Summary: Atlantic Legal Foundation remains at the forefront of the fight to ensure that the courts make informed and fair judgments on matters of corporate governance. In December 2003, we filed an amicus brief in a case that promises to be a landmark in corporate litigation. The brief supported Philip Smith’s appeal to the United States Court of Appeals for the Second Circuit, and was filed on behalf of the Corporate Law Departments Section of the Los Angeles County Bar Association and twelve current and former general counsels of major corporations. The trial court found Smith liable for over $20 million for allegedly failing to discharge his duties as chief legal officer of Trace International Holdings, a closely held Delaware company, 294 B.R. 449 (2003).
Atlantic Legal’s brief contends that an in-house chief legal officer’s responsibilities did not include those activities for which he was held liable.
Trace’s majority shareholder, directors and officers were sued by the United States Bankruptcy Trustee for violating their fiduciary duties to creditors and minority shareholders. The suit claimed that Marshall Cogan, Trace’s majority shareholder, CEO, and Chairman, had effectively "looted" the company when he paid himself excessively, paid illegal dividends, hired his daughter, made inappropriate loans to himself and other insiders, and engineered an illegal share buy-back transaction. The suit further charged that because Trace’s officers and directors did not prevent Cogan’s looting, they were liable for it.
Philip Smith, Trace’s chief legal officer, was among those named in the suit. Smith was not a director and thus had no decision-making or supervisory power at Trace. He was not a financial officer or an auditor, and thus had no responsibilities regarding Trace’s financial dealings. During his tenure as general counsel, he was unaware of Trace’s precise financial circumstances, and he was likewise unaware of Cogan’s "looting" activities other than as disclosed in Trace’s financial statements. Smith’s role as Trace’s CLO was to respond promptly and competently to requests for legal guidance. He fulfilled this role. He was nonetheless found liable for failing to do much more.
The trial court based its ruling on Smith’s participation in two transactions. The first, a legal repurchase of preferred stock, saved Trace millions of dollars in dividends. Though neither Cogan nor Smith reaped any personal gain from this transaction, and though Smith did not know Trace’s financial circumstances at the time of the deal, the court found Smith personally liable because Trace was "in the vicinity of insolvency" when he structured the repurchase. Convinced that the transaction was not "entirely fair" to the corporation, its creditors, or stockholders, the court called Smith’s entirely legal structure for the buy-back "subterfuge" and ruled that Smith should not have recommended it. The second transaction for which Smith was found liable involved a series of loans Trace made to Cogan. Though Smith did not know about most of these when they were made, though he did not benefit from them, and though he was not negligent, the court found Smith liable for all of the Cogan loans because he "should have" known of them and should thereby have acted to prevent them.
Atlantic Legal’s brief argued two main points: That the trial court should have, but did not, apply the Delaware Business Judgment Rule, and that it failed to distinguish the nature of the Chief Legal Officer’s responsibilities from those of directors and other officers. The Delaware Business Judgment Rule presumes directors and officers have acted in good faith where there is no gross negligence and where no one benefits personally from a given transaction. Philip Smith was not negligent, and he did not benefit personally from either transaction. Even so, the trial court held that he neglected to ensure that Trace’s directors and other officers–his clients–were running Trace in a sound manner.
In so doing, the trial court fundamentally confused the traditional relationship between lawyer and client. It is the job of the CLO, the court ruled, not only to advise his corporate clients, but also to police their activities. Moreover, the ruling stated, it is the fault of the CLO if his clients do not conduct themselves properly in every particular. Atlantic Legal’s brief argued that the trial court in Pereira v. Cogan imposed an impossible standard of responsibility on CLOs, one that, in making them liable for the actions of all officers and directors of a corporation, will almost certainly deter capable lawyers from accepting in-house legal positions.
Our brief urged the appellate court to reverse the ruling that found Smith liable, and so to restore the Delaware Business Judgment Rule to its proper function in adjudicating corporate governance disputes. The implications of this case reach far beyond the pocket of Philip Smith’s 40 percent of NYSE corporations and approximately 50 percent of Fortune 500 companies are incorporated in Delaware; many states model their corporation statutes on Delaware’s.
On June 30, 2005, the U.S. Court of Appeals for the Second Circuit reversed the district court, and remanded the case for trail, holding that because Pereira sought money damages it was erroneous for the district court to reject defendants’ demand for a jury trial. On December 5, 2005, Pereira filed a petition for a writ of certiorari in the United States Supreme Court.