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Recent landmark decisions by the Delaware Supreme Court and California’s Third Appellate District Court have clarified the duties of corporate officers to stockholders. As a result of these decisions, officers should carefully consider their role in corporate activities to assure that they are fulfilling these duties, take steps to avoid conflicts of interest and defer to the board of directors for guidance and direction where there is any possible conflict of interest.

In addition, the recent Delaware Supreme Court decision also held that (i) a board of directors’ decision not to pursue a merger opportunity is not entitled to business judgment rule review where there is evidence of disloyalty by the board, (ii) false statements in the proxy statement about the board’s review of a merger proposal are material to stockholders and (iii) stockholder approval of director actions where stockholder approval is statutorily required is not sufficient to act as stockholder ratification.

Delaware: Officer Fiduciary Duties; Directors’ Duties in an Acquisition Context; and Stockholder Ratification Doctrine

In the recently decided Gantler v. Stephens, the Delaware Supreme Court reversed the Court of Chancery’s dismissal of a complaint challenging a board’s decision to approve a going private transaction (through a reclassification of shares) involving First Niles Financial, Inc. (First Niles), a Delaware corporation headquartered in Niles, Ohio. First Niles is the holding company for the Home Federal Savings and Loan Association (Home Federal), and conducts substantially all of its operations through Home Federal.

According to the complaint, in late 2003, the officers and directors of First Niles began discussing strategic options and subsequently hired legal and financial advisors to assist with exploring a sale of the company. By December 2004, First Niles had received three bids; its financial advisor had advised the board of directors (the Board) that each was reasonable. During this period, management of First Niles had also advocated to the Board that it abandon the sale process and instead explore a privatization of First Niles, whereby holders of fewer than 300 shares would be reclassified as non-voting holders of a preferred stock that would pay higher dividends than the common stock. The proposal would allow First Niles to de-list its common stock and as a result save the costs of public disclosure and reporting requirements, while also enabling the Board and management to remain in place.

Subsequently, the Board authorized a due diligence phase for two of the three potential bidders seeking to acquire the company, rejecting the other potential bidder, which allegedly had stated in its bid proposal that it had no plans to retain the Board. Thereafter, the complaint alleges, the chief executive officer and chairman of First Niles failed to provide due diligence materials to one of the accepted bidders, causing it to withdraw from the process, and delivery of requested due diligence materials to the other accepted bidder was delayed by several weeks. This second bidder ultimately submitted a revised proposal following its due diligence investigation, which First Niles’ financial advisor advised the Board was within an acceptable range. First Niles’ financial advisor also advised the Board that the bidder might increase its offer, and in fact the bidder did so. The Board subsequently rejected this bidder’s revised offer, allegedly “without any discussion or deliberation,” and at the same meeting decided to further investigate the privatization proposal advocated by management of First Niles.

Five weeks later, the Board determined that the privatization proposal was fair to First Niles’ stockholders. It voted unanimously to amend the company’s certificate of incorporation and move forward with the privatization proposal, including the provision to retain the existing Board and management. In late summer 2006, while seeking stockholder approval for the proposed privatization, the Board submitted a preliminary and later an amended proxy statement to the Securities and Exchange Commission.

The plaintiffs initiated their suit shortly after First Niles filed its amended proxy statement. The complaint alleged that the various defendants, which included First Niles’ officers and directors, breached their respective duties of loyalty and care in several ways: by sabotaging the due diligence process involving the first bidder; rejecting the other bidder’s proposal; distributing a proxy statement that contained materially misleading statements about the Board’s decision regarding the sale process; and, ultimately, by terminating the sale process in favor of effecting the privatization proposal so that they could maintain their positions within First Niles.

The Court of Chancery initially dismissed each of the plaintiffs’ three claims. In dismissing all three of the plaintiffs’ claims, the Court of Chancery ruled that the business judgment rule, not the enhanced scrutiny or entire fairness standards, applied to the Board’s decision to terminate the sale process, that the proxy statement did not contain any material misstatements or omissions, and that the approval of the privatization proposal by First Niles’ stockholders holding a majority of the unaffiliated shares of common stock constituted a stockholder ratification of the privatization. The plaintiffs then appealed the dismissal to the Delaware Supreme Court, which reversed the lower court on all counts and allowed the plaintiffs to proceed with their suit.

In its decision, the Delaware Supreme Court held that the entire fairness standard should be applied to the Board’s decision to terminate the sale process because the plaintiffs had alleged facts sufficient, for purposes of a motion to dismiss, to establish a cognizable claim that a majority of the Board acted disloyally, and thus had rebutted the business judgment rule presumption, even though the Board did not implement improper defensive measures. The Delaware Supreme Court noted that, to rebut the business judgment presumption, the plaintiffs had to plead more than an entrenchment motivation; in this case, they had pled sufficient facts to establish the disloyalty of a majority of the Board—that is, the CEO and chairman had acted disloyally by sabotaging the due diligence process and two other directors had acted disloyally because, as principals in two companies that provided services to First Niles, they had, favored terminating the sale process out of concern of losing business from First Niles.

Finally, the Delaware Supreme Court explicitly held that officers of Delaware corporations have fiduciary duties of care and loyalty and that those fiduciary duties are the same as those of directors. The court also concluded that the complaint alleged sufficiently detailed acts of wrongdoing by the officers to state a claim that here they breached their fiduciary duties. Noting allegations in the complaint that supported a reasonable inference that the officers attempted to sabotage the diligence process, the court held that the Court of Chancery was not free to disregard that reasonable inference or to discount it by weighing it against other contrary inferences that could also be drawn.

With respect to the plaintiffs’ second claim, the Delaware Supreme Court held that the disclosure in the proxy statement that the Board had rejected the merger proposal after “careful deliberations” was materially misleading. Given the directors’ and officers’ conflicts of interest with the privatization proposal, the Delaware court found, the company’s stockholders would likely have found significant a representation by a conflicted Board that the privatization proposal was superior to a potential merger that the Board rejected after “careful deliberations.”

With respect to the plaintiffs’ third claim, the Delaware Supreme Court held that the Court of Chancery should have not rejected the claim for two reasons: first, because a stockholder vote was required to approve the privatization proposal, that vote could not also operate to ratify the Board’s actions; and second, since the proxy statement contained a material misrepresentation, the stockholder vote was therefore not fully informed. The Delaware Supreme Court also further clarified that the common law stockholder ratification doctrine is limited to circumstances in which a fully informed stockholder vote approves director action that does not legally require stockholder approval in order to become legally effective. Accordingly, the Delaware Supreme Court held that doctrine was not applicable in the present context, in which a stockholder vote was required for the privatization proposal to become legally effective.

California Expands Personal Liability for Directors and Officers

In a decision rendered on December 26, 2008, California’s Third Appellate District Court expanded the 65-year old Responsible Corporate Officer Doctrine (the RCOD) to hold individual corporate officers personally liable for a $2.5 million fine resulting from the actions of the corporation they served. The court opined that these officers were the persons in the best position to prevent the offense and that public policy requires enforcement against such individuals, even though the conduct that necessitated the fine was committed by the corporation.

History of the RCOD Doctrine

The RCOD is a common law theory of liability separate from “piercing the corporate veil” or imposing personal liability for direct participation in tortious conduct. It was developed by the Untied States Supreme Court in its 1943 decision U.S. v. Dotterweich.¹ In Dotterweich, the Supreme Court applied the civil penalties of the Food and Drug Act of 1906 to an officer of a corporation that was violating the act by improperly modifying and reselling drugs. This decision is noteworthy because directors and officers were previously shielded from individual liability for violations of civil laws if their respective corporations were the party actually committing the offense. The Dotterweich court held that the legislature intended for the actual wrong-doer to be punished and that allowing a director or officer to hide behind a corporation would violate public policy. Dotterweich is often cited by courts holding officers liable under public welfare statutes, with the reasoning that the public is only protected by such statutes if there is a deterrent effect. Currently, the use of the RCOD is limited to cases where the public welfare is at issue.

People v. Roscoe

In 2008, California’s Third Appellate District Court expanded the RCOD in the People v. Roscoe decision.² In Roscoe, the Sacramento County District Attorney brought an action against The Customer Company (the Company) and John and Ned Roscoe jointly and severally based on their roles as the Company’s officers and directors. The Company is a family-run business that owns an underground gasoline storage tank in the City of Galt. The tank leaked 3,000 gallons of gasoline into the ground. A Company employee reported the leak, which led to scrutiny from local environmental officials. Over the course of several years, John Roscoe received numerous citations and correspondence related to the leak, specifically for violations of the California Health and Safety Code. John Roscoe forwarded this correspondence to a Company employee for action, but considered these documents to be “form letters” and never followed up to ensure that the Company acknowledged or responded appropriately. Eventually, the Company hired a remediation consultant, but it did not take any action to repair the damage caused by the gasoline leak.

The trial court found both the Company and the Roscoes guilty of violating environmental laws under separate theories. It held John and Ned Roscoe liable under the RCOD due to their “overall authority for company affairs” and because “they could have prevented or remedied the violations of the regulations, but they did not exercise their responsibilities and power to use all objectively possible means to discover, prevent and remedy any and all violations.”

In its decision affirming the trial court’s ruling, the Third Appellate District Court listed three essential elements that must be satisfied before liability will be imposed under the RCOD:

1. the individual must be in a position of responsibility which allows the person to influence corporate policies or activities;

2. there must be a nexus between the individual’s position and the violation in question such that the individual could have influenced the corporate actions or inactions which constituted the violations; and

3. the individual’s actions or inactions facilitated the violations.

Because the Roscoes received numerous notifications regarding the Company’s environmental violations, retained overall authority for the Company’s affairs and failed to take action to prevent the various violations, the appellate court upheld the lower court’s ruling, including the $2.5 million fine against the Roscoes.

Roscoe May Extend Limits of RCOD, Jeopardize Sanctity of the Corporate Entity

One of the major advantages of forming a corporation is that it generally shields directors and corporate officers from individual liability for corporate actions, so long as they act in the best interests of the company and in accordance with their respective duties of care, loyalty and good judgment. Similarly, directors and officers can typically be assured that the “veil” of a corporation will prevent a plaintiff suing their corporation from reaching their individual assets so long as a clear distinction is made between the assets of the individual and those of the corporation.

The RCOD erodes this protection by holding that individual directors and officers can be liable for the actions or inactions of their company if, by the nature of their positions, they could have prevented a violation of a certain law, rule or regulation but failed to take such an action.

The RCOD has been used sparingly by courts, which tend to be reluctant to usurp the power of the legislature by imposing fines on individuals where the underlying laws failed to explicitly provide such liability. Before Roscoe, California environmental regulatory agencies occasionally used the RCOD to collect penalties against individual corporate officers when the person had the ability to control the activities at a particular site.³ The Roscoe decision, however, marks an adoption of this previously limited policy by an appellate court. Though this doctrine is currently limited to enforcement of public welfare laws, it still sets precedent for possible use in other areas, such as stockholder derivative actions, which may be held to have similar public benefit. The apparent rationale for decisions based on the RCOD is that the legislature intended this extensive liability to be imposed on directors and officers, regardless of the actual text of the underlying law.

As evidenced by the actions of the Sacramento County District Attorney and the affirmations by the trial and appellate courts, Californians in particular can expect increased use of this doctrine to enforce civil penalties against corporate directors and officers, particularly in the context of environmental regulations. It remains to be seen if this doctrine will be expanded for use in other enforcement actions or in other jurisdictions around the country. The sanctity of the corporate entity and the relative protection from individual liability that it offers may be in serious jeopardy unless subsequent decisions refine and limit the use of the RCOD in a way that is predictable.

Next Steps Following Roscoe and Gantler

Important lessons can be learned from both the Roscoe and Gantler decisions. Overall, directors and officers must be mindful of their responsibilities to the companies they serve. Though a California court decided Roscoe, Delaware also recognizes the RCOD for public welfare offenses committed by corporations.⁴

In light of these cases, corporate officers and directors should keep in mind the following points:

• There is no distinction between the fiduciary duty owed to a company and its stockholders by a director versus that owed by a corporate officer. Officers and directors must act in the best interests of both the company that they represent and its stockholders.
• A breach of the duty of care by a director may have vastly different results compared to those arising from a similar breach by a corporate officer. Under Delaware law, a corporation may adopt a provision in its charter exculpating its directors from monetary liability for an adjudicated breach of their duty of care.⁵ There is no such exculpatory provision available for corporate officers under Delaware law. This is true in other jurisdictions as well. For example, under California law, similar protection is provided for directors, but it is explicitly disallowed for corporate officers.⁶
• Neither an officer nor a director may engage in self-interested acts or breach the duty of loyalty. Even though many directors and officers have a financial interest in their company, they must remain objective when considering alternatives that impact the company and its stockholders. Individual interests must be disclosed and should not factor into the decision-making or influence the manner in which the officers carry out their activities in support of board of directors directives.
• Any corporate reorganization plans, including mergers, acquisitions, initial public offerings or going-private transactions, should be thoroughly discussed at board of directors meetings and those discussions should be properly memorialized in meeting minutes. The disinterested members of the board of directors should control decisions with regard to such matters.
• Director and officer insurance policies should be examined regarding coverage for civil fines and/or environmental issues. Similarly, indemnification agreements must also be reviewed to determine the scope of indemnity.
• Internal policies with respect to environmental issues should be reviewed to ensure that there is a formalized process for receiving and responding to correspondence from regulatory entities and ensuring matters are handled appropriately.