Super Director: Personal Liability for Legal Officer If Judge Finds Corporate Transaction Unfair
Trace was a holding company with limited operations; it was not an active business enterprise and did not run a business. Trace was founded by Marshall Cogan, its chief executive officer and chairman of its board. Cogan owned more than fifty percent of Trace stock. The trial court found that Cogan was “a widely respected figure in the investment community.” Other board members during the relevant period were also seasoned business executives who were involved in the day to day business operations of the firm, including the former managing director of investment banking at Lehman Brothers, a former senior executive at Drexel Burnham.
Phillip Smith, vice president, general counsel, and secretary at Trace, who specialized in securities trades, only dedicated a portion of his time to Trace matters, spending most his time counseling Trace’s publicly held subsidiaries. When Trace matters were brought to his attention, he would seek the help of outside counsel. Smith did not actively advise the board of directors at Trace. Despite his limited role, and his lack of knowledge about the transactions in controversy, he was held personally liable by the trial court for the so called “Dow-transaction,” and for loans to Cogan and others. The trial court held that Smith violated his fiduciary duty to the shareholders of Trace, having the discretionary authority to prevent redemption when Trace was insolvent, and by not “direct[ing] the Board to supervise Cogan and to insure the financial integrity of Trace.”
Pereira v. Trace Foam, (2nd Cir.)
Read the Amicus Brief:
Whether the attorney-client relationship be turned upside down, by holding legal officers personally liable if corporate directors execute unfair transactions.
ALF’s Amicus Brief:
ALF argues that in Delaware corporate officers are given the presumption of good faith, that must be rebutted by a showing a of gross negligence. Smith’s legal advice was not grossly negligent. He helped structure loans for a stock purchase that saved Trace millions of dollars. The loan and resulting stock purchase were only illegal if Trace was insolvent. It took the trial court extensive expert testimony to establish that Trace may have been negatively valued at $5.1 million at the time of the repurchase, but had a positive balance sheet of $51 million only two months later. Smith was not an accountant, and did not hold the credentials or knowledge that Trace’s board of directors had, let alone the knowledge and expertise that the court was able to bring to bear in hindsight to determine via complex testimony that Trace was likely insolvent at the time of the deal.
The trial court’s sweeping pronouncement is a complete inversion of the client-attorney relationship, which traditionally is that “the client by and large controls the actions of the lawyer, not vice versa.” The trial court effectively held that as a matter of law that a general counsel is responsible for educating and directing the board. No authority is cited for the sweeping rule that a legal counsel must actively educate and supervise his client, even when not asked to, or be liable for the client’s actions. Such a rule ignores the role of auditors, who unlike Smith are trained in accounting, and other safeguards for monitoring senior management. The general counsel advises on legal issues brought to his attention, he does not actively ensure that financial matters such as dividends and insider compensation are monitored and flagged. Unless Smith was tasked with designing, implementing, and monitoring good governance safeguards, then he cannot be held liable for failing to do so.
On June 30, 2005, the Second Circuit vacated and remanded the case for a jury trial.
Date Originally Posted: December 9, 2003