A Delaware court’s recent decision has suggested that a director with specialized expertise may be held to a higher standard of fiduciary duty than other directors on the board. On May 3, 2004, the Delaware Court of Chancery decided In Re Emerging Communications, Inc. Shareholders Litigation, No. CIV.A. 16415 (Del. Ch. May 3, 2004, revised June 4, 2004), in which the court imposed liability on the defendant corporation and several of its directors in connection with the plaintiffs’ assertion that the sale price in a two-step “going private” acquisition was too low.

Background

Emerging Communications, Inc. (“ECM”) was a publicly-traded company which owned and operated certain telecommunications businesses. Jeffrey J. Prosser (“Prosser”) was the Chairman and Chief Executive Officer of ECM and also owned 100% of Innovative Communication Company, LLC (“ICC”), the holding company which owned 52% of ECM and 100% of Innovative Communications Corporation, L.L.C. (“Innovative”). Prosser, having acquired through ICC certain other telecommunications and media businesses with an eye towards combining them with ECM, recognized that ECM’s stock was undervalued and proposed a two-step “going private” acquisition of the publicly-owned shares of ECM.

ECM’s board, consisting of Prosser and six other individuals, appointed a special committee of three directors to review the fairness of the proposed transaction. Negotiations between the special committee and Prosser led to several increases in the offering price (resulting in a final transaction price of $10.25 per share) and receipt of a fairness opinion from ECM’s financial advisors. The special committee then recommended that ECM’s board approve the proposed transaction, which it did on August 17, 1998. Innovative acquired the ECM shares through a tender offer followed by a cash-out merger of ECM with an Innovative subsidiary. The transaction was challenged by former ECM shareholders seeking appraisal and a ruling that the ECM board had breached its fiduciary duties by agreeing to an unfairly low price.

The Decision

Because Prosser was on both sides of the transaction, the court held that the appropriate standard of review was one of entire fairness, which has two aspects: fair dealing and a fair price. After a lengthy analysis, the court concluded that a fair price was $38.05 per share, not the $10.25 per share approved by the ECM board.

Turning to the question of whether the transaction was the product of fair dealing, the court concluded in the negative. The court relied on a number of facts to justify its conclusion, the most prominent of which were that (i) the work of the special committee was “fatally compromised” and inadequate because the members did not meet regularly and their communications were passed through Prosser’s office, and (ii) Prosser withheld favorable financial projections from the board of directors and ECM’s financial advisors, thereby depriving them of information needed to make an informed assessment of the offered merger price.

The court then analyzed the liability consequences to the ECM directors. The court held that four of the seven directors violated at most their duty of care and had no liability because ECM’s charter contained a provision, pursuant to Section 102(b)(7) of the Delaware General Corporation Law, that exonerated directors for breaches of their duty of care but not for breaches of their duty of loyalty or good faith. All three members of the special committee were among this group.

The court held that Prosser breached his duty of loyalty by “eliminating ECM’s minority stockholders for an unfair price in an unfair transaction that afforded the minority no procedural protections.” Similarly, the court found that fellow director John Raynor (also Prosser’s personal attorney) had breached his duty of loyalty and/or good faith because he actively assisted Prosser in carrying out the transaction and acted to further Prosser’s interests in the transaction, which were antithetical to those of the minority stockholders.

The court’s most significant finding was that the seventh director, Salvatore Muoio, had breached his duty of loyalty and/or good faith, despite the fact that he did nothing affirmatively to assist Prosser. The court found that, at the time the transaction was approved by the ECM board, Muoio was a principal and general partner of an investment advisory firm and had more than ten years of experience in the telecommunications sector, first as an analyst and then as a portfolio manager of a well-known telecommunications mutual fund. As such, “he knew, or at the very least had strong reasons to believe, that the $10.25 per share merger price was unfair.” The evidence at trial also indicated that, at one point, Muoio had conceded that $10.25 was at the low end of the value range and had expressed to the special committee his view that it might be able to get up to $20 per share.

The court stated that “it was incumbent upon Muoio, as a fiduciary, to advocate that the board reject the $10.25 price” recommended by the special committee. The record at trial also indicated that Muoio had done independent business with Prosser in the past and that he was seeking future business. Based on the evidence, the court concluded that either (i) Muoio made an affirmative decision that it was in his best interests to demonstrate his loyalty to Prosser or (ii) he “consciously and intentionally disregarded” his responsibility to protect the minority from a risk, of which he had unique knowledge, that the transaction was unfair. According to the court, either conduct amounted to a violation by Muoio of his duty of loyalty and/or good faith.

Conclusion

It is possible that the holding of this case will be limited to its facts and will not be interpreted generally to increase the risk of liability for directors with special expertise. Until subsequent case law provides clarification and guidance, however, this case is a cautious reminder to directors and potential directors (particularly potential outside directors being recruited for their expert knowledge) that any specialized expertise they have may place upon them duties which are greater than those expected of directors generally.

For additional information, please contact

Ward Wellman(1) (704-335-9048 or wardwellman@parkerpoe.com), or

Kent Workman(2) (704-335-9064 or kentworkman@parkerpoe.com)

This Client Alert is intended to inform readers of recent developments and should not be considered as providing conclusive answers to specific legal problems.

(1) Licensed in North Carolina, New York and Connecticut

(2) Not licensed in North Carolina; licensed in New York and the District of Columbia