New Developments

Delaware Court of Chancery on nominating directors

The Delaware Court of Chancery has held that being dilatory in figuring out somewhat confusing bylaws is not a ground for excusing compliance with those bylaws. In Openwave Systems Inc. v. Harbinger Capital Partners Master Fund I, Ltd., Openwave called its annual meeting of stockholders on December 1, 2006, with the meeting to be held January 17, 2007. Under Openwave’s bylaws, advance notice of nominations for directors had to be given to the corporation by the close of business on December 11th.

Harbinger, which owned about 10% of Openwave, decided to run a slate of nominees for the two open seats on Openwave’s board. Harbinger submitted its nominees to Openwave on December 28th and simultaneously changed from a 13G to a 13D filing. Openwave allowed the two nominees to appear on the ballot but reserved its right to challenge their nomination and election. The two highest vote-getters were one of Harbinger’s nominees and one of Openwave’s nominees. Hilarity (read, litigation) obviously ensued.

After a one day trial, Vice Chancellor Lamb held that Harbinger’s nominees had not been properly nominated, thus the two Openwave management nominees were the validly elected directors. The Vice Chancellor did not believe testimony that Harbinger’s principals were diligent but confused about the application of Openwave’s bylaws and so were unable to nominate candidates by December 11th. Rather, he found that Harbinger was simply lax in deciding whether to run a slate at all and, by the time it decided to do so, had missed the bylaw deadline. Although Harbinger sought legal advice about the effect of Openwave’s bylaws, it did not receive that advice before mid-December, after the December 11th deadline.

Vice Chancellor Lamb certainly decided this case correctly. Pedagogically, this case could be taught in conjunction with McKesson Corp. v. Derdiger (casebook page 546).

The bylaws in effect when this case arose are here.

As usual, Francis Pileggi has good posts on this case here and here.

Delaware Court of Chancery on the actual and apparent authority of a transaction lawyer

In MetCap Securities LLC v. Pearl Senior Care, Inc., NASC struck a deal to acquire Beverly Enterprises. The merger agreement contained a parenthetical requiring NASC to pay a finder’s fee to MetCap, an investment banker. NASC could not raise sufficient funds to complete the all-cash deal so it entered into an agreement with Pearl Senior Care to assume all of NASC’s obligations to purchase Beverly, including the obligation to pay MetCap’s finder’s fee.

Beverly, NASC, and Pearl negotiated a revised merger agreement and, as is typical, the final negotiating and drafting went late into the night. Around 10 p.m. on a Sunday, the two main lawyers for NASC went home, leaving one of their partners, Dickerson, to finish the work and leaving signature pages with him. Three hours later, Pearl’s counsel deleted the parenthetical and Dickerson apparently acquiesced or didn’t notice. Thus Pearl neither assumed nor was assigned NASC’s obligation to MetCap. The final version of the amended merger agreement was finalized at 4 a.m. and Dickerson attached the signature pages. Four months later the acquisition closed and MetCap discovered that NASC, not Pearl, was the only entity obligated to pay its finder’s fee. NASC was formed for the express purpose of acquiring Beverly and did not have any assets, which MetCap knew when it agreed to perform investment advisory services. MetCap and NASC sued Beverly and Pearl for reformation and damages.

Vice Chancellor Noble dismissed a fraud claim and a third party beneficiary claim. He also dismissed an unjust enrichment claim against NASC but declined to dismiss an unjust enrichment claim against Pearl. Finally, he denied MetCap’s claim for reformation but not NASC’s claim for reformation.

This case is particularly intriguing in its consideration of Dickerson’s power to bind NASC. NASC argued that Dickerson’s power to bind it was circumscribed because he was “deal counsel”, apparently suggesting a status with less power to bind the principal than a transaction lawyer would ordinarily have. The Vice Chancellor held that the scope of a deal counsel’s actual authority would, of course, be fact-specific. He rightly focused, however, on Pearl’s lawyer’s reasonable perception of Dickerson’s powers and found no evidence that suggested knowledge of any limits on Dickerson’s authority. Nonetheless, evidence suggested that Dickerson did not tell NASC that he had acquiesced to the omission of the parenthetical. Ordinarily, an agent’s knowledge binds the principal but here, said Vice Chancellor Noble, the complaint sufficiently (though weakly) alleged that Dickerson might have been conflicted in his role so that ascription of his knowledge to his principal was not appropriate.

In a footnote in a later opinion denying reargument, Vice Chancellor Noble wrote,

MetCap’s insistence that the Court look to the “circumstances” surrounding the Third Amendment and focus on MetCap’s perceived lack of any means to obtain payment of its fee, requires the Court to address an issue that it had sought to avoid. The Court, thus, turns to the allegations regarding the conduct of the attorney representing … NASC (but not MetCap) when he made the final revisions to the Third Amendment that eliminated the provision that arguably would have transferred NASC’s liability for MetCap’s fee to Pearl …. If that attorney, negligently or without authorization (and the Amended Complaint at ¶ 23 alleges that he was without authority), revised the Third Amendment to deprive NASC of its entitlement to have its $20 million obligation to MetCap paid at closing, then NASC would seem to have a claim against that attorney and his firm through which it would be able to meet its obligations (perhaps reduced by the cost of collection) to MetCap. This observation is not essential to resolution of the motion for reargument, but the Amended Complaint’s description of the obvious source of funding induces a skeptical view toward the allegation that NASC is unable to pay, an allegation that is accepted for present purposes under Court of Chancery Rule 12(b)(6). In short, NASC may not now have the funds to meet its obligation to MetCap, but the Amended Complaint, if its allegations are correct, suggests a way for NASC to recover the needed funds.

Francis Pileggi has two posts on this case (here and here) and Steven Davidoff has a terrific post on it, as well (here)

Delaware Court of Chancery on books and records inspection

The Delaware Court of Chancery has denied stockholder inspection of three letters on the grounds that the stockholder does not have a proper purpose and that, even if the purpose were proper, the letters are confidential and the harm from disclosure would outweigh the benefits. In Pershing Square, L.P. v. Ceridian Corp., Pershing Square, Ceridian’s largest stockholder, learned that Mr. Krow, the president of one of Ceridian’s two operating units, had sold a significant amount of stock and intended to quit because he disagreed with the business plan of Ceridian’s CEO, Ms. Marinello. Ms. Marinello confirmed those business plans in a meeting with Pershing Square and other significant stockholders. Pershing Square then met with Krow who disclosed the existence of some letters to the board that, inter alia, hinted at mismanagement by the prior CEO and hinted that the board had been lax in its oversight. Pershing Square then announced its intention to run an opposition slate of directors at the Ceridian annual meeting. All these events occurred within two weeks.

A month later, Pershing Square made a books and records demand under DGCL § 220 seeking the letters and a few other items. Ceridian allowed inspection of the other items but denied inspection of the letters. Pershing Square filed suit and a trial ensued.

Chancellor Chandler denied inspection. He held that Pershing Square’s ostensible purposes, to communicate with stockholders for the purpose of soliciting proxies and to investigate the suitability of directors, were not its actual purpose. Pershing Square’s actual purpose was legally to make public the information in the letters, which it could not otherwise publicize without acknowledging that it had obtained that information improperly. Chancellor Chandler also held that the letters were confidential, that their confidentiality had been maintained, and that the harm of disclosure would outweigh the benefits.

Chancellor Chandler is absolutely right here and the case is pedagogically interesting on at least three levels. First, the Chancellor sets out in wonderfully clear and concise language the Delaware rules for books and records disclosure. That is, that the burden is on the stockholder to assert a proper purpose, to prove that it has evidence warranting further investigation, and to prove that the information is necessary and essential to its stated purpose. The corporation may defeat inspection by showing that the stockholder’s ostensible purpose is not a proper purpose or, if it is proper, that it is not the stockholder’s actual, improper, purpose. A stockholder may inspect for a proper purpose even if the stockholder’s additional purposes are improper. Books and records inspection is commonly coupled with a confidentiality order.

Second, it makes a nice contrast with Seinfeld v. Verizon Communications Inc., (Casebook Supplement), which is replacing Compaq Computer Corp. v. Horton, casebook page 567. This case could be inserted at page 571. The two cases taken together would make a nice class discussion of the contours for stockholder inspection.

Finally, and perhaps most importantly, there are distinct fiduciary and professional responsibility aspects to this case. Pershing Square’s counsel and Mr. Krow’s personal counsel attended the meeting between Pershing Square and Mr. Krow. Chancellor Chandler, in his understated way, lays out the problems:

While Krow was a Ceridian fiduciary, but contemplating resignation, he formed an alliance with his employer’s largest stockholder to achieve one common goal—the replacement of the current board with a board that would spin-off Comdata and retain Krow as CEO. To further this goal, Krow participated in two secret meetings with Pershing Square. In the first, he discussed Ceridian’s strategic plans, aligned himself with Pershing Square, and schemed to unseat Ceridian’s current management and board. In the second meeting, held on one day’s notice in an airport, Krow reassured Pershing Square that he was adverse to the current board and at least allied with, if not loyal to, Pershing Square. Krow advised Pershing Square of Ceridian stockholders who were loyal to Krow and would likely support Pershing Square’s opposition slate. He also advised Pershing Square on the suitability of at least one of its nominees. Further, he disclosed confidential information written not only by himself, but also by another Ceridian executive officer.

Notably, Pershing Square and Krow were both represented by counsel, who informed them that Krow might face legal issues if he joined Pershing Square’s slate. Yet, neither party seemed concerned that Ceridian, the company that employed Krow, was not represented at this meeting. Both participants ignored all duties that Krow owed to Ceridian, including Krow’s duty to report to management elected by and responsible to all stockholders. It appears that self-interest, not the best interest of the corporation or its stockholders, drove Krow’s actions, and Pershing Square stood to benefit from Krow’s self-interested actions.

Law professors who teach this case can and should raise questions about Mr. Krow’s behavior under Agency and Corporate law, Pershing Square’s ethics, and counsel for Pershing Square and for Mr. Krow’s professional responsibility.

Francis Pileggi has a very nice discussion of this opinion here.

North Carolina Court of Appeals on director conflict of interest safe harbor

The North Carolina Court of Appeals has erroneously held that directors do not face conflicts of interest when they elect a family member as an officer, approve compensation for officer-family members, and approve “matters related to” those family members. The court also erroneously focused on the directors’ voting (rather than on the underlying transaction) to determine that election of a family member as an officer and compensation paid to officer-family members are not transactions “with the corporation”. The court erroneously held that those transactions are not subject to the North Carolina conflict of interest safe harbor statute.

In Geitner v. Mullins, a corporation was owned equally by Ms. Geitner and Ms. Mullins, two daughters of the founder. The six person board was not equally divided between the sisters. The board consisted of Ms. Geitner and her husband, on the one hand and Ms. Mullins, her husband (Mr. Mullins), her daughter (Ms. Shehan), and her son on the other hand. The Mullins branch controlled the corporation.

The board approved bonuses for Mr. Mullins, who was the president, and, after his death, voted to appoint Ms. Shehan as president and to give her a substantial raise. Mr. Mullins abstained from voting on his bonuses and Ms. Shehan abstained from voting on her appointment as president and concomitant raise. Each vote was approved by the remaining three Mullins directors (a non-family member replaced Mr. Mullins on the board and voted with the Mullins family); the two Geitner family directors voted against each transaction. The Geitners brought suit seeking a declaration that the Mullins directors’ votes were invalid and that any future votes “on matters related to” Mr. Mullins and Ms. Shehan would be invalid because they were not in conformity with the North Carolina conflict of interest statute. That statute is substantially identical to pre-1990 MBCA § 8.31, which is in effect in about a dozen states. It is comparable to Delaware’s approach in DGCL § 144.

Judge Tyson held that the family relationships, vel non, are insufficient to trigger the conflict of interest statute because the statute does not explicitly state that family relationships are conflicts of interest. He also held that the statute is not triggered because voting is not a transaction with the corporation. Thus the court affirmed entry of summary judgment for defendants.

Judge Geer, in her concurrence, disagreed with both of Judge Tyson’s assertions, and she is exactly right. She looked to both the standard treatise on North Carolina corporate law and, more pertinently, to the MBCA Official Comments for guidance. Both sources make salient the intuitive notion that a transaction between a corporation and a director’s immediate family member is a conflict of interest for the director. She then moved to a more central point, which Judge Tyson did not address at all: the operative effect of the conflict of interest statute. The statute does not invalidate director votes; it provides a safe harbor for transactions that might otherwise be voidable. Because the statute does not invalidate director votes, plaintiff’s declaratory relief request failed. Judge Geer mercifully declined to deal with Judge Tyson’s second ground. Had she done so, she doubtless would have pointed out that voting is obviously not the statute’s concern. The statute speaks to transactions with the corporation such as, oh, I don’t know, contracting with officers and agreeing to compensate them.

Washington State Supreme Court on apparent authority

The Supreme Court of Washington has held that a principal is bound by an agent acting within apparent authority and that the agent’s offer to sell at a price below the authorized price was not, by itself, ground to set aside the transaction. In Udall v. T.D. Escrow Services, Inc., T.D. Escrow Services, the trustee of a deed of trust on a private residence, foreclosed the property at the direction of the lender. T.D. Escrow retained ABC Legal Services (yes, that’s the real name) to conduct the sale. T.D. Escrow advertised the property and stated the property would be sold to the highest bidder.

T.D. Escrow authorized ABC to accept a minimum bid of about $159,000. ABC distributed a sheet at the auction erroneously stating that the minimum bid was about $59,000; Udall bid one dollar more and was declared the winner.

Udall tendered full payment, T.D. Escrow Services refused to convey the property after it discovered the error, and Udall brought suit to quiet title.

Justice Fairhurst held that ABC had apparent authority to sell the property for $59,000 and so T.D. Escrow was bound by the sale contract and was required to deliver title to Udall. Relying on Restatement (Third) of Agency §§ 2.03 and 3.03, she held that the sale notice constituted a manifestation by T.D. Escrow to Udall that caused Udall to believe, reasonably, that ABC was T.D. Escrow’s agent for the sale and was authorized to accept his bid. Justice Fairhurst also found apparent authority from the fact that T.D. Escrow had engaged ABC to engage in a general class of transactions, selling foreclosure properties on its behalf. Finally, the court found that the price discrepancy did not defeat apparent authority in this instance, though the court observed that a gross disparity coupled with “circumstances indicating some additional unfairness” might be sufficient to award equitable relief from consequence of apparent authority.

This opinion is obviously absolutely correct. I have substituted this case for In re Matter of McDuffie on page 96 because the facts are easier, the discussion of Agency law is better, and so the policy discussion is probably more effective. You can find the edited version of Udall, along with Notes and Questions, in the casebook Supplement.

Connecticut Court of Appeals on LLC promoter liability/power

The Appellate Court of Connecticut has held that a promoter of an LLC is liable on a contract made in the LLC’s name but before formation and therefore had the power to transfer the contract to another entity that could sue to enforce the contract. In BRJM, LLC v. Output Systems, Inc., Nicholas Kepple agreed to purchase real estate from Output Systems, Inc. The purchase contract was made in the name of M & K Realty, LLC, which was an entity to be co-owned by Kepple and his friend McGuiness (gee, how’d they think of THAT name?). After the contract was formed, McGuiness pulled out and Kepple assigned the contract to BRJM, LLC, an entity he owned. When a subsequent appraisal revealed that the property was worth twice the contract price, Output Systems refused to close and BRJM sued. One defense was that the contract was void because M & K Realty, LLC had not been formed when the contract was executed.

Justice Schaller held that, as a matter of first impression, the individual entering into a contract on behalf of a non-existent LLC is personally liable. The court relied on Restatement (Third) of Agency § 6.04 for the proposition that an “agent” is liable on a contract entered into on behalf of a non-existent principal. Justice Schaller acknowledged that this rule was to protect third parties, not to empower individuals who contract on behalf of non-existent entities. The court also drew an analogy to promoter liability in the corporate setting, both under common law and under MBCA § 2.04, which would hold the promoter liable.

Although the court acknowledged that the Restatement section and promoter liability rule are intended to protect third parties rather than to empower promoters, it held nonetheless that those rules allow promoters to enforce such contracts as well. Thus Kepple was liable on the contract, could enforce it, and thus could (and did) assign it to a third party.

It’s not clear to me that this case must be correct. Certainly the legal rules the court invokes do not stand for the result the court reached. The doctrine of entity by estoppel might do the trick. Here, Output Systems intended to deal solely with M & K Realty, LLC, which could induce the court to hold that Output Systems was estopped to challenge that entity’s existence. That doesn’t, by itself, permit Kepple to transfer the contract in M & K Realty’s name to another entity, though. However, given that the plaintiff is, in effect, a limited liability entity owned and controlled by Kepple, one might analogize this situation to the entity by estoppel setting.

This case could be taught after, or instead of, P.D. 2000, L.L.C. v. First Financial Planners, Inc. on page 745.

Illinois on direct participation theory of parent corporation liability

In a case of first impression, the Supreme Court of Illinois has held that a parent corporation may be liable for its subsidiary corporation’s debt under the direct participation theory. In Forsythe v. Clark USA, Inc., plaintiff’s decedent was killed while working at an oil refinery owned and operated by Clark Refining and Marketing (Sub),a wholly owned subsidiary of Clark USA, Inc. (Parent). After recovering workers’ compensation payments from Sub, plaintiff sued Parent.

Plaintiff’s theory of the case was that Parent’s business strategy at the time of the accident consisted of being in “survival mode” and adopting a policy of reducing spending to “minimum sustainable levels” until Parent’s cash reserve reached $200 million. Plaintiff alleged that implementing this strategy resulted in foreseeable reductions in safety at Sub, which reductions were a proximate cause of the accident. Parent’s defense was that it owed no duty to plaintiff’s decedent simply because it owned all the stock of Sub.

Justice Garman distinguished direct participant liability from piercing theories and noted that parent corporations owe no duties to third parties to ensure that subsidiaries act with due care. However, relying on inapposite federal and state cases, Justice Garman held that a parent may be liable as a direct participant where the parent specifically directs or authorizes the manner in which an activity of the subsidiary is undertaken, that direction or authorization surpasses the control exercised as a normal incident of ownership in disregard for the interests of the subsidiary, and the harm is sufficiently foreseeability.

Here, summary judgment for Parent was precluded because evidence suggested that Melnuk, Parent’s president and Sub’s CEO, might have planned the budget cuts in his capacity as Parent’s president, might have directed or authorized the manner in which those cuts were implemented knowing that safety at the refinery might be compromised, and that he did those things superseding the discretion and interest of Sub.

To the extent that this case combines Agency law with director/officer liability under the direct participation theory (e.g., Saltiel v. GSI Consultants, Inc., casebook page 307), it seems to me to be on solid ground. The court doesn’t talk about Agency, however, but it could readily be implied by any decent business entities prof. Further, if there’s really evidence here that Melnuk’s actions as Parent’s agent were intended to cause Sub to reduce safety (or that Melnuk should have known that they would have that effect) then liability is fine with me. What this case sounds like, though, is a claim for relief for malbudgeting. That is, it may well be that Melnuk, acting as agent for Parent, devised or required a budget for Sub that required cutbacks in many areas and that costs that do not directly constrict revenues or net profits, including safety costs, would be the most natural items to cut. In the absence of more, that does not seem to me to be appropriate facts on which to hold Parent (or Melnuk, for that matter) liable.

Nebraska Supreme Court on partnership buyout and partnership property

The Supreme Court of Nebraska has held that a partnership agreement’s buyout option is triggered by service of process of a lawsuit for dissolution rather than by the court’s judgment in that lawsuit. The supreme court also applied the presumptions in the UPA to determine whether two pieces of real estate were partnership property. In Mogensen v. Mogensen, three brothers formed a partnership to operate a family farm. After a falling out, Steven Morgensen sued for dissolution. The court entered summary judgment for the defendants on the ground that the partnership agreement provided an avenue for withdrawal and therefore the UPA’s provisions for dissolution were inapplicable. The partnership agreement permitted the other partners to purchase a withdrawing partner’s interest if they gave notice within 90 days of receiving notice of the intent to withdraw. About a month after the court’s judgment, Keith Morgensen gave notice of his intent to purchase Steven’s partnership interest. Steven refused. Keith brought suit for specific performance and Steven counterclaimed for declaratory relief as to whether two parcels were partnership property.

Justice Connolly held that the 90 day window began when Keith received service of process rather than when the court granted summary judgment. This holding was based on caselaw from other jurisdictions. The court determined that one of the disputed parcels was partnership property because it was purchased in part with partnership funds, but that the other disputed property was not partnership property because it was not acquired with partnership property. These holdings are quite straightforward but the discussions of the two parcels make a very nice contrast with one another. That part of the opinion would teach well because the facts are readily apprehended, the statutory provisions clear, and the application reasonable.

Delaware Court of Chancery on cancelling a shareholder meeting

The Delaware Court of Chancery has held that a new board chair has the power to rescind a prior chair’s valid calling of a special stockholder meeting. In Perlegos v. Atmel Corp., the plaintiff was chairman, president, and CEO of the defendant. Following an internal investigation, a special committee of the board resolved to terminate plaintiff for cause because he obtained personal travel at corporate expense. The special committee also requested plaintiff to resign from the board.

The committee emailed notice of Perlegos’ termination as president and CEO to his lawyer. A few hours later, plaintiff, as chairman of the board, called a special meeting of stockholders for the purpose of amoving the directors on the special committee. The next day, the board elected Sugishita as “non-executive chairman”, although it did not remove plaintiff as chairman. The board also authorized and directed Sugishita to rescind plaintiff’s call of the special meeting, which he did. Plaintiff brought suit against the company and board seeking, among other things, an order that the special meeting be held.

Vice Chancellor Noble, after a trial on the merits, held that the special meeting must be held. Although plaintiff had been terminated from employment earlier that day, he remained the chairman when he called the special meeting. He had the power to act because, under the company bylaws, the board, the chairman, or the president may call special meetings of stockholders. The Vice Chancellor rejected defendants’ argument that plaintiff’s motivation in calling the meeting was inequitable, although that surely was a close call. The Vice Chancellor ruled that electing Sugishita as non-executive chairman had the effect of removing plaintiff as chairman, even though the resolution did not explicitly remove plaintiff from that office. This is so because the company’s bylaws clearly anticipate only one chairman.

The Vice Chancellor then faced two other questions. First, whether a properly called stockholder meeting can be canceled and, second, whether the cancellation here was consistent with the duty of loyalty. As to the first question, Vice Chancellor Noble held, in essence, that a board chair can’t make a rock so heavy he or she can’t lift it. Thus, Sugishita had the power to rescind the meeting notice even in the absence of an explicit grant in the bylaws. This is surely consistent with Omnicare, which the Vice Chancellor cites.

On the second question, the Vice Chancellor pretty much held that Blasius, in its original incarnation, applied. As a fallback, he held that the defendants could not pass muster under Unocal, either. He did not acknowledge that Blasius has been subsumed under Unocal, in practical effect, at least since MM Companies, if not much earlier. Here, the compelling justification test applied because canceling the meeting had the effect of precluding a vote on replacing the defendants until the next annual meeting.

The Vice Chancellor didn’t buy defendants’ argument that the effect was postponing (permitted) rather than preventing (not permitted) a shareholder vote. I think the Vice Chancellor was incorrect in that holding. Regardless of whether the vote is one to amove directors at a special meeting or elect the board at an annual meeting, the stockholders will have an unfettered opportunity to vote on retaining the defendants as directors. The trigger is whether the defendants’ action would “interfere with or impede the effective exercise of” the franchise. In my view, the defendants’ actions would do neither.

In any event, whether the compelling justification test is considered part of Blasius alone or Blasius under Unocal, the defendants fail. The stated reasons for canceling the meeting were that the board had been elected only three months previously, the time and expense of the meeting would distract management, and the meeting could confuse stockholders and employees. A post-hoc reason was concern that amoving the directors would put the company’s NASDAQ listing in jeopardy. I think the Vice Chancellor was clearly right on this. None of those reasons is compelling justification.

Alternatively, the Vice Chancellor held that the defendants fail Unocal, as well. Although the opinion is not explicit, it seems likely that the defendants failed the second prong of the test. That is, they likely showed that they had reasonable grounds to perceive a danger to corporate policy and effectiveness but did not show that their response was reasonable in relation to the threat posed. More precisely, the Vice Chancellor held that the corporation could have implemented “a less preclusive and more reasoned response”. The word “preclusive” is, as the corporate cognoscenti know, a term of art. It’s one of the two ways to show that a response is “Draconian” and therefore impermissible. It’s less clear whether, if not Draconian, the response would be within the range of reasonableness, as required by Unitrin. “[M]ore reasoned” is not the same as outside the range of reasonableness.

The court is arguably right here, but I’m not completely convinced. The threat can be seen as punishing independent directors by removal because they properly performed a special committee function. That punishment is likely to have a chilling effect on board members in this corporation. The response is neither coercive nor preclusive and certainly reasonable. Thus I think the decision to rescind the call was proper.

Francis Pileggi has a very good post (here) on this case.

Maryland Court of Appeals on duty of loyalty when director sues corporation

The Court of Appeals of Maryland has held that a director did not breach his fiduciary duty when he remained silent after he knew that the corporation had no actual knowledge that he had taken a default judgment against the corporation and attached the corporation’s bank account. In Storetrax.com, Inc. v. Gurland, (watch oral argument here), Gurland was a board member and officer of Storetrax.com, Inc (Storetrax), a Delaware corporation. His employment was terminated, though he remained as a director. After a series of letters between the parties, Gurland filed an action for breach of contract. After filing, Gurland visited the corporate offices twice but did not mention the lawsuit. Service was effected on the corporation’s registered agent. Through a concatenation of errors by the registered agent and its independent contractor, neither notice of the lawsuit nor notice of default reached the corporation. Gurland took a default judgment and obtained a writ of attachment on the corporation’s bank account. When the corporation discovered the facts, it sought relief from the judgment over Gurland’s objection. The appellate court ordered the judgment vacated and a jury returned a $150,000 verdict for Gurland. Storetrax filed an action against Gurland alleging breach of fiduciary duties.

Judge Harnell held that directors are not prohibited from suing their corporations or from becoming creditors. Thus Gurland’s actions in filing suit, taking a default judgment, obtaining a writ of attachment, declining to relinquish the writ, and opposing Storetrax’s efforts to seek relief from the judgment did not violate his fiduciary duties. Storetrax’s principal argument was that Gurland breached his duties by remaining silent after it became apparent to him that Storetrax did not know of the lawsuit or default. Finding a complete absence of caselaw, Judge Harnell analogized the situation to director conflict of interest safe harbor statutes, such as DGCL §144. Thus he held that a director must notify his or her corporation of an intention to file a lawsuit against the corporation. This requirement appropriately balances the director’s right to pursue a claim against the corporation with the director’s fiduciary duty to act in the best interest of the corporation.

On these facts, Judge Harnell held that Gurland met his duties because the letters between the parties put Storetrax on notice that Gurland might sue and they set a clear timeline for filing an action. Further, it was clear that Storetrax anticipated and was preparing for litigation. The court noted that no evidence suggests that Gurland knew that the corporation had no actual knowledge of his lawsuit and default. Only circumstantial evidence, i.e. the corporation’s failing to file an answer, might have suggested to Gurland that Storetrax had no actual knowledge of his lawsuit.

The court’s analogy to CoI safe harbor statutes is obviously misplaced. Those statutes are non-exclusive safe harbors. That is, they provide one avenue by which directors can insulate self-dealing transactions from attack. Moreover, under common law as well as under the statutes, a self-dealing transaction can be approved, even in the absence of disclosure by the director, if the director can show entire fairness. Nothing in the court’s discussion suggests that any action other than disclosure to the corporation of concrete litigation plans, will suffice to meet the duty of loyalty.

I think this case is actually quite difficult. A director with a colorable claim against the corporation can surely act in his or her own interest in filing suit. In the vast majority of instances the director and corporation will have had preliminary discussions before litigation, but I don’t believe that actual knowledge by the corporation that the director has a colorable claim is a prerequisite to the director’s filing suit. The more difficult setting is, as here, where the corporation acts toward the dispute or litigation in a way that seems not to be in the range of rational responses. Does the director’s obligation to act in the corporation’s best interest include a duty to seek to have the corporation act rationally or at least to provide facts that the corporation either may not possess or of which it may not recognize the significance? In answering that question, does the director’s duty of care require him or her to obtain reasonably available facts surrounding the corporation’s non-rational behavior? My sense is that the conflict of interest results in the director being disabled from taking any action qua director apropos the litigation. That would preclude any investigation by the director as to the corporation’s actions and would also preclude the director from providing information to the corporation except qua litigant. Thus I would agree that Gurland did not violate his fiduciary duty but not because he sufficiently informed the corporation of his intentions.