M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Thursday, March 7, 2013

Puda, Caremark, and Director Engagement

Many times my students will ask me, well how bad does director inattentiveness to board duties have to be win on a care claim much less a Caremark claim? There are, of course, multiple levels of answers to that question, but the simplest is, "pretty bad".  Now we have a stark example of some facts from a recent Delaware transcript ruling that might get you there - In re Puda Coal (Puda_Coal Transcript_Ruling).  In Puda, we have a Chinese coal company incorporate in Delaware and trading on US markets with five directors - 2 inside Chinese directors and 3 outside American directors.  OK, so it turns out that the 2 inside directors stole all the corporate assets and appropriated them all for themselves.  For two years, the outside directors had no idea.   They relied on reports from the CEO and sat in the US all the while assuming there were corporate assets somewhere in China.  So, the directors, including the outside directors all get sued.  OK, so far so good. 

During the course of an internal investigation, all the outside directors realizes what had been going on and quit in response, leaving the inside directors in charge of their own malfeseance.  Then outside directors turn up in Chancellor Strine's court as defendants seeking to have the derivative suits dismissed for because demand was not excused.  Theory: a majority of the directors were independnet and could well have sought to prosecute this case, had it been presented to them.  That didn't go well for them:

A Delaware lawyer is telling me, I think, if I dismiss the case on demand excusal grounds, I dismissed it because control of the lawsuit belongs to the company,  therefore the decision to sue the insiders who took the assets belongs to the company. The company might conclude that it's perfectly okay to take the assets, or there's a cost benefit analysis of suing and it's just not worth it. I can't take on to myself in that situation. I can't enter a judgment at the instance of derivative plaintiffs because control of a lawsuit belongs to the board, which is now controlled by the guy who your clients suspect stole the assets out from under them.

What stuck in Strine's craw, I think, was the fact that when the outside directors who were a majority realized that the all the assets of the corporation had been sold out from under them that their response was not to sue the bad directors and seek to defend the corporation, but to resign and walk away: 

When, as a matter of undisputed reality, when they were faced with knowing in their view that there had been the most extreme sort of fiduciary violation you could imagine, rather than have the company sue, they quit, then come into court and seek to use 23.1 and, frankly, disable the derivative plaintiffs from even going after the bad guys. When I mean bad guys, I'm using your client's own view of these people. I'm trying to understand how my state -- if I were to embrace this -- my state's corporate law would not be justly subject to ridicule.

And that's when the hearing starts to go really bad for the outside directors. Turns out only one of the outside directors speaks Chinese.  Whoops.  (Note to self, pick up a Rosetta Stone before taking that directorship in the Mongolian company).  Strine then let them have it with this: 

I think those of us who actually -- judges in Delaware who participate in corporate law in Delaware take legitimate umbrage when folks say that we don't hold managers accountable for breaches of fiduciary duty in Delaware. I find that claim to be astonishingly outdated and simple-minded, when any review of our corporate law will see -- just out of our statutory corporate law will say that is, frankly, much more pro stockholder and more balanced than any of our other states, most of which have stronger insulations against director liability, many of which allow directors in the context of takeovers to use takeover defenses not permissible in Delaware, and when the major controversies that have come out of Delaware over the last 30 years, some of them have been about things that are anti-stockholder. Many of them are cases like Van Gorkom, Omnicare, Quickturn. Guys like me, El Paso, Southern Peru, Loral, where we've held people accountable in big ways for things. And we take seriously in the derivative suit contest that, frankly, you shouldn't lightly take away from the board of directors the ability to control a lawsuit. But to use doctrinal law in some sort of gotcha way is just not appropriate

Now, he's just venting; he's right, but he's just venting.  So by now it's pretty obvious that the defendants made an error is seeking to dismissal on failure to make demand.  Then Strine turned to the question of whether a 12(b)(6) motion can survive.  Sorry, it's not going to get any better for these defendants.  But here, Strine lays out some minimum standards for independent directors of Delaware corporations headquartered abroad, and it's pretty sensible:

Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors. I'm not mixing up care in the sense of negligence with loyalty here, in the sense of your duty of loyalty. I'm talking about the loyalty issue of understanding that if the assets are in Russia, if they're in Nigeria, if they're in the Middle East, if they're in China, that you're not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won't cut it. That there will be special challenges that deal with linguistic, cultural and others in terms of the effort that you have to put in to discharge your duty of loyalty. There's no such thing as being a dummy director in Delaware, a shill, someone who just puts themselves up and represents to the investing public that they're a monitor. Because the only reason to have independent directors -- remember, you don't pick them for their industry expertise. You pick them because of their independence and their ability to monitor the people who are managing the company. And a lot of life – I would not serve on -- if I were in the private sector -- not that anybody would want me -- but there are a lot of companies on boards I would not serve because the industry's too complex. So if I can't understand how the company makes money, that's a danger. If it's a situation where, frankly, all the flow of information is in the language that I don't understand, in a culture where there's, frankly, not legal strictures or structures or ethical mores yet that may be advanced to the level where I'm comfortable? It would be very difficult if I didn't know the language, the tools. You better be careful there. You have a duty to think. You can't just go on this and act like this was an S&L regulated by the federal government in Iowa and you live in Iowa.

So on Caremark alone, I have no problem saying that it passes muster under 12(b)(6). 

This is a case to watch as it winds its way through the courts.  It may well start making its way into case books soon.







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