Buzz

Recent Liability Issues Associated with Down Rounds

Michael Halloran and Tom Gump, Pillsbury Winthrop


Reprinted by permission. ¸2003 Aspen Publishers. Please note that this work is part of a larger work, Venture Capital & Public Offering Negotiation, by Michael Halloran et al., Aspen Publishers.

Down rounds have the potential to create a perception of unfair dealing on the part of the investors who lead the financing because they can be perceived as using the leverage created by the financial distress of the issuer, or in the case of a down round led by existing shareholders, their inside or control position, to dilute existing shareholders of the company. Even more important, however, down round financings represent potential sources of legal liability for both members of the issuer's board of directors as well as for the controlling shareholders, if any, of such issuer. The remainder of this section examines how legal liabilities may arise for both interested and disinterested members of the board of directors, as well as for such issuer's controlling shareholders, in a down financing and methods for reducing or minimizing prospects for such liabilities. [1]

A. General Claims Against Corporate Directors

Given the high level of discontent among a corporation's stakeholders that a down financing can generate, corporate boards should take care to ensure that they comply with their fiduciary duties when undertaking such financings. For corporate boards that do not contain one or more "interested" directors, three principal sources of legal liability exist. These sources of potential liability include claims that the corporate board violated its duty of due care in managing the business and affairs of the corporation, its duty of candor in communicating to shareholders, and, if the issuer is in the "vicinity of insolvency," its fiduciary duties to the corporation's creditors.

i. Duty of Due Care

Under Delaware corporate law, the duty of care requires that directors, prior to making any business decision, inform themselves of all material information reasonably available to them so that they can arrive at an informed decision while acting in good faith. For example, in passing on the issue of the general standard of care applicable to director conduct, the Delaware courts have stated that "directors . . . in managing the corporate affairs are bound to use that amount of care which ordinarily careful and prudent men would use in similar circumstances." [2] Subsequent cases have since clarified that the Delaware standard for finding director liability with respect to a failure to exercise due care is based on a gross negligence standard. [3] In such a context, the Delaware courts have indicated that gross negligence means "reckless indifference to or a deliberate disregard of the whole body of stockholders or actions that are without the bounds of reason. [4] Similarly, California has established that the duty of due care requires that directors exercise the care that an ordinarily prudent person in a like position would exercise under similar circumstances. [5]

Corporate directors who consider and authorize their company to execute a down financing should take care to document their compliance with their fiduciary duty to exercise due care in a manner that maximizes the likelihood that the protections of the business judgment rule will be available. [6] While the liquidity crises that commonly give rise to the need to consider a down financing rarely afford directors a leisurely consideration of their options, the members of a company's board of directors should take care to exhaust other reasonable possibilities for raising debt and equity financing prior to consummation of the down financing. In addition to considering other sources of financing, corporate directors will want to fully consider other possible courses of action to maximize value for the shareholders, including arranging a merger or sale of the company, seeking bankruptcy protection, and other reasonable options under the circumstances.

Corporate boards often hire financial advisors as a means to ensure that all realistic options for the company have been considered. Both the Delaware and California corporation laws recognize the right of directors to rely upon the results of the work of such advisors. [7] Given the significant expense involved in retaining such advisors and the tight timeframe for executing a transaction, however, corporate boards often find that they are unable to work effectively with outside financial advisors in the process of arranging financing for the distressed issuer.

After reasonable alternatives to the down financing have been considered, corporate directors should take care that their efforts have been documented in detailed board minutes that review the alternatives to the down financing that were pursued. These minutes should also make clear that the board took action based upon a complete understanding of all available facts. In the event the board decides to proceed with the down financing, the directors should carefully document the basis for their conclusion that the valuation of the company was fair. Part of this documentation can come from financial advisors retained for the transaction who often prepare a report to document the basis for the down round valuation as part of their engagement. Hiring an independent financial advisor to consult with the issuer's board of directors is more important in these cases where the down financing is led by existing stockholders of the company or other corporate insiders as a means to defend against charges of self-dealing. Where the down round is led by investors who are not current stockholders or otherwise affiliated with the issuer, the valuation can be more easily said to be the product of an arm's-length negotiation, with the result that the risk of subsequent litigation is somewhat mitigated. In addition, corporate directors should take care to document the basis of the valuation in the down round by reference to developments in the broader market for the corporation's goods and services, the actual performance of the corporation versus prior expectations, the terms and conditions of the securities being issued, and the valuations attained by similarly situated companies.

Moreover, corporations engaged in a down financing will often execute a rights offering as a means to limit the liability of their board of directors in the transaction. In a rights offering, the company offers all existing shareholders the chance to participate in the down financing on the same terms and conditions as are offered to the investors leading the round. Although perhaps not a specific remedy for a breach of fiduciary duty by the board of directors of the issuer, undertaking a rights offering represents strong evidence of the board's good faith because it permits the other shareholders to participate in the offering if they deem it to be in their interest to do so. As a result, the fact that the issuer undertook a rights offering as part of the down round may prove to be an important equity that weighs heavily in the minds of a court or jury hearing claims in subsequent litigation. Although issuers often look to a rights offering to limit legal liabilities that result from a down round, such rights offerings often involve significant expenditures of time and money in order to execute and can raise securities law issues, particularly where the offering is to be made to a substantial number of non-accredited investors.

Directors of an issuer undertaking a down financing will want to make sure that the corporation on whose board they sit has eliminated or limited their personal liability for damages for breach of fiduciary duty to the maximum extent permitted by law. The starting point for such protection is, of course, the relevant state statutes. For example, while the Delaware General Corporation Law provides that a corporation may adopt in its certificate of incorporation provisions which broadly eliminate or limit the "the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty." [8] Such liability may not, however, be eliminated or limited for:

  • any breach of the director's duty of loyalty to the corporation or its stockholders;
  • acts or omissions not in good faith or which involve intentional misconduct or knowing violation of the law;
  • liability in connection with the unlawful payment of dividends or otherwise as provided by section 174 of the Delaware General Corporation Law; or
  • any transaction from which the director derived improper personal benefit. [9]

Similarly, the California General Corporation Law also allows corporations to eliminate or limit the personal liability of directors, subject again to certain enumerated exceptions. [10]

In addition to seeking charter amendments that require the corporation to provide for the elimination of personal liability of directors to the maximum extent permitted by law, [11] directors of issuers in down rounds would be well advised to ensure that they have contractual indemnification agreements with the issuer in place as well. While these agreements cannot expand the scope of indemnification permissible by the issuer, [12] they can establish contractual rights in favor of the covered director requiring the corporation to provide such indemnification, where available under applicable law, maintain adequate D&O insurance in favor of the director, advance or promptly reimburse the director's defense costs and expenses, and ensure that the director has access to separate counsel in subsequent litigation, if such separate representation is reasonably requested or required.

Finally, while not a legal defense to a breach of fiduciary duty claim, many corporations involved in down rounds have in the last several years sought to prepare themselves from a practical perspective for the prospect of subsequent litigation by purchasing directors' and officers' insurance. Although such insurance has become more common in the developing company context, the costs associated with it have also recently increased, with the result that the protections afforded directors by such insurance in the future may become less available. [13]

ii. Duty of Candor

Delaware courts have long recognized that corporate directors have a duty to fully and fairly inform shareholders of material information respecting the corporation and its affairs. [14] This duty generally requires directors to disclose material information when seeking stockholder action. [15] While these courts have issued varying pronouncements on whether this "duty of candor" is a separate fiduciary duty (or instead a subset of other fiduciary duties of directors, such as the duties of due care and loyalty), the duty of candor has been consistently described as requiring directors to disclose material information to a corporation's stockholders, including all information which a reasonable stockholder would consider important in deciding whether to sell or retain his or her shareholdings. [16]

The materiality standard adopted by the Delaware courts with respect to the duty of candor does not require that corporate boards ensure that all available information is disclosed to the corporation's shareholders. [17] Instead, corporate directors must only ensure that information which "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information be made available." [18] While materiality will ultimately be a mixed question of law and fact in any particular case, [19] the Delaware courts will generally find a fact to be material "if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." [20] Thus, when determining materiality, courts will look to the objective perspective of a reasonable stockholder, not a director's subjective perspective. [21] "As a result, at least one Delaware court has indicated that a fiduciary's duty is best discharged through a broad rather than a restrictive approach to disclosure." [22]

Delaware courts have found the duty of candor to apply in at least two different sets of circumstances. To begin, the Delaware cases establish that a duty of candor exists in situations where the board of directors of a corporation solicits stockholder consents to a corporate action. In an early case, Lynch v. Vickers, the Delaware Supreme Court held that the duty owed to stockholders is one of "complete candor," requiring directors to disclose all germane information to the stockholders. [23] In that case, former stockholders of TransOcean Oil, Inc. filed a class action against the directors of TransOcean and its majority stockholder for failure to disclose information in connection with a tender offer. [24] The Court held that the directors and the majority stockholder of the company owed a duty of complete candor, requiring the disclosure of all germane information. [25] Germane information included information that a reasonable shareholder would consider important in deciding whether to sell or retain stock. [26]

Similarly, in Stroud v. Grace, the Delaware Supreme Court clarified the duty owed by directors, holding that the duty of candor requires directors of Delaware corporations to fully and fairly disclose all material information within the board's control when requesting shareholder action. [27] In Stroud, minority stockholders brought an action against Milliken Enterprises, a closely held corporation, and its board of directors. [28] Plaintiffs alleged that the directors had breached their fiduciary duties and, in particular, their duty of candor in connection with the approval of various charter amendments and notice of the annual meeting. [29] The Chancery Court, sua sponte, granted summary judgment in defendant's favor, concluding that the defendant directors had not breached their fiduciary duties. [30] On appeal, the Delaware Supreme Court held that, absent a proxy solicitation, the directors did not have a duty to disclose information to shareholders beyond that required under Delaware General Corporation Law. [31]

However, more recently, even when no specific stockholder consent is being sought by a corporation's board, the Delaware courts have found that the duty of candor requires that directors be candid whenever they communicate publicly or directly with shareholders about the corporation's affairs. [32] For example, in Malone v. Brincat, [33] the Delaware Supreme Court resolved a conflict in the Chancery Courts regarding whether the duty of candor requires directors to disclose material information absent a request for stockholder action. [34] The Court held that directors must communicate truthfully when they disseminate information to shareholders, regardless of whether shareholder action is requested. [35] When they fail to do so, they violate their general fiduciary duties of care, good faith and loyalty. [36]

Irrespective of whether the duty of candor is triggered by the solicitation of a stockholder consent or by more general communications between a corporation and its shareholders, directors have a duty to avoid misleading partial disclosures. As the Delaware courts have stated, once defendants "travel down the road" by making a partial disclosure, they have an obligation to provide the shareholders with "an accurate, full, and fair characterization of those events." [37] This situation may arise when directors are complying with federal, state or common law disclosure requirements, [38] or when directors make voluntary disclosures to shareholders. [39]

The Delaware courts first applied the duty of candor to a corporate board which arranged a down round financing in a decision released in 2003. The case, known as Goldman v. Pogo.com, [40] involved a company which designed and provided Internet gaming content, which experienced serious financial distress due to its continuing need for new capital. [41]

After examining available alternatives, the board of directors in Pogo.com authorized the company to raise additional financing through consummation of a convertible bridge loan financing that would significantly dilute the equity interests of existing shareholders. The Pogo.com plaintiff alleged in his complaint that the convertible bridge loan financing in fact diluted his equity interest in the company from 13.2% to 0.1%. [42] While there was general agreement between the litigants that the issuer did disclose to its shareholders that they would suffer dilution as a result of the financing, the plaintiff argued that the defendant's failure to disclose the extent of the dilution he would suffer if he failed to participate in the convertible bridge loan financing represented a violation of directors' duty of candor. In denying the defendant's motion to dismiss the plaintiff's claims, the Delaware Chancery Court reaffirmed that, when making disclosures to shareholders in the context of a request for shareholder action, directors must "provide shareholders with all information that is material to the action being requested." [43] Moreover, the court stated that directors must provide a "balanced, truthful account of all matters disclosed in the communications with shareholders." [44]

The Pogo.com court articulated a four-part test to determine whether corporate boards have breached their duty of candor by omission. Under this test, in order for a plaintiff to properly state a claim for a breach of the duty of disclosure, he must allege that (1) the violations were material; (2) the information was reasonably available to the directors; (3) the information related to the transaction; and (4) the information was omitted from the disclosure materials. [45] Emphasizing the importance of materiality, the Pogo.com court concluded that failure to disclose the magnitude of the dilution of plaintiff's equity interest could constitute the omission of material information because if plaintiff had been aware of the extent of the dilution he might have decided to participate in the transaction. [46] Thus, the court held that for purposes of review on a motion to dismiss, the complaint adequately alleged that directors failed to disclose known, material information. [47]

The defendants in Pogo.com sought to prevail on their motion to dismiss the plaintiff's claims by invoking the protections of the business judgment rule. [48] The court refused to allow the defendants the benefit of this rule, however, because it determined that it was impossible to determine without further proceedings that a majority of directors who approved the challenged transactions were independent. This potential lack of independence of a majority of the Pogo.com board was found to exist based upon the prior relationships between the lead investor in the transaction and certain of the directors who served on the Pogo.com board. In reaching this conclusion, the court pointed to facts that included (i) the fact that one of the Pogo.com directors had previously served on corporate boards of other portfolio companies of the lead investor for the challenged transaction, (ii) that the lead investor often used one of the Pogo.com directors as a "short-term high ranking executive" in companies in which it invested, and (iii) that another Pogo.com director was the President and Chief Executive Officer of another one of the lead investor's portfolio companies. In light of the tangled web of prior connections and pre-existing business relationships which characterize the venture community, this aspect of the court's decision in Pogo.com may in the future present a formidable obstacle to the availability of the protections of the business judgment rule in down round litigation.

Down round financings commonly involve numerous scenarios which implicate the duty of candor. For example, the Delaware General Corporation Law and the California Corporations Code will typically require (in the absence of "blank check preferred" powers having been lodged in the issuer's board) that stockholder consents be obtained to amend the issuer's certificate or articles of incorporation to establish the rights, preferences, and privileges of any preferred stock to be issued in the down round. In addition to these general stockholder consent requirements, prior round investors may have negotiated additional consent rights (such as consent rights with respect to the issuance of senior or pari passu securities, etc.) that may be triggered by a down round. Moreover, issuers in down rounds may seek disinterested stockholder approval of the down financing where one or more of the directors on the issuer's board is financially interested in the transaction. [49] Finally, prior round financing documents (such as stockholders agreements or registration rights agreements) must often be amended as a condition to consummation of the new financing, which amendment requires the consent of some or all of the prior round investors. When requesting stockholder consents to such actions, corporate directors must take care to ensure that they comply with their duty of candor when communicating with their stockholders. [50]

iii. Duties Owed to Creditors

Delaware case law has long established that directors owe fiduciary duties to the stockholders of the company. Case law in that state, however, has also made clear that the scope of a director's fiduciary duties may, in certain circumstances, extend to the creditors of the corporation in addition to its stockholders. [51] In fact, these cases make clear that when the corporation is insolvent, the fiduciary duties of the directors shift from the stockholders to the creditors of the corporation. [52]

Fiduciary duties to creditors arise when the corporation becomes insolvent in fact, regardless of whether a statutory filing has occurred. [53] Thus, no formal bankruptcy or insolvency proceeding needs to have been commenced by the corporation for these fiduciary duties to be triggered. The Delaware courts have generally applied two tests to determine whether a corporation has become insolvent in fact. First, a corporation becomes insolvent when it is unable to pay its debts as they come due in the usual course of business. [54] Second, insolvency arises when a corporation has liabilities in excess of the reasonable market value of assets held. [55] If either of these tests are met, the corporation will generally be deemed insolvent in fact.

Recent cases have extended the duty owed to creditors by directors to situations where the corporation enters the "vicinity of insolvency." [56] The case of Credit Lyonnais Bank Nederland, N.V., et al. v. Pathe Communications Corp. et al. [57] demonstrates the application of this principle. In that case, Credit Lyonnais Bank Nederland (CLBN) had advanced considerable sums to MGM-Pathe Communications Corporation (MGM). MGM subsequently became unable to pay its bills as they became due, and MGM's creditors initiated Chapter 7 proceedings. [58] These proceedings were dismissed shortly thereafter on the condition that Paretti, a 98% shareholder, step down from his position as chief executive officer. [59]

MGM's new management subsequently failed to facilitate a series of transactions sought by Paretti in order to regain control. [60] Paretti argued that the failure to facilitate such transactions amounted to a breach of the fiduciary duties owed to him as a shareholder. [61] The Delaware Chancery Court disagreed, concluding, "where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise." [62] Moreover, once the corporation entered the vicinity of insolvency, the management had a duty to maximize the long-term wealth creating capacity of the corporation for both the shareholders and the creditors. [63] While no court has set forth a test to determine when a corporation enters the vicinity of insolvency, [64] presumably, a corporation enters the vicinity when it nears insolvency or enters bankruptcy. [65]

While the law in this area remains generally unsettled, directors of an issuer involved in a down round should consider a number of strategies to limit claims that they violated their fiduciary duties to creditors. To begin, such directors should consistently and carefully monitor the financial health of the corporation to determine if and when the corporation becomes insolvent or enters the "vicinity of insolvency" under the principles set forth above. In monitoring the corporation's financial health, the directors may choose to rely upon the issuer's own financial and accounting staff, as well as information provided by outside auditors and financial consultants. [66] At the same time, by ensuring that their decision-making occurs on a fully informed basis, corporate directors will help to maximize the likelihood that the protections of the business judgment rule are available.

As is the case with documenting compliance with the duty of care generally, corporate boards of an insolvent issuer should hold multiple meetings where detailed minutes are produced which document that the issuer's board allowed its decision-making to be guided by the principle of long-term wealth maximization of the corporation for the benefit of the shareholders and the creditors. These minutes should reflect that the directors considered all reasonable alternatives to the down round available to the corporation, as well as the potential impact of each of these alternatives on the creditors and the reasons why they were better served by consummation of a down round and/or further attempts to arrange such a financing.

In fact, prudent directors of an issuer considering a down round will immediately recognize that the corporation is (or may shortly be) insolvent, as many issuers who seek to arrange a down financing face severe shortages of operating funds, and will proactively begin to consider the interests of creditors of the venture in their decision-making. Thus, at the same time they are negotiating with potential equity investors, these directors should assemble lists of the corporation's creditors and take steps to ensure that their recovery will be maximized in the event that the financing cannot be arranged as planned, and the company fails. Moreover, directors involved in planning a down round should ensure that the expenditures of the corporation are trimmed to the fullest extent possible to preserve assets for distribution to the corporation's creditors if the down round cannot be arranged, and that corporate assets are not otherwise wasted.

Finally, directors should refrain from taking any actions which suggest that they failed to exercise good care or independent judgment, or otherwise engaged in a form of self-dealing. Thus, when an insolvent corporation does make payments to creditors, the board should take care that corporate insiders who are also creditors of the venture are not favored over otherwise unaffiliated creditors.

It is important to note that while many jurisdictions permit the directors of a corporation to limit their liability for breaches of the duty of care by inserting an exculpatory provision into the certificate or articles of incorporation, [67] a number of courts have expressly held that such exculpatory provisions do not operate as a bar to suits for breach of fiduciary duties brought by creditors or by the trustee on behalf of creditors. [68] These courts have characterized the certificate or articles of incorporation as a contract between the corporation and its shareholders whereby each party establishes the rights and responsibilities of the other, and have concluded that if the shareholders wish to provide for exculpation of the directors, they may do so. However, these courts have been unwilling to bind third parties who are not party to the articles of incorporation, such as creditors, to such limitations. As the Pereira court explained,

the development of such clauses was premised on the rationale that shareholders should have the ability to contract with the corporation and its directors, via the articles of incorporation, regarding the directors' liability to the corporation or the shareholders. . . . the Exculpatory Clause, both by its terms and in accordance with the underlying policy rationale, allocates the risk of loss between the parties to the articles of incorporation, i.e., the shareholders and directors. The clause does not allocate this risk with respect to third parties... [69]

This approach has also been followed by other courts which have indicated that creditors should not be bound by the exculpatory provision because they were not parties to the contract. [70]

B. Special Concerns for Interested Directors

The previous section reviewed concerns which should be addressed by corporate directors who guide their companies through down financings. This section will review concerns unique to down financings authorized by corporate boards that include one or more interested directors. To begin, both Delaware and California law provide that corporate directors owe duties of loyalty to the corporation and its shareholders, and as discussed above, to the corporation's creditors. This duty was described in an early California case as follows:

Directors owe a duty of highest good faith to the corporation and its stockholders. It is a cardinal principle of corporate law that a director cannot, at the expense of the corporation, make an unfair profit from his position. [71]

Thus, the duty of loyalty will be implicated by transactions involving the corporation as a party which may result in personal financial gain to one or more of the corporation's directors. [72]

Venture capitalists often obtain the right to be represented on the board of directors of their portfolio companies while negotiating the terms of their participation in rounds of financing for the company. Such designated directors plainly perform important roles for portfolio companies in terms of expanding the scope of experience of the board while simultaneously helping the venture capitalist monitor the performance of its investment. While funds with contractual rights to board representation infrequently designate directors who are not financially interested in the fund in any way, [73] in most cases venture capitalists fill their contractual board seats with directors, officers, or employees of the fund itself. In such cases, these "fund affiliated directors" share in the success of the fund through the payment of salaries, bonuses, or sharing in the fund's "carry." As a result, such a director can properly be said to be financially interested in the down round financing in which his or her related fund participates, as the negotiation of better terms for the affiliated venture capitalist can, in the long run, result in the payment of additional sums to the director if the fund's portfolio company attains financial success.

Corporations pursuing a down financing will want to protect their board from the impact of having one or more interested directors by taking advantage of available safe harbors. Specifically, section 144(a) of the Delaware General Corporation Law offers four statutory safe harbors for interested director transactions:

Disinterested Director Approval−if the material facts pertaining to the conflict of interest are known by or disclosed to the board of directors approving the down round and a majority of the disinterested directors (even if the number of disinterested directors constitutes less than a quorum) in good faith authorizes the transaction.

Special Committee Approval−if the material facts pertaining to the conflict of interest are known by or disclosed to a special committee of the board of directors charged with considering the down round and a majority of the disinterested members of the special committee in good faith authorizes the transaction (again, even if the number of disinterested directors approving the transaction constitutes less than a quorum). It is important to note that the effectiveness of the protection offered by this safe harbor is increased if the special committee has been charged with negotiating all aspects of the down financing, rather than merely being brought in at a late hour to approve a transaction that has been negotiated by a group that includes one or more interested directors. Moreover, the special committee would ideally consist only of directors who are not conflicted or otherwise interested in the transaction. [74]

Stockholder Approval−if the material facts pertaining to the conflict of interest are known by or disclosed to the shareholders entitled to vote thereon and the transaction is specifically approved in good faith by a vote of the shareholders. Note that the Delaware General Corporation Law does not on its face require ratification by a majority of the disinterested shareholders in order for this safe harbor to be available. In interpreting this provision, however, at least one Delaware court has found that the transaction must be approved by a majority of the disinterested shareholders (not merely a majority of all shareholders) in order for the safe harbor to be available. [75]

Fundamental Fairness−if the down round financing is fair as to the corporation as of the time authorized, approved, or ratified by the board of directors, a committee of the board, or the shareholders.

In considering which of these safe harbors to rely upon, it is important to note that, while the first three defenses are relatively objective tests, questions regarding whether a transaction was fundamentally fair to the corporation will, by their nature, be very fact-intensive. As a result, summary judgment often will be unavailable in cases in which the principal defense to the interested director transaction is the transaction's fundamental fairness. Corporations confronting interested director situations in down financings would, therefore, be well advised to ensure that at least one of the first three defenses mentioned above is also available to improve their chances of resolving subsequent litigation at summary judgment and without a full tria1. [76]

C. Controlling Shareholder Liability

American corporate law has long established that, as a general matter, shareholders can vote their interests on matters that come before them. For example, an early Delaware court indicated that the general rule is that:

... a stockholder is not deprived of the right to vote upon a question in which he has an individual interest in the result of the vote apart from his general interest in the corporation. His relation as a stockholder to other individual stockholders and to the body of stockholders is not a fiduciary one. Consequently, when he is called upon to decide at a stockholders' meeting between his own interest as an individual and what may be his interest along with other stockholders in benefiting the corporation, he is free to exercise his own judgment, and to act in accordance with selfish rather than altruistic motives. [77]

Thus, when voting to approve or otherwise taking steps to arrange down round financings, shareholders generally need not consider the interests of other shareholders or the impact of the contemplated transaction upon them, as this doctrine offers a safe harbor for many, if not most, actions taken by existing shareholders of the issuer in arranging a down round. [78]

Courts have, however, imposed limitations on this general principle when a transaction involves the controlling shareholder of the corporation. [79] For example, under Delaware case law a shareholder who owns a majority interest in a corporation, or exercises actual control over its business affairs, occupies the status of a fiduciary to the corporation and its minority shareholders. [80] A shareholder must be a controlling shareholder for this fiduciary duty to attach, either by owning a majority of the corporation's stock or by exercising actual control over the business affairs of the corporation. [81] Similarly, California case law holds that a controlling shareholder of a corporation is viewed as a fiduciary and his dealings with the corporation are subject to rigorous scrutiny. [82]

The California Supreme Court, in Jones v. H.F. Ahmanson & Co., offers perhaps the most eloquent discussion of the duties of controlling shareholders in a closely held corporation. [83] The court held that "the comprehensive rule of good faith and inherent fairness to the minority in any transaction where control of the corporation is material properly governs controlling shareholders in this state." [84]

This fiduciary status placed upon controlling shareholders a duty of good faith and an obligation not to use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority, or that is otherwise not just, fair, and equitable. [85] Moreover, the court stated broadly that any use to which controlling shareholders put the corporation, or their power to control the corporation, must benefit all shareholders proportionately and must not conflict with the proper conduct of the corporation's business. [86] The Jones court also indicated that a controlling shareholder charged with a breach of fiduciary duty could successfully defend such charges by showing that the challenged transactions were indeed inherently fair from the point of view of the corporation and all of its shareholders and that the transaction was entered into in good faith. The court further opined that the inherent fairness of the transaction can be demonstrated by showing that under the circumstances the transaction carries the earmarks of an arm's-length deal. [87] Finally, while Jones involved perhaps the most eloquent discussion of the fiduciary duties of controlling shareholders to a corporation, breach of fiduciary duty is by no means the sole source of liability of a controlling shareholder for his or her corporate acts. [88]

Many venture capitalists have, in the past, been careful to minimize potential legal liabilities from their financing activities; however, the recent case of Kalashian v. Advent VI Limited Partnership [89] (the "Alantec Case") demonstrates the significant potential liabilities directors and controlling shareholders face in the down round context. That case involved two entrepreneurs who had formed Alantec Corporation ("Alantec") in 1987 to compete in the then-developing multibillion-dollar market for the inter-networking of local area networks (LANs). The Alantec founders invested $60,000 of their own money in the venture. In addition, Alantec received financing from venture capitalists who invested approximately $6 million over the next few years, obtaining an ownership stake of approximately 90% as a result. In connection with their investment, the venture capital investors obtained seats on Alantec's board of directors.

In 1989 and 1990, after the founders left Alantec, Alantec entered into a series of down round financings which substantially diluted the founders' interests from approximately 8% to 0.007%. After successfully raising capital through these down rounds, Alantec went public in February 1994. On March 23, 1994, the Alantec founders filed their complaint against Alantec, its board, and certain venture capital investors for fraud and breach of fiduciary duties, claiming that the defendants intentionally acted to wash out the founders' stakes in the company by issuing new preferred stock to their own venture funds at less than fair market value. The plaintiffs also alleged that Alantec's board issued additional common stock to Alantec's new management in order to ensure that it obtained the required shareholder class approvals for its additional rounds of financing. In response to the allegations, the defendants argued that Alantec was approaching bankruptcy at the time of the down rounds and that their actions were in good faith and were necessary to secure the survival and success of the company. While the court never issued a final decision in the case, the subsequent out-of-court settlement reportedly involved a $15 million payment made by the defendants. [90]

Although the facts of the Alantec Case were perhaps extreme, and the ultimate teachings from a legal perspective uncertain in light of the fact that the case was settled out of court, the significant sums ultimately paid by the defendants strongly suggest that venture capitalists must be mindful of the potential liabilities they can incur in connection with down round financings. However, by crafting a strategy based upon the items set forth above, together with their counsel, savvy venture capitalists will be able to continue to maximize the potential returns of their investing activities while effectively managing litigation risks.


Footnotes

[1] The discussion in this Section 4 is limited to potential sources of director liability based upon claims of breach of fiduciary duty. Other sources of liability for a director of a corporation involved in a down round exist and need to be carefully analyzed. For example, directors of issuers involved in down rounds may find that if the financing ultimately cannot be arranged, the portfolio company becomes unable to pay all employee wage and vacation pay entitlements. If the issuer has employees in the State of California, the directors should note that the California Department of Industrial Relations Division of Labor Standards Enforcement (the "Labor Standards Enforcement Division) has made awards individually against corporate executives whose companies have failed to pay employee wage entitlements, including entitlements for vacation pay. For a summary of the Labor Standards Enforcement Division's view of its authority to make such awards, see, e.g., the June 18, 2002 Labor Standards Enforcement Division Letter to Judge John. M. Watson appearing at http://www.dir.ca.gov/dlse/OpinionLetters-byDate.htm. The view expressed therein is that liability for unpaid employee wages properly attaches not only to employers in the most literal sense, but also to any person who exercises control over the wages, hours or working conditions of employees. Id. Under this approach, corporate directors could be found liable for unpaid employee wages for an issuer who has employees in the State of California if the requisite indicia of director control over "wages, hours, or working conditions" of the employees exists. Moreover, states other than California have already imposed liability upon corporate directors for unpaid employee wages. See, e.g., Yatron v. Lydon, 20 Pa. D & C.4th 251 (1993). In addition, corporate directors may be held separately and individually liable for an issuer's failure to collect, account for and pay over employment taxes such as FICA from its employees to the Internal Revenue Service if such director is considered a "responsible person" under Sections 6672 and 6671(b) of the Internal Revenue Code of 1986 ("IRC"), see, United States v. Graham, 309 F. 2d 120 (9th Cir. 1962), and may also be assessed a 100 percent penalty (trust fund recovery penalty) if the failure to pay over employment taxes was willful. See, IRC Section 6672(a); Monday v. United States, 421 F. 2d 1210 (7th Cir. 1970). Courts have used a variety of factors to support the conclusion that the requisite degree of authority and control over the decision to pay employment taxes exists for purposes of determining whether such person constitutes a "responsible person" under IRC Section 6672. Such factors include whether the individual is (1) an officer or a member of the board of directors; (2) owns shares or possesses an entrepreneurial stake in the company; (3) is active in the management of day-to-day affairs of the company; (4) has the ability to hire and fire employees; (5) makes decisions regarding which, when and in what order outstanding debts or taxes will be paid; (6) exercises control over daily bank accounts and disbursement records; and (7) has check-writing authority. See, Jones v. United States, 33 F. 3d 1137 (9th Cir. 1992)(gathering other Ninth Circuit cases); see also, Hewitt v. United States, 377 F. 2d 921 (5th Cir. 1967); Haffa v. United States, 516 F. 2d 931 (7th Cir. 1975); Turnbull v. United States, 929 F. 2d 173 (5th Cir. 1991).

[2] Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125, 130 (Del. Ch. 1963).

[3] See Aronson v. Lewis, 473 A.2d 805 (Del. Supr. 1984).

[4] Kahn ex re DeKalb Genetics Corp. v. Roberts, No. 12324, 1995 Del. Ch. LEXIS 151 *11 (Dec. 6, 1955); Tomczak v. Morton Thiokol Inc., Del. Ch. No. 7861, Hartnett, UC (Apr. 5, 1990) Mem. Op. at 31-32 (quoting Allaun v. Consolidated Oil Co., 147 A. 257, 261 (Del. Ch. 1929)).

[5] See Section 309 of the California General Corporation Law. A form of the California standard has been adopted in New York and in most of the other 40-odd states that follow an approach based upon the Model Business Corporations Act.

[6] The business judgment rule is a process-oriented judicial doctrine that has the effect of precluding reviewing courts from second guessing the judgment of a corporation's board of directors or special committee thereof. Under this rule, directors are presumed to have acted on an informed basis, in good faith, and with the honest belief that the action was taken in the best interest of the corporation. To overcome the "due care" element of this presumption, plaintiffs must, in essence, demonstrate that the director's fact-gathering process was fundamentally flawed. Thus, if an appropriate process is observed, a director's action should be protected from charges of a violation of the duty of due care. Flaws in the fact-gathering process which can result in the business judgment rule not being available include that a majority of the directors which approved the challenged transaction lacked independence or were not disinterested. Goldman v. Pogo.com, No. 18532, 2002 Del. Ch. LEXIS 71 (June 14, 2002) at *1. See discussion in text at note 94, infra.

[7] See, e.g., section 141 (e) of the Delaware General Corporation Law and section 309(6) of the California General Corporation Law.

[8] See õ 102(b) and õ102(b)(7) of the Delaware General Corporation Law.

[9] Id.

[10] See õ 204(a)(10) of the California General Corporation Law. Note, however, that the California provision has more exceptions to the general rule that personal monetary liability may be eliminated or limited for corporate directors than can be found in the analogous provisions of the Delaware statute.

[11] See, e.g., Chapter 8, supra, at pp. 8-54 to 8-55 for a sample charter provision and related commentary.

[12] See, e.g., õ 145 of the Delaware General Corporation Law and õ 317 of the California General Corporation Law.

[13] See Officers See Insurance Cost Rising, With Less Coverage, N.Y.L.J. (Aug. 29, 2002); see also Pitfalls in a New World, Nat'l L.J. (Aug. 26-Sept. 2, 2002).

[14] Lynch v. Vickers Energy Corp., 383 A.2d 278, 281 (Del. 1977); Rosenblatt v. Getty Oil, 493 A.2d 929, 944 (Del. 1985); Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992). Majority stockholders also owe a duty of disclosure to minority stockholders when they seek their consent in the context of a merger. Lynch, 383 A.2d at 281; Shell Petroleum, Inc. v. Smith, 606 A.2d 112 (Del. 1992).

[15] Stroud, 606 A.2d at 84; Malone v. Brincat, 722 A.2d 5, 11 (Del. 1998). Under more recent decisions, the Delaware courts have indicated that "[w]hen directors disseminate information to stockholders when no stockholder action is sought, the fiduciary duties of care, loyalty and good faith apply" and "dissemination of false information could violate one or more of those duties." Malone, 722 A.2d at 10; see also, Jackson National Life Insurance Co. v. Kennedy, 741 A.2d 377, 389 (Del. Ch. 1999).

[16] Early cases treated the duty of candor or disclosure as a separate fiduciary duty. See, e.g., Lynch, 383 A.2d at 278. Later cases clarified that the duty to disclose arises under the fiduciary duties of care, good faith and loyalty. Zirn v. VLI Corp., 621 A.2d 773 (Del. 1993) ("The requirement that directors disclose to shareholders all material facts bearing upon a merger vote arises under the duties of care and loyalty."); Malone, 722 A.2d at 10 ("The duty of disclosure is, and always has been a specific application of the general fiduciary duty owed by directors."); Jackson National Life Insurance Co., 741 A.2d at 388-89 ("The duty of disclosure is merely a specific application of the more general fiduciary duty of loyalty that applies only in the setting of a transaction or other corporate event that is being presented to the stockholders for action."). Professor Lawrence A. Hamermesh has attempted to harmonize this conflict, noting, "[r]ecent treatment of the duty by the Delaware Supreme Court identifies the duty of disclosure as a distinct legal obligation which is derivative of the duties of care and loyalty, but apparently distinct and separate from those duties." Lawrence A. Hamermesh, Calling Off the Lynch Mob: The Corporate Director's Fiduciary Disclosure Duty, 49 Vand. L. Rev. 1087, 1097 n.34.

[17] Stroud, 606 A.2d at 85.

[18] Id. (quoting TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976), and, thus, the typical materiality standard and in securities fraud cases).

[19] Cede & Co. v. Technicolor, Inc., 636 A.2d 956, 957 (Del. 1994).

[20] Rosenblatt, 493 A.2d at 944 (citing TSC Industries Inc., 426 U.S. at 449).

[21] Arnold v. Society for Life Savings Bancorp Inc., 650 A.2d 1270, 1277 (Del 1994).

[22] Zirn v. VLI Corp., 621 A.2d at 779-80.

[23] Lynch, 383 A.2d at 281.

[24] In September 1974, Vickers, a majority shareholder in TransOcean, commenced a tender offer to purchase the remaining shares in the company at $12 per share. The plaintiff rendered her 100 shares in response to the tender offer. She later filed suit, alleging that the defendants had violated their fiduciary duties by failing to make a full and frank disclosure in regard to the tender offer. The Court concluded that the tender offer failed to disclose two critical facts. First, a qualified petroleum engineer, who was also a member of TransOcean's management, calculated the net asset value to be $250.8 million, or $20 per share. Second, the majority stockholder's management had authorized open market purchases of TransOcean's stock during the period immediately preceding the $12 per share tender offer for bids up to $15 per share. In regard to the net asset value of the company, the tender offer disclosed that TransOcean's net asset value was "not less than $200,000,000 . . . and could be substantially greater." The Court held that while this statement was technically correct, it did not meet the requirements of the duty of complete candor given that more specific facts regarding possible value were available. The Court further held that the directors had a duty to disclose to the minority shareholder the authorization price because it was germane to the terms of the tender offer. Id. at 279-81.

[25] Id. at 281.

[26] Id. (citing TSC Industries Inc., 426 U.S. 438 (1976)).

[27] Stroud, 606 A.2d at 84.

[28] Id. at 79.

[29] The defendant directors had originally solicited proxies in connection with an upcoming annual meeting. Plaintiffs sued to enjoin the meeting, alleging that the proxy materials contained misleading information. The directors subsequently withdrew the proxies, proceeding with the annual meeting and receiving 79% approval from the shareholders entitled to vote. After the meeting, plaintiffs again filed suit against the defendants, contesting the validity of the notice of the annual meeting and the amendments. Id.

[30] Id. at 81.

[31] The Court limited its holding to the context of privately held corporations. Id. Recent cases have also held that directors have a duty to disclose all material information when soliciting shareholder consents. See, e.g., Malpiede v. Townson, 780 A.2d 1075 (Del. 2001) (holding that while materiality determinations are generally fact-intensive, certain statements or omissions in a consent solicitation may be immaterial as a matter of law); Millenco L.P. v. meVC Draper Fisher Jurveston Fund I, Inc. et al., No. 19523, 2202 Del. Ch. LEXIS 140 (December 19, 2002, revised December 30, 2002) (holding that the omission of information regarding whether a director was independent in a consent solicitation issued in connection with the proposed reelection of the directors alleged a violation of the duty of disclosure sufficient to survive a motion for summary judgment).

[32] Malone, 722 A.2d at 5; see also Jackson Nat'l Life Insurance Co., 741 A.2d at 389 (holding that a claim for a violation of the fiduciary duty of loyalty could be brought when directors intentionally omit information from a communication to stockholders under circumstances that suggest an intent to mislead).

[33] Malone, 722 A.2d at 5.

[34] 1 R. Franklin Balotti & Jesse A. Finkelstein, The Delaware Law of Corporations and Business Organizations, õ17.10(B), at 17-18 (2d ed. 1988).

[35] Id. at 10-11.

[36] Id.

[37] Zirn v. VLI Corp., 681 A.2d 1050, 1056 (1996) (quoting Arnold v. Society for San. Bancorp., 650 A.2d 1270, 1280 (1994)).

[38] See, e.g., Zirn, 621 A.2d at 773; Zirn., 681 A.2d at 1050.

[39] See, e.g., Arnold v. Society for Life Savings Bancorp, 650 A.2d 1270 (Del. 1994).

[40] Goldman v. Pogo.com, No. 18532, 2002 Del. Ch. LEXIS 71 (June 14, 2002).

[41] Id., slip op. at 4.

[42] Id., slip op. at 5-6.

[43] Id, slip op. at 35-36.

[44] Id., slip op. at 36.

[45] Id.; see also Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002) (holding that the failure to disclose certain information in a proxy in the context of a cash-out merger constituted a material omission in violation of the duty of candor).

[46] Pogo.com, 2002 Del. Ch. LEXIS 71, at 37-39.

[47] The Chancery Court in Pogo.com never issued a decision on the merits (i.e., after a full trial) regarding whether the directors' failure to disclose constituted an omission of material information, as the case subsequently (and typically in these situations) settled after the defendant's motion to dismiss the claims brought by the Pogo.com plaintiff failed.

[48] For a discussion of the business judgment rule, see note 52, supra.

[49] See discussion in Section 4.B., infra.

[50] In addition to those situations where the duty of candor arises in connection with a shareholder consent solicitation, rights offerings made to stockholders (which are often required pursuant to right‑of‑first refusal provisions contained in prior round financing documents or advisable as a means to minimize the potential for director liability) can also trigger the duty of candor, particularly where issuers provide information to their shareholders to help them make investment decisions. See discussion in Section 4.A.(i), supra.

[51] Geyer v. Ingersoll Publications, Co., 621 A.2d 784, 787 (Del. 1992); see also Katz v. Oak Industries Inv., 508 A.2d 873, 879 (Del. Ch. 1986).

[52] Geyer, 261 A.2d at 787; see also Bovay v. H.M. Byllesby & Co., 38 A.2d 808, 813 (Del. 1944).

[53] Id.

[54] Id. at 789; Lasalle Nat'l Bank v. Perelman, 82 F. Supp. 2d 279, 290 (D. Del. 2000).

[55] Geyer, 261 A.2d at 789; In re PWS Holding Corp., 228 F.3d 224, 233 (3d Cir. 2000) (noting that two approaches to the solvency evaluation: asset-by-asset evaluation and enterprise evaluation).

[56] Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., No. 12150, 1991 Del. Ch. LEXIS 215 (Dec. 30, 1991); see also In re Hechinger Investment Co. of Delaware, 280 B.R. 90, 92 (D. Del. 2002); In re Buckhead America Corp., 178 B.R. 956 (D. Del. 1994). Courts have also held that directors have duties of loyalty and care owing to creditors even in the absence of a corporation being in the zone of insolvency where a proposed transaction may render the corporation insolvent. Brandt v. Hicks, Muse & Co. (In re Healthco Int'l, Inc.), 208 B.R. 288, 301 (Bankr. D. Mass 1997) ("distribution to stockholders which renders the corporation insolvent, or leaves it with unreasonably small capital, threatens the very existence of the corporation [and] . . . is prejudicial to all its constituencies, including creditors").

[57] Credit Lyonnais Bank Nederland, N.V. et al. v. Pathe Communications Corp. et al., No. 12150, 1991 Del. Ch. LEXIS 215 (December 30, 1991).

[58] Credit Lyonnais, 1991 Del. Ch. LEXIS 215, 25.

[59] Id. slip op. at 30-31.

[60] Id. slip op. at 106.

[61] Id.

[62] Id.

[63] Id. It is not entirely clear what duties shift when a corporation enters the zone of insolvency. The Credit Lyonnais opinion suggests that the duties owed in the zone of insolvency differ from the traditional fiduciary duties of good faith, care and loyalty. According to the Credit Lyonnais court, the directors had an obligation to the "community interest" to "exercise judgment in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity." Id. slip op. at 109. Other jurisdictions, however, have adopted a "trust fund" theory, likening the director to a trustee acting for the benefit of the corporation's creditors. See, e.g., American Nat'l Bank v. Mortgage America Corp., 714 F.2d 1266, 1268 (5th Cir. 1983); Federal Deposit Insurance Corp. v. Sea Pines Co., 682 F.2d 973, 977 (4th Cir. 1982); Clarkson Co. v. Shaheen, 660 F.2d 506, 512 (2d Cir. 1981).

[64] Mark Olson, Detecting Financial Reporting Fraud and Understanding Insolvency Risks, 1325 PLI/Corp. 517, 564 (2002).

[65] See Mathew P. Quilter et al., Duties of Directors: Venture Capitalist Board Representatives and Conflicts of Interest, 1312 PLI/Corp. 1101, 1104 n.3 (2002). A recent article has suggested that in order to determine whether a corporation has entered the zone of insolvency, courts will look at the same insolvency tests, but take a forward-looking approach. Eric Simonson, Distressed Investing: Selected Legal Issues, 1339 PLI/Corp. 541, 549 (2002).

[66] Financial advisors have often been hired in other transactional contexts to provide "solvency opinions," which are then relied upon by corporate directors in their decision-making. However, in the down round context, these insolvency opinions, like the fairness opinions discussed in Section 4.B, infra, are not commonly sought due to the time and expense required to obtain them.

[67] See discussion in Part 4.A.(i), supra.

[68] See, e.g., Pereira v. Cogan, 2001 WL 243537 at *9-11 (S.D.N.Y. 2001) and Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), 2000 WL 28266 at *7-8 (N.D. Ill. 2000).

[69] 2001 WL 243537 at *11.

[70] See, e.g., Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), 2000 WL 28266 at *8

[71] Remillard Brick Co. v. Remillard-Dandini Co., 109 Cal. App. 2d 405, 419 (1952).

[72] Balotti, Finkelstein et al., Delaware Law of Corporations and Business Organizations, 4.35.

[73] The clearest example of a financially disinterested director designated by a venture capitalist would involve the venture capital fund that selects the dean of the local business school, who has no financial interest in the fund, to fill the fund's contractual board seat. This dean would not be an officer, director, or employee of the fund, and would not otherwise share in the financial benefits of the fund's success. In fact, the only compensation by the dean for his board service would be the director's fees and other benefits afforded by the company to all of its directors.

[74] See Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997), in which the Delaware Supreme Court found that the decision of an ill-formed and ill-functioning special committee would not be afforded the effect of the full protections available under Delaware law in a controlling shareholder conflict of interest case. Specifically, in Tremont, the reviewing court found defects in the special committee process that included (i) that the members of the special committee failed to attend many of the meetings of the committee, including one member who failed to attend a single meeting with the committee's outside financial and legal advisors and another member who failed to attend a full half of the committee meetings, and (ii) that pre-existing relationships of several of the special committee members with the conflicted controlling shareholder made such special committee members beholden to such shareholder and otherwise not independent. As such, any special committee in a down round charged with negotiating and approving the financing must be truly independent, particularly in light of the tangled web of venture capitalists, directors, issuers, and employees that characterizes the developing company community, and such committee must spend adequate time and resources to ensure that it complies with its fiduciary duties.

[75] See Fliegler v. Lawrence, 361 A.2d 218 (Del. 1976).

[76] In California, transactions in which a director has a material financial interest may be upheld under section 310 of the California General Corporation Law, which establishes safe harbors for transactions where the material facts concerning the director's interests are fully disclosed (i) to shareholders who approve such transaction in good faith, with the shares owned by the interested director or directors not being entitled to vote thereon, or (ii) to the board of directors or committee thereof which authorizes the transaction in good faith by a vote sufficient without counting the vote(s) of the interested director(s) and the contract is just and reasonable as to the corporation as to the time it is authorized, approved, or ratified. For those interested director transactions which cannot be sanitized under either (i) or (ii) above, the person asserting the validity of the transaction sustains the burden of otherwise proving that the transaction was just and reasonable as to the corporation at the time it was authorized, approved, or ratified. California courts have in the past, however, allowed transactions which were judged unfair and unreasonable to the corporation to be avoided by a corporation, even though the statutory requirements for sanitizing an interested director transaction appeared to have been complied with, on the ground that such transaction could not have been done in "good faith." See Remillard Brick Company v. Remillard-Dandini Co., 241 P.2d 66 (Cal. App. 1952).

[77] Dupont v. Dupont, 251 F. 937, 944 (D. Del. 1918). See also Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling, 53 A.2d 441, 447 (Del. 1947) (citing Heil v. Standard G. & E. Co., 151 A. 303, 304 (Del. Ch. 1930)) (holding that a shareholder may exercise wide liberality of judgment in the matter of voting, and it is not objectionable if his motives are for personal profit, or determined by whims or caprice, as long as he does not violate any duty owed to his fellow shareholders).

[78] Similarly, in Smith v. San Francisco & NP. Ry. Co., 115 Cal. 584, 604 (1897), the Supreme Court of California upheld properly established voting trusts based on the rationale that each stockholder "has the clear right to cast his ballot as he pleases, wisely or unwisely, and no other stockholder can control his conduct or gainsay his discretion." Id.

[79] In fact, only a few jurisdictions have established that a controlling shareholder is not a fiduciary. See Jacobs v. Regas, 221 N.E.2d 140 Ill. App. Ct. 1966), rev'd on other grounds, 229 N.E.2d 487 (1967). Almost every state recognizes controlling shareholders' fiduciary duty to minority shareholders, as well as to the corporation. Such obligations are generally viewed as comparable to the obligation owed by the officers and directors of the corporation. 18 Am. Jur. 2d Corporations õ 764 (2002).

[80] Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1344 (Del. 1987). See also In re MAXXAM, Inc., 659 A.2d 760,771 (Del. Ch. 1995) (citing Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1113 (Del. 1994)).

[81] Ivanhoe Partners, 535 A.2d at 1344. An interesting situation arises when a director is at the same time a shareholder, albeit a minority and non-controlling shareholder, of the issuer. In such situations, the prudent director would disclose his conflict of interest and seek to sanitize the transaction through approval by a majority of the disinterested directors, members of a special committee of the board, or the stockholders, as discussed above. At the same time, and so long as the director is not a majority or controlling shareholder, it would appear that the individual who is also a director, when acting in the capacity of a shareholder, could vote his or her shares as he or she sees fit without concern for such a conflicted position.

[82] Kennerson v. Burbank Amusement Co., 120 Cal. App. 2d 157, 171 (1953). It is important to note that exercise of contractually negotiated consent rights by a minority shareholder, even if they can be used to block a down round or other corporate event, have not been held sufficient to transform a minority shareholder into a "controlling" shareholder for purposes of this liability analysis.

[83] In Jones, the controlling shareholders of a closely held savings and loan association formed a holding company to which they transferred their shares without offering the same opportunity to the minority. The holding company made a public offering of its shares and created a public market for its shares, while the minority shareholders were left with nonmarketable stock of the savings and loan association. In addition, the controlling shareholders through the holding company caused the savings and loan association to stop paying dividends, other than the regular $4.00 per share annual dividend, although large extra dividends had been paid previously. The controlling shareholders also caused the holding company to offer to purchase the minority shares of the savings and loan association at less than one-third of the price at which an equivalent block of stock in the holding company was selling in the market. The court concluded that the plaintiff in Jones should have been able to exercise her statutory appraisal rights or obtain the economic benefits of having exchanged her shares for the fully marketable stock and remanded the case to the trial court for further proceedings consistent with its opinion. See Jones v. H.F. Ahmanson & Co., 460 P.2d 464 (Cal. 1969).

[84] Id. at 474.

[85] Jones, 460 P.2d at 471.

[86] Id.

[87] Id.

[88] For example, the Delaware courts first held controlling shareholders who engineered the sale of a corporation's stock at a price which was grossly inadequate liable on a theory of constructive fraud. See Bennett v. Breuil Petroleum Corp., 99 A.2d 236 (Del Ch. 1953). See also Schnell v. Chris-Craft Industries, Inc., 285 A.2d 430, 433 (Del. Ch. 1971) (citing Bennett v. Breuil Petroleum Corp. for the proposition that attempts by majority stockholders to freeze out minority stockholders by increasing a corporation's authorized capital stock and then issuing such capital stock for improper consideration are actionable).

[89] Case No. CV-739278 (Sup. Ct. Santa Clara Co., Cal., filed March 23, 1994).

[90] See Down (Round) and Out, The Recorder (July 31, 2002) and Warning: Rescue May Raise Risks, The National Law Journal (November 24, 1997, at B9).