When one director sues other directors, do the defendant-directors have the benefit of the attorney-client privilege to shield internal communications with counsel from discovery? That was one issue before the Delaware Court of Chancery in the fast-moving litigation contesting a proposed recapitalization of Morgans Hotel Group Co. ("Morgans"). Kalisman, et al. v. Friedman, et al., C.A. No. 8447-VCL, 2013 WL 1668205 (Del. Ch. Apr. 17, 2013).

In resolving the issue, the court carefully drew the line to allow discovery of communications between counsel and a special committee that the plaintiff-director was a member of, but shielded communications between counsel and a sub-committee on which the plaintiff-director did not serve.

Background

In December 2011, Morgans appointed a Special Committee, including the plaintiff, Kalisman, to investigate strategic alternatives. Those efforts stalled in November 2012, and resumed March 18, 2013, when OTK Associates LLC ("OTK"), a 14 percent shareholder, announced it would nominate an alternative slate of directors and make business proposals at the company’s May 15 annual meeting. Kalisman was a director of Morgans and also the founder of and a participant in OTK.

Kalisman alleged in the Delaware case that the defendant-directors secretly "sprang into action" after OTK made its proposal and began searching for an alternative deal, while at the same time telling Kalisman that "nothing was in the works." Kalisman, at *1. The defendants then secured an alternative plan – a recapitalization backed by an entity affiliated with one of the defendant-directors.

Kalisman first heard of defendants’ plan when he received notice March 29, 2013, that the Board and the Special Committee would meet the next day to consider the recapitalization. When the Special Committee met March 30, it voted to create a sub-committee, excluding Kalisman, and adjourned the meeting. Later that same day the full Board met, and the recapitalization was approved. Morgans announced the recapitalization April 1 and plaintiff filed suit that same day.

Kalisman filed his complaint and sought immediate discovery. Among other claims, he asserted that notice of the Special Committee and full Board meetings was inadequate. He sued derivatively on behalf of the company, and also asserted direct claims. He subpoenaed the law firms retained by the company and the Special Committee. Defendants refused to produce documents, asserting the attorney-client privilege and work product doctrine. Kalisman then filed a motion to compel.

Ruling on Application of Attorney-Client Privilege

The court recognized that Kalisman has a right of equal access to the materials he seeks, both in his capacity as a director of Morgans and in light of his status as a joint client of the subpoenaed law firms. Kalisman, at *4. Generally, "all directors are responsible for the proper management of the corporation." Therefore, "a corporation cannot assert the [attorney-client] privilege to deny a director access to legal advice furnished to the board during the director’s tenure." Kalisman, at *4 (quoting Moore Bus. Forms, Inc. v. Cordant Hldgs, Corp., 1996 WL 307444, at *4 (Del. Ch. June 4, 1996)). In short, Morgans could not pick and choose which directors would get information by asserting the attorney-client privilege against Kalisman but not asserting it against the defendant-directors.

The court noted, however, three recognized limitations to a director’s ability to access privileged information: (i) an agreement among the contracting parties that might limit access to privileged materials (although such an agreement could impact a director’s ability to discharge the director’s fiduciary duties); (ii) board action appointing a special committee pursuant to 8 Del. C. §　141(c) with the excluded director’s knowledge; and (iii) upon a showing of sufficient adversity between the director and the corporation, such that the director could no longer have a reasonable expectation that he was a client of the board’s counsel. Kalisman, at *4-5 (quoting Moore, 1996 WL 307444, at *5, 6 (citing SBC Interactive, Inc. v. Corporate Media P’rs, 1994 WL 770715, at *6 (Del. Ch. Dec. 9, 1997)).

The court held that prior to the formation of the sub-committee, Kalisman was a member of the Special Committee and therefore a joint client of its retained counsel. However, the court also ruled that Kalisman’s right to information ceased under the second and third exceptions on March 30, after Kalisman became aware of the defendants’ plan and after the sub-committee was formed. Accordingly, the court ruled that Kalisman was entitled to otherwise privileged documents generated before that time.

In so ruling, the court was critical of the company’s concealment of information from a director, and stated as follows:

Although tensions likely began rising between Kalisman and his fellow directors as soon as OTK proposed to nominate its own slate, the defendants chose to respond in secret and to conceal their activities until March 30. Company counsel went so far as to represent to Kalisman, days before the March 30 meeting, that no transaction was under consideration. In light of the defendants’ efforts to mislead Kalisman, it would be inequitable to give them the benefit of an earlier date for purposes of limiting Kalisman’s informational rights.

Kalisman, at *5 (emphasis added).

Derivative or Direct Claims?

The court also ruled that Kalisman did not need to assert his claims derivatively because he has standing to maintain, and can seek discovery with respect to, his direct claims. Under Delaware law, a plaintiff has standing if he can demonstrate: (i) he suffered an injury, (ii) there is a causal connection between the injury and the conduct complained of, and (iii) the injury would likely be redressed by a favorable decision. Kalisman, at *7 (citing In re Celera Corp. S’holder Litig., 59 A.3d 418, 429 (Del. 2012)).

Kalisman pleaded that the Board and Special Committee meetings were improperly noticed and that the defendants breached their obligation to deal candidly with him as a director. He alleged that he suffered an injury to his rights when the defendants allegedly violated Delaware law and the company’s bylaws by failing to provide adequate notice of the March 30 meetings, and more generally when they froze him out of the deliberative process.

The court concluded that (i) the alleged injuries to Kalisman and to his legal rights resulted directly from the defendants’ actions, and (ii) a favorable decision would remedy Kalisman’s injuries by potentially invalidating the votes taken at the meetings and the resulting transactions. "Kalisman therefore has standing to pursue his direct claims. All of the information that Kalisman seeks is relevant to and discoverable in connection with his direct claims." Kalisman, at *8.

Client Alert 2013-107