The Board’s primary duty is to focus on the best interests of the company, which is not necessarily the same as short-term profitability.
Even as economic shocks may add short-term pressures, the board’s responsibility remains to take actions that are in the company’s best interests. Unless the board has determined to sell the company for cash, directors are “not under any per se duty to maximize shareholder value in the short term.”1 Rather, directors “are obliged to chart a course for a corporation which is in its best interests without regard to a fixed investment horizon.”2 Directors must show the discipline to chart the course they believe to be best for the company, even if short-term earnings shortfalls due to macroeconomic events may affect stockholders’ decision-making.
Duty of oversight: establishing and maintaining a system for monitoring risks.
While no one should fault any board for not foreseeing the impact of COVID-19 prior to the domestic outbreak, now that it is upon us, boards should tailor their oversight in light of the risks confronting their companies. Under Delaware’s Caremark doctrine, directors will face liability for a failure of oversight if the board (1) “utterly failed” to establish a risk monitoring system, or (2) intentionally disregarded known “red flags.”3 Recent case law suggests that such claims are more likely to succeed where they concern a company’s “central compliance risks.”4 For example, last year, the Delaware Supreme Court in Marchand v. Barnhill found a Caremark claim was adequately pleaded based on allegations that the board minutes of an ice cream maker reflected no regular reporting or discussion regarding the food safety for its one product.5 However, these decisions do not disturb the well-established principle that boards have substantial discretion to fit their oversight to their company’s particular circumstances and to delegate to management, advisors, and specialists — so long as there is a reporting mechanism to regularly update the board and elevate significant problems. Delaware courts recognize that “requir[ing] directors to possess detailed information about all aspects” of the company would “be inconsistent with the scale and scope of efficient organization size in this technological age.”6 While the outcome depends on the particular facts, generally speaking oversight claims against directors rarely succeed, and courts have repeatedly referred to such claims as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”7
The COVID-19 pandemic may well result in shareholder litigation alleging a board failed to adequately monitor and respond to risks. For many companies, managing the risks and challenges posed by COVID-19 will have significant implications going forward and will require dynamic systems that can adjust to an ever-changing regulatory and public health landscape. Boards should give the company’s response attention commensurate to the size of the challenge — including memorializing their strategy for monitoring the “new normal” and receiving regular updates on any initiatives underway. This might include delegating particular oversight responsibilities to a committee, such as an audit or risk committee. An appropriate COVID-19 response will likely require significant coordination with various constituencies, including suppliers, customers, regulators, and employees. This coordination will be led by management but should start at the top with guidance from the board. Further, boards should not lose sight of traditional risks unrelated to the pandemic — such as accounting fraud, regulatory violations, and workplace accidents. An appropriate monitoring system must continue to handle these and other situations while expanding to accommodate risks created by the pandemic.
M&A during periods of distress.
While the overall market has largely recovered from the shock of COVID-19, many companies and entire industries remain severely affected by the virus and its attendant economic disruptions. This likely will lead to increased numbers of unsolicited merger offers and/or rapid position buildups by activist shareholders. In some circumstances, a sale or merger may be preferable to remaining a standalone entity. However, it is within a board’s business judgment to determine that offers based on current market values do not fully reflect their company’s intrinsic value. Accordingly, a board may decide not to engage with an offer that might in other times constitute an attractive premium to market value, or to proactively combat such offers by adopting a shareholder rights plan (or “poison pill”) to prevent significant accumulations of stock ownership without negotiation with the board.8 Conversely, the recent market distress may provide companies with opportunities for attractive acquisitions, or to shore up their positions through a merger of equals.
Boards should seek to manage the current environment proactively and opportunistically through the prism of a long-term strategic vision, and they should diligently monitor and prepare for potential M&A activity. For instance, even if meetings cannot happen in person, directors should maintain open and active lines of communication with managers, advisors, and potential deal partners. Directors should encourage their managers and advisors to think creatively in identifying strategic opportunities, while at the same time resisting the notion that a major M&A transaction is the only solution to current challenges. And given the volatile and fast-moving economic climate, directors should not wait until an M&A opportunity presents itself to have a well-developed sense of the company’s stand-alone prospects and strategy.
Directors should also familiarize themselves with the legal framework applicable to sale-of-control transactions. Under Delaware’s Revlon doctrine, “when a board engages in a change of control transaction, it must not take actions inconsistent with achieving the highest immediate value reasonably attainable.”9 However, “Revlon and its progeny do not set out a specific route that a board must follow when fulfilling its fiduciary duties, and an independent board is entitled to use its business judgment to decide to enter into a strategic transaction that promises great benefit, even when it creates certain risks.”10 During these novel times, it is even more important that boards have great flexibility in determining how to market, negotiate, and structure major M&A transactions. Of course, early and regular communication with counsel remains critical, as certain actions that occur in the nascent stages of M&A transactions can have significant ramifications for lawsuits challenging such transactions.
How insolvency or potential insolvency changes the equation.
Given the rate of economic change in recent months, directors should keep in mind how insolvency affects the fulfillment of their fiduciary duties. Directors of a Delaware corporation ordinarily owe a fiduciary duty to run the company for the benefit of its shareholders — not for the benefit of other constituencies, such as creditors. This remains the standard even when a corporation is almost insolvent, known as the “zone of insolvency.”11 “When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.”12 Thus, while directors do not technically owe fiduciary duties to creditors in this circumstance, creditors may assert claims on behalf of the corporation if the directors have breached the fiduciary duties owed to the corporation.13
Accordingly, directors may “continu[e] to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors.”14 For instance, “[d]irectors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.”15 However, if the board takes an action that harms the insolvent corporation (and thereby lowers the value available to repay the company’s debts), the board may face fiduciary duty litigation from creditors. During turbulent times, boards should consider requesting updated forecasts and regular assessments of the company’s liquidity, financing options, financial condition, and performance. And they should understand that “last ditch” efforts to salvage value for equity-holders may face scrutiny from creditors.
Vigilance in public reporting is more necessary than ever.
As we previously noted, we have already seen an uptick in securities lawsuits alleging inadequate disclosures in the wake of COVID-19. While it remains to be seen how successful these suits will be, we expect that courts and regulators will be realistic regarding the reporting challenges presented by this unprecedented time. Nevertheless, boards should do what they can to minimize the risks. The rapidly changing economic environment makes public disclosures and guidance particularly fraught. Indeed, companies (including many in the energy sector) have recently withdrawn earnings guidance on the ground that it is too difficult to accurately forecast in current market conditions. Even in the early stages of the outbreak, the SEC acknowledged that the pandemic may make it “difficult to assess or predict with meaningful precision both generally and as an industry- or issuer-specific basis.”16 Every company is different, but boards should consider whether to update, supplement, or withdraw prior guidance. The SEC has also encouraged companies to provide risk factor disclosures “regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable.”17 Boards should accordingly make sure that the company’s management and legal counsel have considered updating the company’s disclosures to reflect the impact of COVID-19. If and when companies do provide updated disclosure regarding financial performance or risks relating to COVID-19, they should take care to avoid Regulation FD issues regarding selective disclosure of material non-public information. Boards should also confirm that there are mechanisms in place to ensure that any public filings, presentations, or statements regarding the impact of COVID-19 are appropriately vetted, caveated, and updated to reflect the company’s current understanding.
1 Paramount Comms., Inc. v. Time Inc., 571 A.2d 1140, 1150 (Del. 1989).
2 Id. (“[W]e think it unwise to place undue emphasis upon long-term versus short-term corporate strategy.”).
3 Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 370, 372 (Del. 2006); In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 971 (Del. Ch. 1996).
4 Marchand v. Barnhill, 212 A.3d 805, 824 (Del. 2019); In re Clovis Oncology, Inc. Derivative Litig., 2019 WL 4850188 (Del. Ch. Oct. 1, 2019).
5 Marchand, 212 A.3d at 822.
6 In re Caremark, 698 A.2d at 971; Marchand, 212 A.3d at 821 (“As with any other disinterested business judgment, directors have great discretion to design context- and industry-specific approaches tailored to their companies’ businesses and resources.”).
7 In re Caremark, 698 A.2d at 967; Stone, 911 A.2d at 372.
8 Air Prods. & Chems., Inc. v. Airgas, Inc., 16 A.3d 48, 55 (Del. Ch. 2011).
9 C&J Energy Servs., Inc. v. City of Miami Gen. Emps. Ret. Trust, 107 A.3d 1049, 1067 (Del. 2014).
10 Id. at 1053.
11 North Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).
12 Id. at 101.
13 Id. at 103.
14 Quadrant Structured Prods. Co., Ltd. v. Vertin, 115 A.3d 535, 547 (Del. Ch. 2015).
15 Gheewalla, 930 A.2d at 103.
16 Jay Clayton, Chairman, U.S. Securities & Exchange Comm’n, Statement on Proposed Amendments to Modernize and Enhance Financial Disclosures; Other Ongoing Disclosure Modernization Initiatives; Impact of the Coronavirus; Environmental and Climate-Related Disclosure (Jan. 30, 2020), available at https://www.sec.gov/news/public-statement/clayton-mda-2020-01-30.
17 SEC Press Release, SEC Provides Conditional Regulatory Relief and Assistance for Companies Affected by the Coronavirus Disease 2019 (COVID-19) (Mar. 4, 2020), available at https://www.sec.gov/news/press-release/2020-53.
