The Delaware Court of Chancery has found that corporate directors breach their duty of good faith if they knowingly allow their corporation to violate positive law, for profit or otherwise.[1] Directors of Delaware corporations can be held personally liable for fines and other damages resulting from known violations of law. In Kandell v. Nviv, Civil Action No. 11812-VCG (Sept. 29, 2017), the stockholder plaintiff brought a derivative action against the directors of FXCM, Inc., a “foreign exchange broker” engaged in the business of buying and selling foreign currencies on customers’ orders. Industry practice was that customers’ trades were highly leveraged, but FXCM distinguished itself by promising clients that it would not attempt to collect on their losses beyond the relatively small amounts they invested. That policy at first led to significantly higher revenues.
The Corporation’s Violations of Law
However, rules promulgated by the United States Commodity Futures Trading Commission (CFTC) in connection with the Dodd-Frank Act of 2010 prohibit foreign exchange traders such as FXCM from representing that they will limit their clients’ trading losses. According to the plaintiff, FXCM’s board knowingly allowed the corporation to violate 17 C.F.R. (Code of Federal Regulations) § 5.16 (Regulation 5.16). The directors’ knowledge was evidenced by the company’s public filings, which disclosed a “risk” that Regulation 5.16 forbade making guarantees against loss to retail foreign exchange customers. The directors were thus aware of Regulation 5.16 and of the company’s advertised policy of not pursuing customer losses beyond the investment amount.
The policy eventually led to catastrophic losses for FXCM. On January 15, 2015, the Swiss National Bank announced that it would allow the Swiss franc to “float freely” against the euro, leading to a “Flash Crash.” In the 45 minutes following the announcement, FXCM customers “locked in” losses of $276 million, which FXCM was unable to collect because of its liberal policy regarding customer losses.
The Complaint and the Court’s Ruling
The derivative complaint, initially filed in December 2015, sought damages from the directors on behalf of the corporation for losses incurred in the Flash Crash. The defendants moved to dismiss the complaint, arguing that while they knew of Regulation 5.16 and of the corporation’s policy, they did not know that the policy violated Regulation 5.16.
Denying the motions to dismiss, Vice Chancellor Glasscock looked to the text of Regulation 5.16, which provides that no retail foreign exchange dealer may “guarantee” a customer against loss or “Limit the loss of such person.” The Court found that “the Regulation itself, on my reading, clearly prohibits touting loss limitations to clients, and I find that the Company did precisely that.” The Court stated that “my reading of Regulation 5.16 is sufficient at the pleadings stage to infer scienter” on the part of the board. Because the Regulation clearly prohibited the corporation’s conduct, the Court inferred that the directors were aware that the corporation was in violation of Regulation 5.16. The Court emphasized that the case presented “a highly unusual set of facts” in which a corporation’s business model relied on “a clear violation of a federal regulation” of which it could be inferred that the board had knowledge.
The Court noted that this case did not involve a typical Caremark claim because it did not involve “a director’s bad-faith failure to exercise oversight over the company” to ensure that violations of law did not occur, but rather involved violations of law that were actually known to the directors. In Caremark, the Court of Chancery approved a settlement because it found that the record did not “tend to show knowing or intentional violation of law” by the director defendants. In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959, 961 (Del. Ch. 1996). Neither Caremark nor FXCM involved a mere breach of the duty of care that could be exculpated by a corporate charter provision under Section 102(b)(7) of the Delaware General Corporation Law. The statute expressly excludes exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” 8 Del. C. § 102(b)(7).[2]
Practice Pointers
Attorneys advising boards of directors should stress that corporate directors may not tolerate known violations of law, including regulatory law, even if it might make economic sense to do so in the board’s exercise of its business judgment. In the case of FXCM, the corporation may have taken a risk in violating the law that proved disastrous in a crisis. As the Court stated, “Where directors intentionally cause their corporation to violate positive law, they act in bad faith…. a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profits by violating the law.”
[1] According to Wikipedia, positive law consists of “human-made laws that oblige or specify an action,” from the verb “to posit,” as opposed to “natural law.”
[2] Exclusions for illegal conduct or violation of law, and possibly bad faith, would typically apply to directors’ and officers’ insurance policies as well.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.
