Delaware Supreme Court Expands Directors' Liability for "Misdisclosures"

In a decision expanding directors' potential liability for public statements, the Supreme Court of Delaware sitting en banc recently held 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," even where stockholder action is not sought.

In Malone v. Brincat, the shareholders of Mercury Finance Company ("Mercury") brought suit in the Delaware Chancery Court alleging that Mercury's directors breached their fiduciary duties by authorizing false SEC filings that overstated company earnings, which, when restated, eliminated virtually all, if not all, of the company's $2 billion market capitalization. The Chancery Court rejected plaintiffs' claim, holding that disclosures not made in connection with a request for shareholder action do not implicate the fiduciary duty to disclose. The Chancery Court further opined that federal securities laws regarding trading and accurate disclosure impliedly preempted and eliminated the need for the cause of action plaintiffs sought to assert under Delaware law. Because the disclosure at issue was not made in connection with a request for shareholder action, the Chancery Court dismissed the complaint with prejudice.

The Delaware Supreme Court disagreed with the Chancery Court's rationale, and held that a claim may lie for communications made to shareholders even in the absence of a request for shareholder action. The court reasoned that the fiduciary duties of due care, good faith and loyalty entitle shareholders to rely on their directors for every public or direct communication, "with or without" a request for action by shareholders. In contrast, the court noted that the duty to disclose simply is a specific application of the more general fiduciary duty rule, and applies only where shareholder action is requested. The court further explained that a general fiduciary duty action focuses on whether the directors dealt with stockholders honestly when disseminating information to the public, whereas a disclosure action focuses on the directors' obligation to disseminate material information relevant to the requested shareholder action.

The Delaware Supreme Court then "endeavored to provide directors with clear signal beacons and brightly-lined channel markers as they navigate with due care, good faith, and loyalty on behalf of a Delaware corporation and its shareholders." Specifically, the Brincat court delineated three situations where liability may attach for dissemination of inaccurate information. First, the court stated that directors may be liable for breach of fiduciary duty of disclosure if they fail to distribute information with the required candor when requesting shareholder action. According to the court, the central issues in a duty to disclose action are whether the information is (i) material to the shareholder action being sought and (ii) communicated in a balanced and truthful manner. The court further noted that reliance, causation and actual quantifiable monetary damages need not be proven in such action.

Second, the court stated that directors may be liable in a derivative action or individual claim for breach of fiduciary duty of care, loyalty and/or good faith if, in the absence of a request for shareholder action, they "deliberately misinform shareholders about the business of the corporation, either directly or by a public statement." The court noted that both monetary damages and equitable relief may be awarded on such claims.

Finally, the court stated that directors may be liable exclusively under federal law for some disclosure-based claims. For example, the Brincat court noted that Delaware does not recognize a common law fraud-on-the-market claim (where directors' misleading public statements defraud stock purchasers) because federal securities laws already protect investors with respect to trading securities in connection with false disclosures. The Brincat court also observed that many securities claims are now preempted by the recently enacted Securities Litigation Uniform Standards Act of 1998. The court noted, however, that the Uniform Standards Act will not preclude "Delaware carve-out" claims where, as in Brincat, a state chartered company has derivative claims based on directors' misleading disclosures, and state law provides a remedy based on that breach of fiduciary duty.

Accordingly, the Brincat court noted that the proper inquiry in the case before it was not whether the directors breached their duty of disclosure, as there was no request for shareholder action, but "whether they breached their more general fiduciary duty of loyalty and good faith by knowingly disseminating to the stockholders false information about the financial condition of the company." While the court agreed that the plaintiffs could not sue for breach of fiduciary duty on the facts alleged, the court held that the complaint should not have been dismissed with prejudice. Rather, the Brincat court held that the plaintiffs should have been granted leave to amend to plead a derivative action, individual and/or class claims based on a directors' breach of general fiduciary duties theory.

Malone v. Brincat, C.A. No. 15510, 1998 WL 919123 (Del. Supr. Ct. Dec. 18, 1998).

  • Proxy Worthy? Substance, Not Form, Governs
    "Whereas Chemed Corp. is managed more like a private fiefdom than as a publicly-owned corporation, I suggest that the Board of Directors have a majority of outside members."

    May a company exclude the above shareholder proposal from proxy materials under Rule 14a-8(i)(3) of the Securities Exchange Act of 1934? That rule permits exclusion of materials that are "contrary to any of the Commission's proxy rules, including Rule 14a-9 which prohibits materially false and misleading statements in proxy soliciting materials." Under Note (b) to Rule 14a-9, such statements include "material which directly or indirectly impugns character, integrity or personal reputation, or directly or indirectly makes charges concerning improper, illegal or immoral conduct or associations, without factual foundation."

    According to the Staff of the SEC Division of Corporate Finance, substance, not form, governs. The Staff advised that the entire shareholder proposal could not be excluded from the proxy materials pursuant to Rule 14-a8(i)(3) of the Exchange Act. Rather, only the statement that the company was managed like a "private fiefdom" could be excluded as being "materially false or misleading" under Rule 14a-9, as it lacked factual foundation. The Staff thus stated that it would not recommend enforcement action to the Commission if only the "private fiefdom" language of the shareholder proposal were omitted, but that the remainder of the proposal should be included in the proxy materials.

    Chemed Corp., 1998 WL 792510, S.E.C. No-Action Letter (available Nov. 16, 1998).