Delaware Chancery Court: A Sweeping Vision of Outside Directors' Foreign Operations Oversight Responsibilities?
In the current global economy, many companies have operations and assets in far-flung corners of the world. These geographically dispersed arrangements have a number of implications for the concerned companies. According to a recent decision from the Delaware Court of Chancery, the arrangements may also have important implications of these companies’ outside directors, at least for those companies organized under Delaware law. These implications could include heightened responsibilities and even heightened liability exposures that may come as a surprise to some outside directors.
These issues arose at a February 6, 2013 Delaware Court of Chancery hearing before Chancellor Leo E. Strine, Jr. in a shareholders’ derivative lawsuit involving Puda Coal, a Delaware corporation with significant operations in China. As a clear from the hearing transcript (a copy of which can be found here, Hat Tip to the Delaware Corporate & Commercial Litigation Blog) the parties at the hearing conceded that one of the Chinese members of the board –and at the time of the hearing, the sole remaining board director – had, in the words of Chancellor Strine “stolen” significant assets from the company, and that the “theft” had gone undetected for an extended period of time. (Further background regarding these events can be found here.) After the misappropriation of corporate assets was discovered (apparently by an online analyst) and after the two outside company directors who were represented at the hearing were unable to get answers to their questions, the two individual directors had resigned.
The shareholders’ derivative suit had been filed before the two individuals had resigned. The two individuals moved to dismiss the suit, arguing that the plaintiffs had failed to make the requisite demand on the company’s board, and also arguing that the plaintiffs had failed to state a claim on which relief could be granted.
Chancellor Strine largely denied the defendants’ motions, granting the motion (with leave to amend) solely with respect to the plaintiffs’ unjust enrichment claims. Chancellor Strine was particularly contemptuous of the defendants’ demand failure arguments, given that upon uncovering the problems at the company, the individuals did not take up the suit against the wrongdoer, but rather quit, which had the effect of leaving the alleged wrongdoer as the sole remaining director.
In rejecting the defendants’ motion in this regard, Chancellor Strine called the defendants’ arguments “astonishing” particularly since the if the motion were to be granted “control of the entire lawsuit” belongs to the remaining director’s determination. Among other things, Chancellor Strine invoked Kafka to characterize the result that the individual defendants sought in their demand failure argument.
The far more significant portion of Chancellor Strine’s discussion of the defendants’ dismissal motion has to do with his rejection of the defendants’ arguments that the plaintiffs had failed to state a claim. In rejecting the defendants’ arguments, Chancellor Strine articulated a vision of responsibility for independent directors of companies with overseas operations or assets that I think might come as a shock to many outside directors; he said that
If you’re going to have a company domiciled for purposes of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company
This is a very troubling case in terms that, the use of a Delaware entity in something along these lines. 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 our duty of loyalty. I’m talking about the loyalty issue of understanding that if 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.
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.
Chancellor’s comments appear in a hearing transcript and not in written order, but as Francis Pileggi notes in a February 19, 2013 post on his Delaware Corporate and Commercial Litigation Blog about the ruling in the Puda Coal case (here), in Delaware courts, transcript rulings can be cited in the briefs.
As Tariq Mundiya of the Willkie Farr law firm noted in a February 23, 2013 post about the case on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), Chancellor Strine’s ruling “highlights the risks and challenges that may exist for directors of Delaware corporations with significant foreign assets or operations.”
Chancellor Strine articulates a very broad vision of independent directors’ oversight responsibilities for Delaware companies’ foreign operations or assets. The expectation that independent directors physically visit and inspect the foreign operations and also speak the local language in the foreign locations may come as something of a shock to many outside directors. These days many companies have operations in multiple companies; larger companies have operations around the world. Chancellor Strine’s expectation that outside directors must be both regularly physically present and culturally literate in the each of the locations of the company’s overseas operations may represent a vision of board responsibility that likely would exceed the expectations of many company directors.
As if that were not enough, Chancellor Strine also had words about the independent directors’ decisions to resign. As he said, “there are some circumstances in which running away does not immunize you. In fact it involves a breach of fiduciary duty.” He added that “if these directors are going to eventually testify that tat the time that they quit they believed that the chief executive officer of the company had stolen assets out from under the company, and they did not cause the company to sue or do anything, but they simply quit, I’m not sure that that’s a decision that itself is not a breach of fiduciary duty. And that’s another reason for sustaining the complaint.”
To be sure, this case involved admittedly extreme circumstances. And arguably Strine’s comments could be limited to cases in which a company’s assets or operations are exclusively concentrated in a single foreign country. But the sweeping vision of independent directors’ oversight responsibilities for their companies’ overseas operations -- premised as it is on the presumption that it is the job of the directors to try to prevent what happened here – arguably could require a complete overhaul of the way that the boards of global companies think about their directors’ responsibilities. At a minimum, the requirements for a regular physical presence and a cultural literacy in the locations where a Delaware company has operations or assets may far exceed the expectations of many independent board members. If Strine’s vision of board oversight responsibilities were to become established and come to represent the Delaware standard, it could require a substantial revision of the way that many Delaware boards and directors think about their board responsibilities.
At a minium, I expect that Chancellor Strine's comments will launch a discussion on the question of directors' roles in overseeing a company's far-flung operations. The hot topic for directors used to be financial literacy. Perhaps the question will soon become language fluency and cultural literacy.