Sitting on a board of directors today is a more serious undertaking than
ever before. The obligations, and potentially the liabilities, of directors have
been significantly heightened by corporate governance reforms under the
Sarbanes-Oxley Act of 2002, the rules of the stock exchanges and, perhaps now,
the evolution of Delaware's case law on directors' fiduciary duties. As a result
of the Delaware Chancery Court's recent decision in In re Emerging
Communications, Inc. Shareholders Litigation (Emerging
Communications).1 current and prospective directors would
be well-advised to consider not only their own qualifications, skills and time
commitments, but also the expertise of their colleagues around the board table.
Under the Sarbanes-Oxley Act, public companies must now disclose in their
annual reports on Form 10-K whether they have a "financial expert" on their
audit committee. The SEC's test is strict enough that even a highly competent
person with a financial background might fail to qualify. But aside from
qualification problems, directors may be reluctant to be singled out as an audit
committee's financial expert if the decision in Emerging Communications
is extended beyond the facts of that case.
Background Of The Emerging Communications Case
The case involved the privatization of ECM, a telephone company in the
U.S. Virgin Islands, by ECM's controlling shareholder, Jeffrey Prosser, who was
also ECM's chair and CEO. ECM's board of directors formed a special committee to
negotiate the merger on behalf of the minority shareholders. The special
committee recommended the merger, which the board approved at a price of $10.25
per share. The privatization was completed in October 1998. Shareholders sued
ECM and its board for breach of fiduciary duty and sought an appraisal of their
shares. Because of Prosser's conflict of interest, the business judgment rule
was inapplicable. Instead, the defendant directors had to prove that the
transaction satisfied Delaware's entire fairness test.
The Court appraised ECM's fair value at $38.05 per share and found that
the transaction was unfair to the minority shareholders. The Court held one
director, Salvatore Muoio, to a higher standard than the other directors because
he had specialized expertise as a former securities analyst with substantial
experience in the telecommunications industry. Other than Muoio, only two of
ECM's directors were held liable for breach of fiduciary duty: Prosser, who was
found by the Court to have had a conflict of interest and to have deliberately
breached his duty of loyalty; and Prosser's attorney, who was found by the Court
to have knowingly breached his duty of loyalty by advising both sides of the
transaction. The remaining directors were not found liable, even though they may
have breached their duty of care, because ECM's charter had an exculpatory
provision under Delaware law for such breaches.
Director With Financial Expertise Treated Differently
The Court held that Muoio was not entitled to rely on the fairness
opinion of the board's financial adviser because he had substantial industry
experience that was equivalent, if not superior, to the financial adviser's (a
well-known investment banking firm). While other ECM directors could plausibly
claim that they relied on the fairness opinion, the Court concluded that the
same claim by Muoio was implausible. The Court found that Muoio had one of two
possible mindsets: (i) he knew the merger was unfair to the minority, and
therefore acted wrongfully on purpose; or (ii) he had strong reason to believe
the merger was unfair, and therefore should not have approved it.
The Court did not affirmatively find that Muoio had acted wrongfully on
purpose, leaving it to apply a gross negligence standard to his conduct,
comparing his actions with what a reasonable person of his background and
experience would have done in the same circumstances. The gross negligence
standard was established in the seminal case of Smith v. Van
Gorkam.2 In that case, the Court held that gross
negligence is the correct standard to determine whether a director has violated
the duty of care. The Van Gorkam decision created a concern that
directors could face liability even when they acted in good faith, albeit
negligently. The exculpatory provision for breaches of the duty of care, which
the Delaware statute now permits to be included in a Delaware corporation's
charter, was a direct response to the Van Gorkam decision. However, the
statute does not permit a director to be shielded from liability if he or she
acts in bad faith or breaches the duty of loyalty. Therefore, the Delaware
statute makes a distinction between breaches of fiduciary duty involving bad
faith and breaches caused by negligence, even gross negligence. Negligence may
be excused under a company's charter, but bad faith is not permitted to be
excused.
Potential Implications Of The Case
Muoio's liability in the Emerging Communications case raises a
serious question about the extent of the liability of financial and other
experts sitting on boards of directors and board committees. In the SEC's rule
under the Sarbanes-Oxley Act, which requires public companies to disclose in
their annual reports whether they have a financial expert on their audit
committee, the SEC has attempted to provide comfort on the issue of experts'
liability. The rule contains a specific safe harbor for financial experts,
attempting to assure them that they are not subject to any liability, duties or
obligations greater than those of other directors (nor are the liabilities,
duties or obligations of the remainder of the board members supposed to be
diminished by the expert's presence). The safe harbor is meant to protect
directors from extra liability under the federal securities laws. However, it is
state law that imposes fiduciary duties upon directors, and state courts may not
necessarily agree that a person designated as a financial expert by an audit
committee does not have a higher level of fiduciary duty than other directors.
Delaware case law on fiduciary duties, as well as the case law of other
states, is not necessarily going to evolve consistently with the SEC's attempt
to create a safe harbor under the Sarbanes-Oxley Act. Although the safe harbor
may protect a director from liability under federal securities law, once he or
she is identified as a financial expert in a company's public filings, it may
prove to be difficult to avoid the results under state corporate law that the
Court reached in Emerging Communications.
It is difficult to predict whether the higher Delaware courts, or courts
in other jurisdictions, will uphold or follow Emerging Communications. At
present, the case is a vivid reminder to directors that when they rely on
fairness opinions or participate in board decisions generally, they must be
diligent in bringing their unique skills and experience to bear on all matters
of judgment. And they must make every effort to ensure that all their decisions
are made with the utmost good faith. It is hoped that the case will not create
an incentive for directors to look around the board table and assess the
expertise of their colleagues. After all, it is better for a director to sit on
a board of peers whose qualifications match or approximate one's own, than to be
the only director with a special set of skills that could ultimately lead to
heightened liability.
1 C.A. No. 16415 (Del. Ch. May 3, 2004, revised June 4,
2004)(Jacobs, V.C.).
2 488 A.2d 858 (Del.
1985).
Published January 1, 2005.
