Navigating Litigation Conflicts in Troubled Corporations

Corporate officers, like directors, also owe fiduciary duties to the corporation they serve. Indeed, officers are often held to a standard of care higher than directors, as it is the officers who are typically responsible for the daily management of the corporation. Consequently, officers not only have an affirmative duty to protect the interests of the corporation, but also are prohibited from engaging in any action or inaction that would injure the corporation. Because the fiduciary duties of officers and directors flow to the corporation itself rather than directly to particular individual shareholders or creditors, it has long since been recognized that allegations regarding a breach of directors' or officers' duties may be brought only as derivative (rather than direct) actions.

The Impact of Corporate Insolvency

While insolvency does not relieve corporate officers or directors of their respective fiduciary duties, it does introduce additional claimants into the equation ” namely, creditors. Indeed, in the case of an insolvent corporation, the duty of the directors is widely said to shift to the duty of maximizing value for the corporation's creditors. This often-touted maxim, however, is largely inaccurate as it suggests that upon insolvency, a dramatic shift takes place whereby creditors wholly replace shareholders as the company's residual claimants. In fact, shareholders generally remain residual claimants (albeit secondarily) in insolvency. Rather, because shareholders' residual claim to the corporation's assets becomes essentially valueless upon insolvency, creditors consequently become the company's principal residual claimants while the shareholders remain secondary claimants.

Thus, a far more accurate statement is that upon a corporation's insolvency, creditors gain standing to bring derivate actions for breaches of fiduciary duty. This standing is not a new or special privilege granted to creditors, nor does it deprive shareholders of standing to bring such a suit. Rather, allowing creditors to bring a derivative claim against an insolvent corporation is simply an extension of the principal that, irrespective of whether a corporation is solvent or insolvent, the directors owe a duty to maximize corporate value for the benefit of the respective residual claimants.

Derivative Actions

Under ordinary circumstances, a company's board of directors holds the exclusive ability to determine what litigation claims (if any) are brought by the company and against whom those claims are made. Derivative actions are an exception to this rule. In a derivative action, suit is brought by third parties (shareholders or creditors) on behalf of a corporation for alleged wrongdoing committed by corporate officers or directors. Although the corporation is named as a nominal defendant in derivative actions, the corporation is more properly treated as a plaintiff since it is for the corporation's benefit that the suit is brought and it is the corporation that receives any relief obtained.

Because a derivative action divests the board of an important corporate power ” namely the authority to control litigation ” both Delaware and California have implemented statutory mechanisms aimed at minimizing abuse of derivative power. Accordingly, a plaintiff will generally only have standing to bring a derivative action if that plaintiff has first made a demand on the board that it institute the action itself. Under ordinary circumstances, if a pre-suit demand is made on a company's board of directors and the board subsequently determines not to pursue the claim, that determination is accorded considerable deference under the business judgment rule and constitutes a defense to the suit. However, given that directors who have been named as defendants cannot be logically expected to impartially consider suing themselves, derivative plaintiffs are permitted to allege that the demand requirement is excused on the basis of futility. In order to avoid abuse of this exception, however, both California and Delaware require that a derivative plaintiff alleging demand futility state specific facts demonstrating that there are insufficient disinterested directors to properly consider the demand.

Conflicts of Interest in the Derivative Context

When litigation is brought against a corporation and its individual officers or directors in the context of a direct-action suit, the corporation's regular counsel often jointly represents both the corporation and the individual defendants. Assuming proper disclosures are made and consent obtained, such joint representation is generally permitted, at least initially, as all defendants share a common interest in having the suit dismissed. However, in the context of a derivative action, the situation becomes far more complex.

Former Corporate Counsel

Following termination of an attorney-client relationship, an attorney is prohibited from acting in a way as to have an injurious impact upon the former client in any matter in which the attorney formerly represented that client. Likewise, an attorney is similarly prohibited from using information or know- ledge garnered though the previous relationship against a former client. However, because the corporation is the sole beneficiary of derivative claims, counsel representing a derivative plaintiff essentially represents the corporation and the corporation's interests. Given the alignment of interests between the corporation and the derivative plaintiff, a derivative action brought against a corporation's officers and/or directors does not create a conflict between the plaintiff and the corporation. Accordingly, barring the existence of other conflicts, an attorney who has formerly represented the corporation is generally not disqualified from representing derivative plaintiffs against directors and officers of the corporation.

Representation in Both Direct and Derivative Actions

In class action litigation and other direct action suits, plaintiffs seek recovery of personal damages and, unlike derivative actions, any recovery is distributed to the plaintiffs and not to the corporation. As such, in representing direct-action claimants, counsel is charged with obtaining the greatest possible recovery for the individual plaintiffs. Indeed, obtaining recovery for the direct-action plaintiffs very often requires making claims against the corporation. Accordingly, in representing both derivative and direct-action plaintiffs, counsel risks conflicts inherent in representing clients with adverse interests. Specifically, while advocating for the interests of the corporation (via the derivative action), an attorney cannot simultaneously advocate for the claims of individuals against the corporation (via the direct-action suit). Doing so would be to take a position directly adverse to the corporation, which is prohibited under ethical rules.

The situation is potentially different when counsel has previously represented a derivative plaintiff and subsequently seeks to represent plaintiffs in a direct-action suit against the corporation. In such instances, so long as no actual conflict has developed out of any theoretical conflict presented by the prior representation, California courts have shown reluctance to disqualify the attorney from the subsequent representation.

Joint Representation of Corporation and Other Derivative Defendants

California Rules of Professional Conduct generally permit an attorney to jointly represent a corporation and the company's directors, officers, and other agents. Joint representation of clients whose interests potentially conflict in the same matter, however, is permitted only after obtaining each client's informed written consent. In the context of derivative litigation, obtaining informed written consent of the corporation is extremely problematic. Specifically, because a corporation can consent only through its officers and directors, and because these same directors and officers are also the named defendants, the corporation generally has no disinterested means of providing such consent.

Even presupposing that informed consent could be obtained, joint representation of both the corporation and named officer or director defendants nonetheless creates a scenario whereby the attorney may be required to choose between divergent client interests. The conflict is evident: On the one hand, the attorney seeks to gain recovery for the corporation for harm purportedly caused by the officer and director defendants; on the other hand, the attorney seeks to exonerate the officers and director defendants from liability to the corporation.

As such, it is virtually ethically impossible for a single attorney or firm to jointly represent officers and directors on one hand and the corporation on the other in derivative litigation. Indeed, in California an attorney attempting to represent both the company and its individual officers and directors in a derivative action is very likely subject to disqualification.

Conclusion

Derivative litigation presents complex ethical questions for counsel, particularly relating to conflicts of interest. As such, it is critical that an attorney considering representation in a derivative action conduct a careful review at the outset of a case in order to determine what actual and potential conflicts are inherent to that representation. Where serious charges of wrongdoing are alleged, separate counsel should be obtained for the corporation and for each of the other defendants. To the extent that an attorney wishes to represent plaintiffs in both derivative and direct action litigation, counsel must be certain that no actual conflicts have ripened that would prohibit this joint representation. Indeed, even where only potential conflicts exist, counsel should be careful to not only comply with all disclosure and consent requirements, but also monitor them to ensure that appropriate timely action is taken if these potential conflicts become actual conflicts.

Tamara Kurtzman is the founder of TMK, a Beverly Hills-based law firm. She provides business advice to clients and serves as an outsourced general counsel for companies and entertainment entrepreneurs. Kurtzman can be reached at [email protected] or 323-782-6999.

When a corporation finds itself in troubled financial waters, litigation by shareholders and creditors alike often follows. Increasingly, such litigation takes the form of a class action suit commenced against the company, followed closely by a derivative action against the directors and officers. In the context of derivative claims, a thorough understanding of both the duties of a corporation's officers and directors and to whom such duties are owed, is paramount. These dynamics, however, give rise to conflicts of interest that may pose significant ethical challenges for the attorneys representing the various parties.

Duties of Officers and Directors of Solvent Corporations

Under Delaware law, in the case of a solvent corporation, the duty of corporate directors is to maximize corporate value for the company's shareholders. To that end, corporate directors owe the corporation fiduciary duties of both care and loyalty. The duty of care mandates that directors be diligent in making decisions and in overseeing the corporation. Thus, for example, approval by directors of unreasonably high salaries to corporate officers in some circumstances may constitute a waste of corporate assets and thereby constitute a violation of the directors' duty of care. The duty of loyalty generally requires a director refrain from placing his or her own personal interests above the interests of the corporation. Accordingly, the duty of loyalty prohibits directors from unduly usurping corporate opportunities, competing with the corporation, and similar acts.

Corporate officers, like directors, also owe fiduciary duties to the corporation they serve. Indeed, officers are often held to a standard of care higher than directors, as it is the officers who are typically responsible for the daily management of the corporation. Consequently, officers not only have an affirmative duty to protect the interests of the corporation, but also are prohibited from engaging in any action or inaction that would injure the corporation. Because the fiduciary duties of officers and directors flow to the corporation itself rather than directly to particular individual shareholders or creditors, it has long since been recognized that allegations regarding a breach of directors' or officers' duties may be brought only as derivative (rather than direct) actions.

The Impact of Corporate Insolvency

While insolvency does not relieve corporate officers or directors of their respective fiduciary duties, it does introduce additional claimants into the equation ” namely, creditors. Indeed, in the case of an insolvent corporation, the duty of the directors is widely said to shift to the duty of maximizing value for the corporation's creditors. This often-touted maxim, however, is largely inaccurate as it suggests that upon insolvency, a dramatic shift takes place whereby creditors wholly replace shareholders as the company's residual claimants. In fact, shareholders generally remain residual claimants (albeit secondarily) in insolvency. Rather, because shareholders' residual claim to the corporation's assets becomes essentially valueless upon insolvency, creditors consequently become the company's principal residual claimants while the shareholders remain secondary claimants.

Thus, a far more accurate statement is that upon a corporation's insolvency, creditors gain standing to bring derivate actions for breaches of fiduciary duty. This standing is not a new or special privilege granted to creditors, nor does it deprive shareholders of standing to bring such a suit. Rather, allowing creditors to bring a derivative claim against an insolvent corporation is simply an extension of the principal that, irrespective of whether a corporation is solvent or insolvent, the directors owe a duty to maximize corporate value for the benefit of the respective residual claimants.

Derivative Actions

Under ordinary circumstances, a company's board of directors holds the exclusive ability to determine what litigation claims (if any) are brought by the company and against whom those claims are made. Derivative actions are an exception to this rule. In a derivative action, suit is brought by third parties (shareholders or creditors) on behalf of a corporation for alleged wrongdoing committed by corporate officers or directors. Although the corporation is named as a nominal defendant in derivative actions, the corporation is more properly treated as a plaintiff since it is for the corporation's benefit that the suit is brought and it is the corporation that receives any relief obtained.

Because a derivative action divests the board of an important corporate power ” namely the authority to control litigation ” both Delaware and California have implemented statutory mechanisms aimed at minimizing abuse of derivative power. Accordingly, a plaintiff will generally only have standing to bring a derivative action if that plaintiff has first made a demand on the board that it institute the action itself. Under ordinary circumstances, if a pre-suit demand is made on a company's board of directors and the board subsequently determines not to pursue the claim, that determination is accorded considerable deference under the business judgment rule and constitutes a defense to the suit. However, given that directors who have been named as defendants cannot be logically expected to impartially consider suing themselves, derivative plaintiffs are permitted to allege that the demand requirement is excused on the basis of futility. In order to avoid abuse of this exception, however, both California and Delaware require that a derivative plaintiff alleging demand futility state specific facts demonstrating that there are insufficient disinterested directors to properly consider the demand.

Conflicts of Interest in the Derivative Context

When litigation is brought against a corporation and its individual officers or directors in the context of a direct-action suit, the corporation's regular counsel often jointly represents both the corporation and the individual defendants. Assuming proper disclosures are made and consent obtained, such joint representation is generally permitted, at least initially, as all defendants share a common interest in having the suit dismissed. However, in the context of a derivative action, the situation becomes far more complex.

Former Corporate Counsel

Following termination of an attorney-client relationship, an attorney is prohibited from acting in a way as to have an injurious impact upon the former client in any matter in which the attorney formerly represented that client. Likewise, an attorney is similarly prohibited from using information or know- ledge garnered though the previous relationship against a former client. However, because the corporation is the sole beneficiary of derivative claims, counsel representing a derivative plaintiff essentially represents the corporation and the corporation's interests. Given the alignment of interests between the corporation and the derivative plaintiff, a derivative action brought against a corporation's officers and/or directors does not create a conflict between the plaintiff and the corporation. Accordingly, barring the existence of other conflicts, an attorney who has formerly represented the corporation is generally not disqualified from representing derivative plaintiffs against directors and officers of the corporation.

Representation in Both Direct and Derivative Actions

In class action litigation and other direct action suits, plaintiffs seek recovery of personal damages and, unlike derivative actions, any recovery is distributed to the plaintiffs and not to the corporation. As such, in representing direct-action claimants, counsel is charged with obtaining the greatest possible recovery for the individual plaintiffs. Indeed, obtaining recovery for the direct-action plaintiffs very often requires making claims against the corporation. Accordingly, in representing both derivative and direct-action plaintiffs, counsel risks conflicts inherent in representing clients with adverse interests. Specifically, while advocating for the interests of the corporation (via the derivative action), an attorney cannot simultaneously advocate for the claims of individuals against the corporation (via the direct-action suit). Doing so would be to take a position directly adverse to the corporation, which is prohibited under ethical rules.

The situation is potentially different when counsel has previously represented a derivative plaintiff and subsequently seeks to represent plaintiffs in a direct-action suit against the corporation. In such instances, so long as no actual conflict has developed out of any theoretical conflict presented by the prior representation, California courts have shown reluctance to disqualify the attorney from the subsequent representation.

Joint Representation of Corporation and Other Derivative Defendants

California Rules of Professional Conduct generally permit an attorney to jointly represent a corporation and the company's directors, officers, and other agents. Joint representation of clients whose interests potentially conflict in the same matter, however, is permitted only after obtaining each client's informed written consent. In the context of derivative litigation, obtaining informed written consent of the corporation is extremely problematic. Specifically, because a corporation can consent only through its officers and directors, and because these same directors and officers are also the named defendants, the corporation generally has no disinterested means of providing such consent.

Even presupposing that informed consent could be obtained, joint representation of both the corporation and named officer or director defendants nonetheless creates a scenario whereby the attorney may be required to choose between divergent client interests. The conflict is evident: On the one hand, the attorney seeks to gain recovery for the corporation for harm purportedly caused by the officer and director defendants; on the other hand, the attorney seeks to exonerate the officers and director defendants from liability to the corporation.

As such, it is virtually ethically impossible for a single attorney or firm to jointly represent officers and directors on one hand and the corporation on the other in derivative litigation. Indeed, in California an attorney attempting to represent both the company and its individual officers and directors in a derivative action is very likely subject to disqualification.

Conclusion

Derivative litigation presents complex ethical questions for counsel, particularly relating to conflicts of interest. As such, it is critical that an attorney considering representation in a derivative action conduct a careful review at the outset of a case in order to determine what actual and potential conflicts are inherent to that representation. Where serious charges of wrongdoing are alleged, separate counsel should be obtained for the corporation and for each of the other defendants. To the extent that an attorney wishes to represent plaintiffs in both derivative and direct action litigation, counsel must be certain that no actual conflicts have ripened that would prohibit this joint representation. Indeed, even where only potential conflicts exist, counsel should be careful to not only comply with all disclosure and consent requirements, but also monitor them to ensure that appropriate timely action is taken if these potential conflicts become actual conflicts.

Tamara Kurtzman is the founder of TMK, a Beverly Hills-based law firm. She provides business advice to clients and serves as an outsourced general counsel for companies and entertainment entrepreneurs. Kurtzman can be reached at [email protected] or 323-782-6999.