Confronting the Problem of Fraud on the Board

Joel Friedlander is a partner at Friedlander & Gorris, P.A and Lecturer on Law at Harvard Law School. This post is based on Professor Friedlander’s recent paper, and is part of the Delaware law series; links to other posts in the series are available here.

Recent precedents make it difficult to challenge transactions approved by a board of directors and a stockholder majority. When should such cases be filed, proceed beyond the pleading stage, and prevail? My answer is that litigation rules should remedy and deter tortious misconduct that corrupts board decision-making. Commission of fraud on the board is an omnipresent temptation for self-interested controllers, activist stockholders, officers, financial advisors, and their legal counsel. Fraud can be used to put a company in play, steer a sale process toward a favored bidder, suppress the sale price to a controller, or make a favored bid look more attractive. Successful stockholder actions in recent decades can be reinterpreted as occasions when courts made tentative or final determinations that a board decision was corrupted by fraud or related tortious misconduct. Going forward, problematic legal rules bearing on fraud on the board need to be confronted. Stockholder plaintiffs should be permitted to inspect contemporaneously created electronic books and records to test whether the publicly disclosed narrative of a sale process conceals undisclosed fraud on a board. A non-fiduciary’s corruption of a board’s decision-making processes should be considered a free-standing tort, without the need to establish that duped fiduciaries breached their fiduciary duties. Recognizing a tort of fraud on the board would be consistent with tort principles and a sound stockholder litigation regime.

Corporate law litigation has entered a new phase. Decades-old canonical cases—Weinberger, Unocal, Revlon, Blasius, and Unitrin—and the associated procedural weapons of enhanced judicial scrutiny and expedited discovery no longer carry much salience to a corporate law litigator. Under the current dispensation, and the new leading cases of Synthes, MFW, C&J, Corwin, Trulia, and Dell, the default litigation landscape for a variety of transaction structures is judicial consideration of defendant-drafted public filings at the pleading stage, no discovery, dismissal in the event of an affirmative stockholder vote, and a worse outcome if pursuing appraisal.

The rationale for the new litigation regime is that managerial preference for a particular form of change-of-control transaction, or no transaction at all, is an obsolete problem. Stockholder activism is rampant, CEO and director compensation is tied to the stock price, and stockholder value maximization is a deeply embedded norm. No longer is the central question in corporate law how to adjudicate between the presumptive authority of a board of directors and a temporary stockholder majority. Cases are not filed by hostile bidders claiming to speak for the best interests of stockholders. There are almost no occasions to refine levels of judicial scrutiny for board decisions that alter a battle for corporate control. Virtually all deal litigation this century challenged transactions approved by a unanimous board of directors and supported by the great majority of stockholders.

The current litigation environment reflects an unchallenged consensus about the parameters of judicial review. A board of directors consisting almost exclusively of independent outsiders should have broad discretion when overseeing a sale process, or to reject a sale process. Decisions of disinterested and independent directors should not be second-guessed as unreasonable. A fully informed stockholder majority, consisting largely of sophisticated institutions, approves a third-party transaction conclusively. As stated in Corwin, “the core rationale of the business judgment rule … is that judges are poorly positioned to evaluate the wisdom of business decisions and there is little utility to having them second-guess the determination of impartial decision-makers with more information (in the case of directors) or an actual economic stake in the outcome (in the case of informed, disinterested stockholders).” [1]

These premises raise the question of what proper role exists for stockholder deal litigation. For transaction structures that implicate irrebuttable business judgment rule review, when should stockholder litigation be filed, proceed beyond the pleading stage, and prevail on the merits? What cases and doctrines should retain their vitality and be further developed?

My short answer is that stockholder litigation, properly administered, should remedy and deter tortious misconduct that corrupts board decision-making. Such tortious misconduct can take several forms. As Vice Chancellor Laster recently observed, “coercion, the misuse of confidential information, secret conflicts, or fraud” can lead to liability and damages, notwithstanding negotiation of a fair price. [2] In this essay I use the shorthand descriptor “fraud on the board.”

If not detected and disclosed while a deal is pending, fraud on the board becomes a fraud on the stockholders. Deference to the decision-making of independent directors and sophisticated stockholders necessarily presumes the absence of fraud. Yet, commission of fraud on the board is an omnipresent temptation for self-interested controllers, activist stockholder/directors, officers, financial advisors, and their legal counsel. Fraud can be used to put a company in play, steer a sale process toward a favored bidder, suppress the sale price to a controller, or make a favored bid look more attractive. In notable cases, fraud on the board has been revealed. When discovered, fraud on the board is not countenanced.

My thesis is that corporate law governing stockholder litigation should be focused on deterring and redressing fraud on the board. Embedded within that thesis are two propositions.

First, fraud on the board is an enduring and central problem for corporate governance. It has not been eradicated by evolution in the market for corporate control. I argue that the presence of fraud on the board lies at the heart of the most meritorious breach of fiduciary duty cases adjudicated in recent decades. Well-pled allegations of fraud on the board are also central to significant settled cases and pending cases. Corporate law doctrine is not articulated in these terms, but standards of enhanced scrutiny can be reinterpreted as determinations of when it is appropriate to inquire into whether a board decision was corrupted by fraud or related tortious misconduct. Put differently, I wonder whether any board decision would be invalidated as unreasonable, unfair, disloyal, or the product of bad faith absent some element of fraud or coercion. [3]

Second, I argue that problematic aspects of legal rules bearing on fraud on the board need to be confronted. Two legal reforms would aid judicial inquiry into, and redress for, fraud on the board.

Building on a prior article, I discuss what I refer to as the “El Paso problem.” [4] The El Paso problem is that MFW, Synthes, C&J, Corwin, Trulia, and Dell operate in combination to diminish the opportunities and incentives that existed when El Paso was litigated for contingently compensated stockholder plaintiffs’ counsel to discover and establish fraud on the board. A proposed solution has evolved in response to Corwin. Stockholder plaintiffs now seek to inspect corporate books and records underlying proxy disclosures for the purpose of testing whether a stockholder vote was fully informed. Nascent case law supports this innovative application of Section 220 of the Delaware General Corporation Law. This development is vital to the integrity of the current stockholder litigation regime. For it to be effective, use of Section 220 requires access to contemporaneously created electronic records. Section 220 should also be amended to allow former stockholders to file suit post-merger for inspection of books and records regarding the merger.

I also discuss what I refer to as the “TIBCO problem.” [5] As a matter of substantive law, as currently enunciated in TIBCO and other cases, a third-party’s duping of an innocent (or merely negligent) board of directors may present a wrong without a remedy.

Fraud on a board, if committed by a fiduciary, is a breach of the duty of loyalty. If committed by a non-fiduciary in league with a fiduciary, such tortious misconduct is aiding and abetting a breach of fiduciary duty. But what if a non-fiduciary intentionally dupes an innocent board of directors into making a value-destroying decision?

Under current law, there is no extra-contractual stockholder claim against the non-fiduciary absent a finding that the board breached its duty of care. Establishing a breach of the duty of care is no small feat, creating a gap in the law that could allow a financial advisor to escape penalty for having duped a board of directors for self-interested purposes. Misconduct by a financial advisor in connection with the sale of a corporation may only give rise to a breach of contract claim by the client corporation—a claim that will not be enforced by the acquirer who benefited at the expense of the selling corporation’s former stockholders.

This gap in the law has been hidden by the legal fiction that duped boards of directors breached their duty of care. To close the gap when the legal fiction is untenable, I advocate a new legal rule. A non-fiduciary’s corruption of a board’s decision-making processes should be considered a free-standing tort, without the need to establish a breach of fiduciary duty by the board. Recognizing such a tort would be consistent with tort principles and a sound stockholder litigation regime.

The complete paper is available here.

Endnotes

1Corwin v. KKR Financial Holdings LLC, 125 A.3d 304, 313-14 (Del. 2015).(go back)

2ACP Master, Ltd. v. Sprint Corp., 2017 WL 3421142, at *19 (Del. Ch. July 21, 2017, corrected Aug. 8, 2017), aff’d, 184 A.3d 1291 (Del. 2018) (Table).(go back)

3Two clarifications to this general statement come to mind. First, elements of fraud and coercion are present when a board or special committee is populated with directors who are denominated as “independent” but lack disinterest or independence. Second, a close cousin of coercion is when directors of a controlled company operate “in the altered state of a controlled mindset.” In re Southern Peru Corp. S’holder Deriv. Litig., 52 A.3d 761, 802 (Del. Ch. 2011), aff’d sub nom., Americas Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012).(go back)

4Joel E. Friedlander, Vindicating the Duty of Loyalty: Using Data Points of Successful Stockholder Litigation As a Tool for Reform, 72(3) Bus. Law. 623, 642-48 (Summer 2017) (discussing evolutions in corporate law since In re El Paso Corp. S’holder Litig., 41 A.3d 432 (Del. Ch. 2012).(go back)

5See In re TIBCO Software Inc. S’holders Litig., 2015 WL 6155894l (Del. Ch. Oct. 20, 2015).(go back)

Both comments and trackbacks are currently closed.
  • Subscribe or Follow

  • Supported By:

  • Program on Corporate Governance Advisory Board

  • Programs Faculty & Senior Fellows