Steven Haas summarizes the facts set out in VC Glasscock's recent decision in Kandell v. Niv:
Kandell v. Niv involved a derivative lawsuit brought by a stockholder of FXCM, Inc. (the “Company”), a foreign exchange broker that executed customer trades primarily for retail customers. In placing customer trades, the Company’s policy was to limit the customers’ risk to the amount of their original investment. According to the plaintiff, the Company’s stated policy was “generally not to pursue claims for negative equity against our customers.” When a customer’s investment appeared likely to go into a negative balance, the Company would try to close out the open position. But, according to the court, if “[the Company was] unable to close out a customer account before its losses exceed the amount the customer invested, [the Company], and not the customer, takes the loss.”
The Company was regulated by the Commodity Futures Trading Commission (the “CFTC”). The stockholder-plaintiff alleged that the Company’s policy of limiting its customers’ exposure violated 17 C.F.R. § 5.16 (“Regulation 5.16”), enacted under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Regulation 5.16 states that
“[n]o retail foreign exchange dealer, futures commission merchant or introducing broker may in any way represent that it will, with respect to any retail foreign exchange transaction in any account carried … on behalf of any person … limit the loss of such person.”
Prior to the litigation, a “flash crash” occurred that prevented the Company from closing out many of its trades, thus leading to significant losses. Also, while the stockholder lawsuit was pending, the CFTC brought an enforcement action against the Company alleging violations of Regulation 5.16. The Company later entered into a consent order in which it paid a $650,000 fine without admitting or denying the allegations.
Haas then summarizes the holding:
The issue before the court was whether it would have been futile for the stockholder to make a derivative demand on the board. Demand is futile if a board cannot exercise an independent business judgment in considering whether to bring the claims. ...
The court concluded that, because “a fiduciary of a Delaware corporation cannot be loyal [to the company] by knowingly causing it to seek profits by violating the law,” the directors faced personal liability sufficient to excuse the derivative demand and allow the stockholder lawsuit to proceed.
There's a also a useful discussion on Francis Pileggi's blog.
In a client memo, Potter Anderson & Corroon explains that:
... demand was excused with respect to the claim that defendants knowingly caused or permitted FXCM to violate the law. Because the plaintiff did not contend that a majority of the board was interested or lacked independence, the relevant question was whether the defendants faced a substantial likelihood of liability from the claims. As a result of the exculpatory provision in FXCM’s charter, the directors would face liability only if they knowingly caused or permitted FXCM to violate the law. In that regard, the Court concluded that the relevant CFTC regulation “clearly prohibits touting loss limitations to clients,” that FXCM had an established policy of doing precisely that, and that there was a strong inference that the directors knew that FXCM’s policy violated the regulation. The Court concluded that demand was excused under the “highly unusual” facts alleged in the complaint because the directors faced a substantial threat of liability that rendered them incapable of disinterestedly evaluating a demand.
As VC Glasscock explained, the unusual facts were these: "a Delaware corporation with a business model allegedly reliant on a clear violation of a federal regulation; a situation of which I can reasonably infer the Board was aware." Presumably, VC Glassock thinks the more usual case would be one in which a Caremark claim is brought where the board allegedly failed to exercise adequate oversight and supervision of managers who caused the company to break the law in isolated cases as opposed to doing so routinely as part of their business model.
VC Glasscock's statement of the law is doubtless correct:
Where directors intentionally cause their corporation to violate positive law, they act in bad faith; this state does not “charter lawbreakers.” While a Delaware corporation may “pursue diverse means to make a profit,” it remains “subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue ‘lawful business’ by ‘lawful acts.’” “As a result, a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profits by violating the law.”
Similarly, knowing failure to prevent such a violation implies bad faith. “Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”
Long time readers, however, will recall the numerous occasions on which I have argued that-as a matter of policy--this is exactly the wrong result. Instead of being analyzed under the bad faith/duty of loyalty issue (and don't get me started on the absurdity of pulling bad faith into loyalty to begin with), the issue of corporate criminality should be analyzed under the duty of care (and, as a result, the corollary business judgment rule).
In a leading Third Circuit case arising under New York law, for example, the court treated the problem as involving an alleged “a breach of the defendant directors' duty to exercise diligence in handling the affairs of the corporation.”[5] The ALI Principles likewise treat the issue as one involving “a duty of care action.”[6]
The business judgment rule will not insulate from judicial review decisions tainted by fraud or illegality.[7] The key issue in this context is whether the board has a duty to act lawfully. In the oft-cited Miller v. American Telephone & Telegraph Co. decision,[8] the Third Circuit held that directors have such a duty. AT & T failed to collect a debt owed it by the Democratic National Committee for telecommunications services provided during the 1968 Democrat Party’s convention. Several AT & T shareholders brought a derivative suit against AT & T’s directors, alleging that the failure to collect the debt violated both federal telecommunications and campaign finance laws. Ordinarily, a board decision not to collect a debt would be protected by the business judgment rule. Citing a 1909 New York precedent,[9] however, the Third Circuit held that the business judgment rule did not insulate defendant directors from liability for illegal acts “even though committed to benefit the corporation.”[10]
Assuming a duty to act lawfully exists, operationalizing it is a nontrivial task. Should there be a de minimis exception?[11] If a package delivery firm told its drivers to illegally double-park, so as to speed up the delivery process, for example, it is hardly clear that liability should follow. Should the business judgment rule be set aside only where the board ordered violations of criminal statutes or should it also be set aside where the board authorized violation of some civil regulation? The criminal law long has distinguished between crimes that are malum in se and those that are merely malum prohibitum. The latter are acts that are criminal merely because they are prohibited by statute, not because they violate natural law. It is said that “misdemeanors such as jaywalking and running a stoplight are mala prohibita, as are most securities-lawviolations.”[12] Individuals routinely make cost-benefit analyses before deciding to comply with some malum prohibitum law, such as when deciding to violate the speed limit. Is it self-evident that directors of a corporation should be barred from engaging in similar cost-benefit analyses?[13]
And, yet, still more questions must be answered if a duty to act lawfully is to be imposed. If neither the corporation nor the board was convicted or even indicted, for example, should plaintiff have to make out the elements of the criminal charge?[14] If so, to what extent does the criminal law concept of reasonable doubt come into play? Is a knowing violation of criminal law a per se violation of the duty of care unprotected by the business judgment rule?[15] How are damages to be measured and is causation an issue?[16] And so on.
The point is not that corporations should be allowed to break the law. They should not. If a corporation breaks the law, criminal sanctions should follow for the entity and/or the responsible individuals. The point is only that fiduciary obligation and the duty to act lawfully make a bad fit. If the question is one of reconciling authority and accountability, it is not self-evident that corporate law should hold directors accountable simply for deciding that the corporation’s interests are served by violating a particular statute. After all, “[a] business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.”[17]
Put another way, the point of the business judgment rule is that shareholders should not be allowed to recover monetary damages simply because the directors made the wrong decision. Allowing shareholders to sue over a decision made with the intent of maximizing corporate profits is nothing less than double dipping, even if the decision proves misguided. This claim is further supported by the realities of shareholder litigation. Shareholder lawsuits alleging that directors violated the purported duty to act lawfully will be brought as derivative actions. The real party in interest in derivative litigation is the plaintiff’s attorney, not the nominal shareholder-plaintiff. In most cases, the bulk of any monetary benefits go to the plaintiffs’ lawyers rather than the corporation or its shareholders. In practice, such litigation is more likely to be a mere wealth transfer from corporations and their managers to the plaintiff bar than a significant deterrent to corporate criminality. Accordingly, the illegality of a board decision—standing alone—should not result in automatic director liability. Indeed, one could make the case that illegality should not constitute a basis—again, standing alone—for rebutting the business judgment rule. At the very least, however, courts should carefully consider whether the decision to cause an illegal act was in fact so grossly negligent as to violate the director’s duty of care.
[5] Miller v. Am. Tel. & Tel. Co., 507 F.2d 759, 761 (3d Cir. 1974).
[6] ALI, Principles of Corp. Governance § 4.01 (1994).
[8] 507 F.2d 759, 762 (3d Cir.1974) (diversity case arising under New York corporation law).
[10] Miller v. AT & T Co., 507 F.2d 759, 762 (3d Cir.1974). See also Abrams v. Allen, 74 N.E.2d 305 (N.Y.1947) (directors can be sued where they used corporate property to commit “an unlawful or immoral act”); Di Tomasso v. Loverro, 12 N.E.2d 570 (N.Y.App.1937) (directors liable for entering into a contract that was an illegal restraint of trade).
[11] Cf. ALI Principles § 2.01 cmt. g (acknowledging that the “de minimis principle” applies to corporate law compliance “as elsewhere in the law”).
[12] Black’s Law Dictionary 401 (pocket ed. 1996) (emphasis supplied).
[13] But cf. ALI Principles § 2.01 cmt. g (“With few exceptions, dollar liability is not a ‘price’ that can properly be paid for the privilege of engaging in legally wrongful conduct.”).
[14] Miller answered that question in the affirmative. Miller v. American Telephone & Telegraph Co., 507 F.2d 759, 763–64 (3d Cir.1974). Accord ALI Principles § 4.01(a) cmt. d.
[15] That question is answered in the negative by ALI Principles § 4.01(a) cmt. d.
[16] Under the so-called net loss rule, directors cannot be held monetarily liable if the overall gains to the corporation from the violation exceed the losses directly attributable thereto, such as fines or legal expenses. See James D. Cox, Compensation, Deterrence, and the Market as Boundaries for Derivative Suit Procedures, 52 Geo. Wash. L. Rev. 745, 765 (1984).
