Business Court Blockbuster: If You Only Read One Corporate Governance Case This Year, Make It This One

I'm not sure we've ever had the opportunity to describe a Business Court opinion as "epic" before, but here we are.  On Friday, in State v. Custard, the Court delivered a 70-page, 4-appendix opinion that's the corporate governance equivalent of The Ten Commandments or Ben-HurIn addition to a thorough discussion of directors' duties under North Carolina and Delaware law, the opinion answers four previously unanswered questions posed in the Robinson on North Carolina Corporation Law treatise that occupies a prominent shelf in every North Carolina business lawyer's library.

Custard was a breach of fiduciary duty case brought by the Commissioner of Insurance as the liquidator of Commercial Casualty Insurance Company of North Carolina ("CCIC") against three directors of CCIC.  To make a long story short, CCIC focused on "artisan" liability insurance policies for small contractors and tradesmen in California.  For a period of time, it also offered non-standard auto policies in North Carolina and redomesticated itself from Georgia to North Carolina in 2001, thus becoming subject to NCDOI regulation.  In hindsight, CCIC set its premiums too low and wrote too many policies.  As the Court tactfully phrased it, "CCIC’s growth outperformed the Company’s ability to generate policyholder surplus."  It became insolvent in 2004.

Key points from Judge Tennille's opinion include:


Standard of conduct vs. standard of review:  As the Court originally discussed in First Union Corp. v. SunTrust Banks, Inc., 2001 NCBC 9A ¶¶ 22–30 (Aug. 10, 2001), corporate governance is one area of the law in which standards of conduct diverge from standards of review.  The exception to this divergence is a conflict of interest transaction involving a director.

Good faith is not an independent duty:  "[T]here is no duty of good faith separate and apart from the duties of care and loyalty under either Delaware or North Carolina law."  [This is the first of the Robinson questions that the Court answered].  Good faith instead means that "officers and directors have a loyal state of mind: that is, a justifiable, honestly held belief that they are acting in the best interests of the corporation, whether they are making operating decisions or monitoring certain aspects of corporate functions."  Motive is a significant factor, but "[n]either errors in judgment nor negligence establish bad motive."

Context determines director duties:  Director duties are judged contextually, and the duties of a director in one industry may be qualitatively different than those of a director in another industry.  [This is the second Robinson question answered].  In the context of an insurance company, a plaintiff must show that "the officers and/or directors displayed a conscious indifference to risks in the face of clear signals of the existence of problems likely to lead to insolvency."  The insurance industry is based upon risk, so the presence of risk alone is insufficient.

On the other hand, if the directors knew of an imminent threat of insolvency and decided to adopt a "go-for-broke" strategy to write excessive premiums to attempt to survive the insolvency threat, that would be a bad faith action that would avoid the protections of the business judgment rule.  In addition, directors have a duty to act lawfully, so honest regulatory filings take priority over profit-seeking in the insurance industry.

In some situations, both a duty of loyalty and a duty of care may be implicated:  For example, when disclosure is required, both loyalty and care can be at issue.

The duty of loyalty can have an affirmative component:  "[T]here may be circumstances devoid of a conflict of interest in which the duty of loyalty requires a director to act."

Summary judgment is appropriate in some governance cases:  Issues of motive and state of mind of a director do not preclude summary judgment.

The business judgment rule is a gross negligence standard, not an ordinary negligence standard:    [This is the third Robinson question answered].  In other words, "Absent proof of bad faith, conflict of interest, or disloyalty, the business decisions of officers and directors will not be second-guessed if they are 'the product of a rational process,' and the officers and directors 'availed themselves of all material and reasonably available information' and honestly believed they were acting in the best interest of the corporation."  Proof that a decision was "wrong, stupid, or egregiously dumb" is insufficient.  On the other hand, in a self-interest transaction, the standard drops to ordinary negligence.

Hire advisors and follow their advice:  The Court was persuaded that the directors discharged their duties because they took action:  they increased rates, they cut unprofitable insurance lines, and they attempted to raise capital. 

They also relied on third-party actuarial experts.  Although the experts' analysis may have proven incorrect, the Court noted that the methodology was accepted by the DOI.  In addition, a director is statutorily entitled to rely on third-party advisors as long as the director believes the advisor's work is within the advisor's "professional or expert competence."  The data upon which the advisor chooses to rely is a judgment call.

The Court expressed reservation regarding the accuracy of computer models, but reliance upon them still discharged directorial duties (although it may not in the future):

Our recent economic downturn is a stark reminder that computer models of risk are not always accurate and reliance on them can prove disastrous. The entire regulatory scheme and our statutes encourage use of and reliance upon experts and their computer models. Whether that is a good policy is debatable following our recent economic crisis. Nonetheless, it was the policy in effect during the period at issue and is still supported by statute.

Breach of a duty to monitor requires bad faith:  Following the Delaware Court of Chancery's decisions in In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 971 (Del. Ch. 1996) and In re Citigroup Inc. Shareholder Derivative Litig., 964 A.2d 106, 122 (Del. Ch. 2009), along with the Delaware Supreme Court's decision in Stone v. Ritter, 911 A.2d 362, 364–65 (Del. 2006), a plaintiff asserting that directors breached a duty of oversight must show "(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."

The Court identified a non-exclusive list of conduct that would constitute bad faith:

(a) Taking or approving action which, though legal, the Courts find to be inequitable;

(b) Taking or approving action which is not in the best interest of the corporation in order to advance a personal interest, either financial or nonfinancial, in nature;

(c) Knowingly taking or approving action which violates the law and exposes the corporation to liability or other forms of harm;

(d) A sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system or deliberate, conscious, or intentional disregard of duty; or

(e) A failure of the directors of an insurance company to exercise adequate oversight to ensure that the company’s filings with the appropriate regulatory agency charged with overseeing its solvency were in compliance with regulatory requirements.

There is no cause of action for "negligent mismanagement of an insurance company":  Language in State ex rel. Long v. ILA Corp., 132 N.C. App. 587, 513 S.E.2d 812 (1999), does not suggest otherwise because the director in that case engaged in a self-interested transaction, which avoided the business judgment rule and triggered an ordinary negligence standard for his conduct, but the cause of action itself was still for breach of fiduciary duty.

A director's knowledge affects his duties:  As long as a director follows the advice given, and as long as that director has no knowledge to the contrary, he or she may rely upon the analysis of other directors or employees.  The corollary is that, if knowledge levels differ among directors of the same company, those directors may have different duties.  [This is the fourth Robinson question answered].

Stuff happens:  Given the business judgment rule, the Court is skeptical of hindsight in governance cases:  "History teaches us at least three things. First, our knowledge is vulnerable. What we think we know with certainty can and probably will be proven wrong. Second, things will change. Third, bad things will happen, randomly."


Full Opinion


The Business Judgment Rule Applies To Actions By Managers Of North Carolina Limited Liability Companies

It might seem self-evident that the Business Judgment Rule applies to decisions made by the managers of a limited liability company, but if you were looking for a North Carolina case to cite on that point before last week, you wouldn't have found one.

But now, we have Mooring Capital Fund, LLC v. Comstock North Carolina, LLCa November 13, 2009 decision from the North Carolina Business Court. The case addresses not only the business judgment rule, but also two other significant aspects of litigation involving LLCs.

The Business Judgment Rule And LLC Managers

Mooring Capital, a minority member of Comstock North Carolina, LLC, filed a lawsuit seeking an accounting and making derivative claims for a diversion of funds by the majority member and manager of the LLC, CHCI. CHCI contended that it was entitled to dismissal because it had limited liability as a member-manager.

Judge Jolly agreed that "member-managers generally are shielded from liability when acting as LLC managers," Op. ¶29, and further held that "the managers of an LLC may also be entitled to the protections of the 'business judgment rule.'" Op. ¶30. The Court based the business judgment rule portion of its ruling on G.S. §57C-3-22(b), which states that an LLC manager is bound to act "in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in the manner the manager reasonably believes to be in the best interests of the limited liability company."

The Court nevertheless denied the manager's motion to dismiss, holding that "while the business judgment rule limits the liability of member-managers when acting on behalf of an LLC, this liability is not limited when managers act outside the scope of managing the LLC." Op. ¶33. Dismissal of Plaintiff's claims wasn't warranted because the Complaint made allegations that the manager had taken "actions clearly in conflict with the interests of the LLC" and had "entered into transactions from which" the manager had "derived an improper personal benefit." Op. ¶36. Those included unauthorized distributions from the LLC to the manager and entities with which the manager it was affiliated.

Derivative Actions On Behalf Of LLCs, And Stays Pending Investigation

There are at least two other LLC-related litigation points worth noting in Mooring Capital. One involves the standing of an LLC member to make a derivative claim, the other involves the right of the LLC to a stay of the action while it investigates the charges.

On the first point, although the LLC Act doesn't specify that a demand be made before a member can file a derivative action, the statute does require that the complaint "allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the managers, directors, or other applicable authority and the reasons for the plaintiff's failure to obtain the action, or for not making the effort." N.C. Gen. Stat. §57C-8-01(b).

The Defendant claimed the Plaintiff hadn't made sufficient effort to have the LLC take action. The Court disagreed, referencing Plaintiff's contentions that "its minority status alone show[ed]" that it lacked the authority to cause the LLC to bring suit," and furthermore that it had made "repeated requests for financial information" to which the LLC had not responded.

On the point of the LLC's right to a stay pending its investigation, the LLC had retained PriceWaterhouseCoopers to investigate some of the matters raised by Plaintiff. The LLC said that it therefore was entitled to a stay per G.S. §57C-8-01(b). The Court denied the stay, however, noting that it had concerns about the scope of the accounting firm's investigation. The engagement letter between the LLC and PWC said that the accounting firm would perform a review of the LLC's financial statements, but did not speak to an investigation of other allegations made by the Plaintiff in its Complaint.

Brief in Support of Motion to Dismiss

Brief in Opposition to Motion to Dismiss

Brief in Support of Motion to Stay

Brief in Opposition to Motion to Stay

Reasonable Expectations Of Minority Shareholders Frustrated By Dilution of Ownership, But Not By Termination Of Employment

The "reasonable expectations" of minority shareholders as to continued employment and continued stock ownership were the issue in Vernon v. Cuomo, 2009 NCBC 6 (N.C. Super. Ct. March 17, 2009), decided yesterday by the North Carolina Business Court.

Judge Tennille ruled after a one week trial that the Plaintiffs did not have a reasonable expectation of continued employment, given extreme animosity that had developed among the shareholders of the Company. 

On the dilution issue, however, the Court ruled that Plaintiffs had a reasonable expectation that their ownership interest in the Company would not be diluted, at least not through the means that the Defendants chose to accomplish that dilution. Plaintiffs were restored by the Court to their original ownership position and the Court ordered dissolution of the Company.

The Plaintiffs were two shareholders with a 40% ownership in TriboFilm, Inc., which was developing technology to eliminate silicone as a necessary lubricant in syringes.  They had a serious falling out with the Defendants, five other shareholders who controlled the remaining 60% of the Company.  The Court described the situation as "intolerable" and "dysfunctional."

The majority stripped the Plaintiffs of their status as employees, officers, and directors. Then, after each faction rejected an offer by the other to be bought out, the Defendants implemented a plan to virtually eliminate the Plaintiffs' ownership interest.  Here's what happened as the Court described it:

  • Defendants voted themselves "unrealistic" and "inflated" salaries (most of them had not had any salary at all before this) or salary increases.  The Company did not have the financial ability to pay these salaries.
  • The Defendants then agreed to defer a substantial portion of their new salaries.
  • None of this information regarding salaries and deferral was disclosed to Plaintiffs.
  • Next, the Directors voted to convert a portion of the deferred salary into Company stock at a penny per share, much less than they had been offered by Plaintiffs.
  • Defendants, in their capacities as Board members, then recommended to the shareholders that the number of outstanding shares be increased from 1 million shares to 15 million shares to permit the deferred salary conversion.
  • The Defendants informed the Plaintiffs that the reason for the new shares was to raise additional capital and pay certain obligations.  They did not disclose their plan to exchange their deferred salaries for some of the new stock.
  • The share issuance resolution was approved by the shareholders, over Plaintiffs' objections.
  • The Defendants then each forgave $15,000 of deferred salary (an essentially worthless claim, given the financial state of the Company) in exchange for 1,500,000 shares of Company stock.
  • The effect of the transfer was to immediately reduce each Plaintiff's ownership interest in the Company from 20.2% to 2.4%.

Plaintiffs sued, asserting that their "reasonable expectations" as shareholders to continued employment and continued ownership of their stock had been frustrated.  They lost on the first point, but won on the second.

There Were No Reasonable Expectations To Continued Employment

The Court rejected the argument that the Plaintiffs had a reasonable expectation of continued employment with TriboFilm, at least once they became at odds with their fellow shareholders.  It held:

While shareholders may hold reasonable expectations as a result of their ownership of a small, closely held company, those expectations may be subverted to the overall business interest of the company or may become unsustainable under certain circumstances. At the outset of their involvement, Vernon and Williams had a reasonable expectation that they would continue to work with TriboFilm. That expectation ceased to be reasonable when the Company and the relationships among the shareholders became dysfunctional. It is undisputed on this record that by fall 2005, all trust among the parties had disappeared. The Company could not operate and fulfill its function. There was no communication or cooperation among the small group of researchers who were required to work closely together. A company is not required to fulfill once-reasonable expectations of continued employment where that employment may be detrimental to the ongoing survival of the business. Something had to be done to keep the Company alive and functioning. A majority of shareholders agreed on how to accomplish that goal. The majority was within its rights to terminate the employment of Vernon and Williams, and it did not breach a fiduciary duty by doing so under the circumstances that existed in this case.

Op. ¶78.

There Were Reasonable Expectations Of Undiluted Stock Ownership

The reasonable expectations of the Plaintiffs regarding their continued stock ownership were different.   The Court observed that while startup companies "often have to issue new stock to angel investors," Vernon and Williams "had reasonable expectations that their ownership percentage in TriboFilm in relation to the Individual Defendants' ownership percentage would not be changed without their consent,"  at least not "purely to benefit other shareholders."  Op. ¶72. 

The Court held that the Defendants had been engaged in self-dealing through the transactions which diluted the ownership interest of the Plaintiffs.  It rejected the argument that the Defendants were entitled to the protection of N.C. Gen. Stat. §55-8-31(a), which allows for conflict of interest transactions under certain defined circumstances.

Given the receipt by the directors of a personal financial benefit from the transaction, the Court held that the directors were not entitled to the benefit of the Business Judgment Rule.  And in light of the self-dealing nature of the transaction, the burden of proof fell on the Defendant to prove that the transactions were fair, just, and reasonable. They were unable to carry that burden.

The remedy ordered by the Court was to rescind the issuance of additional shares to the Defendants, restoring the Plaintiffs to their previous ownership percentages.  The Court also held that the actions taken by the Defendants showed "the majority is not operating, and will not operate, the Company in the best interest of all the shareholders."  Op. ¶91.  It therefore ordered the dissolution of the Company, subject to the right of the Company to purchase the Plaintiffs' shares at fair value.


Fiduciary Duty Claims Can Proceed Against Director And Employee Who Allegedly Sank $100 Million IPO

Voyager Pharmaceutical Corp. v. Bowen, April 15, 2008 (Jolly)(unpublished)

Voyager, a company engaged in pharmaceutical research directed at slowing or halting Alzheimer's disease, was attempting a $100 million public offering in 2005.  It alleged in its Complaint that it was unable to complete the IPO due to the actions of one of its directors, Bowen, and one of its employees, Atwood.  It made a variety of claims, including claims for breach of fiduciary duty.

The allegations as to what Bowen had done are pretty interesting.  Here's how the Court characterized some of them:

While Voyager's management was in the 4:30 p.m. conference with Hambrecht, Bowen was in a hospitality suite in the Marriott Marquis Hotel that had been set up to accommodate Voyager's shareholders. (Compl. ¶ 66.)  There, Bowen told one or more shareholders that the IPO was not going to proceed because "God had told him so," and because Voyager had refused to add "the glorification of God" to its mission statement.  (Compl. ¶ 66.)  Bowen also told the shareholders present that day that any further attempts to complete the IPO would fail until his demands were met, including giving credit to God in Voyager's mission statement.  (Compl. ¶ 66.)  Bowen also asked one of the shareholders whether he would be willing to serve as a director of Voyager "when I regain control of the Company."  (Compl ¶ 66.)  Bowen also falsely told one or more shareholders that there was a problem with the Phase I data that had not been resolved and also falsely stated that when he raised this issue with management, management had locked him out of his office.  (Compl. ¶ 68.)

The Court first confronted the issue of choice of law on Voyager's claims for breach of fiduciary duty. The Court noted that there was little guidance in North Carolina as to the proper application of the internal affairs doctrine.  It determined that it would apply the law of Delaware, the state of Voyager's incorporation, to those claims.

It then rejected Bowen's argument that his actions were protected by the business judgment rule.  It held:

Voyager has alleged that Bowen, during his tenure as a board member and in his capacity as a director, made false statements designed to materially affect Voyager without consulting or informing other board members.  Such conduct, even if well-motivated, does not constitute the type of "business decision" the business judgment rule is meant to insulate.

The Court then turned to the breach of fiduciary duty claims against Atwood, who was formerly employed as a researcher with Voyager.  The Court noted that "an employer-employee relationship is not generally a fiduciary relationship," but held that this determination involved a fact-intensive inquiry, and denied the Motion to Dismiss. 

The unfair and deceptive practices claims brought by Voyager was dismissed, however.  The Court held that all of Voyager's claimed injuries related to the failed IPO, and that "the IPO, which is clearly a securities transaction, is beyond the scope of Chapter 75."

The Court let stand claims for aiding and abetting breach of fiduciary duty.

Bowen's Brief in Support of Motion to Dismiss

Atwood's Brief in Support of Motion to Dismiss

Voyager's Brief in Opposition to Motion to Dismiss