(As published in Private Company Director)

Disputes regarding ownership interests often arise in the context of closely held corporations, particularly when directors, officers, or majority shareholders sell or acquire ownership interests in the company. These individuals owe fiduciary duties to act in the best interest of the company. Many minority shareholders are surprised to learn, however, that those obligations do not extend to them when they are negotiating the purchase or sale of their interests in the enterprise. Instead, both Delaware and California have treated such transactions as arms-length negotiations, which do not give rise to any fiduciary obligation on the part of the directors, officers, or majority shareholders on the other end of those transactions. 

Even in the absence of liability, however, such disputes can be time-consuming and expensive. If the corporation carries directors and officers liability insurance, the attorney’s fees and costs might be covered under the policy. It is important for directors, officers, or majority shareholders to be aware of their rights and obligations under such policies in order to perfect their claim to coverage. We address one of the most common coverage issues that arise in disputes like this, which, if not avoided, can negatively impact available insurance.

We turn first to the idea that directors, officers, or controlling shareholders owe no fiduciary duty to minority shareholders when buying or selling ownership interests in the corporation. This principle has been upheld in a variety of circumstances.[1]

For example, a California appellate court[2] held that no fiduciary duty existed when one shareholder negotiated with another to sell his shares back to the corporation. What was surprising in this case was that the selling shareholder alleged—and the jury found—that the other shareholder had fraudulently concealed the existence of a new and lucrative product in the works at the time of the sale, resulting in a depressed purchase price. Notwithstanding the misrepresentations, the court rejected the argument that the remaining shareholder’s conduct constituted a breach of fiduciary duty “simply because one undertakes to paint you the truest picture possible of where the company is right now, and the other relies on him to do so.”[3] (Notably, the court qualified its holding by noting that both shareholders owned equal shares of the company and were represented by counsel and accountants.)

In another case, the Delaware Chancery Court found that no fiduciary duty applied in connection with an “arms-length negotiation” between controlling stockholders and the directors of a corporation, on the one hand, and a minority shareholder, on the other hand, over the terms of a share repurchase.[4] The plaintiff minority shareholder had negotiated at arms-length a shareholder agreement and, over a decade later, attempted to negotiate a repurchase of her shares. The company, however, rejected the minority shareholder’s proposal and would only repurchase her shares at a much lower price. The parties “were engaged in an arms-length negotiation over the terms by which the Company might repurchase [the plaintiff’s] shares—a process that likely mirrored the parties' negotiations over the Shareholders' Agreement. [The plaintiff’s] interest in obtaining a higher redemption price was in opposition to the interests of [the company] and its shareholders generally. That circumstance is not one that, by itself, would give rise to a fiduciary relationship . . .”[5] The court found that the defendants had no duty to repurchase the shares at a reasonable price.

The case law and underlying policy support this common-sense view of the limits of the fiduciary duty. A majority shareholder does not owe a fiduciary duty to a minority shareholder for all shareholder transactions. Instead, under California law, majority shareholders owe fiduciary duties to minority shareholders, only with regard to “[a]ny use to which they [majority shareholder] put the corporation or their power to control the corporation.”[6]

We conclude by identifying perennial insurance issues that can prevent directors, officers, or majority shareholders from obtaining coverage should they be caught in such a dispute. Directors and officers liability insurance policies (D&O insurance) can be relatively inexpensive for non-public companies, and the coverage afforded under them can be surprisingly broad.[7] Those policies, however, often contain requirements that, if not followed, can forfeit coverage altogether (an extremely costly result for the insureds).

One of the most important prerequisites is that the insurer receive timely notice of a “claim,” a word that is usually defined in the policy (and discussed further below). D&O insurance is written on a “claims-made-and-reported” basis. This means that to trigger coverage, the “claim” must first be made during the policy period. In addition, it must also be reported to the insurer either during that same policy period or during an extended reporting period, usually between 30-90 days following the end of the policy period. Both conditions must be satisfied in order to obtain coverage under these types of policies.

Generally, the reporting requirement is strictly enforced in the insurer’s favor. That means that if an otherwise-covered “claim” is made during the policy period, but the insured does not report it before the end of the policy period or extended reporting period, there likely will be no coverage.   Although it sounds simple, insureds (both the officers, directors, and majority shareholders as well as the company itself) sometimes neglect to provide timely notice of a “claim” and lose coverage for the attorney’s fees and costs they might incur in a dispute with a minority shareholder. Just ask Harvard. In August 2023, it lost its bid for $15 million in insurance to cover the legal fees and costs incurred defending against the lawsuit challenging its affirmative action policies. The reason for the defeat? The “claim,” i.e., the lawsuit, was filed in 2014 but Harvard did not report it to the insurer until 2017, well after the policy period and extended reporting period had expired.

Sometimes, notice is not given because the insured does not realize how broadly “claim” is defined in the policy or that the notice requirement has been triggered. For example, “claim” is not limited just to lawsuits (like the Harvard case) or arbitration. The definition often also includes a “written demand for monetary or non-monetary relief.” A “written demand” could be, for example, a letter from an attorney or even an email from the minority shareholder, something insureds might not immediately recognize as a “claim” that should be reported to the D&O insurer.

In fact, most disputes between shareholders do not begin with a lawsuit but are instead preceded by an exchange of letters, often seeking relief for the perceived wrong. Such a demand letter might constitute a “claim” that must be reported during the policy’s reporting period. The following is a common scenario. The insured director, officer, or majority shareholder (along with the company) has just been sued in a dispute over the plaintiff minority shareholder’s alleged ownership interests in the company. Notice is promptly given to the current D&O insurer, which immediately asks for all prior correspondence between the plaintiff and defendant. Not surprisingly, it turns out that the legal action was not the beginning of the dispute but rather the culmination of many months (if not longer) of wrangling. Moreover, the plaintiff had previously sent letters demanding money or other forms of relief regarding the purchase or sale of the ownership interest. That is, the plaintiff has previously asserted a “claim” within the meaning of the policy. If the first “claim” was made during the prior policy period and not timely reported, the insured director, officer, or majority shareholder may have already lost out on coverage.

So if a dispute is brewing, consult with the company’s insurance broker or legal counsel to ensure that a “claim,” if made, is recognized as such and action taken to timely report it to the carrier. That way, even if there is no merit to the claims asserted, the insured director, officer, or majority shareholder gets coverage for their attorney’s fees and costs.