Directors Beware: Court Decision Applies Public Rules to Private Companies –

The recent Pereira v. Cogan1 (“Trace”) federal court decision could have far-reaching implications for directors and officers of private companies, particularly those designated by equity sponsors and private equity firms. The judge presiding over the case ruled that Marshall S. Cogan, the founder, chairman, CEO and controlling shareholder of Trace International Holdings Inc., a bankrupt, privately held Delaware corporation, along with his co-defendants, breached their fiduciary duties under Delaware law and held the group personally liable for damages in excess of $40 million.

The Trace ruling is highly significant for two reasons: The judge applied fiduciary duty standards normally associated with public companies to the directors and officers of a private company; and the defendants other than Cogan were held personally liable for Cogan’s “looting” of the company even though they did not personally gain.


Cogan and the other defendants were sued by the bankrupt trustee for their alleged self-dealing and breach of fiduciary duty. Prior to filing for bankruptcy, Trace served as a non-operating holding company for three principal investments: substantial minority positions in two public companies (Foamex International Inc. and United Auto Group Inc.) and ownership of a private company, all of which were controlled by Cogan. He controlled the management and operations of Trace and received compensation both from it and the three companies it controlled. Trace had no independent directors. All of the other defendants were directors and officers of Trace who either worked for, or otherwise had a material relationship with, Cogan, Trace or its affiliates (e.g., outside legal counsel, investment banker, etc.). All permitted Cogan to run the show.

The judge found that Cogan, either without formal board approval or by attempting to obtain after-the-fact board ratification, engaged during a 15-year period in self-dealing transactions with an aggregate value in excess of $40 million. His self dealings included deciding on his own excessive compensation, borrowing money from Trace, throwing himself a lavish birthday party and hiring his daughter.

The two main issues in the case were: Can a controlling stockholder and founder of a privately held corporation be held liable for causing one entity under the corporation’s control to transfer funds to another entity under its control without a legitimate business purpose?

What actions must officers and directors take to fulfill their fiduciary duties when they learn that a controlling stockholder may be engaging in self-dealing transactions?

The Decision

Overview. The judge found that Cogan’s actions constituted self-dealing in breach of his fiduciary duty to the corporation. Its shareholders and subsequently, its creditors, and the other defendants also breached their fiduciary duties by subordinating their duties to the corporation to the personal interests of Cogan. As a result, the judge ruled that the defendants would not have the benefit of the business judgment rule, meaning they would have to prove the “entire fairness” of the transactions to avoid personal liability.

Claims Against Cogan. The judge held that under Delaware law a controlling shareholder that engages in self-dealing assumes the initial burden of demonstrating the “entire fairness” of the transaction (i.e. whether it was on terms at least as favorable as might be available from third-parties (the “fair price” test), and whether the board acted with due care (the “fair process” test). If the controlling shareholder demonstrates that the transaction was approved by independent and fully informed directors who acted with care and engaged in arms-length negotiation with Cogan, the burden shifts to the plaintiff.

The judge found that because the director defendants were not independent and had not acted with appropriate due care the burden of proof remained with Cogan. The challenged transactions did not meet the “entire fairness” standard because Cogan failed to demonstrate that they satisfied either the fair price test or the fair process test.

Claims against the Other Defendants. The judge also held that the other defendants breached their fiduciary duties of care and loyalty in connection with Cogan’s self-dealing transactions, pointing to their close relationships to, and their failure to engage in arms-length negotiations with, Cogan and their almost complete reliance on the conclusions of committees and advisors with little or no information gathering or supporting materials. The judge further held that the directors’ failure to monitor was a breach of their duty of care. Finally, he held that under Delaware law, the business judgment rule does not protect against alleged director inaction, absent a conscious decision not to act. As a result, even though the other defendants did not personally gain from the transactions, the judge required them to prove the “entire fairness” of Cogan’s self-dealing transactions in order to avoid personal liability.

The Impact on Directors and Private Equity Firms.

Private company directors and private equity firms should pay attention to this decision. Directors of private companies are fiduciaries and, particularly if a controlling shareholder such as a private equity firm dominates the board, their dealings with the company will be subject to close scrutiny comparable to that applied to the directors of public companies.

Because of this decision public and private companies subject to Delaware law will be held to the same standards of corporate governance practice, so private company directors should evaluate their corporate governance policies and procedures in light of comparable public companies. Although inapplicable to many private companies, private company directors (and private equity firms with director designees) should look to the federal securities laws, including the Sarbanes-Oxley Act of 2002 and the listing standards of the New York Stock Exchange and Nasdaq, for guidance. At a minimum, private company boards should consider having independent board members, and audit and compensation committees similar to public companies, with functions and responsibilities that include:

-setting corporate governance policies and procedures;

-monitoring internal controls and disclosure controls and procedures;

-approving related party transactions and officer and director compensation;

-establishing a business code of conduct and ethics;

-monitoring compliance with applicable laws;

-having responsibility for pre-approval of all audit and non-audit services and hiring, retaining and overseeing the auditor; and

-establishing procedures to receive and respond to confidential employee concerns about questionable accounting or auditing matters.

These are particularly important where a board of directors consists entirely of management and designees of private equity firms or equity sponsors. Arguably, if there are no independent directors on a board, directors approving transactions with the private equity firm, its principals, or its other portfolio companies will not have the benefit of the business judgment rule even when they do not benefit personally from the transactions. In addition, the judge’s holding that the directors’ failure to monitor breached both their duties of loyalty and care arguably renders meaningless the exculpatory provisions for breaches of the duty of care permitted by DGCL Section 102(a)(7) and similar state statutes. This could have significant negative implications for D&O coverage and the application of exclusions under such policies.


Although the decision limited the protections under Delaware law of the business judgment rule for private company directors, it did not change the legal standards governing the conduct of directors, who always have had both a duty of loyalty and a duty of care. Directors who act in good faith and in a manner they reasonably believe to be in the best interests of the corporation should continue to be free from personal liability for their actions (or inaction). In addition, the business judgment rule continues to protect disinterested directors from personal liability to the corporation and its shareholders for actions taken on an informed basis, in good faith and in the honest belief that the action was in the best interests of the corporation. What has changed is that judicial scrutiny of the actions of directors of private companies has been ratcheted up a notch: They now must take affirmative steps to ensure that the business judgment rule will apply to their decisions, because courts in Delaware, and other states that choose to follow this decision, will be watching more closely.

Todd E. Lenson is an attorney in the Securities Group of the law firm of Stroock & Stroock & Lavan LLP. Todd’s practice includes regularly representing private equity funds, including funds engaged in leveraged buyouts and venture capital investment, and emerging companies in financings and mergers and acquisitions, as well as advising public companies on corporate governance issues.

1 2003 WL 21039976 (S.D.N.Y.)