms the long standing view that creditors replace shareholders as the firm's residual claimants:

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.  (Emphasis in original).

The opinion suggests, therefore, that the ZOI concept famously described in Credit Lyonnais will no longer have any continuing relevance as a legal concept.  On balance, this is probably the right result.  It's hard for directors to know when they're in an ill-defined "zone" of insolvency.  So for purposes of "providing directors with definitive guidance," as the Gheewalla court attempts to do, doing away with ZOI is probably a good thing.

OTOH, drawing the line at insolvency seems somewhat arbitrary, and ZOI is not without some conceptual basis.  As I wrote in Gap Filling in the Zone of Insolvency,

Insolvency is not some magic event that triggers perverse incentives for managers that do not exist before insolvency. Instead, the agency cost of debt is increasing in the percentage of outside financing comprised of debt versus equity.

Insolvency, then, is just the extreme case of perverse managerial incentives to make inefficient investment decisions on behalf of equity.  What ZOI does--under any reasonable definition--is simply capture a larger share of those states of the world in which managers may have these perverse incentives.  For a legal rule, though, it's pretty vague.  Of course, one might suggest drawing a different line--say, when the debt-equity ratio hits 9:1.  The valuation issues are probably no worse at 9:1 than at insolvency (and the factual issues for equitable insolvency are likely to be even more intractible).  OTOH, the insolvency line may be defensible as a sort of focal point?

Finally, the court held that even for insolvent firms, creditors could not assert direct claims, but only derivative claims.  The court expressly overruled the Chancery Court's Production Resources decision in this regard.

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The W$J has an article on unexpected conflicts faced by venture capitalists whose portfolio companies change course. These problems are exacerbated by intense competition for profitable business models and the increased holding periods that result from a relatively weak IPO market.

The response has been for VC firms or portfolio companies to adopt conflict-of-interest policies. Another option would be to waive the director's fiduciary duty, though this introduces additional complexity and uncertainty on the legal side, as the ability to contract out of fiduciary duty varies by form of entity and state of organization.

It's a shame that the law relating to the waiver of fiduciary obligation is not clearer because it could provide useful guidance to business people. For some more thoughts on contracting out of fiduciary duty, see the appropriate section of this article.

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So yesterday everyone is chuckling at the fourth-year associate who attached a complaint that was filed under seal to a motion, thereby letting it sit where it would inevitably be found (by someone at the WSJ) and leaked.  However, this is least interesting part of the story to me.  This is the interesting part.

Mercury Interactive was one of the first company to fess up to backdating options, restating earnings by $570 million.  The board formed a special litigation committee which filed a derivative lawsuit on behalf of two shareholders (wow, just like it's supposed to work), against the four former officers who engaged in the backdating.  The board files the complaint in California state court on September 22, 2006.  The defendants fight to have the complaint sealed because it contains fairly incriminating information from emails that talked about using "magic backdating ink" on stock options and stated "the stock price drop made us change the grant date."  OK, so the suit seems to have some legs, if a court thinks that backdating options is either a breach of fiduciary duty of in violation of the California Corporations Code (which brings treble damages).

However, in November 2006, Hewlitt-Packard buys Mercury.  A month or two later, the California court dismisses the suit because the shareholders no longer have standing.  (The acquiring firm by operation of law acquired all the liabilities of Mercury, but apparently the old shareholders had their claimed purchased by operation of law.)  I cannot find a copy of the dismissal order, if there is one, but I would like to ponder it for awhile.

So, I have some questions for the fiduciary duty gurus:  First, what did the board of Mercury want to happen with the suit?  Did they really want it to succeed?  Where they happy to negotiate the acquisition by H-P to make it go away?  Is that some strange conflict of interest for the board to represent the shareholders in litigation but also negotiate an acquisition that will make it disappear?  Second, did the shareholders actually receive as compensation for their shares an amount equal to what they would have gotten (directly or indirectly) if the officers had been found liable and paid damages?  If two shareholders wanted the suit, are these the majority?  Did the board just find away to wash out the litigious shareholders?

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In 1993 Justice Horsey of the Delaware Supreme Court penned this unfortunate sentence in the second major Technicolor opinion: "To rebut the [business judgment] rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty -- good faith, loyalty or due care."

Triads?

In Gaylord, Vice-Chancellor Strine tweaked the Delaware Supreme Court for its use of the plural "triads" and for identifying "good faith" as a separate fiduciary duty: "Indeed, the very Supreme Court opinion that refers to a board's 'triads [sic] of fiduciary duty [sic] -- good faith, loyalty [and] due care,' equates good faith with loyalty."

In subsequent opinions, the Delaware courts and commentators charitably reduced the number of triads to one, but confusion remained about the role of "good faith" in fiduciary litigation. We had a lot to say here about the Disney litigation, and if you were following that conversation, you might remember a lingering issue from the Supreme Court's most recent opinion: does the duty of good faith provide an independent basis for director liability?

My initial take on the Disney opinion was unequivocal:

The Court clearly embraces the duty of good faith as a distinct duty, separate from care and loyalty. For example, "grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith."

In a subsequent post, I addressed Footnote 112 of Disney, which reads as follows:

[W]e do not reach or otherwise address the issue of whether the fiduciary duty to act in good faith is a duty that, like the duties of care and loyalty, can serve as an independent basis for imposing liability upon corporate officers and directors. That issue is not before us on this appeal.

I argued that "footnote 112 was an afterthought designed to secure a vote for the opinion in pursuit of unanimity." I speculated privately to several colleagues that Justice Holland had demanded the footnote, though what he intended to do with it I wasn't sure.

Now I know. The triad is dead.

Yesterday, the Delaware Supreme Court issued a unanimous, en banc opinion that seems to drive a stake in the heart of "the fiduciary duty of good faith." The following comes from Stone v. Ritter:

It is important, in this context, to clarify a doctrinal issue that is critical to understanding fiduciary liability under Caremark as we construe that case. The phraseology used in Caremark and that we employ here—describing the lack of good faith as a "necessary condition to liability"—is deliberate. The purpose of that formulation is to communicate that a failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability. The failure to act in good faith may result in liability because the requirement to act in good faith "is a subsidiary element[,]" i.e., a condition, "of the fundamental duty of loyalty." It follows that because a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.

This view of a failure to act in good faith results in two additional doctrinal consequences. First, although good faith may be described colloquially as part of a "triad" of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal consequence is that the fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, "[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation's best interest."

I will have a lot to say about this at some future date, probably in a law review article, but the first question that springs to mind is this: Has the Delaware Supreme Court been acting in good faith in its development of the duty of good faith?

Over the past decade, the Court has had numerous opportunities to "clarify" this issue, and the Court has consistently muddied the waters. As noted above in my Gaylord citation above, the Court of Chancery responded to Justice Horsey's unfortunate sentence by treating the mysterious duty of good faith as a species of loyalty violation, but the Supreme Court repeatedly emphasized the distinctiveness of "the duty of good faith." I never liked the idea that good faith was part of the duty of loyalty, but if that's where the Supreme Court wanted it, did we really need over a decade to figure that out?

We are told that the duty of good faith is connected to Caremark, which the Supreme Court has cited in three other cases, though never with the complete endorsement of the Caremark standard that appears in Stone. This makes sense to me, given the notion of "good faith" articulated in the Disney cases.

Then we are told that Caremark is really a duty of loyalty case. Not duty of loyalty in the traditional sense -- you know, those cases "involving a financial or other cognizable fiduciary conflict of interest" -- but something different. More like a good faithy version of loyalty. Ok, I think I basically get good faith after Disney, but why dilute a useful and longstanding conception of loyalty with these other fact situations? Was the post-Disney triad broken and in need of repair?

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While today might be about Enron rather than Disney, I promised two posts on Disney, so here goes the second...

In response to Disney, Lisa asked why courts feel the need to distinguish between best practices and acceptable practices, as only the latter are relevant to legal liability. Both Melvin Eisenberg, see 62 Fordham L. Rev. 437 (1993), and Gordon have argued that a dual structure of corporate law which bifurcates best practices and acceptable practices does serve a purpose. By aiming discussions of best practices at directors, it encourages better behavior; by aiming discussions of acceptable practices at courts, it tells them when to impose liability. In my last post on individual vs. collective director liability, I noted that courts have used the laxer collective approach to assess liability in duty of care cases, meaning that a single director’s carelessness is legally excused if the other directors complied with their duties. I also noted that courts have only implicitly adopted this approach. Could courts be hiding the ball on the collective approach because they aren’t eager to announce to directors just how low the bar is set, perhaps in the hopes of encouraging better conduct?

I’m skeptical that hiding the ball in this way pays great dividends in practice, as directors surely know how low the bar is set for careless behavior. Even if directors don’t know that liability will be assessed only collectively, they have to be aware of the business judgment rule and § 102(b)(7). Also, it could be that courts haven’t explicitly addressed the choice of assessment approach for other reasons (maybe it’s obvious? or maybe courts haven’t thought it through?). But I like to think that the courts’ handling of the individual/collective question may support Gordon’s and Eisenberg’s very interesting work.

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When the Delaware Supreme Court issued its most recent opinion in Disney, Lisa posted on two very interesting aspects of the case: first, that the Supreme Court punted on whether a director’s fiduciary duty breach should be assessed individually or collectively; and second, that the Supreme Court, like the Chancery Court, distinguished between a board’s best practices and its acceptable practices. In my next two posts, I’ll revisit those issues.

First, should director liability in fiduciary duty suits be assessed individually or collectively? This is a question that few courts or academics have explicitly addressed. However, in looking at the case law, it’s clear that courts analyze duty of loyalty breaches individually, meaning that a disloyal director may be liable even if all other directors complied with their fiduciary duties. On the other hand, although it’s less clear, courts have tended to analyze duty of care breaches collectively, meaning that one director’s carelessness is legally excused if the remaining directors have met their duties. Although my initial thinking was that collective liability might operate as a collective sanction, punishing non-breachers (as well as the breacher) for lax monitoring, courts don’t appear to use it in this way. Instead, they shield the breacher so as not to punish the non-breachers.

In a work-in-progress, I argue that an individual/collective focus that shifts based on fiduciary duty type is desirable on corporate governance policy grounds because it strikes the right balance between a board’s authority and its accountability. (Both Gordon and Stephen Bainbridge have discussed the importance of this balance, and I draw heavily on their work.) In short, self-dealing is intentional wrongdoing, typically by inside directors, and can therefore taint the board’s process in a meaningfully way even if only one director does it. To preserve a functioning board, courts must favor accountability over authority in these situations. Conversely, negligence (even gross negligence) is unintentional wrongdoing, typically by outside directors, and is therefore less likely to meaningfully impact the board’s functioning if there's only one culprit. The board can still function adequately, if not perfectly, with an absentee director (either in body or in mind), so courts should favor authority over accountability in these situations.

In its current form, my paper argues that this duty-based answer to the individual/collective question is both descriptively accurate and normatively desirable. As I continue to work through the implications of this framework, I hope to illustrate how it would be used in concrete cases; e.g., in derivative suits over stock option backdating. Also, I’m less clear on how relevant the issue is to the early stages of litigation – discovery, demand, etc. – as opposed to the trial stage, which is the paper’s focus. I welcome your comments, either publicly or privately.

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So, we've all heard theories about how fiduciary duties should run from directors to stakeholders, to employees, or even that these groups should be third-party beneficiaries of these duties.  How about this one:  fiduciary duties to a corporation should run from a plaintiffs lawyer in a derivative suit to the company the lawyer is suing?  This law.com article tries to describe the scenario.  Tenet Healthcare faced three suits; a suit for securities fraud, a derivative suit in federal court for breach of fiduciary duty, and a derivative suit in state court for breach of fiduciary duty.  Tenet was represented at least on the derivative suits by Skadden, Arps.  A judge stayed the state court suit pending action in the federal suit.  The plaintiff's attorneys in the federal suit, Cauley, Bowman, Carney & Williams, say that they diligently worked for two years to obtain a resolution in the federal case.   According to Cauley, Bowman, Tenet determined that the federal plaintiffs' demands were too high, turned to the state plaintiffs, and settled in one day.  This settlement provided the state plaintiffs' attorneys, Faruqi & Faruqi and Robins, Umeda & Fink with $5M in attorney fees.

So, everybody's happy except for Cauley, Bowman, who have lost in the "reverse auction" and receive no attorney fees for its work.  So, Cauley, Bowman is now suing the state plaintiffs' attorneys and Skadden, Arps under the theory that they all breached their duties to the company by settling too low.  If the case has any merit at all, the case must turn not on which plaintiffs attorney deserves the settlement or which firm worked longer or harder.  The case must turn on (1) the nature of the duty that the plaintiffs' attorneys owed to the corporation and (2) whether the settlement was reasonable.  Everything else is just part of the nature of the beast.

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On two occasions at the just-concluded Annual Meeting of the Association of American Law Schools, I experienced the jarring clash of ideology that divides business law professors. Last Wednesday, the first day of the conference, I attended the Section on Business Associations and the Section on Securities Regulation. At the same time, the Section on Socio-Economics was sponsoring an all-day series of panels, including "Corporate Governance, Fiduciary Duties and Social Responsibility" and "Control Fraud and the Market for (Financial) Lemons: Socio-Economics Perspectives on Corporate Looting." After a day full of fairly conventional discussions in the Section on Business Associations and the Section on Securities Regulation, I decided to attend this last session and was struck by the dramatic change in atmosphere as I moved from one group to the other.

The Section on Business Associations and the Section on Securities Regulation are dominated by free marketeers, while the Section on Socio-Economics has a high(er) concentration of progressives. There is, among this latter group, a pervasive sense that the corporate governance system is corrupt and that legal intervention would make the world a better place. Their discourse is Naderesque,* with hyperbolic caricatures of the status quo and urgent calls for reform. While the free marketeers tend to favor the descriptive, the progressives lean toward the normative.

I was surprised to find this same air of moral outrage the next morning in several presentations at the Section on Agency, Partnership, LLCs, and Unincorporated Associations, which sponsored a panel entitled, "What's Left of Fiduciary Duty?" Among some in this group, the word "contract" was articulated with venom, while Cardozo was exalted.

Unfortunately, I don't sense much real engagement across ideological boundaries. Perhaps surprisingly, given the usual portrayals of the legal academy, free marketeers dominate at elite law schools, and they can afford to ignore progressive critiques (or assign those critiques to footnotes). Progressives talk amongst themselves, reinforcing each other and becoming increasingly exasperated with the free marketeers.

* I met Ralph Nader for the second time while at the conference. He asked me about the panel on "Empirical Scholarship in Contract Law" and seemed genuinely interested. Unfortunately, I had to cut the conversation short so that I could make a lunch appointment. I would have enjoyed a more extended discussion.

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In his letter to the Time Warner board of directors released yesterday, Carl Icahn objects to Time Warner's exclusive negotiations with Google over AOL. Icahn argues that Google is the wrong strategic partner, and that a deal with Microsoft or Yahoo or eBay might unlock more value for Time Warner shareholders. Then he writes this:

On the eve of a proxy contest, I believe it would be a blatant breach of fiduciary duty to enter into an agreement with Google that would either foreclose the possibility of entering into a transaction that would be more beneficial for Time Warner shareholders or make such a transaction more difficult to achieve. (emphasis added)

Hmm. Icahn points to no conflicts of interest in this transaction. He simply claims that a Google transaction would be a bad idea. Here is some Fiduciary Duty 101: bad business decisions, even egregiously bad business decisions, are not actionable breaches of fiduciary duty. The business judgment rule would protect Time Warner's board of directors in this instance, even if they entered into a transaction that many people believed was substantively horrible.

Another aspect of Icahn's statement that I find interesting is that business people seem to have a more expansive notion of fiduciary duty than lawyers. If I am right about that, then fiduciary law may be working pretty well. Let me briefly explain why.

In this short symposium paper, I borrow from the work of Meir Dan-Cohen, Mel Eisenberg, and others to discuss the difference between "standards of conduct" [edited: see comments] and "standards of liability." The basic idea is that we want directors to hear this message: be diligent and make wise decisions. This is the standard of conduct. But we don't want to hold directors liable merely for a failure of diligence or wisdom. (Why? Two reasons: because we want directors to be bold and because we want to preserve the value of centralized decision making.) Before imposing liability, we want some evidence of wrongdoing, such as a conflict of interest. This is the standard of liability.

My sense is that many business people think about the standard of conduct when they contemplate fiduciary duties, even though they know about the standard of liability. Consider Icahn's concluding paragraph to the Time Warner board:

Once again, I am not opposed to the board using its business judgment to enter into a transaction with Google or another suitor so long as the transaction does not destroy or impede Time Warner's flexibility to unlock shareholder value in the near and long term. However, I want this letter to serve as notice to Time Warner's directors that if they enter into a transaction that has that effect, shareholders will seek to hold directors responsible. (emphasis added)

The reference to "business judgment" seems clear enough: he recognizes the board's legal authority to act in that sphere. So how will shareholders "hold directors responsible"? At the ballot box.

And this is as it should be.

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