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Nevada vs. Delaware

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This research will review the accuracy of the claims made in the "Nevada vs. Delaware" reported on many web sites in our industry. The issues will be discussed in the order presented in the report. Specifically, there are five areas wherein it is asserted that a specific act would be protected under Nevada law, but that a corporate director or officer would be exposed to liability in Delaware. Research reveals that the report is quite accurate.

ACTS OR OMISSIONS NOT IN GOOD FAITH

Before it was amended effective June 15, 2001, Nevada Revised Statutes (NRS) 78.037(1) allowed a Nevada corporation's articles of incorporation to contain:

A provision eliminating or limiting the personal liability of a director or officeholder to the corporation or its stockholders for damages for breach of fiduciary duty as a director or officer[.]

However, such protection was prohibited for "[a]cts or omissions which involve intentional misconduct, fraud or a knowing violation of law[.]" NRS 78.037(1)(a). [Repealed as of 6/15/01; the current version of NRS 78.037 allows corporate articles to contain any provision not prohibited by law.]

Prior to the change, this section was discussed in David Mace Roberts & Rob Pivnick, "Tale of the Corporate Tape: Delaware, Nevada and Texas," 52 Baylor L. Rev. 45 (2000). They wrote:

Without doubt on this subject, Nevada is more director and officer friendly than either Delaware or Texas . . . .

The NRS seems to imply that a limitation of liability statement may exculpate directors for a breach of the duty of loyalty, acts not in good faith, and receiving improper benefits. If true, directors may act contrary to the interests of the corporation by receiving improper benefits or otherwise act in bad faith, without vicarious liability, if the articles of incorporation eliminate director liability for such acts.

Id. at 51 (footnotes omitted)(emphasis added).

Concurrent with the change to NRS 78.037 came an amendment to NRS 78.138. Effective June 15, 2001, a subsection (7) was added to the statute:

[A] director or officer is not individually liable to the corporation or its stockholders for any damages as a result of any act or failure to act in his capacity as a director or officer unless it is proven that:

(a) His act or failure to act constituted a breach of his fiduciary duties as a director or officer; and

(b) His breach of those duties involved intentional misconduct, fraud or a knowing violation of law.

This subsection, in effect, gives all directors and officers of Nevada corporations the protection that the former NRS 78.037(1) merely allowed corporations to include in their articles. In other words, all Nevada corporations now have a limitation of liability statement for directors and officers imposed by law. And, this protection includes acts not in good faith, since NRS 78.138(7)tracks the language of the former NRS 78.037(1).

With these amendments, there no longer exists in Nevada corporations which have limitation of liability statements and corporations which do not.

In Delaware, such is not the case.

When a Delaware corporation's articles of incorporation do not contain a limitation of liability statement, the protection provided for directors from personal liability is the business judgment rule. "As a substantive rule of law, the business judgment rule provides that there is no liability for an injury or loss to the corporation arising from corporate action when the directors, in authorizing such action, proceeded in good faith and with appropriate care." Rodman Ward, Jr., Edward P. Welch & Andrew J. Turezyn, Folk on the Delaware General Corporation Law, 4th ed. (Aspen Law & Business, 2002), Vol. I, § 141.2.2.2 at GCL-TV-33 (emphasis added). See also Roberts & Pivnick, supra, at 48 (Directors of Delaware corporations must act in good faith to invoke the protection of the business judgment rule, citing Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) and Aronson v. Lewis, 473 A.2d 805 (Del. 1984)). (As discussed previously, the standard of liability under the business judgment rule is "gross negligence." See Roberts & Pivnick, supra, at 48; Ward, et al., supra, § 141.2.2.4 at GCL-IV-35.)

This being the case, an act of a Delaware corporate director not in good faith which rises to the level of "gross negligence" can lead to personal liability, if the corporation has no limitation of liability statement in its articles. When such a statement does exist, acts not in good faith are still not protected.

The Delaware General Corporation Law (GCL) is codified at Del. Code Ann. title 8. GCL § 102(b)(7) was added to the law in 1986. Ward, et al., supra, § 102.15 at GCL-I-27. This section, which covers only directors, allows a provision in the articles of incorporation:

[E]liminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit. No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective.

GCL § 102(b)(7) (emphasis added).

The legislative commentary states that § 102(b)(7) "makes clear that no such provision shall eliminate or limit the liability of a director for . . . failing to act in good faith[.]" S. 533, 133d Gen. Assembly 2, 65 Del. Laws ch. 289, §§ 1-2 (1986)(quoted in Ward, et al., supra, § 102.15 at GCL-1-27 n. 56).

Delaware statute quoted above treats intentional acts of misconduct and knowing violations of law as different from acts or omissions not in good faith.

It is noteworthy to mention that section (ii) of the Delaware statute quoted above treats intentional acts of misconduct and knowing violations of law as different from acts or omissions not in good faith. This bolsters the interpretation of NRS 78.138(7) above, as under that statute a Nevada director is only liable for breaches of fiduciary duty which involve intentional misconduct, fraud, or knowing violations of law. Thus, such acts are not acts "not in good faith."

Thus, in Delaware, under no circumstance is a director protected for acts not in good faith. However, in Nevada, such acts are protected, either by a limitation of liability statement found in the articles of incorporation prior to June 15, 2001, or by NRS 78.138(7) since that date. Therefore, on the issue of corporate director acts not in good faith, Nevada law provides protection not found in Delaware law.

ACTS BY OFFICERS EXEMPT FROM MONETARY DAMAGES

Under the former NRS 78.037(1), a limitation of liability statement in the articles of incorporation could include officers as well as directors. This made Nevada one of only six states to have such laws cover officers as well as directors. (The other five states are Louisiana, Maryland, New Hampshire, New Jersey, and Virginia.) See Clarence E. Hagglund, Britton D. Weimer & Joseph P. Monteleone, D & 0: Directors & Officers Liability: Guide to Risk Exposure and Coverage (The National Underwriter Co., 1999), at 9.

With the recent changes to Nevada's corporate laws, a limitation of liability statement is no longer needed for officers or directors, as NRS 78.138(7) covers both. To repeat, this section, applicable since June 15, 2001, is a statutorily-imposed limitation of liability statement for officers and directors. Only acts of intentional misconduct, fraud, prior a knowing violation of law will lead to an officer's (or director's) liability.

With the recent changes to Nevada's corporate laws, a limitation of liability statement is no longer needed for officers or directors

Protection for officers in Delaware corporations is nearly non-existent. GCL § 102(b)(7), which allows limitation of liability statements in the articles of Delaware corporations, applies on its face to directors only. See Ward, et al., supra, § 102.15 at GCL-I-32.1 ("Section 102(b)(7) exempts only directors from liability").

Protection for officers in Delaware corporations is nearly non-existent.

When a director is not protected by a limitation of liability statement in the articles, he can still find solace in the business judgment rule. Not so for officers of Delaware corporations. "Some states extend the business judgment rule to officers as well as directors, limiting officers' liability to gross negligence." Hagglund, et al., supra, at 8 (citing cases from Ohio, Minnesota, Washington, and Illinois. See at 17 n. 37). "Most jurisdictions, though, have not addressed the application of the business judgment rule to officers. The reason for this is unclear[.] . . . In any event, it is prudent for officers to assume that they will have exposure for ordinary negligence." Id. at 9.

As can be seen, Nevada corporate law provides substantial protection for corporate officers from monetary damages. Conversely, Delaware provides little to no protection for officers. On this issue, Nevada law is superior.

Delaware provides little to no protection for officers. On this issue, Nevada law is superior.


BREACH OF A DIRECTOR'S DUTY OF LOYALTY

Under the former NRS 78.037(1), a limitation of liability statement in a Nevada corporation's articles of incorporation protected directors from personal liability except in cases of intentional misconduct, fraud, or a knowing violation of law. As previously stated, this protection has now been codified at NRS 78.138(7), thus giving all Nevada directors a limitation of liability statement as a matter of law.

In reviewing the "intentional conduct, fraud, or a knowing violation of law" language of the former NRS 78.037(1), Roberts & Pivnick, supra, stated that this "seems to imply that a limitation of liability statement may exculpate directors for a breach of the duty of loyalty[.]" Id. at 51. Their conclusion is sound, given the language of the statute. Since NRS 78.138(7) mirrors the language of the former NRS 78.037(1), their conclusion is equally applicable to the new statute. Thus, Nevada laws appear to protect Nevada corporate directors from breaches of the duty of loyalty. Delaware law does not follow suit.

Thus, Nevada laws appear to protect Nevada corporate directors from breaches of the duty of loyalty. Delaware law does not follow suit.

In Delaware corporations wherein the articles include a limitation of liability statement, the limits of GCL § 102(b)(7) come into play. This section reads, in pertinent part, that a limitation of liability

provision shall not eliminate or limit the liability of a director: (i) for any breach of the director's duty of loyalty to the corporation or its stockholders[.]

The courts in Delaware have construed this section literally, holding that a limitation of liability statement in a Delaware corporation's articles pursuant to § 102(b)(7) shields directors from breaches of the duty of care (i.e., for acts of "gross negligence"), but not for breaches of the duty of loyalty. See Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001); Graham v. Taylor Capital Group, 91 F. Supp.2d 706, 732 (D. Del. 2000). "A breach of loyalty claim requires some form of self-dealing or misuse of corporate office for personal gain." Id. at 732.

Where a corporation's articles do not include a limitation of liability statement, and thus §102(b)(7) is inapplicable, the only protection available for Delaware directors is the business judgment rule. However, this rule does not protect directors who breach their duty of loyalty.

Under Smith v. Van Corkom, 488 A.2d 858 (Del. 1985), the fiduciary duties of directors include a duty of care and a duty of loyalty. Id. at 872-73. This latter duty has been described as follows:

The duty of loyalty is a broad and encompassing duty that, in appropriate circumstances, is capable of impressing a special obligation upon a director in any of his relationships with the corporation. This duty of loyalty embodies both an affirmative duty to protect the interests of the corporation and an obligation to refrain from conduct that would injure the corporation and its stockholders or deprive them of profit or advantage. In other words, directors must eschew any conflict between duty and self-interest.

Ward, et al., supra, § 141.2.1.1 at GCL-IV-18.

In Delaware, a breach of the duty of loyalty is not protected by the business judgment rule. See, e.g., Smith, supra; Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993); In re TriStar Pictures Litigation, 634 A.2d 319 (Del. 1993).

Thus, on this issue once again, Nevada law provides more protection for directors than does the law of Delaware.


TRANSACTIONS INVOLVING UNDISCLOSED PERSONAL BENEFIT TO A DIRECTOR

This issue is closely related to the issue of the duty of loyalty just reviewed. In Delaware, interested director transactions are allowed and are valid if 1) there is good faith approval by a majority of disinterested directors upon full disclosure; 2) there is approval by shareholders after full disclosure (interested shareholder votes do not count); or 3) the transaction is fair and either approved or ratified by the directors or shareholders. GCL § 144(a). Nevada law is similar. See NRS 78.140. These statutes involve disclosed transactions. When an undisclosed transaction occurs, the two states differ.

In Nevada, the former NRS 78.037(1) allowed limitation of liability statements in corporate articles, except for acts or omissions involving either intentional misconduct, fraud, or a knowing violation of law. As interpreted by Roberts & Pivnick, supra, this seemed "to imply that a limitation of liability statement may exculpate directors for . . . receiving improper benefits." Id. at 51 (citing Keith Paul Bishop, "The Delaware of the West: Does Nevada Offer Better Treatment for Directors?," 7 no. 3 Insights 20, 23 (Mar. 1993)).

Once again, since the new NRS 78.138(7) codifies the limitation of liability statement as a matter of law for Nevada corporate directors, the same conclusion still pertains. That is, Nevada corporate directors are apparently protected in situations involving transactions wherein they receive undisclosed personal benefits. This is not the case in Delaware.

Nevada corporate directors are apparently protected in situations involving transactions wherein they receive undisclosed personal benefits.

This is not the case in Delaware

Undisclosed personal benefits to a Delaware director is an issue of the duty of loyalty. (See the previous section, especially the quotes from Graham v. Taylor Capital and Ward, et al.) As such, Delaware law does not protect them, either in situations involving GCL § 102(b)(7) or under the business judgment rule.

Even beyond this, in cases involving director interest in a corporate transaction, the business judgment rule is inapplicable, and the director has the burden of proving the transaction is "fair." If he cannot do so, he is liable. See Ward, et al., supra, § 141.2.3. at GCL-IV-48 to 51; AC Acquisitions Corp. v. Anderson, Clayton & Co., 519 A.2d 103 (Del. 1986). The director's only hope is to disclose the transaction, and come within the terms of GCL § 144(a), supra. If he does so, the business judgment rule applies, unless the transaction rises to the level of disloyalty to the corporation. See Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993).

On the issue of undisclosed personal benefits to corporate directors, Nevada law appears to provide protection, whereas Delaware law clearly provides none.

ACTS OR OMMISSIONS OCCURRING PRIOR TO STATUTORY INDEMNIFICATION

Both Nevada and Delaware allow for the indemnification of corporate directors for acts performed in good faith and with a reasonable belief that the act was in the best interest of the corporation. See NRS 78.7502; GCL § 145. However, as stated by Roberts & Pivnick, supra, at 52, "[t]he battle of director friendly indemnification laws goes to Nevada, with . . .Delaware struggling to get out of the starting gate . . . . Nevada allows corporations to provide broad indemnification to their directors and officers . . . . Delaware's indemnification provisions are comparatively narrow." The reason for this conclusion is NRS 78.752, which allows a corporation to make "other financial arrangements" on behalf of its directors, beyond the maintenance of insurance. "As such, greater protection for directors is possible." Roberts & Pivnick, supra, at 52.

The battle of director friendly indemnification laws goes to Nevada, with Delaware struggling to get out of the starting gate!

However, there is nothing in the indemnification statute in Delaware which states that indemnification is not available for an act or omission which occurred prior to the date the statute was created. Perhaps there is some confusion on this issue because of GCL § 102(b)(7), which allows Delaware corporations to have an article provision limiting or eliminating director liability in certain situations. This section states, in part:

No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective.

In other words, in Delaware, a § 102(b)(7) provision which is created after an act or omission occurs provides no help to a director, whose only defense would then be the business judgment rule. In such a situation, liability follows if "gross negligence" is found. (When such a provision pre-dates the act or omission, the director is exempt from breaches of the duty of care, i.e., from acts of "gross negligence.") However, this has nothing to do with "indemnification," which is a completely separate issue.

CONCLUSION

On the above issues, as argued in the report entitled "Nevada vs. Delaware," Nevada law provides much more protection for directors and officers than does Delaware law. As stated by Roberts & Pivnick, supra:

[B]ecause Delaware's laws are designed to protect the rights of minority shareholders in large corporations, it has found itself in a difficult position regarding closely held companies. This may have come at the expense of protecting the directors and officers of Delaware corporations . ...
Nevada is striving on an ongoing basis to challenge Delaware as the state of choice for incorporation. In this vein, Nevada has adopted statutes that are more director friendly and anti-takeover favorable than Delaware's.

Id. at 46-47 (quotation marks and citation omitted).


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