Eric B. Porter

The Delaware General Corporation Law grants stockholders and directors wide latitude to pass and implement corporate bylaws, and the boards of Delaware companies may be tempted to revise bylaws in the face of a hostile takeover bid to help defend against that bid. However, the Delaware Supreme Court recently issued an important decision reaffirming its willingness to strike down bylaws issued in such situations under a two-pronged “enhanced scrutiny” test. In Kellner v. AIM ImmunoTech, 2024 WL 3370273 (Del., Jul. 11, 2024), the Supreme Court on July 11 addressed a long-simmering dispute between a rotating cast of activist stockholders seeking to assume control of the publicly traded biopharmaceutical company AIM ImmunoTech Inc. (AIM) and the members of AIM’s existing board. Blaming AIM’s management for downturns in the company’s value, the activists made two prior attempts to nominate a slate of new directors to AIM’s board. These attempts were each rejected for failure to comply with AIM’s existing bylaws. Delaware General Corporation Law – Enhanced Scrutiny: When the activists initiated a third attempt to nominate their preferred slate, the existing board responded by passing a series of new and amended bylaws imposing onerous advance-notice requirements. These bylaws required the activist stockholders to satisfy a lengthy and detailed set of procedural and substantive preconditions to get their nominees on the ballot for the next stockholder vote. The board rejected the activists’ nominations for failing to comply with these new bylaws, and the activists sued. In its decision, the court made clear that advance notice bylaws are a legitimate exercise of board power and an important tool to “assist the board’s information-gathering and disclosure functions, allowing boards of directors to knowledgeably make recommendations about nominees and ensuring that stockholders cast well-informed votes” (internal quotation marks omitted). But the court also recognized that such bylaws “can be misused to thwart stockholder choice and entrench the existing board of directors.” As a result, “bylaws must, as a matter of equity, be reasonable in their application and not unfairly interfere with stockholder voting” (internal quotation marks omitted). Enhanced Legal Scrutiny & Balance: To strike this balance, the court reaffirmed the two-part “enhanced scrutiny” test first applied in Coster v. UIP, 300 A.3d 656 (Del. 2023). Under this test, a court assessing whether a board acted properly in accordance with its fiduciary duties in enacting or amending advance notice bylaws during a proxy contest (and therefore, the validity of such advance notice bylaw provisions) must first assess whether the board acted in response to a “threat ‘to an important corporate interest or to the achievement of a significant corporate benefit.’ The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal.” Actions taken for the primary purpose of precluding challenges to the existing board’s control are “selfish or disloyal” and are therefore prohibited. A court must next determine “whether the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder[’s]” right to vote. Applying this two-part test, the court accepted the Delaware Court of Chancery’s prior conclusion that the board had amended its bylaws specifically to thwart activist stockholders’ efforts and maintain control of AIM. The court, therefore, held that the amended bylaws failed the first prong of the “enhanced scrutiny” test and were, therefore, invalid. Boards of Delaware corporations considering any change to existing bylaws in the face of a hostile takeover bid or otherwise dealing with activist stockholders should carefully study the Kellner decision to ensure that their actions are lawful and valid when assessed under the higher two-pronged enhanced scrutiny standard of review rather than a simple analysis under the traditional business judgment rule. New bylaws or amendments issued in such circumstances should further legitimate corporate interests separate and apart from the mere preservation or entrenchment of the existing board and should be narrowly tailored to the issue or threat being addressed.

When whistleblowers lose their jobs or otherwise experience an adverse employment action, employers often face retaliation claims. With respect to retaliation claims brought under the Sarbanes-Oxley Act, the U.S. Supreme Court recently clarified the parties’ respective burdens of proof in a way that may encourage more whistleblower suits and impact an employer’s litigation strategy and settlement calculus. In Murray v. UBS Securities, the Supreme Court resolved a split that had arisen between the U.S. Court of Appeals for the Second Circuit and the Fifth and Ninth circuits regarding whether a whistleblower plaintiff under Sarbanes-Oxley is required to prove that his or her employer acted with “retaliatory intent.” Rejecting the Second Circuit’s position — and in line with the Fifth and Ninth circuits — the court on February 8 unanimously ruled that a Sarbanes-Oxley plaintiff is not required to make such a showing. As the Supreme Court noted in Murray, Sarbanes-Oxley was passed in the wake of the Enron scandal, where Congress’ subsequent investigation uncovered “abundant evidence” that Enron’s “massive shareholder fraud” had succeeded in large measure as the result of a “corporate code of silence” enforced through firing employees who attempted to report misconduct. Congress accordingly incorporated into Sarbanes-Oxley an express provision, 18 U.S.C. Section 1514A, to prohibit “publicly traded companies from retaliating against employees who report what they reasonably believe to be instances of criminal fraud or securities law violations,” the court said. In Murray, plaintiff Trevor Murray worked for UBS as a research strategist in the firm’s commercial mortgage-backed securities business. U.S. Securities and Exchange Commission regulations required Murray to certify his reports to UBS’s current and potential customers as accurately reflecting his views. Murray alleged that his direct supervisors pressured him to alter his reports and that he was terminated after bringing this pressure to the attention of other superiors. He filed an action against UBS in federal court alleging a violation of Section 1514A. UBS argued on summary judgment that Murray had failed to supply evidence that UBS held any “retaliatory animus” toward him. The district court rejected that argument, holding that Murray was not required to make any such showing, and the jury later found in Murray’s favor. But the Second Circuit reversed on appeal, finding that “retaliatory intent is an element of a Section 1514A claim.” After engaging in a detailed statutory analysis of the language of Section 1514A and the burden-shifting framework it imposes on employees and employers, the Supreme Court rejected the Second Circuit’s interpretation in its entirety. As the district court had instructed the jury, the plaintiff alleging retaliation under Sarbanes-Oxley must only prove that: (1) the employee engaged in whistleblowing activity protected under the act; (2) the employer knew of the protected activity; (3) the employee was fired or suffered some other adverse employment action; and (4) the protected activity was a “contributing factor” in the adverse employment action. The employee is not additionally required to prove the employer’s “retaliatory intent,” the Supreme Court said. If the plaintiff proves each of the required four elements, the burden then shifts to the employer to prove that it would have terminated the plaintiff’s employment (or taken the adverse employment action at issue) even if the employee had not engaged in the whistleblowing activity. By removing the requirement that whistleblower plaintiffs under Sarbanes-Oxley show “retaliatory intent,” the court’s decision lowers a plaintiff’s evidentiary bar and makes defending a retaliation claim trickier for employers. Indeed, finding and presenting evidence of the employer’s intent was previously one of the most difficult burdens placed on a whistleblower plaintiff. Now, however, the whistleblower only needs to show that the whistleblowing activity was a “contributing factor” to the adverse employment action. This may lead to publicly traded companies facing more whistleblower suits and being incentivized to settle where they may have previously opted to defend aggressively. Employers covered by Sarbanes-Oxley should acquaint themselves with the Murray decision and take steps to ensure they are in a position to succeed if a retaliation action is brought and the burden ultimately shifts to the employer. Thoroughly documenting the adverse employment action and the full set of bases for such action, along with ensuring that the employer has put in place both comprehensive policies to protect whistleblowers and meaningful employee training regarding such policies, will help set the company up to demonstrate that the adverse employment action would have occurred even if the employee had not engaged in protected whistleblowing activity.

When a dispute erupts into litigation between a corporation and one of its investors, the corporation will likely seek to invoke the attorney-client privilege to prevent the investor from accessing otherwise relevant communications between the corporation’s board of directors and its counsel. However, according to a recent decision by the Delaware Court of Chancery, the attorney-client privilege may not shield such materials from production to the investor in situations where the director wears two hats because of affiliation with the investor. Corporations governed by Delaware law should familiarize themselves with this decision to ensure that privileged information is properly protected from disclosure. In Hyde Park Venture Partners Fund III, L.P. et al. v. FairXchange, Inc., C.A. No. 2022-0344-JTL (March 9, 2023), the corporation in question, FairXchange, Inc. (FairXchange), sought to withhold communications between its board of directors and FairXchange’s counsel from production to two of its investors (the Funds). The Funds had been represented on FairXchange’s board of directors by a director who was also a manager of the Funds. When a third party offered to purchase FairXchange, the Board member affiliated with the Funds opposed the proposed sale (preferring a process where the company would seek other strategic alternatives), while the remaining directors favored pursuing the offer. The remaining directors then took steps to remove FairXchange’s representative from the board, and following such director’s removal by the requisite stockholder vote, the board unanimously approved the sale. After the sale closed, the Funds then brought an appraisal proceeding against FairXchange. When the Funds sought the production of pre-sale communications between the board and its attorneys during the discovery phase of the proceeding, the corporation objected on the grounds of attorney-client privilege. The Chancery Court rejected FairXchange’s privilege claim and ordered the corporation to produce the attorney-client communications to the Funds. The Court explained that Delaware had adopted the so-called “joint client rule,” whereby members of a corporation’s board of directors are each considered joint clients of the corporation’s attorneys. According to the Court, such joint clients are each “within the circle of confidentiality” and, therefore, cannot assert a privilege against one another concerning advice sought from counsel relevant to their service to the corporation. A corporation, therefore, cannot have a reasonable expectation of confidentiality that excludes a member of its board. If a director is removed from the board, that director is excluded from the “circle” from that point forward. But the former director remains within the circle as to advice received from counsel before the former director’s removal. Moreover, where an investor in the corporation is represented by a director on the board, the investor’s designee is presumed to share information with the investor because, according to the Court, humans “ha[ve] only one brain [and] cannot partition their brains so that they only use particular knowledge for particular purposes.” For this reason, the Court held, the corporation similarly cannot have a reasonable expectation of confidentiality that excludes an investor represented by a member of the board of directors. While the Court held that the corporation was required to produce the privileged material to the Funds, the material remains privileged as to the rest of the world. But it cannot be withheld from another party “within the circle of confidentiality” established by the joint representation. The Chancery Court clarified that corporations have options if they wish to exclude particular directors (or the investors they represent) from the “circle of confidentiality” concerning certain legal communications. Corporations can do so by contract, typically via a confidentiality agreement laying out limitations to a director’s or investor’s right to receive or access information. They can do so by appointing (openly and with the excluded director’s knowledge) a special committee not including the excluded director, which could then retain its own counsel and enjoy confidentiality only within its own ranks. Or they can do so by advising the excluded director that an adversity of interest exists between the director and the corporation, such that the director can no longer rely upon the advice of the corporation’s counsel with respect to the matters related to the adversity. Notably, the Chancery Court recognized that Federal courts generally apply a different rule to this circumstance: the so-called “entity rule.” Under this approach, directors are treated as agents of the corporation, and the corporation, not the directors, holds the privilege. When a director resigns or is removed from the board, the former director has no claim to privileged material that she may have previously accessed during her period serving as a director. Simply put, corporations governed by Delaware law (or potentially subject to Delaware law) should consider how the Chancery Court’s recent decision in Hyde Park could impact their ability to maintain the confidentiality of attorney-client communications if relations with a director or the investor she represents turn adverse. Taking some reasonable precautions in advance – such as through the execution of a fulsome confidentiality agreement – may avoid a negative outcome down the road.

Angel investors, venture capital and private equity funds often seek to secure some presence, formal or informal, within the board meetings of the corporations in which they invest. Such representation and participation in corporate governance provide potential benefits to both the investor and the portfolio corporation. The corporation can benefit from having experienced investors participate and provide guidance in board meetings and beyond. While some corporations may be wary of offering such investors a formal seat on the board of directors, one option commonly employed is to grant investors or their representatives rights as “board observers.” Such persons may observe and even participate, usually in some limited fashion, in meetings of the board of directors. They generally get rights to attend meetings and obtain all materials provided to formal members of the board, but in a non-voting capacity. Granting such rights, however, introduces a number of unique issues and subtle potential pitfalls that both the corporation1 and the investor should carefully assess. Little caselaw or statutory guidance exists on the rights and obligations of board observers. Corporations and investors, each seeking to protect themselves, should therefore ensure that they expressly delineate those rights and obligations in advance via a detailed board observer agreement executed by both the corporation and the observer. Some of the key considerations to address in such an agreement, and related issues, are discussed below. Fiduciary Duties Corporate law generally does not impose fiduciary duties on board observers. Such fiduciary duties typically arise where one party manages an asset or group of assets for another, as a result of which the law will accordingly impose on the manager certain duties of loyalty and care with respect to the beneficiary. Directors, officers and managers of the corporation, having been charged with the duty to manage the assets of the corporation, are deemed fiduciaries with respect to the stockholders. But since board observers, by contrast, will typically have no formal responsibility for managing the corporation’s assets, they will typically not be deemed to owe the corporation any fiduciary duty. From the corporation’s perspective, the lack of fiduciary duties can lead to conflicts of interest, especially with strategic investors who may be in the same industry or business as the corporation. Such conflicts would not be addressed by an overriding duty of loyalty or duty not to act in a self-interested manner. Where an investor designates a representative to sit on the board, either formally or informally, that director could be said to be wearing two hats, one as a representative of the investor and one as a fiduciary to the corporation. In fact, that representative may even owe fiduciary duties to the investor who designated such person to sit on the board. As a formal board member, the duty of loyalty would protect the corporation from such conflicts. Therefore, on the one hand, companies often attempt to include language in board observer agreements that requires the board observer to act as if it were subject to fiduciary duties. On the other hand, investors often want the opposite, to expressly state that the board observer is not a fiduciary of the corporation. In fact, often, an investor will prefer an observer seat specifically because they are concerned about conflicts of interest created by such fiduciary obligations. The investor is interested in access to information and a window into its investment but doesn’t necessarily feel the need for a formal board seat that would give it the power to direct the affairs of the corporation through a vote on the board. Regardless of whether the board observer agreement expressly addresses fiduciary obligations, the agreement should both define the scope of the board observer’s rights to participation and access to information as well as seek to protect the corporation by imposing express limitations on such rights. For instance, the agreement should make clear that the observer is not entitled to vote at board meetings, may not veto any decision or action taken or being considered by management and may be excluded from receiving certain information or attending portions of meetings, as more fully discussed below. It may even subject the observer to additional restrictions on the use and disclosure of information that are not necessary for voting members of the board. The agreement may also specify the conditions upon which the board observer’s rights may sunset, for instance, if the investor who has the right to designate the observer does not continue to hold a specified amount of stock or by or before an identified end date. Confidentiality and Privilege As a non-member of the board and a representative of a third party, the board observer’s mere presence in the board meeting may compromise the confidentiality of information shared or discussed in the meeting. The observer’s presence may also destroy the privilege that attaches to a meeting between the corporation’s board and the corporation’s attorneys. Special care should accordingly be taken to address these issues in the board observer agreement. Courts considering the issue have reached varying conclusions on whether the provision of confidential or privileged information to a board observer waives the attorney/client privilege with respect to such information. In Finjan, Inc. v. SonicWall, Inc., a decision issued by the United States District Court for the Northern District of California in 2020, the Court found that a corporation’s disclosure to a board observer of information otherwise protected by the attorney/client privilege constituted a waiver of the privilege with respect to that information. By contrast, the United States District Court for the Eastern District of North Carolina held the exact opposite in a 2005 case, PharmaNetics, Inc. v. Aventis Pharmaceuticals, Inc. Corporations and investors should attempt to address this uncertainty upfront through their board observer agreement. The agreement should expressly define “Confidential Information” and impose unambiguous obligations on the observer to protect and maintain the confidentiality of such information and to not use the information for any purpose other than for monitoring the relevant investor’s investment in the corporation. In many situations, it should also contain appropriate limitations upon the sharing of competitively sensitive information. The agreement should also make clear that all such information is proprietary to the corporation and may contain trade secrets, the disclosure of which would harm the corporation. The restrictions imposed should apply broadly to all those parties with whom the observer is authorized to share information obtained from the corporation. The board observer agreement may also expressly provide the corporation the right to withhold certain proprietary information, especially if it could jeopardize trade secret protection for such information. The board observer agreement should also give the corporation the tools necessary to protect the corporation’s attorney/client privilege by expressly stating the corporation’s right to exclude the observer from any meetings or discussions with counsel where the observer’s presence might constitute a waiver of privilege. The corporation’s right to exclude the observer should also extend to situations in which matters being discussed may give rise to a potential conflict of interest. Of course, even when an agreement allows the corporation to exclude the observer for privilege reasons, the corporation must remain vigilant and actually exercise such right at appropriate times, or the privilege could be inadvertently waived. Conclusion Though the presence of board observers is fairly common in privately held corporations, corporations should think twice before liberally agreeing to allow any investor to appoint an observer, as their access to information and participation in a corporation’s board meetings raises a number of potentially significant issues for both the corporation and the investor. Given the relative lack of statutory guidance or caselaw governing the rights and obligations of these observers, both sides should ensure that they protect themselves in advance through the careful drafting and execution of a comprehensive board observer agreement. Stradley Ronon has a deep bench of experienced attorneys who regularly draft board observer agreements for a variety of corporate and investor clients. We are well-prepared to assist you with any legal needs you may have in this area or any related area, including those involving startup investments, compliance and governance. 1 Though this article focuses on observer rights with respect to corporations, observer rights can also be granted in entities that use other forms if they have boards or functionally similar governing bodies.