Court of Chancery Re-Affirms that Director-Designating Investor is Entitled to Privileged Communications from Company Counsel in Appraisal Litigation

An employee, agent or principal of an investor is often designated to serve on a company’s board of directors when that company receives an investment or acquires the investor. That board member then becomes privy to legal advice the company receives from its counsel. If the director leaves the board he or she is no longer within the circle of confidentiality that entitles the director to have access to the company’s future privileged communications. What happens however when there is a cash out merger, the investor seeks appraisal and then seeks privileged communications its designee received while on the board related to the transaction that spawned the appraisal action? In Hyde Park Venture Partners Fund III v. Fairxchange, C. A. No. 2022-0344-JTL (Del. Ch. March 9, 2023) the Delaware Court of Chancery reaffirmed the joint client concept of corporate privilege and held that the company could not assert privilege against a former director or his designating investor except as to a books and records demand in which the company and the director were contemporaneously adverse.

Background

The plaintiff, a venture capital firm, invested in a Delaware corporation and acquired the right to designate a person to serve on the company’s board of directors. While so serving, the designee received privileged communications and other information that he presumptively shared with his designating investor. Later the director disagreed with the other members of the board as to whether the company should accept a merger proposal, preferring that the company retain a financial advisor to provide valuation advice and to assist in pursuing financing. When he disagreed with the rest of the board as it considered the merger proposal, he made a demand for books and records as a director. Thereafter, other stockholders acted by written consent to remove him as a director. The merger closed and the designating investor pursued an appraisal action. In the appraisal litigation the company’s successor in the merger asserted the attorney-client privilege to withhold documents reflecting privileged communications while the director had been on the board. The designating investor moved to compel as to all documents so withheld except for those relating to the former director’s books and records claim as to which both parties agreed the company and the designated director were adverse.

Court Adheres to Delaware’s Joint Client Approach to Corporate Privilege

In a thoughtful and scholarly opinion, the Court of Chancery traced the history of Delaware’s treatment of a board as a joint client of company or board counsel. This means that the company can have no expectation of confidentiality vis-à-vis directors on communications to and from counsel and the board. For that reason, the factual predicate of an expectation of confidentiality necessary to assert the privilege against a director does not exist. Three exceptions could alter that result: a contractual agreement concerning confidentiality, the company acting to create a special committee of the board from which the director is excluded, or the existence of legal adversity about which the company had put the director on notice. Since none of those exceptions existed in this case, except as to the director’s assertion of a books and records demand under Section 220(d) of the Delaware General Corporation Law (DGCL), the court granted the investor’s motion to compel except as to communications involving the books and records demand.

Court of Chancery Finds Privilege Unavailable Against the Investor as Well as Its Director Designee

Although there had been precedent and commentary suggesting that while a director is within the circle of confidentiality for board advice, the designating investor is not, the court re-affirmed that this is not a realistic proposition. That is because “a human has only one brain.” As the court stated, “Many investors appoint director representatives to monitor corporate performance—think of controlling stockholders, venture capital firms, and private equity firms—and information sharing is part of that process … The bottom line for the attorney-client privilege is that under the joint client approach, the investor presumptively joins the director within the circle of confidentiality, and the corporation cannot invoke privilege against the investor for materials created during the director’s tenure.” The court therefore rejected the company’s attempt to assert privilege because the plaintiff was the designating investor instead of the board designee.

Court Rejects Company’s Attempt to Rely on Section 220(d) Case Law to Uphold Its Privilege Assertion

Under Section 220(d) of the DGCL, a director has a right to virtually unfettered access to company information related to his or her service as a director. The right exists only for so long as a person is actually a director. The court re-affirmed that to assert privilege because the investor’s designee was not a director at the time of the discovery demand (and therefore outside the circle of confidentiality at that time) would conflate improperly a plaintiff’s right to discovery under Rule 26 of the Court of Chancery Rules with a director’s rights to information under the DGCL. The issue in litigation is whether the director was within the circle of confidentiality when privileged communications relevant to the litigation occurred. Moreover, under well-settled law, a former joint client cannot assert a privilege against another joint client in an action between or among the joint clients. As the court stated, “Under the joint client approach, confidentiality and privilege do not spring into being when the director’s tenure ends.”

Lessons Learned

A Delaware corporation’s ability to assert privilege in litigation to avoid disclosure to a former director for relevant communications that occurred while the person served as a director likely will fail unless the communication was subject to a contractual agreement, the corporation had created a special committee from which the director was excluded or the corporation had put the director on notice of legal adversity. If none of these exceptions applies, a Delaware corporation cannot expect to assert the attorney-client privilege to withhold relevant documents from a litigant generated when its designee had served on the corporation’s board.

Delaware Business Court Insider | April 12, 2023