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Should Directors Sue Their Company for Its Misdeeds?

 Authored by Edward M. McNally
This article was originally published in the Delaware Business Court Insider May 8, 2013

What should directors do when their company ignores their efforts to end corporate mismanagement? Until recently, this question rarely came up. Rogue companies are rare in the sense of openly refusing to comply with the law. Directors almost always were able to obtain corrective action when violations of the law came to light. But what if those directors were not able to cure serious management problems? What should they do?

This is not just a hypothetical question. In just the last three months, two Delaware Court of Chancery decisions suggested that directors who resigned in protest over the failure to take corrective action at their companies might well still be held liable for corporate wrongdoing. Their resignation did not immunize them. That is no big surprise. But what was a surprise was the court's questioning of whether the very act of resigning was itself a dereliction of the directors' duty to stockholders and if it might make them liable for wrongdoing that occurred even after they resigned.

Both those decisions did involve very unusual facts. For example, the April 25 decision in Rich v. Chong, Del. Ch. C.A. 7616-VCG, dealt with a corporation's refusal to pay for an investigation of obvious illegal conduct or to follow up to prevent similar conduct from reoccurring. The corporate entity, Fuqi International Inc., had refused to hold a stockholders' meeting for years, despite a court order to do so, and had failed to prove it had recovered $120 million in cash improperly transferred to a third party. That sort of recurring conduct might well have led to government intervention here in the United States had the company's assets not been located only in China.

It is wrong to suggest this sort of persistent failure to obey the law is confined to Chinese-based companies. Similar patterns of continuing bad conduct have been found to exist in U.S.-based companies as well. Several recent decisions have upheld continuing derivative litigation that alleged a conscious failure to govern properly by corporate directors. Such claims, known in Delaware as Caremark cases, may be difficult to win, but they continue to be filed with detailed factual allegations that suggest they have some merit.

So then what should a director do if she believes her corporation's management has or still is acting improperly and will not stop despite her demands that it do so? Just quietly resigning is not enough, particularly if the bad governance is ongoing. After all, just resigning does not inform the stockholders of the harm to their interests caused by bad conduct. It does not seem too much to ask of a fiduciary that she warn her wards that they are being harmed.

There are at least three steps the director might take after her attempts to stop bad conduct are unsuccessful. Each has its own pitfalls, however. The law in this area is still undeveloped. That makes the consequences of these choices hard to predict. Here are the choices and what to consider.

First, a director may make a "noisy withdraw" when she resigns. By announcing why she is resigning, she will at least warn stockholders they need to consider what is going on with their investment. It can then be argued that should transfer to the stockholders the obligation to protect themselves. This course of action does not correct past harm to the corporation. The departing director may then still be charged with responsibility for the harm that occurred on her watch. Moreover, it is not clear how effective a noisy withdrawal really will be, particularly if the corporation refuses to file any public statement to notify stockholders whose identities may be unknown to the director.

Another alternative may be for the director to pursue legal action against those corporate officers and even her fellow directors who fail to do their duty to the corporation. After all, we would expect a trustee to file suit against anyone who would harm the trust's assets. Why should a director not have that same duty? Yet such suits by a current director are very rare. That is not just because such litigation would be unpleasant. Litigation is expensive and, as in the case of the two recent Court of Chancery decisions that criticized directors for inaction, the defendants may not be able to pay any recovery. It is not at all clear that a suit by a director is covered by D&O insurance. Insurance policies often exclude coverage of "insured versus insured" litigation, for example. Hence, the plaintiff-director may find herself much poorer for her efforts.

A third choice for the director may be to support action filed by entrepreneurial plaintiffs' law firms. So long as the director does not initiate the litigation, her support may not trigger the "insured versus insured" clause of a D&O policy. If she can prove that she resisted the wrongful conduct after she knew about it, she should be able to defend against claims against her. A smart plaintiffs lawyer would then welcome that director's support in the litigation. He gains insider knowledge and gives up nothing by way of forgoing a claim against the cooperating director that is not worth much anyway.

I am aware that joining with the plaintiffs somehow seems unsavory, like deserting to the enemy. That reaction is unjustified. The director's duty is to the corporation and its stockholders, not to her former fellow directors or the corporate officers who failed to do their own duty to the corporation. This point was made by Chancellor Leo E. Strine Jr. in In re Puda Coal Stockholders Litigation, C.A. No. 6476-CS (Feb. 6, 2013), where he noted that the directors who had resigned might have been better to join with the plaintiffs in the litigation.

The director who finds herself unable to get corrective action when faced with bad management is in a difficult position. Is it better to stay to continue the fight for what is right, to resign in noisy protest, or even to join with stockholder-plaintiffs in litigation? While the right choice will depend on the particular circumstances, it does seem clear that a silent withdrawal is not enough in many cases.

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