NVCA Today

by Lee Shepard and Jacob D. Bernstein, Morrison & Foerster LLP¹

In the current economic downturn, it has never been more important for directors to understand their fiduciary duties and protect themselves and the venture capital funds or other significant stockholders with which they may be affiliated. In several recent Delaware law decisions, courts have eroded the protection of the business judgment rule applicable in distressed corporations and clarified the risk of personal liability faced by directors and others. These cases are particularly relevant to directors of venture-backed companies when deciding whether to invest more money into a troubled company, to sell a distressed business, or to shut down the business.

Fiduciary Duty Basics and the Business Judgment Rule

Directors have two well-known fiduciary duties: the duty of care, which requires directors to make informed decisions, and the duty of loyalty, which requires directors to act in the corporation's best interests. Part of the duty of loyalty is the duty of good faith. Bad faith behavior includes conduct motivated by intent to harm the company or, more importantly, the intentional dereliction of duty or conscious disregard for a director's responsibilities. Each constitutes a breach of the duty of good faith and, in turn, the duty of loyalty.

In a transaction by a solvent corporation, directors are protected by the business judgment rule, if they make a reasonably informed decision (duty of care), have no personal interest in the transaction (duty of loyalty), and act in the good faith belief that the transaction is in the corporation's best interests. In those circumstances, directors are generally immune from liability. A plaintiff cannot prevail against a director, unless it shows that no ordinary person of sound business judgment could view the transaction as fair. Directors of Delaware corporations may also be protected against due care (but not loyalty) claims under the exculpation clause contained in most Delaware charters as permitted by Section 102(b)(7) of the Delaware General Corporation Law (DGCL).

If a director has a direct or indirect interest in a transaction, such as one with an existing venture fund, the protection of the business judgment rule is lost. However, a fully-informed vote of disinterested directors or, in some cases, stockholders, will generally protect the transaction from attack² and preserve the protection of the business judgment rule.³ Absent such ratification, the burden shifts to the interested directors to show that the transaction was fair.⁴

Recent Cases Have Eroded the Business Judgment Rule and Clarified Directors' Potential Liability in Distressed Companies

1. Liability for Failure to Properly Supervise a Distressed Sale

In Bridgeport Holdings,⁵ the Delaware Bankruptcy Court held that the failure of directors to properly supervise or execute a distressed sale may subject them to liability for breach of both the duty of loyalty (even in a disinterested transaction) and the duty of care, irrespective of any §102(b)(7) exculpation clause. The case involved the sale of a distressed company in a rushed process in which the directors failed to take an active role and abdicated crucial decision-making authority to turnaround management. The court held that these acts or omissions constituted bad faith conduct. Even though the plaintiffs did not allege that the directors had acted out of self-interest, the court allowed the duty of loyalty claim to proceed as a result of their bad faith conduct. Furthermore, the court allowed duty of care claims to proceed, notwithstanding a §102(b)(7) exculpation clause, and held that the business judgment rule did not apply, because of the board's lack of diligence.

The Delaware courts subsequently limited the exposure of directors in a flawed sale process. In McPadden v. Sidhu,⁶ the Delaware Court of Chancery clarified that directors' gross negligence did not, by itself, constitute non-exculpable, non-indemnifiable bad faith without a showing of intentional dereliction of duty, conscious disregard of responsibilities, or subjective bad intent. In In re Lear Corp.,⁷ the court held that an extreme set of facts would be required to sustain a duty of loyalty claim premised on intentional dereliction of duty.

2. Liability for Restructuring a Distressed Company

In Brown Schools,⁸ the Delaware Bankruptcy Court allowed plaintiffs to sue a financial sponsor and its board representatives for breach of the duty of loyalty in connection with their restructuring of a portfolio company. As part of the restructuring, the sponsor loaned money to the company and later received management fees and loan repayments from the proceeds of asset sales. In addition to allowing claims related to these interested-party transactions to proceed, the court held that "deepening insolvency" (i.e., wrongfully extending the life of the company in a death spiral) could be a basis for assessing damages, even though deepening insolvency itself is no longer recognized as a valid claim.

3. Directors of Solvent Companies Merely in the Zone of Insolvency Have No Obligation to Act in Creditors' Best Interests

For years, directors have been counseled that when a corporation enters the "zone of insolvency," their fiduciary duties shift to creditors and, accordingly, they must make decisions in the creditors' interests. That is no longer entirely correct. In Production Resources Group,⁹ the Chancery Court held that directors of solvent companies merely in the "zone of insolvency" may undertake risky strategies that might benefit stockholders, provided they do not breach any specific duties owed to creditors, such as contractual obligations or the implied covenant of good faith and fair dealing. The court also held that a corporation's insolvency does not change the primary object of directors' duties, which is to the corporation. Accordingly, in Gheewalla,¹⁰ the Delaware Supreme Court held that creditors of a corporation that is insolvent or in the zone of insolvency may not bring direct fiduciary duty claims against directors. Creditors of an insolvent corporation, however, may bring derivative claims on behalf of the corporation, leaving unresolved the question of derivative claims for corporations in the zone of insolvency.

4. Directors of Distressed Companies are Not Protected by the Business Judgment Rule or Disinterested Director/Stockholder Ratification in Transactions Involving Their Employer

Delaware courts have made clear that a director of a distressed corporation employed by a significant stockholder, or otherwise dependent on that stockholder for compensation or benefits, is not protected by the business judgment rule for transactions between the corporation and that stockholder.¹¹ This arguably includes directors affiliated with venture capital funds or other significant stockholders. A 2003 bankruptcy court decision held that the decision to approve such a related party transaction (particularly a loan) was not protected by an informed vote of disinterested directors or stockholders against later attack by a bankruptcy trustee.¹²

Practical Advice for Directors

The good news is that these court decisions do not create any new duties. Directors need not do anything differently than they should already have been doing. A director must act diligently and in the corporation's best interests. The cases do, however, underscore the critical importance of process-not just optics, but substance. Directors should be actively involved in any restructuring or sale process, and obtain valuations, fairness opinions and sound advice of counsel, even if the company is short on funds. As a last resort, it may be prudent for directors to question whether to remain on the board of an insolvent or distressed corporation at all.

More specifically, a director affiliated with a venture capital fund can be faced with the sometimes irreconcilable conflict of serving two masters. On the one hand, a director must act in the best interests of the corporation and all of its constituencies-including creditors. On the other hand, a director will want to act in the best interests of the investors with which he or she is affiliated-particularly when it comes to leading new rounds of investment or bridge loans. Unfortunately, there is no clear way to safely resolve the conflict in a manner that escapes litigation challenges, and the best way a director can avoid personal liability and protect his or her venture capital fund is to ensure that all transactions involving the fund are entirely fair to the corporation and to obtain meticulous supporting documentation. Extra caution is warranted when lending money, especially secured financing, because it affects creditors' interests. If possible, an investor represented on the board should try to arrange for a friendly third party to provide needed debt.

¹ Lee Shepard (email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) and Jacob D. Bernstein (email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) are corporate associates in Morrison & Foerster's Palo Alto and Northern Virginia offices, respectively.

² See Section 144(a) of the DGCL. The Delaware Supreme Court recently held that common law shareholder ratification does not "cleanse" an interested transaction if a shareholder vote on the transaction is otherwise required. Gantler v. Stephens, C. A. No. 2392 (Del. Jan. 27, 2009).

³ See In re The Walt Disney Co. Derivative Litig., 731 A.2d 342, 368-369 (Del. Ch. 1998).

⁴ It is almost always a risky idea to rely on fairness as the primary defense to a claim for breach of the duty of loyalty arising out of an interested party transaction. The factual and proof issues involved in that defense require substantial litigation expense, delay and burdens.

⁵ Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 388 B.R. 548 (Bankr. D. Del. 2008).

⁶ McPadden v. Sidhu, No. 3310-CC, 2008 WL 4017052, at *9 (Del. Ch. Aug. 29, 2008).

⁷ In re Lear Corp. S'holder Litig., C.A. No. 2728‑VCS (Del. Ch. Sept. 2, 2008).

⁸ Miller v. McCown De Leeuw & Co., Inc. (In re The Brown Sch.), 386 B.R. 37 (Bankr. D. Del. 2008).

⁹ Prod. Res. Group L.L.C. v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004).

¹⁰ N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).

¹¹ See, e.g., The Responsible Person of Musicland Holding Corp. v. Best Buy, Inc. (In Re Musicland Holding Corp.), No. 08-01023, 2008 WL 537701, at *18-19 (Bankr. D. Del. Dec. 23, 2008).

¹² See Decker v. Mitchell (In re JTS Corp.), 305 B.R. 529, 540 (Bankr. N.D. Cal. 2003) (corporate or stockholder ratification under DGCL § 144(a) does not apply to creditors who would be prejudiced thereby).