Do Directors of Foreign-Based Companies Have Greater Liability Exposure?

Authored by Edward M. McNally
This article was originally published in the Delaware Business Court Insider March 20, 2013

There is a minor uproar over the recent Delaware decision that some suggest holds the directors of a Delaware corporation to a higher standard of corporate governance when the corporation's business is in a foreign country. In a bench ruling declining to dismiss a derivative suit, the court said in In re Puda Coal Stockholders Litigation, Del. Ch. C.A. 6476-CS (February 6, 2013):

"If you're going to have a company domiciled for purpose of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company."

Does this really change Delaware law?

We do not think so. To begin with, Puda Coal was decided in the context of a motion to dismiss the complaint. The law just about everywhere requires that in deciding such a motion, the court must accept as true the facts alleged in the complaint. The Puda Coal allegations were particularly egregious, including the directors' failure for 18 months or more to discover that all of the company's assets had been stolen. It is hard to understand how directors acting in good faith would fail to find that out.

When viewed in that light, the court's comments reflect not so much rigid requirements of what such directors must do, but instead examples of the steps they might have taken to fulfill their responsibilities. After all, long-standing principles of Delaware law require every director to be aware of the general state of his or her corporation's business affairs. This does not mean a director must investigate every detail of a business' activities, no matter how complex. The court in Puda Coal specifically noted that "you can't watch everybody everywhere."

The Puda Coal court's concerns reflect the balance Delaware law seeks between upholding the business judgments of directors while at the same time providing reasonable protection of stockholders. Delaware is an attractive domicile because it is not a mere mail drop that permits directors to ignore signs of wrongdoing. Instead, a "Delaware" corporation is valuable to investors because they know they can rely upon appropriate corporate governance to protect their investment. As the gold standard, Delaware is able to command the franchise fees that are important to our small state. The Court of Chancery is not about to let those standards slip away for a fast buck.

What then are the real implications of Puda Coal? It is significant that the Puda Coal decision called out those countries with questionable business ethics, such as Russia, Nigeria, China and countries in the Middle East, and with well-publicized scandals in the recent past. Delaware law requires that directors take into account so-called "red lights" that warn of the danger of improper business practices. Directors' Caremark duties, to which the Puda Coal court explicitly referred, include the obligation to take precautions at the board of directors level when red lights appear. Thus, the court seems to suggest that when a company does much of its business in a distant land noted for bad business practices, the directors must be especially on guard. Conceptually, that is no different than asking directors to impose safety measures on hazardous business activities in the United States, such as coal mining and oil drilling.

There is, however, one aspect of the Puda Coal ruling that is unique to Delaware law and that may be troubling for directors. The Puda Coal court suggested that upon their discovery of the theft of Puda Coal's assets, the directors had an obligation to pursue litigation against the thief. On the surface, that seems entirely appropriate. Yet, it has serious implications if carried too far.

Puda Coal's facts illustrate this potential problem. If, as the court seems to suggest, all of Puda Coal's assets were stolen, how could the directors fund litigation to recover those assets in a distant country whose legal system is not friendly to foreign plaintiffs? The court does not answer that question. Given that Puda Coal involved stockholder-filed litigation, perhaps the simplest answer is for the directors to simply consent to those stockholders continuing to act for Puda Coal to pursue its claims. If there is D&O insurance, that is a real possibility, given that the thief was one of the Puda Coal directors who might be insured for his breach of fiduciary duty. Instead, the other directors just resigned and then had their counsel seek to have the entire litigation dismissed. That does seem too much to ask of any court faced with the wholesale theft of corporate assets and a proposed dismissal that would let the thief walk away from any claim.

The real lesson of Puda Coal is that it is hazardous to a director's health to be on the board of directors of a company whose business he or she does not really understand and cannot really oversee. The Puda Coal judge said he would not let himself be put in that position. Neither should you.

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