Good Fences Make Good Neighbors and Preserve Attorney-Client Privilege in the Boardroom: A Word of Caution for Boards Navigating Potential Disputes Among Directors or With Funds They Manage
The boardroom frequently presents attorney-client privilege and work product protection issues. The Delaware Court of Chancery’s recent decision in Hyde Park Venture Partners Fund III, LP v. FairXchange, LLC, C.A. No. 2022-0344-JTL (Del. Ch. March 9, 2023), provides a reminder of the importance of vigilance in considering when and how to limit a director’s access to privileged materials in circumstances where directors’ interests may diverge – particularly where directors manage, or are affiliated with, investment funds owning stock of the Company.
Delaware’s “Joint Client” Rule and Application to Directors
As Hyde Park makes clear, under the “joint client rule” in Delaware, “[a] director’s ability to access corporate information affects whether a corporation can claim that a communication was confidential as to the director and thereby invoke the attorney-client privilege.” Under Delaware law, a “director’s right to information is ‘essentially unfettered in nature,’ and that right includes access to privileged material” because “‘[d]irectors of Delaware corporations are generally entitled to share in legal advice the corporation receives.’” In short, in the normal course, “the corporation has no expectation of confidentiality as to a director,” and “the general rule is that ‘a corporation cannot assert the privilege to deny a director access to legal advice furnished to the board during the director’s tenure.’” Of course, “[w]hen a director’s tenure ends, the director leaves the circle of confidentiality for purposes of any subsequent communications, but that does not retroactively alter the fact that the director was within the circle of confidentiality for purposes of communications during his tenure.”
Significantly, because “human beings [cannot] partition their brains,” Delaware courts also hold that where a director is a representative of an investment fund invested in the corporation’s stock, such investment fund “in effect[] is a member of [the company’s] board” and the investment fund is “as much the ‘client’ of [the board’s outside counsel] as [the other directors] are.” What’s more, because the rationale for the rule depends only on the director’s ability to access the privileged information, it does not matter whether the director ever in fact received the information.
Factual and Procedural History in Hyde Park
In Hyde Park, Ira Weiss was a director of FairXchange, Inc. (“FairX” or the “Company”) as well as a partner and manager of two venture capital investment funds (the “Funds”). In connection with the Funds’ investment, FairX issued preferred stock to the Funds, granting them a 15% equity stake as well as the right to designate a representative director – Weiss. As a director of FairX, Weiss routinely received and had access to privileged communications from the Company’s outside counsel.
FairX sought an investment from a third party in the summer of 2021, but after due diligence, the third party instead sought to acquire the entire Company. Shortly after receiving the preliminary offer, Weiss wrote to the other directors: “While we should be flattered by this surprise offer, I believe we have to take a step back and make sure that (1) selling now would maximize shareholder value, and (2) if we do sell now, that we are getting a market price for the company.” Weiss wanted the Company to retain an investment bank for purposes of undertaking a sale process to solicit bids from other potential buyers, and said that he would not vote to approve the transaction without such a market check. Four days later, the other directors rejected Weiss’s proposal and decided to move forward with the third party’s offer to buy the Company. Weiss thereafter was informally frozen out by the other directors as the Company and the third party worked on the transaction.
A few weeks later, Weiss served a director’s books and records request pursuant to DGCL 220(d) on the Company, seeking a wide variety of documents and communications related to the transaction. Behind the scenes, FairX’s other directors understood that the third party wanted unanimous director approval of the transaction, and they had been seeking consent from the majority of the Company’s other preferred stockholders to remove Weiss as a director. The day after Weiss served his books and records request, the other directors secured consent from the majority of the other preferred stockholders to remove Weiss from the board and informed him that they no longer considered the books and records request to be “relevant.” The next month, the Company’s board unanimously approved the transaction, and the transaction closed shortly thereafter.
The Funds commenced an appraisal proceeding, and during discovery, FairX and its outside counsel asserted attorney-client privilege over materials prepared during Weiss’s tenure as a director. The Company further believed that the Funds had received privileged information from Weiss and demanded that the Funds destroy that information. The Funds moved to compel production of the privileged material, and the Company cross-moved for a protective order seeking destruction of the privileged information in the Funds’ possession.
The Delaware Court of Chancery Highlights the Importance of a Factual Predicate for an Expectation of Confidentiality
Applying the general rule that a director is within the Company’s privilege, the court held that “the Company cannot assert the attorney-client privilege to withhold information generated while Weiss was a director.” He explained that “Weiss was . . . within the circle of confidentiality for purposes of privilege,” and “[t]he Company had no expectation of confidentiality as to Weiss.”
In reaching this conclusion, the court emphasized that the Company and the other directors never took the necessary steps to establish a factual predicate supporting an expectation of confidentiality as to Weiss or the Funds. Informally freezing him out of discussions after Weiss expressed his wish to undertake a sale process instead of accepting the existing offer from the third party was not enough. The court explained that the “Company did not take any of the recognized steps that would have created an expectation of confidentiality as to Weiss and provided the factual predicate for asserting privilege.” For example, before ultimately removing Weiss from the board, the Company did not (1) enter into an ex ante confidentiality agreement with Weiss; (2) form a special committee for purposes of considering the transaction; or (3) otherwise put Weiss on notice that the other directors considered him adverse to the Company’s interests with respect to the third-party transaction. In addition to rejecting the argument that the informal freeze out by the Company’s other directors was sufficient to support the assertion of privilege as to Weiss, the court also rejected arguments that the merger extinguished Weiss’s rights to the privileged material and that Weiss’s removal from the board applied retroactively to extinguish his rights to the privileged materials created prior to his removal.
Ultimately, the court found that the Funds, by virtue of Weiss’s role as a director of the Company, were entitled to discovery of all of the privileged materials related to the third-party transaction that were created up until Weiss was removed from the board. However, the court did allow the Company to assert privilege over documents related specifically to Weiss’s inspection request.
Conclusion
With the variety of hats that directors may wear, the Delaware Court of Chancery’s decision in Hyde Park serves as an important reminder. Companies and their boards must be attentive to directors’ access to privileged materials when the potential for disputes among directors or the funds they represent arises. They should make sure to take the steps set out by the court in Hyde Park to preserve the Company’s opportunity to assert privilege against a director and/or the funds they represent in the event of resulting books and records demand or litigation.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.
