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Fiduciary Responsibility During COVID-19

ATTORNEY: THOMAS PRZYBYLOWSKI | POMERANTZ MONITOR | JULY/AUGUST 2020

The COVID-19 pandemic has significantly disrupted the financial and operational health of businesses across a variety of industries, with companies facing tremendous uncertainty in both their short-term and long-term planning. With companies left more vulnerable to both external and internal attacks, the fiduciary responsibility of their officers, directors, and all other executives to the companies and their shareholders is more important than ever.

On March 23, 2020, the Delaware Chancery Court released a transcript ruling in K-Bar Holdings LLC v. Tile Shop Holdings, Inc. that demonstrates that, even in times of great uncertainty, fiduciary duties may not be relaxed. Specifically, the Court found a colorable claim that the board of a publicly traded company breached its fiduciary duties by allowing a stockholder group, three of whom were board members, to take advantage of the company’s trading price to increase the group’s ownership percentage.

The conduct at issue in the case, which was brought by an unaffiliated stockholder, dates back to October of 2019, when the Tile Shop board of directors announced that the company would go dark, delist from the Nasdaq, and deregister from the SEC. While providing a brief background to the Court, plaintiff’s counsel explained the significant impact of the company’s announcement, stating that:

“[i]mmediately after the announcement, the market price of the company’s stock dropped about 60 percent and the board members began to purchase, and continue to purchase, the company’s stock at a frenzied pace at depressed prices.

Since October 22nd to today, Your Honor, defendants Kamin and Jacullo have bought over 13 percent of the company and now defendants Rucker, Kamin, and Jacullo own about 42 percent of the company.

One member of the board, Christopher Cook, immediately resigned from the board after the board approved the going dark. And the rest have done nothing since the approval to protect the company from the three insiders taking control.

Moreover, plaintiff’s counsel explained that “since the going dark and the defendants buying up the shares, there’s been no attempts to reach a standstill, from our understanding. There’s been no poison pill put in place. Rather, they’ve been rushing to complete the going dark scheme.”

The two primary fiduciary duties of officers and directors are that of (1) care, which requires them to make informed decisions in good faith and in the best interests of the company, and (2) loyalty, which requires them not to engage in self-dealing and to put the interests of the company ahead of their own. To determine whether officers and directors have performed in accordance with these duties, courts assess their conduct in the context of the business judgment rule, which is a rebuttable presumption that the officer or director acted in good faith and in the corporation’s best interest. When applied, this presumption protects internal business decisions from external criticism.

The fiduciary duties of officers and directors persist regardless of whether the company is solvent, insolvent, or in the “zone of insolvency” (in which a company is only approaching insolvency). Indeed, while solvency dictates who may bring a claim against the company and whether such a claim may be direct or derivative, officers and directors owe the duties of care and loyalty to the company and shareholders until those duties are officially discharged. Finally, although recent Delaware case law has suggested that creditors can no longer bring derivative claims based on actions taken while a company was in the zone of insolvency, it is still difficult to determine exactly when a company has actually reached insolvency. Accordingly, creditors may still challenge decisions even when made in the zone of insolvency.

In the Tile Shop case, the Court ultimately directed the stockholder group to cease purchasing shares of the company, explaining that the threat of irreparable harm to the corporation and its shareholders was too great to allow any further purchases. In reaching this ruling, the Court stated multiple times that it believed there to be a colorable claim before it. Furthermore, the Court noted that, although a colorable claim simply means a claim that is nonfrivolous, “at the very least, the timing of the events is such that it would raise – well, my equitable antenna is set aquiver. When I look at the time frame, which doesn’t prove anything, it just tells me, as I have already expressed, that there is a colorable claim here that mischief is afoot.”

The ruling in Tile Shop provides good insight into the attitude courts have towards fiduciary duties. Indeed, the Court found that the board’s simple inaction in allowing such an aggressive series of share purchases allowed for a colorable claim. Applying this ruling to the Covid-19 pandemic, Tile Shop should act as a reminder to officers and directors that they must be extra vigilant when a company is experiencing enhanced volatility. Accordingly, officers and directors should take measures to ensure that any decisions made are in compliance with their fiduciary obligations, such as:

  • maintaining oversight of the company’s results of operations and forward-looking strategy;

  • increasing upward reporting from management; organizing more frequent board or committee meetings and keeping detailed and timely minutes;

  • coordinating a task force specifically designed to address Covid-19 concerns;

  • retaining experts to provide advice on matters such as operational viability, legal compliance, and governmental/ regulatory updates; and

  • monitoring the availability of transactions that could potentially enhance stockholder value.

Certainly, this list is not exhaustive. As Tile Shop demonstrated, courts conduct a factual analysis to determine whether, in the particular circumstances facing the company, officers and directors conducted themselves appropriately.

As such, what is most important is that that boards take actions that comply with their basic fiduciary obligations, fall within the business judgment rule, and protect the interests of the stockholders. Officers and directors should consult with their own counsel to determine the specific needs and interests of the company. Moreover, officers and directors must be mindful of the company’s solvency, in order to assess the company’s vulnerability to potential shareholder or creditor litigation. Boards must remember that market volatility and uncertainty can make companies especially vulnerable to attack. Ultimately, regardless of how these duties materialize, officers and directors must remember that their primary goal is to protect the shareholders. Finally, it is important to note that, although this article has primarily addressed the considerations of companies incorporated in Delaware, the utility of these suggestions can extend to LLCs, partnerships, or any other company facing the uncertainties of the COVID-19 pandemic.