Good News for Corporate Defendants (and for Everyone Who Works for a Corporation)

Effective November 1, 2006, the U.S. Sentencing Commission rescinded its prior policy authorizing (and encouraging) federal prosecutors to force corporations and other business entities to waive their attorney-client privilege and related protections in order to qualify as "cooperating" with government investigations. Let's not mince words. This was an unfair, unjust policy that forced corporations to throw their executives under the bus in the name of protecting shareholder value. Good riddance.

Trustee Liability in Conflicted Transaction

A decision last month from the Massachusetts Business Litigation Session offers some pretty clear statements about the procedural and substantive requirements for a trustee to follow in a conflicted transaction -- i.e., one where the trustee is standing on both sides of the deal -- here as buyer and seller. Murphy v. Murphy, Docket No. 2004-3937-BLS2, 2006 Mass. Super. Lexis 530 (Oct. 3, 2006) (Gants, J.).

The facts are pretty complicated as the plaintiff asserted a variety of claims arising out a series of stock redemptions in a closely held business. Most of the claims failed, but the Court held that the former trustee and her sister were liable for one of the challenged stock redemptions. The former trustee was also a director and officer of the company at the time of the redemption. Accordingly, in her role as trustee, her duty was to secure the highest price possible for the stock. In her role as company officer and director, her duty was to secure the lowest price. Rough spot to be in. See id. at *41.

There were a series of redemptions of a relatively long period of time, all based on an earlier valuation. The Court held that the trustee should have presented the proposed redemption to the disinterested trustee (who had pretty much abdicated his role). Having failed to do so, the trustee bore the burden to prove the transactions were fair to the beneficiaries.

The Court then held that the trustee had carried her burden with respect to all but the last redemption, by which time circumstances had changed sufficiently that the transaction was not fair.

The Court did not fix the damages, but held that they were equal to the difference between what was paid to the beneficiaries and what would have been fair at the time of the transaction (as opposed to a much later date championed by the plaintiff).

The Court instructed the parties to confer to see whether they could stipulate to a number, or return for a second phase of the trial.

Looks to me like the Court is hinting that the number is in the $700,000 range, and perhaps higher -- 5,402 shares were redeemed at $285 per share in the last redemption. In footnote 15, the Court notes that based upon only some of the applicable factors, the redemption price would have risen to "more than $400" per share.

Holiday Trip Down Memory Lane . . .

So during this holiday week I have not been working all that hard, which has been a nice change of pace. I was just looking back at some of my old blog entries to see where my thinking was when I started this thing -- over three years ago now -- compared to now, and tripped over the following, which I still think is one of my best ideas. So in the spirt of holiday giving, I'm going to re-post it. Happy holidays.

From September 2003:

The Dennis Kozlowski trial is underway and they've begun picking a jury. I heard on the news this morning that jurors were asked whether they could serve for 3 or 4 months. That's a long time to put your life on hold.Now, granted, this is a contender for trial of the century so far. The jurors will dine out on this one for a decade once it's over, but still, imagine that length of time in the jury box.And a trial that long isn't exactly rare. Imagine getting socked with the same length of service on some complicated patent dispute. Ouch.

Here's an idea that might raise an outcry. Trial lawyers should be told that they have a week to put on their case. The total trial will be two weeks. If they can't put on their case in that time, then they can only have a bench trial, unless they're willing to pay jurors real money to sit for all those months. So one side will agree to do it in a week. The side that won't agree has to pay the jurors. (If by some miracle the parties agree, then they can just split it.)

Under the current system, the jurors get some pittance that varies from jurisdiction to jurisdiction -- basically an amount that is supposed to cover lunch and parking and never quite does.

I'd make a party who wants an endless jury trial pay about $600 a week per juror. That's a pittance compared to what they'll spend on legal fees, and it will take the sting out of being banished to the jury box for months. It'll also shorten up many trials. Then what do we do with the party that said they could put their case on in a week?

Well, if the other side insists on taking three months, then they probably need some rebuttal time. I'd have to work on that piece, but maybe they get another free day per week for rebutttal (again, the party that makes the trial endless pays the jurors), and if they suddenly realize they need more time than that then they get the tab.

This won't work in criminal cases, to be sure, since most criminal defendants are already getting court appointed counsel, but I don't think there is any constitutional right to a four month trial. The courts can control their dockets in criminal cases too. Sure there will be problems, like a party who tries to chew up time during the presentation of the other party's case just to run up the tab. But I'm sure the judges can clamp down on that sort of conduct. It's an idea that needs some fleshing out, but it's got some appeal.

Should Partners Be Able to Waive or Modify Fiduciary Duties Between/Among Themselves?

There was a time once, not so very many years ago, when partnership law was pretty uniform nationwide. But in the last 20 odd years, the general partnership statutes and limited partnership statutes have begun to undergo some tinkering.

One issue that varies among the jurisdictions is whether partners should be permitted to waive or modify their fiduciary duties contractually. You can do that, for example, under Delaware Law.

The argument is heavily based on the extent to which you believe that business entities and the resulting rights and obligations should be a matter of contract. The essential contention in favor of allowing waiver or modification is that partners are entering into a contractually based venture and should be permitted to define their respective rights and obligations. This view is often called the "contractarian" position. The opposing view point is often (some what derogatively) refered to as the "paternalistic" view. "Traditionalist" is probably a less judgmental label. Traditionalists view the fiduciary duty as mandatory -- a necessity to prevent and remedy self dealing and abuse of trust.

I can't claim to have a fully formed view on this point. To me, it really hits the heart of the reason for having these duties. At this point, and while emphasizing that I am still working through my reasoning on the issue, I am inclined to side with the traditionalists. It seems to me that waivers and modifications have a way of finding their way into lawyers' form books and that they may readily be inflicted on clients without sufficient explanation of the consequences. I think such waivers or modifications are likely to have the greatest impact on the least sophisticated clients, and are likely to heavily favor the rascals of the world. So, I have more reading and thinking to do on this point, but that's where I am with it today.

Another Brief Off-Topic Rant, Along the Same Lines as My Last One -- Plagiarism is Wrong

I read this morning that sermons are now available for purchase on line, and that priests (and/or other religious leaders, I'm not good at the correct titles) are giving purchased sermons without attribution.

Maybe I'm missing something, but I am just awe struck that these religious leaders think this is okay. Now, I'm not much of a church goer, and indeed it has been many years since I have seen the inside of church other than for weddings and funerals. But I always understood that the sermon was written by the person giving it. Same thing at weddings and funerals. When the priest is doing a "reading," it is identified as a reading. When the sermon portion of the event is under way, it is understood that the priest wrote it.

So if you want to buy a sermon and give it, fair enough. But you have to give credit to the author. You have to tell the congregation: "Today's sermon is by the Reverend Horton Heat," or whoever it is that actually wrote it. Otherwise, you're implicitly lying to the entire congregation holding the piece out as your own. This is not really a legal issue, but it's a moral one -- so if you're a religious, and therefore moral, leader, I just don't understand how you can not attribute credit to the author of the sermon. Otherwise, in my book, it's called plagiarism.

Nuances of Exception to Bankruptcy Discharge for Defalcations by a Fiduciary

Worthwhile reading from the Bankruptcy Court for the District of Massachusetts: Romano v. Farley, 2006 Bankr. LEXIS 2953 (Bankr. D. Mass. Oct. 30, 2006) (Feeney, J.).

The case includes a long factual history, but the gist boils down to a dispute between shareholders in a closely held company that failed. The original 100% shareholder had a long standing practice of paying personal expenses from the company checkbook. The plaintiff bought a 50% interest in the company, and knew about the practice, which continued right to the end.

Plaintiff brought an action for breach of fiduciary duty, fraud and embezzlement, and asked the court to declare the debts non dischargeable.

The court found that the defendant was liable to the company for taking excessive compensation (a species of breach of fiduciary duty) and embezzlement, but declined to hold the debts non dischargeable.

There is a lot to this case, but the most interesting discussion for me was the court's analysis of who qualifies as a fiduciary under 11 U.S.C. sec. 523(a)(4), which is the provision that would except a debt from discharge if it is predicated on defalcation by a fiduciary.

Under Section 523, "fiduciary" is construed narrowly to apply only to "express or technical trusts," and not to "trusts that are implied in law as a remedy." Farley, 2006 Bankr. LEXIS 2953, at *54. Partners qualify. Id. at *55, 61. But there is a split in authority regarding whether shareholders in a closely held corporation qualify. Id. at 61.

There frankly is a lot of glib authority out there analogizing shareholders in a closely held corporation to partners. There is an element of truth in this comparison to be sure. In both cases, the people involved are joint venturers pursuing a common business goal and relying on each other's good faith, effort and integrity. But there is no doubt that a corporation is a much more formal entity, with chains of command and assigned responsibilities for management and operation. In contrast, a partnership can spring up without any formal agreement other than "let's start a business." So careful analysis in applying the analogy is nice to see.

The court engages in an analysis of the duties from the defendants to the plaintiff and distinguishes it from the duty to the company (a distinction that is also sometimes lost in the hubbub). Bottom line, the court declined to find a section 523 fiduciary duty from the defendants to the plaintiff under the circumstances. Id. at 64.

Corporate Executive Found Liable for Insider Trading Ordered to Repay Company for Advanced Legal Fees

I picked this one up reading the Boston Globe this morning. I think this case demonstrates the disconnect you can get between what a court opinion says and what a reporter claims it says. When you read the Globe article, you come away with the impression that the defendant here was blatantly taken advantage of by the Company. The article is available, at least for the time being, here.

The case is Happ v. Corning, Inc., Appeal No. 06-1324, 2006 U.S. App. LEXIS 26027 (1st Cir. October 20, 2006).

You can read the opinion itself by going to the U.S. Court of Appeals for the First Circuit web site, and clicking through to the opinions section. I couldn't find a way to link directly to the opinion there.

The crux of the issue is whether the Company took advantage of its executive by refusing to advance legal fees when he was accused of insider trading, and extracting a contractual undertaking to repay upon specified findings in the underlying action.

When you read the opinion, the court's reasoning is more nuanced than the article would have you believe. Under the Delaware indeminification statute, which would have governed in the absence of the written agreement, may well have lead to the same result -- its definition of when indemnification is permissible and when not is ambiguous and the written agreement was a negotiated definition. The jury's findings in the underlying matter may well have obligated the executive to repay even if the agreement had never been signed. So, the court's rejection of the executive's contention that the agreement should not be enforced because he signed it under "duress" is not out in left field.

On the other hand, this is not heartwarming stuff if you are a corporate executive, and you have to wonder a bit about the reasoning of the corporate poobahs who turned on their own when the skies grew dark. It may be that they had good reason, but it seems to me that part of the charter between a company and its directors and officers ought to be that the company stands with you unless/until it's demonstrated that you betrayed the company somehow. Lots of accusations get thrown around in this world of ours, and "there but for the grace" and all that. I think you see way too much corporate willingness to throw their former directors and officers under the bus these days, particularly in the context of government investigations when the government plays hard ball. I have not heard about much trouble recruiting officers despite this scary climate (I guess the money is long enough to take the risk), but I have heard anecdotal evidence of diminished enthusiasm to sit on corporate boards. Hard to blame people for not wanting to sign on for a risk if they can't even count on the company to defend them at the accusation stage. Let's never forget that accusations can be false.

Caremark Claims

Corporate directors have a clear duty to keep themselves informed about company operations and to oversee and guide those operations. But they do not have a duty to "install and operate a corporate system of espionage to ferret out wrongdoing they have no reason to suspect exists." Stone v. Ritter, Del. Supreme Court, Appeal No. 93, 2006 (Nov. 6, 2006) (quoting Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963). It is not wrongful for a corporate director to assume the company's employees are honest, unless given cause to believe otherwise. In re Caremark Int'l Derivative Litig., 698 A.2d 959, 970 (Del. 1996). Accordingly, the Caremark decision stated a standard, reiterated in the Stone decision today, that where a claim is made that a director should be held liable for failing to be aware of liability creating activities by others at the company, the plaintiff must allege and prove a "sustained or systematic failure . . . to exercise oversight." The Stone decision affirmed the Chancery Court's dismissal of the complaint based on the Caremark standard.

A Duty of Confidentiality

Some thoughts on a Friday afternoon regarding the contours of a fiduciary duty. As a general proposition, a fiduciary duty includes a duty of confidentiality. See, e.g., Dirks v. SEC, 463 U.S. 646, 661 n.20 (1983) (quoting Loss on Securities Regulation). For example, if you are on the board of directors of a corporation, you will be well advised to keep the company's confidential information confidential. If it's not already public information, you do not want to take it upon yourself to make it so, or even to disclose it to a friend in idle chit chat. This maxim, of course, is particuarly important if the company is publicly traded. In that context, violation of a duty of confidentiality can have nasty consequences, including allegations of insider trading.