Emerging Communications: Enhanced Director Liability for Experts?

Published in The Metropolitan Corporate Counsel, January 2005.

Sitting on a board of directors today is a more serious undertaking than ever before. The obligations, and potentially the liabilities, of directors have been significantly heightened by corporate governance reforms under the Sarbanes-Oxley Act of 2002, the rules of the stock exchanges and, perhaps now, the evolution of Delaware’s case law on directors’ fiduciary duties. As a result of the Delaware Chancery Court’s recent decision in In re Emerging Communications, Inc. Shareholders Litigation (Emerging Communications),¹ current and prospective directors would be well-advised to consider not only their own qualifications, skills and time commitments, but also the expertise of their colleagues around the board table.

Under the Sarbanes-Oxley Act, public companies must now disclose in their annual reports on Form 10-K whether they have a "financial expert" on their audit committee. The SEC’s test is strict enough that even a highly competent person with a financial background might fail to qualify. But aside from qualification problems, directors may be reluctant to be singled out as an audit committee’s financial expert if the decision in Emerging Communications is extended beyond the facts of that case.

The case involved the privatization of ECM, a telephone company in the U.S. Virgin Islands, by ECM’s controlling shareholder, Jeffrey Prosser, who was also ECM’s chair and CEO. ECM’s board of directors formed a special committee to negotiate the merger on behalf of the minority shareholders. The special committee recommended the merger, which the board approved at a price of $10.25 per share. The pri- vatization was completed in October 1998. Shareholders sued ECM and its board for breach of fiduciary duty and sought an appraisal of their shares. Because of Prosser’s conflict of interest, the business judgment rule was inapplicable. Instead, the defendant directors had to prove that the transaction satisfied Delaware’s entire fairness test.

The Court appraised ECM’s fair value at $38.05 per share and found that the transaction was unfair to the minority shareholders. The Court held one director, Salvatore Muoio, to a higher standard than the other directors because he had specialized expertise as a former securities analyst with substantial experience in the telecommunications industry. Other than Muoio, only two of ECM’s directors were held liable for breach of fiduciary duty: Prosser, who was found by the Court to have had a conflict of interest and to have deliberately breached his duty of loyalty; and Prosser’s attorney, who was found by the Court to have knowingly breached his duty of loyalty by advising both sides of the transaction. The remaining directors were not found liable, even though they may have breached their duty of care, because ECM’s charter had an exculpatory provision under Delaware law for such breaches.

The Court held that Muoio was not entitled to rely on the fairness opinion of the board’s financial adviser because he had substantial industry experience that was equivalent, if not superior, to the financial adviser’s (a well-known investment banking firm). While other ECM directors could plausibly claim that they relied on the fairness opinion, the Court concluded that the same claim by Muoio was implausible. The Court found that Muoio had one of two possible mindsets: (i) he knew the merger was unfair to the minority, and therefore acted wrongfully on purpose; or (ii) he had strong reason to believe the merger was unfair, and therefore should not have approved it.

The Court did not affirmatively find that Muoio had acted wrongfully on purpose, leaving it to apply a gross negligence standard to his conduct, comparing his actions with what a reasonable person of his background and experience would have done in the same circumstances. The gross negligence standard was established in the seminal case of Smith v. Van Gorkam.² In that case, the Court held that gross negligence is the correct standard to determine whether a director has violated the duty of care. The Van Gorkam decision created a concern that directors could face liability even when they acted in good faith, albeit negligently. The exculpatory provision for breaches of the duty of care, which the Delaware statute now permits to be included in a Delaware corporation’s charter, was a direct response to the Van Gorkam decision. However, the statute does not permit a director to be shielded from liability if he or she acts in bad faith or breaches the duty of loyalty. Therefore, the Delaware statute makes a distinction between breaches of fiduciary duty involving bad faith and breaches caused by negligence, even gross negligence. Negligence may be excused under a company’s charter, but bad faith is not permitted to be excused.

Muoio’s liability in the Emerging Communications case raises a serious question about the extent of the liability of financial and other experts sitting on boards of directors and board committees. In the SEC’s rule under the Sarbanes-Oxley Act, which requires public companies to disclose in their annual reports whether they have a financial expert on their audit committee, the SEC has attempted to provide comfort on the issue of experts’ liability. The rule contains a specific safe harbor for financial experts, attempting to assure them that they are not subject to any liability, duties or obligations greater than those of other directors (nor are the liabilities, duties or obligations of the remainder of the board members supposed to be diminished by the expert’s presence). The safe harbor is meant to protect directors from extra liability under the federal securities laws. However, it is state law that imposes fiduciary duties upon directors, and state courts may not necessarily agree that a person designated as a financial expert by an audit committee does not have a higher level of fiduciary duty than other directors.

Delaware case law on fiduciary duties, as well as the case law of other states, is not necessarily going to evolve consistently with the SEC’s attempt to create a safe harbor under the Sarbanes-Oxley Act. Although the safe harbor may protect a director from liability under federal securities law, once he or she is identified as a financial expert in a company’s public filings, it may prove to be difficult to avoid the results under state corporate law that the Court reached in Emerging Communications.

It is difficult to predict whether the higher Delaware courts, or courts in other jurisdictions, will uphold or follow Emerging Communications. At present, the case is a vivid reminder to directors that when they rely on fairness opinions or participate in board decisions generally, they must be diligent in bringing their unique skills and experience to bear on all matters of judgment. And they must make every effort to ensure that all their decisions are made with the utmost good faith. It is hoped that the case will not create an incentive for directors to look around the board table and assess the expertise of their colleagues. After all, it is better for a director to sit on a board of peers whose qualifications match or approximate one’s own, than to be the only director with a special set of skills that could ultimately lead to heightened liability.