The Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"), and the rules adopted by the Securities and Exchange Commission (the "SEC") pursuant to these statutes, have served as the primary laws governing disclosures to shareholders and the marketplace in connection with, among other things, offerings of securities, the purchase and sale of securities, proxy solicitations, tender offers and formal and informal reporting of corporate performance and developments in SEC public filings and press releases.
In addition, federal courts have interpreted the federal securities laws to imply causes of action not specifically set forth in the statutes and to address claims brought as class actions. Typically, these claims can be brought against the corporation and its directors and officers, purchasers and sellers of securities, persons otherwise having a duty to investors who participate in the alleged disclosure violation (such as accountants and underwriters) and persons required to make public filings with the SEC.
State Common Law Theories
Notwithstanding the preeminence of the federal securities laws, disclosure claims have also been asserted under state common law theories such as common law fraud and negligent misrepresentation. In addition, disclosure claims have been brought against corporate directors based on theories of breach of fiduciary duty. The Delaware courts have recently addressed the scope and application of the fiduciary duty of disclosure, leaving open several questions, including its continuing viability in light of the recently adopted Securities Litigation Uniform Standards Act of 1998 (the "Uniform Act"). [Pub. L. No. 105-353, 112 Stat. 3227 (to be codified in various sections of 15 U.S.C).]
Private Securities Litigation Reform Act
In an effort to reduce what some have characterized as frivolous class action litigation brought under the federal securities laws, Congress enacted the Private Securities Litigation Reform Act (the "Reform Act") in December 1995 over President Clinton's veto. [Pub. L. No. 104-67, 109 Stat. 737 (codified in 15 U.S.C. §§ 77k-1, 77z-1 to z-2, 78u-4 to u-5, 78j-1 (Supp. II 1996)).]
The Reform Act contained various procedural reforms, including heightened pleading standards, a stay of discovery pending the resolution of motions to dismiss, a safe harbor provision for forward-looking statements and heightened judicial scrutiny of settlement terms.
Following the enactment of the Reform Act, class action plaintiffs increasingly attempted to bring securities claims in state courts under state common law theories in order to avoid the constraints imposed on them under the Reform Act.
The Uniform Act
In response to the perceived increase in securities class actions brought in state courts, Congress enacted the Uniform Act. The Uniform Act prohibited class actions based upon state law alleging either an untrue statement or omission of material fact or the use of a manipulative or deceptive device or contrivance, in connection with the purchase or sale of a covered security as defined in Section 18(b)(1) or (2) of the Securities Act.Accordingly, the Uniform Act seeks to preempt state law fraud class actions in connection with the purchase or sale of a security. Significantly, the Uniform Act recognizes two important exceptions.
First, exclusively derivative actions brought by a shareholder on behalf of a corporation (which by their nature are not "class actions") are excluded from the Uniform Act. Second, the Uniform Act preserves state law class actions involving:
- the purchase or sale of securities by an issuer exclusively from or to the issuer's shareholders or
- any recommendation, position or other communication, with respect to the sale of the issuer's securities, that is made by the issuer to its shareholders concerning the shareholders' decisions with respect to voting, responding to a tender or exchange offer or exercising dissenters' or appraisal rights.
The implications of these exceptions, referred to as the "Delaware carve-outs," are best understood by a review of the Delaware law governing disclosure.
Delaware's Duties of Care, Loyalty and Good Faith
In general, Delaware recognizes that directors owe fiduciary duties to the corporation and its shareholders consisting of the duties of care, loyalty and good faith. [See generally Dennis J. Block, Nancy E. Barton & Stephen A. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors (5th Ed. 1998).]
The duty of care requires directors to act on an informed basis and the duty of loyalty requires directors to serve the corporation and its shareholders to the exclusion of all other interests. The duty of good faith is an overarching duty incorporating principles underlying the duties of care and loyalty.
Delaware law further provides that director decisions are presumed, under the business judgment rule , to be made in a manner consistent with their fiduciary duties and, accordingly, a plaintiff challenging director action bears the evidentiary burden to plead and prove facts that a majority of the directors possessed a disabling conflict of interest or failed to act with the requisite care or in good faith. If the plaintiff succeeds in meeting this burden, the business judgment rule presumption will not apply and the directors are required to prove the "entire fairness" of the transaction.
Under the "entire fairness" standard, the directors must show both fair dealing and fair price. In that regard, fair dealing involves questions concerning the timing of the transaction, how it was initiated, structured and negotiated and the manner by which director and shareholder approval was obtained. Fair price contemplates the economic and financial issues underlying the transaction. [Weinberger v. UOP Inc., 457 A.2d 701 (Del. 1983).]
Delaware's Duty to Disclose
Delaware law also recognizes that directors are subject to a fiduciary duty to disclose fully and fairly all material information within the directors' control when it seeks shareholder action, such as in proxy solicitations or self-tender offers. [Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992).] In such cases, litigants need not establish reliance, causation or actual monetary damages. [Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del. 1995).]
Thus, in a traditional duty of disclosure case, Delaware courts focus on whether the allegedly misrepresented or omitted information is material to the shareholder action requested and whether it was communicated in a balanced and truthful manner. [See Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270, 1277 (Del. 1994).] In this regard, Delaware courts have adopted the materiality standard articulated by the United States Supreme Court with respect to the federal securities laws [Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985).]: "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." [TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).]
The present application of the duty of disclosure is rooted in the Delaware Supreme Court's decision Lynch v. Vickers Energy Corp. [383 A.2d 278 (Del. 1977).] Lynch involved a tender offer by a majority shareholder to acquire the remaining outstanding shares of the corporation it did not already own. A minority shareholder challenged the transaction, alleging that the offer failed to disclose two critical facts in connection with the tender offer. The Delaware Supreme Court held that the majority shareholder had a fiduciary duty to disclose all "germane" facts and circumstances surrounding the tender offer, noting that "[c]ompleteness, not adequacy, is both the norm and the mandate under present circumstances."
Duty Includes Disclosures by Disinterested Directors
The application of the duty of disclosure in self-dealing transactions, as in Lynch, is consistent with Delaware principles underlying the entire fairness standard as well as statutory provisions permitting shareholders to approve self-dealing transactions with directors. [See 8 Del. C.§144(a ).] The Delaware Supreme Court, however, extended duty of disclosure, beyond the self-dealing context to include disclosures by disinterested directors.
In Smith v. Van Gorkom , 488 A.2d 858 (Del. 1985), disinterested directors were held liable for damages emanating from a breach of the duty of care because the directors failed adequately to inform themselves prior to recommending a merger proposal to shareholders. The Delaware Supreme Court also imposed liability on these directors based on a violation of the duty of disclosure for their failure to apprise shareholders of "all material information such as a reasonable stockholder would consider important" in reviewing the merger proposal. In so doing, the Court recognized that the duty of disclosure extended to cases that did not implicate the duty of loyalty.
Business Judgment Rule and Duty to Disclose
Because the duty of disclosure implicates elements of either or both the duties of care and loyalty, interesting issues arise with respect to defenses applicable to claims based on a breach of the duty of disclosure. For example, some courts have addressed the issue of whether the business judgment rule should apply in duty of disclosure cases. [See, e.g., Goodwin v. Live Entertainment, Inc., C.A. No. 15765, 1999 WL 64265 (Del. Ch. Jan. 1999).]
In Goodwin v. Live Entertainment, Inc., C.A. No. 15765, 1999 WL 64265 (Del. Ch. Jan. 1999), the defendants argued that the plaintiff had the burden of establishing sufficient facts to show that the Live directors had an interest different than that of the shareholders in order to find a disclosure violation in connection with the directors' proxy solicitation in favor of a merger proposal with a third-party. Absent such a showing, the directors argued, they were entitled to protection under the business judgment rule.
While acknowledging the logic of defendants' argument (given that the claims rested solely on allegations of bad faith and disloyalty), Vice Chancellor Strine concluded that the limited available authority, arising in different procedural contexts, suggested that the business judgment rule did not apply to disclosure claims. Illustrative of these cases is the Delaware Chancery Court decision in, In re Anderson, Clayton Shareholders' Litigation , 519 A.2d 669, 675 (Del. Ch. 1986), where the court observed that "the question whether shareholders' have, under the circumstances, been provided with appropriate information upon which an informed choice on a matter of fundamental corporate importance may be made, is not a decision concerning the management of business and affairs of the enterprise." Vice Chancellor Strine, while not exclusively applying a business judgment rule analysis, concluded that the fact that a majority of the directors were not interested in the transaction provided strong support that any disclosure violations did not result from disloyalty or bad faith.
Exculpatory Clauses
Similarly, §102(b)(7) of the Delaware Corporation Law permits Delaware corporations to adopt provisions in their articles of incorporation that exculpate directors from liability for damages arising out of a breach of the duty of care. Delaware courts have addressed whether these exculpatory clauses extend to breaches of the disclosure duty. [See, e.g., Arnold v. Society for Savings Bancorp, Inc. 650 A.2d 1270 (Del. 1994); Zirn v. VLI Corp, 621 A.2d 773 (Del. 1993).] For example, in Zirn v. VLI Corp., 621 A.2d 773 (Del. 1993), the Delaware Supreme Court found an exculpatory clause inapplicable to a claim based on equitable fraud, noting that while §102(b)(7) empowers corporations to shield directors from duty of care claims, the statute does not extend to breaches of the duty of loyalty.
The Delaware Supreme Court revisited this issue in Arnold v. Society for Savings Bancorp, Inc. [650 A.2d 1270 (Del. 1994).] In Arnold , the Court concluded that the clear language of §102(b)(7) extended protection to all breaches of fiduciary duty not expressly excepted from coverage. Accordingly, the court concluded that any claims alleging disclosure violations not otherwise falling within the statutory exceptions -- a breach of the duty of loyalty or director acts or omissions not made in good faith or which involve intentional misconduct or a knowing violation of law -- are protected by the statute and any certificate of incorporation adopted pursuant thereto.
Thus, in Goodwin v. Live Entertainment, Inc., C.A. No. 393, 1998 (Del. March 16, 1999), the Chancery Court held that a charter provision enacted pursuant to §102(b)(7) barred any claims based on a breach of the duty of care. Significantly, the Court's analysis of the plaintiff's claims based on the duty of loyalty was heavily influenced by the exculpatory charter provision. In light of that provision, the Court held that summary judgment would be granted in favor of the defendants unless plaintiff could produce sufficient evidence to create a factual dispute in support of his claims that the directors acted in bad faith or with disloyalty.
Most recently, in Emerald Partners v. Berlin, C.A. No. 393, 1998 (Del. March 16, 1999), the Delaware Supreme Court confirmed that disclosure claims solely implicating a violation of the duty of care would be protected by an exculpatory charter provision. The Court noted that because the statute is in the nature of an affirmative defense, defendants seeking to invoke such a provision in the face of claims based on bad faith and disloyalty bear the burden of establishing at trial that they acted in good faith and without a disabling interest.
In contrast, the Emerald Partners decision should be read to require that a complaint asserting a disclosure claim implicating a breach of the duty of care should be dismissed as a matter of law if the corporation's articles of incorporation contain an exculpatory provision. [See also In re General Motors Class H Shareholders Litigation , C.A. No. 15517, slip op. at 18 & n.7 (Del. Ch. March 22, 1999).] Moreover, the allocation of the burden of proof at trial to the director seeking the protection of an exculpatory charter provision should not obviate the plaintiff's obligation to allege particularized facts of disloyalty and bad faith in the complaint in order to avoid dismissal at the pleading stage.
Malone v. Brincat
In a recent decision, the Delaware Supreme Court appeared to expand claims based on disclosure allegations beyond those permitted under the traditional duty of disclosure, although under very narrow circumstances. In Malone v. Brincat , 722 A.2d 5 (Del. 1998), shareholders of Mercury Finance Company brought a class action alleging that Mercury's directors made false and misleading public disclosures and filed reports with the SEC over a four-year period which grossly overstated the company's earnings, financial performance and shareholders' equity. The complaint further alleged that Mercury's announcement in late 1996 that the company would have to restate its earnings for the prior three years caused an almost total depreciation of the company's $2 billion market value.
On appeal, the Delaware Supreme Court sitting en banc held that the complaint should have been dismissed without prejudice because the plaintiffs alleged that defendants damaged the corporation but failed to assert a proper derivative claim. Specifically, the plaintiffs did not make a demand on Mercury's board of directors or establish that such a demand was excused, as required by Chancery Court Rule 23.1. The Court noted, however, that the plaintiffs should be permitted to replead the case as a shareholders' derivative action and possibly as an individual or class action. In this regard, the Court remarked that the alleged conduct did not implicate the traditional duty to disclose, but dismissal should have been without prejudice so that plaintiffs could amend their complaint based on a more general breach of fiduciary duty theory.
Duty to Disclose is a Specific Application
Specifically, the Court recognized that the traditional duty to disclose was not implicated because the directors were not seeking shareholder action. The Court explained that the disclosure duty is a "specific application" of the more general fiduciary duties of care, loyalty and good faith that is implicated only when directors seek such action. [See Lynch v. Vickers Energy Corp., 383 A.2d 278 (Del. 1978); see also Lawrence A. Hamermesh, Calling off the Lynch Mob: The Corporate Director's Fiduciary Disclosure Duty , 49 Vand. L. Rev. 1089 (1996).]
In such cases, the Court noted, directors are required to disclose all material information within the directors' control regarding the requested action. Therefore, litigants need not establish reliance, causation or actual monetary damages to recover under the duty of disclosure. Rather, the central issue is whether the disputed information is material to the shareholder action requested and whether it is communicated in a balanced and truthful manner. In that regard, the Court, quoting Zirn, confirmed that "a good faith erroneous judgment as to the proper scope or context of required disclosure implicates the duty of care rather than the duty of loyalty." [722 A.2d at 12, n.32.]
Tripartite Fiduciary Duty
While acknowledging that plaintiffs could not assert a traditional duty of disclosure claim, the Court noted that the facts in the complaint might implicate a more general fiduciary duty owed by the Mercury directors. In that regard, the Court indicated that corporate directors are charged with a "tripartite fiduciary duty" which includes the duties of due care, good faith and loyalty.
These duties, the Court cautioned, do "not operate intermittently but [are] the constant compass by which all director actions for the corporation and interactions with its shareholders must be guided." In the case of director communications, the Court noted that "the sine qua non of directors' fiduciary duty to shareholders is honesty."
Thus, the Court stated that "shareholders are entitled to rely upon the truthfulness of all information disseminated to them by the directors they elect to manage the corporate enterprise."
In this case, the Court continued, the proper inquiry is not whether the directors breached the narrow duty of disclosure, but whether they breached their more general fiduciary duty "by knowingly disseminating to the stockholders false information about the financial condition of the company." Thus, the Court stated, in dictum, that "directors who knowingly disseminate false information that results in corporate injury or damage to an individual stockholder violate their fiduciary duty, and may be held accountable in a manner appropriate to the circumstances."
Implications of Brincat
The implications of Brincat are unclear. Although the Delaware Supreme Court appears to have extended claims based upon disclosure infirmities beyond the traditional duty of disclosure, such claims also appear to be quite narrow. Thus, disclosure claims based on a generalized breach of fiduciary duty under Brincat must be based on a knowing dissemination of false information.
This scienter standard requires plaintiffs to overcome a high pleading and proof standard, much more exacting than that required under the federal securities laws. In addition, by negative implication, the Brincat court suggested that, unlike the traditional duty of disclosure claim, a plaintiff may be required to establish reliance, causation and actual quantifiable monetary damages.
In that regard, Brincat made clear that Delaware does not recognize a "fraud on the market" theory, thus making a disclosure claim under state law even more difficult by requiring that each class member prove reliance on the alleged disclosure violation.
Application of Uniform Act
Brincat also raises issues concerning the application of the Uniform Act to Delaware law. As the Court noted, the Uniform Act did not apply to that case because the complaint was filed prior to the enactment of the statute. The viability of future cases based on theories apparently acceptable under Brincat , however, is not certain.
To the extent a disclosure claim can be pleaded as a derivative action, such a claim would not be preempted under the Uniform Act. Pleading such a claim, though, would be difficult to accomplish because the plaintiff must allege an injury to the corporation and not to shareholders individually.
Typically, harm caused by disclosure violations is more likely to be suffered by shareholders individually (e.g., losses resulting from declines in the market price for the corporation's shares) than by the corporation.
State Law Exception to the Uniform Act
To the extent the claim is brought as a class action, the state law exceptions to the Uniform Act only apply to disclosures involving:
- the purchase or sale of securities by an issuer from its shareholders or
- a recommendation or other communication made by an issuer concerning voting rights, a tender or exchange offer or appraisal or dissenters' rights, but in connection the sale of securities.
Thus, on the one hand, the state law exceptions to the Uniform Act would only come into play in limited circumstances and only where a purchase or sale of securities is involved. On the other hand, the Uniform Act itself would not be applicable in the absence of a purchase or sale of securities. Undoubtedly, the interplay between the Uniform Act exceptions and applicable state disclosure-based claims will be the subject of continuing controversy.