The Delaware Court of Chancery decision in Kandell v. Niv is based on highly unusual facts but aids in the understanding of some basic elements of the fiduciary duties of directors under Delaware law.  In that case FXCM, Inc., a foreign exchange broker, allegedly agreed to absorb customer trading losses in excess of the customer’s investment.  Such a guaranty against losses may have violated CFTC Regulation 5.16.  The risk of the violation was disclosed in FXCM’s Form 10-K.

FXCM suffered severe liquidity issues as a result of the so called “Flash Crash” in the value of the euro relative to the Swiss franc. This occurred when the Swiss unexpectedly decoupled the two currencies.  The Flash Crash was catastrophic for FXCM.  A derivative suit followed, and the threshold issue was whether pre-suit demand on the directors was excused.

One question before the Court was whether the FXCM Board could bring its independent business judgment to bear on behalf of the corporate interest in responding to a liability demand, so that pre-suit demand was excused under Delaware law. Pre-suit demand on directors is excused where the facts alleged, together with reasonable inferences therefrom, make it substantially likely that any illegality on the part of the Company arose from the directors’ bad faith.

The Court noted if directors knowingly cause or permit a Delaware corporation to violate positive law, they have acted in bad faith, and are liable to the corporation for resulting damages. Directors are not liable for non-compliance with law resulting from their negligence or gross negligence when they are protected by an exculpatory clause in organizational documents.  If the directors knowingly cause a violation of positive law, or knowingly ignore a duty to act, their actions are in bad faith in violation of the duty of loyalty which is not exculpated.

The facts here were different than the Caremark line of cases.  Under Caremark directors are not charged with preventing illegal actions by company employees unless certain “red flags” make it inescapable that the board acted with illegal intent, or in bad faith ignored a duty to act to prevent a violation.  Under Caremark, the pleading standard for such scienter on the part of directors is high.

This case involved no notice to the Board by legal advisors that Company policy—soliciting customers by touting limited risk—was illegal. The Complaint was silent regarding any other red flags. However, the Court found CFTC Regulation 5.16 was so clear on its face it was reasonably likely that the directors knowingly condoned illegal behavior, after drawing appropriate plaintiff-friendly inferences.  The Court discussed, but did not give weight to, Defendant’s contention that CFTC Regulation 5.16 was subject to multiple interpretations.

As noted, the question before the Court was solely whether this Board could bring its independent business judgment to bear on behalf of the corporate interest in responding to a liability demand. According to the Complaint the Board knowingly condoned illegal action by agreeing to a strategy where the Corporation agreed to absorb customer trading losses in excess of the customer’s investment as described in the Form 10-K. The Court found that the substantial likelihood of liability resulting from the Form 10-K disclosures faced by the Defendant Board members prevented an exercise of business judgment when considering whether the Company should proceed with a derivative suit.  Pre-suit demand on the Board in respect of this cause of action was therefore excused.

The Court noted that the plaintiffs faced a high burden showing their theory was substantively met and the theory awaits a developed record. Circumstances not apparent on the face of the pleadings may well show lack of bad faith.