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Are Board Members Fully Protected?
July 6, 2022
Are board members fully protected against officer and director liability claims if they rely on management and the company’s professional advisors in making key decisions? Maybe not.
In evaluating transactions outside the ordinary course that will materially change a company’s balance sheet or capital structure, boards must be more diligent than simply accepting the judgment of management.
Subsections (e) and (f) of § 8.30 of the Model Business Corporation Act say: “In discharging board or board committee duties, a director who does not have knowledge is entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, prepared or presented by any of the persons specified in subsection (f).”
Subsection (f)(1) specifies officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the functions performed or the information, opinions, reports or statements provided. Subsection (f)(2) adds: “[L]egal counsel, public accountants, or other persons retained by the corporation as to matters involving skills or expertise the director reasonably believes are matters within the particular person’s professional or expert competence, or as to which the particular person merits confidence.” And then subsection (f)(3) says that a board member may rely on: “[A] board committee of which the director is not a member if the director reasonably believes the committee merits confidence.”
However, there are several limitations in the Act. The director:
- Has to actually rely on the information;
- Cannot rely on the information if on notice that reliance is unwarranted;
- Must have some reason to believe that the information being provided is pertinent and relevant;
- Must have cause to believe that the information relied upon is within the expertise of the person providing it;
- Cannot rely on persons who have a financial interest in the transaction;
- Cannot rely on expert advice if it is clearly inconsistent with other information provided;
- Must question the conclusion of a report if the circumstances indicate that it is not well-founded.
Under Delaware law, the reliance statute states that members of the board of directors shall, in the performance of duties, be “fully protected in relying” upon experts. However, are they really fully protected? Now comes the “but. . . . ” In a footnote to its decision in In re Rural Metro Corporation Stockholders Litigation, March 7, 2014, the Delaware Court of Chancery touched on what it means for directors to be “fully protected” when they rely on information, opinions, reports or statements provided to them. Section 141(e) was not at issue in the case. But, in its analysis, the Court referred to it in a footnote, as follows: “Along similar lines, if the directors followed a process or reached a result falling outside the range of reasonableness, but did so in reliance on the advice of experts, they could be found to have breached their fiduciary duties under the applicable standard of review and yet be ‘fully protected’ against liability under Section 141 of the DGCL.”
Even conscientious directors may be deemed to have breached their fiduciary duty by following advice received from the expert. The lesson learned is that when certain matters come before a board, they should cause board members to be inquisitive. Some examples are transactions, proceeds of which will be used in whole or in part to make payments to insiders or related parties; transactions where the company’s capital structure will be materially changed; a transaction whereby creditors of the old company will carry over to the new company; when the company is financially distressed; and where significant shareholders or members of management may benefit from the transaction.
With respect to material, out-of-the-ordinary course transactions, it is not a two-party discussion between management and the board. It should be a three-party discussion between the board, management and the company’s professional advisors in order to demonstrate that board members made the right inquiries of all the right people to determine the right questions to be asked, and validated and understood the answers.
Not having financial liability is good, but a finding that the director breached his fiduciary duties can cause reputational damage. You cannot be too cautious.
Kenneth A. Rosen is Of Counsel and Chair Emeritus, Bankruptcy & Restructuring Department, Lowenstein Sandler. He advises on restructuring solutions, including Chapter 11 reorganizations, out-of-court workouts, financial restructurings and litigation.
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