When a majority of a company’s board approves a tender offer in good faith, can it still be avoided as an actually fraudulent transfer? Yes, says the Delaware Bankruptcy Court, holding that the fraudulent intent of a corporation’s CEO who was a board member and exercised control over the board can be imputed to the corporation, even if he was the sole actor with fraudulent intent.

Background

The holding in In re Cyber Litigation arose out of the bankruptcy proceedings for the cyber-fraud prevention company NS8. The company filed for bankruptcy after it was revealed that its founder and CEO, Adam Rogas, had fabricated business records in an effort to defraud the company’s investors. As part of Rogas’s scheme, a tender offer was executed whereby $72 million in new investors’ funds were used to repurchase shares that were essentially worthless. The crux of the complaint was that the share repurchases were actually, not just constructively, fraudulent and thus the payments made by the debtor should be avoided and recovered.

While Rogas’s intent to defraud investors was uncontested, the rest of the board of directors who approved the tender offer were not aware of the fraud. Relying on the records presented by Rogas, they voted to execute the tender offer in good faith. Recognizing that under Delaware law the intent of the majority of the board is controlling, the Court nevertheless imputed Rogas’s fraudulent intent to the debtor.

Discussion

When deciding whether to impute Rogas’s fraudulent intent to the corporate entity, the Bankruptcy Court looked to the justification underlying the tender offer execution; whether the transaction was caused by Rogas’s fraud, or whether the innocent board members could point to reasoning independent of the fraud to support their decision.

The intent imputed to a legal entity is generally based on the intent of those who hold decision-making power. Thus, when a corporate action is subject to approval by a board of directors, corporate intent is found in the intent held by a majority of that board.

However, this general rule is complicated when the majority is under the control of a bad actor. In such instances, the intent of the deceiving party may be imputed to the innocent directors. Thus, the presence of a majority of innocent board members may not be sufficient to break the casual connection between the fraud and the corporate decision if the board was under the control of the fraudulent actor. Key to this inquiry is an analysis of causation. The Court considered whether the cause of the board’s decision was Rogas’s fraud, rather than an independent decision made by innocent board members.

The court found that the majority of the board had fallen under Rogas’s control, and therefore the ultimate cause of the stock repurchase was Rogas’s fraud. There was no reasoning underlying the stock repurchase that was separate from Rogas’s; he maintained exclusive control over the company’s financial information, and all information presented to the board was manipulated by Rogas.

The Court distinguished this case from Boardwalk Pipeline Partners, LP v. Bandera Master Fund LP where imputation of bad faith and scienter was defeated by the use of an outside law firm’s opinion. The facts of Cyber Litigation, however, also involved pre-tender offer investigations conducted by Ernst & Young, Kroll, and Crowell & Moring in response to a whistleblower complaint filed with the SEC. None of those investigations found fraud or wrongdoing. In fact, the board delayed the tender offer pending the results of the investigations. It is not entirely clear from the Cyber Litigation opinion why the investigations done were insufficient to break the causal link to Rogas’s fraud while the outside legal opinion in Boardwalk was sufficient to prevent imputation.

Conclusion

The Cyber Litigation opinion highlights the risk of investors’ exposure to the fraudulent conduct of a single director, who through his or her outsized control over the company’s affairs may be viewed by the courts as controlling the board even where a majority of the board members are unaware of the fraud. And if the outside investigations conducted by three different professional firms is insufficient, it is not clear what is.

It appears that Cyber Litigation is the first opinion that resulted in a final judgement of imputation under these circumstances, unlike decisions denying motions to dismiss, or rulings against imputation. It remains to be seen how it will be treated in future cases. Stay tuned.

The opinion is available here.

The authors would like to thank Madeline Johl for her contribution to this OnPoint.