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AHLA's Speaking of Health Law
Health Care Corporate Governance: The Fiduciary Duty of Candor
Rob Gerberry, Senior Vice President and Chief Legal Officer, Summa Health, speaks with Michael Peregrine, Partner, McDermott Will & Schulte, about a little-known element of fiduciary responsibility that could potentially have an outsized impact on director exposure: the so-called “duty of candor.” They discuss what the duty of candor is, who owes this particular fiduciary duty, how the duty of candor kicks in during a typical corporate scenario, and how a recent decision from the Delaware Chancery Court has highlighted this issue.
Watch this episode: https://www.youtube.com/watch?v=4UejhDhNTh8
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SPEAKER_02:Welcome, everyone, to another in our continuing series of corporate governance podcasts. This is Rob Gerberry. I'm the chief legal officer of Summa Health and the president-elect designate of the HLA. I'd like to welcome you to our latest in our continuing series of podcasts on corporate governance issues affecting healthcare organizations. Today's topic focuses on a little-known element of fiduciary responsibility that could potentially have an outsized impact on director exposure, the so-called duty of candor. In essence, the duty of candor requires that a fiduciary shoots square or be straight, I've learned, with a person or entity to whom or which it owes a fiduciary duty. And it's a duty that's received quite a bit of attention following a recent Delaware decision in which the judge publicly shamed a businessman for the lack of candor he demonstrated in dealing with his investor clients. The substantial attention paid by the vice chancellor to fiduciary duties claims in general and to claims involving breach of duty in particular make it a worthwhile subject for the board of directors to part of their education. As the leading governance advisor of the board, the general counsel, likely teaming up with the chief governance officer, is well situated to brief the board on the basic elements of the duty of candor, how it may apply to certain types of director conduct, and how best to prepare directors to reduce exposure to duty of candor allegations. And as always, I'm joined today by my HLA colleague and friend, Michael Peregrin of McDermott, Will and Schultz, who is also an HLA fellow and a fellow of the American College of Governance counsel. Michael, I think many of us are familiar with the duties of care, the duties of loyalty, but it may be new for some of our listeners to understand more about the separate duty of candor. Would you like to share more?
SPEAKER_01:Well, a little bit of inside baseball, Rob. There certainly is a fiduciary concept related to candor, or as some others describe it, to make full disclosure. You know, whether it's a core duty unto itself or an adjunct or subset of the duty of loyalty is the subject of some debate amongst the academics. Not Not that it ultimately matters, I think. No matter how it's positioned, the concept of candor or shooting square, as you mentioned in your intro, as a fiduciary obligation is pretty widely recognized. And I kind of think of it along the lines of the duty of obedience or the duty to obey the law, which is kind of a part of the duty of loyalty. So it's out there. And I think that's whether it's a duty unto itself or pulled into the duty of loyalty, I'm not sure that matters. The key is courts certainly recognize it.
SPEAKER_02:So Michael, what's the essence of this duty or fiduciary responsibility?
SPEAKER_01:I think it's pretty simple. And again, as you said, it's the concept of an obligation of fiduciary to act with honesty, shooting square, with whom or what the fiduciary has a fiduciary relationship. It also entails an obligation to fully disclose information that could conceivably harm the business or an individual that that's owed the fiduciary duty. The way I describe it, Rob, is a director can't pull his or her punches when it comes to providing information that he or she has a reason to know that would be of relevance to another director or to the company as a whole. And circumstances pop up from time to time where it seems like some directors might be inclined to hold back, and that can lead to real problems. Now, we're going to be talking about this mostly in the context, of course, corporations, but note that the rule applies both the corporate law and the partnership and LLC law. In fact, that case you mentioned came out of a general partnership. The duty of candor applied to a general partner is the same as the duty of candor applied to directors. So for these reasons, the duty is just a little bit more complicated than might seem at first, but ultimately, I think the concept is if you owe a duty to somebody, you owe a duty to shoot square with them.
SPEAKER_02:So I was going to say, I've heard many references so far to fiduciaries and duties Isn't this on the surface of something that's maybe a little more simple than something requiring those big words?
SPEAKER_01:Well, you're kind of right about that. You know, the duty of candor analysis, though, can be a little bit more layered than care and loyalty analyses when you kind of get down to it. But generally speaking, the approach to looking at or evaluating a possible duty of candor breach is kind of the same approach as evaluating other possible fiduciary duty breaches. You know, it's threefold, I think. First, is the question of whether or not the individual in question serves in a recognized fiduciary role. Am I a fiduciary? Would the law consider me to be a fiduciary? Second immediately is, okay, if that's the case, to whom or what do you owe a fiduciary duty to? Who are your obligations owed to? A person like another director or the stockholders or the organization's mission if you're a nonprofit? The third question relates to, okay, fine, if I'm a fiduciary and I owe a duties to Rob Gervais Charities Incorporated, then what are the duties? What's the expected standard of conduct? Is it carol loyalty, candor, obedience, whatever? And then finally, what are the expectations of me? And I'm serving that role. Have I failed to discharge my duties as expected in the standard of conduct? So again, real simple. Am I a I exercise that duty consistent with the prevailing standard of conduct. That's the basic checklist.
SPEAKER_02:So as we start to make a little deeper dive here into some of the legalities around this, can you give us a little more fine point on those first couple of points in some background?
SPEAKER_01:Yeah, I think it's probably good to start just to kind of a reminder of the traditional positions that usually confer fiduciary status. A trustee, a director, an officer, controlling shareholders, and others. The status is going to ultimately be governed by the nature of the relationship. And some state laws may differ a little bit, but you can pretty much be sure if you're dealing with a person or you're advising a client or a client's agent that fits within one of those categories, you're probably going to have a fiduciary relationship. But again, you have to look at the totality of the circumstances and what they involve.
SPEAKER_02:And maybe, Michael, would you mind expanding on some of what those circumstances might be?
SPEAKER_01:Yeah, I suspect, Rob, this will be familiar to a lot of our audience. As you know, in a for-profit corporation, direct directors owe their fiduciary duties to the corporation and the stockholders. In a not-for-profit, they owe their duties to the mission and purposes of the company, not to a person. If you went down a list, I would say directors owe fiduciary duties to common stockholders and preference to preferred stockholders. An insolvent corporation gets into all sorts of ups and downs with respect to whether fiduciary duties are owed to creditors and if so, at what time. A controlling shareholder owes fiduciary duties to the company and the minority shareholders. And what we, I think, forget sometimes, Rob, and I think you have to check your state laws, in a lot of states, certainly Delaware, corporate officers owe fiduciary duties to the company and its stockholders, or if it's a nonprofit, its mission. That's always something I think is important to check if you're advising a board in a particular state. Does that state follow the Delaware concept that corporate officers owe the same duties of care and loyalty as directors owe? That's always a good thing to check on before you start diving into an issue. But remember, the corporation itself doesn't owe duties to its stockholders. It's the directors that owe that duty.
SPEAKER_02:So in your answer, you gave us a pretty good start to a treatise there. Let's maybe go back to a typical corporate scenario. How do you see the duty of candor kicking in?
SPEAKER_01:Well, I think that's a really good question, and we need to think more broadly about that now that this case is out. I would say the directors owe a duty of candor or disclosure to each other with respect to company matters. That's the situation, at least in my practice, where I see this kick in the most. In other words, a director can't knowingly lie or omit information when speaking with other directors. When it comes to topics or information that you know or have every reason to know is relevant and material to the company. This is a concept that was a big deal in Sarbanes. I know it's a funny thing, Rob, but as we get further and further away from Sarbanes. To me, that was like yesterday, but it was 23 years ago. But again, a lot of the duty of candor cases and theories have been based on the issues that arose in the Enron era where directors were, again, pulling their punches, weren't being straight with other members of the board when they knew or suspected it was something going on because of conflict they didn't share it. As one academic has noted, I think it's an extreme example, a director doesn't need to explain to the rest of the board that he got a speeding ticket. However, like if you're on the Cleveland Browns and your defensive end was driving 120 miles an hour in a 60 mile an hour zone, then you probably want to disclose it. If the director is also being investigated, you know, for criminal activity or something of that nature, you know, they could material impact the company's reputation. Then you've got a duty to disclose. And I think the same goes when a director is sitting on information, whether about another direct And I've had that situation a couple of times or other matters that could, again, is it reasonably relevant to the work of the board? Is it reasonably relevant to the company or the exercise by another director of visitor duties like decision making? Then, you know, I think the duty of candor really kicks in. The question I think often is when in doubt, we're going to talk about this in a few more minutes in more detail, I think that's the question that's You go to the general counsel and say, you know, we're going to be talking about this. Is this something I need to disclose? Similar to the kinds of questions board members ask when they're filling out a conflicts of interest questionnaire. When in doubt, ask your general counsel. And if you feel uncomfortable in doing so, ask your own counsel. Don't try and resolve the question yourself because you may be wrong.
SPEAKER_02:So this podcast not only provides the best in corporate governance counsel, but also the best in breaking sports news. I got
SPEAKER_01:a flash about that this morning. I had to rub you about it. I like Garrett too, but that's for a different podcast.
SPEAKER_02:So as I'm listening to you, I'm going back to my bar exam review days. Am I correct in remembering the concept of fiduciary duty and the one of duty of candor has been out there for a while versus something that's new out of a law journal or some obscure case?
SPEAKER_01:Yeah, you're right, Rob. The central theme of candor has been out there for a long time, a long line of cases. And I think some of our audience may remember the old case Smith versus Van Gorkum, which was at the time in 1985. And boy, would I go back to those days. That was the great merger case, which essentially decided that the board blew its fiduciary obligations in approving a merger. And that case specifically held that the director defendants breached their duty of kin by failing to make true and correct disclosures of all the information they had that were material to the transaction that they submitted for stockholder approval. So the bottom line is, yeah, this is not something that some goofy judge came out with and is really obscure. It's been out there, and there are actually more cases than we might think that discuss the duty of candor in various permutations, mostly in the for-profit world, not necessarily in the not-for-profit world, although it does exist in both sides of the fence.
SPEAKER_02:So as we think about how this hit our radar as far as a breaking corporate governance development, what's arisen lately that's really prompted you to think through this topic?
SPEAKER_01:Well, I think it's because a lot of commentators on Delaware law have picked up a new decision from about a month or so ago from the Chancery Court involving what I think the name of the case is, Leo Investments Hong Kong Limited versus Tamales Bay Capital. I It's a very complex fact pattern. You have to read the case about four or five times, and I sketch it out to figure out all the players. It arises in the concept of partnership arrangements, but that, again, for purposes of our discussion, it really is immaterial. In the case, generally speaking, high level, you had a fund manager had planned to create a particular fund to facilitate the purchase of a famous tech company stock, and that got balled up when... foreign investors' mandatory disclosure obligations bumped up against the tech company's policy against investing from the investor's company. In other words, the tech company had a policy saying, we will not accept investors from company X. And that kind of messed up the fund manager's plan to move the stock to the foreign investors. So what the fund manager sought to do was boot the foreign investors investor from the fund. That triggered a bunch of breach of fiduciary duty claims, including those against the fund and a duty of candor claim. When you strip it all away, the Chancery Court held for the fund manager on key fiduciary breach terms, but against him on the candor claim. The court said, and this is a long way to get to this point, that the fund manager failed to really screwed up in failing to recognize and address the investor's disclosure requirements and then for misguiding others on how to access the share purchases. The court specifically noted that when the fund manager sought to discuss withdrawal with the foreign investor, in other words, when he was trying to ease them out so he could go forward with a bigger deal, he took on a duty to speak honestly and completely. In other words, there was a point in time where the court said, here, at this moment in when the fund manager was talking with the foreign investment and talking about his withdrawing from the fund, he said at that point, that crew took on a duty to speak honestly and completely. And the court said by speaking falsely and partially as to the circumstances that have popped up, he failed to comply with the duty of candor. So you go through a lot of pages in the court decision, but the basic takeaway is that the court did not attribute the traditional breach of duties to the fund manager, but it did say that there was a point in time in your discussions with this potential investor where you stepped into a fiduciary relationship and you blew it by BSing him on the fundamental facts and circumstances.
SPEAKER_02:So despite all those legal principles in that court decision, ultimately, though, it had an unusual outcome, didn't it?
SPEAKER_01:It really did. And I think this is what, when you asked the question earlier, Rob, this is what's gotten a lot of the law professors excited about it. You know, in most claims of harm, assuming that the plaintiff isn't seeking injunctive relief, the plaintiff's going to seek to prove damages. And, you know, if he can't do that, the court's either going to dismiss the case or in many duty of candor situations, award nominal damages. And that's exactly what happened at Leo Investments because no measurable monetary money damages were identified. So the court awarded the plaintiff a dollar. And because the court said, look, the fund manager redeemed the investor's investment right away. So there wasn't a situation of the guy was, you know, lost money, but he was The court was concerned about a few other things. So$1 was the award for the duty of candor violation.
SPEAKER_02:So we as general counsels often get asked, we hear about your legal principles, but tell us really what's the risk with$1? How can we get the attention of our board members?
SPEAKER_01:Well, that's the big issue. That's why the Leo case is really important because there's a much bigger potential risk involved and it involves reputation. And you and I have talked about this before, Rob, on these podcasts. I have a tremendous concern these days about issues of corporate trust and reputation and individual director and officer reputation. And that's exactly what was the big takeaway here. In the Leo investments case, the court's finding made it clear that the defendant fund manager was not forthright, had not been shooting square with his investment partner to the point where the court described the guy's conduct as callous. And the court went further to suggest the future investors should think twice about investing with the guy. Now that's, you know, you don't usually see that in a breach of fiduciary duty cases, especially when a dollar's at stake. So I think the answer to your question is, yeah, there's a lot bigger risk involved.
SPEAKER_02:Wow. So is that a one-off opinion or are you seeing a legitimate concern or a trend in dealing with candor claims?
SPEAKER_01:Well, you know, the concept is called judicial shaming. And I think that's something that we would want our listeners to kind of jot down. If you dig into this a little bit, and it's a great way to spend a rainy weekend as I did recently, you find that some courts, including Delaware Chancery, have been periodically willing to, I guess, act as moral guides or arbiters of sorts and to build into the record some explicit criticism of the defendant's conduct when they feel doing so may have a longer-term impact on the defendant than with monetary damages. In other words, is justice served better in a candor situation by shaming the defendant than by awarding some large damages, which may not be justifiable under the facts. The challenge is that, and this is why I think a message we want to pass along, is shaming is going to have a broader impact on the fiduciary community. It's very similar to the practices of some state AGs in the nonprofit sector when they are pursuing a breach of fiduciary duty case to all also tack on the sanction of barring a board member from service for the charitable service in that state. And that's, you know, that is a real powerful motivating factor. But it's been a practice, Rob, that's been criticized by some for concerns about fairness and proportionality. So are you always going to say that there's a risk of shaming? I would say, yeah, I would say that there's precedent for shaming in the situation. We heard the last of this no um i think somebody's going to appeal and you know we'll see but i think that is going back to your question uh it's not a one-off opinion shaming is a legitimate concern with candor claims and again the point is the court feeling that there's no amount of damages that work dollar damages that work here we've got a guy who uh who who was who was less than honest in um in the exercise of his duties that he owed to somebody how do we prevent that for happening again, well, we shame him in the opinion, and that's going to scare others off as well.
SPEAKER_02:Well, Michael, as always, a lot of great content in this podcast, a lot of great background on case law, as we're asked to do here in my organization. How would you assign our board members some key takeaways from this podcast?
SPEAKER_01:Well, I probably wouldn't assign them to read the full Leo case unless they had been really, you know, that may be a penalty for missing a number of meetings in a row. You have to read this case. I think the ultimate takeaway, Rob, is that, number one, that the duty of candor is a real thing. It's a I think in a perfect world, easy to satisfy, but I think it requires a commitment to be more aware of what it means to be a fiduciary, to be more aware of when someone is or could fall into a fiduciary relationship with another person or entity, when could that happen? And what good faith disclosure and being forthright means in a particular circumstance. The latter in particular, I think would benefit from periodic reminding to the board. So I think it's an example of a duty that might be best explained by fact patterns that are presented in board education. And then the general counsel teaming with the chief governance officer can be really effective guys in that regard. Maybe something online, maybe taping something that walks through that the board can listen to it as leisure, but saying, you know, here are examples of what is complying with the duty of candor and here are examples of what's not, but my message is pay attention to it because ultimately, Rob, what I get concerned about is that I'm seeing more and more in my practice situations, whether in the for-profit or not-for-profit world, where there is a disgruntled contracting party, vendor, board member, corporate member, whatever, that is really pissed off and wants to hurt the organization or wants to be a nuisance and is well funded enough to sustain litigation long enough to drag it out and to be named in litigation for breach of the duty of candor would sting and so I think that if you really peel away what I want directors and their counsel to remember is that that's out there and when you have this new case getting a lot of attention and shaming there are those out there that maybe for good reasons or not so good reasons might say, hey, okay, let's pursue, you know, I'm mad at the company. I'm mad at the board. Let's see if we can gin up a candor allegation. That'll teach them. So I do think it's worth the time and effort to say, let's take a little closer look at this. When we're obligated to make disclosures, let's make sure they satisfy the standard of full and complete and good faith for purposes of the duty of candor. Long message, but, you know, it's this one, it troubles me and my life outside this podcast.
SPEAKER_02:Great. Well, Michael, thanks as always. Thanks for surfacing this important topic for us and providing the background that you did today. We'll look forward to being back next month to talk about the Guardians run to the playoffs and the latest developments in the business judgment rule.
SPEAKER_01:I'm not going to make fun of the Guardians. I've learned that lesson. Thanks, Rob, very much.
SPEAKER_02:Thanks, Michael. Have a great day.
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