Officers and Directors Take Note: Don't Check Your Fiduciary Duties at the Door
In Miller v. McDonald, No. 06-10166 (Bkrtcy. Ct. D. Del. Apr. 9, 2008) (available online under the opinions section), an opinion recently released by the United States Bankruptcy Court for the District of Delaware involving a health care company, the court concluded that fiduciary duties apply not only to directors, but also officers, including a company’s general counsel. While the conclusion is well supported by case law, the opinion serves as an important reminder of the strength of the fiduciary duties owed by directors and officers and that courts will not allow such individuals to check their responsibilities at the door. The opinion emphasizes the necessity of implementing strong internal controls and that a court will frown upon directors and officers who fail to put systems of checks and balances in place.
Facts
The facts of Miller are particularly egregious. World Health, Inc. (“World Health”), the debtor in the case, was in the business of providing healthcare staffing services to hospitals and health systems nationally. The company went public on February 20, 2003, and, during 2003 and 2004, used $38 million raised in a series of private placement transactions to acquire eight companies. World Health thereafter obtained secured debt from CapitalSource Finance, LLC to refinance existing indebtedness and obtain additional liquidity. These transactions included a term loan in the amount of $7,500,000 and a revolving credit facility with a $37,000,000 cap. World Health also pledged assets to secure debt obligations due to certain sellers in connection with the acquisitions.
Despite the company’s rapid growth, red flags began to appear, signaling the company’s inescapable demise. For example, in May 2005, World Health issued a press release announcing changes to financial results. On August 16, 2005, announcements of both the discovery of fraudulently reported financials and the abrupt resignation of the company’s president and chief financial officer “for health and family reasons” sent shockwaves. Only a few days later, on August 24, 2005 came the announced the “discovery” of approximately $22 million in debt and the engagement of a professional services firm in connection with a turnaround. The Bristol Investment Fund, Ltd. issued a notification of default on the terms of convertible debentures and related warrants to purchase common stock and demanded payment of over $6 million. In early 2006, the Internal Revenue Service (“IRS”) filed liens against the property owned by a California subsidiary. The IRS alleged that the outstanding tax liability exceeded $4,000,000. A securities class action lawsuit was filed, and World Health filed a Chapter 11 petition for bankruptcy, later converted to a Chapter 7.
Allegations
Miller, the bankruptcy trustee (the “Trustee”), filed a 13 count fiduciary-duty based complaint against World Health’s senior officers and directors that included the following claims: breach of fiduciary duty; corporate waste; negligent misrepresentation; fraud; turnover of property of estate; fraudulent transfer under state and federal law; equitable subordination; multiple counts of aiding and abetting; and professional negligence. The opinion reviews allegations that the defendants, inter alia:
(1) Engaged in corporate waste of the company’s assets by leasing private jets and paying for luxury cars when the company’s financial health was in question;
(2) Failed to implement a system that contained fraud controls;
(3) Filed falsified documents with the IRS to evidence tax payments;
(4) Created a related party loan account to offset discrepancies when funds were not appropriately paid;
(5) Failed to remit payroll tax checks to the IRS;
(6) Made multiple misrepresentations in financial statements and filings with the Securities and Exchange Commission (“SEC”);
(7) Asserted in press releases and SEC filings that World Health was financially healthy when “World Health lacked adequate internal controls and was, therefore, unable to ascertain its true financial condition”;
(8) Borrowed twice on accounts receivable; and
(9) Entered into indemnification agreements with certain individuals that constituted a fraudulent conveyance.
Procedural Posture and Choice of Law
The case was before the court upon a motion to dismiss filed by Brian T. Licastro, World Health’s vice president of operations and in-house general counsel. Florida law applied because Florida is World Health’s state of incorporation. Nevertheless, the opinion has far-reaching impact, as “[e]ven though Florida law governs this claim, Delaware law is still relevant because ‘the Florida courts have relied upon Delaware corporate law to establish their own corporate doctrines.’”
Fiduciary Duty Claims and Analysis
In reliance on In re Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), Stone v. Ritter, 911 A.2d 362 (Del. 2006) and several other cases,the Trustee claimed that Licastro “breached the duty of care by failing to implement an adequate monitoring system and/or the failure to utilize such system to safeguard against corporate wrongdoing.” The court quoted Stone, which provides as follows:
Caremark articulates the necessary conditions predicated for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or control, consciously failed to monitor or oversee its operation thus disabling themselves from being informed of the risks or problems requiring their attention.
The Trustee alleged that Licastro, as the vice president of operation and in-house general counsel, was responsible for failing to implement an internal monitoring system or utilize such system as required by Caremark and its progeny. Licastro countered by arguing that the Caremark line of cases does not apply, stating, “The Trustee has sought to drastically broaden the scope of Caremark by expanding liability for allegedly failure of oversight to not just corporate directors, but also to corporate officers and employees. Delaware law does not recognize this principle.”
The court disagreed with Licastro, holding that the Caremark fiduciary duties apply to officers, including a corporation’s general counsel. The court cited multiple opinions to establish the applicability of the fiduciary duties to corporate officers, including In re Walt Disney Co. Derivative Litigation, No. Civ. A. 15452, 2004 WL 2050138, at 3 (Del. Ch. Sept 10, 2004), which stated,
To date, the fiduciary duties of officers have been assumed to be identical to those of directors. With respect to directors, those duties include the duty of care and the duty of loyalty. There has also been much discussion regarding a duty of good faith, which may or may not be subsumed under the duty of loyalty . . . . [U]pon becoming an officer on October 1, 1995, Ovitz owed fiduciary duties to Disney and its shareholders.
Thus, the court concluded, “it is clear that under both Delaware and Florida law both officers and directors owe fiduciary duties to the corporation,” and such duties extend to general counsel. It was possible that Licastro breached his fiduciary duties by failing to “implement an adequate monitoring system and/or failure to utilize such system to safeguard against corporate wrongdoing.”
This case serves as a reminder that both directors and officers, including a corporation’s general counsel, must strictly adhere to their fiduciary duties and emphasizes the importance of the implementation of strong internal controls designed to protect the corporation against fraudulent activities such as the activities highlighted in this case.
