☀️🏖️ Better weather is ahead, join us for Legal Summit in Ocean City this summer! Early Bird registration ends March 31, 2024, so lock in your registration today.
 

By Scott R. Wilson, Esq.,
William E. Carlson, Esq., and
James J. Hanks, Jr., Esq. 

On March 2, 2023, the Supreme Court of Maryland granted review of Mekhaya v. Eastland Food Corporation, 256 Md. App 497 (2022). The opinion of the Appellate Court of Maryland below fails to properly recognize and navigate the provisions of Section 2-405.1 of the Maryland General Corporation Law (MGCL), which has formed the foundation for director duties in Maryland for nearly 50 years. The opinion compounds this legal error by failing to acknowledge, much less apply, amendments to Section 2-405.1 unanimously adopted by the Maryland General Assembly in 2016 and by rejecting or misapplying the statutory business judgment presumption. The Appellate Court has forced on the Supreme Court of Maryland and, in turn, on Maryland corporation law a critical inflection point: Will the Supreme Court of Maryland reestablish the State as a leader on matters of state corporate law, or will Maryland corporate jurisprudence be allowed to decline? 

Section 2-405.1(c) Is the “Sole Source” of All Legal Duties Owed by a Director of a Maryland Corporation to the Corporation and Its Stockholders.

Since 1976, when the General Assembly enacted Section 2-405.1 of the MGCL, a director of a Maryland corporation has been required to act in “good faith” in “a manner the director reasonably believes to be in the best interests of the corporation” and “with the care that an ordinarily prudent person in a like position would use under similar circumstances.” This Section matched the standard of conduct adopted by the American Bar Association in then-Section 8.30(a) of the Model Business Corporation Act. In adopting a “plain English” codified standard for director conduct, the General Assembly replaced the common law fiduciary duties that had historically governed directors of Maryland corporations, but had yielded multiple standards for directors (and their lawyers) to parse and attempt to apply to the wide range of actions that directors typically confront in the boardroom.[1] In crafting the standard of conduct, the drafters of the Model Act intentionally omitted any reference to “fiduciary” duties “because that term could be confused with the unique attributes and obligations of a fiduciary imposed by the law of trusts, some of which are not appropriate for directors of a corporation.” Model Business Corp. Act Section 8.30, Official Comment (1996); see also Hanks, Maryland Corporation Law § 6.06B, note 129.  For nearly 50 years, Maryland corporations, directors, counsel, and the courts have benefited from the common sense approach and plain language of Section 2-405.1.

By 2009, in Shenker v. Laureate Education, Inc., 411 Md. 317 (2009), the Court of Appeals of Maryland appeared to have forgotten the lessons of the pastreopening the door to the uncertainty that plagued understanding director duties under Maryland law before the enactment of Section 2-405.1. Examining claims brought by stockholders following a cash-out merger, the Court of Appeals held that, among other things, Maryland law recognized certain undefined common law fiduciary duties that govern the actions of a director in addition to the Section 2-405.1 standard of conduct. The court further held that Section 2-405.1 applied to and governed “managerial” decisions, but that there were other, unspecified common law fiduciary duties owed directly to stockholders that “may be triggered by the occurrence of appropriate events.” Id. at 335. Questions understandably arose as to what other common law fiduciary duties might exist under the court’s formulation. Further, while the Court of Appeals recognized that common law fiduciary duties could be triggered by appropriate events, the court failed to explain what factual scenarios might trigger such duties. See Sutton v. Fedfirst Fin. Corp., 226 Md. App. 46, 85-86 (2015). In Sutton, in the absence of any standard, the Court of Special Appeals purported to adopt Delaware corporate law. Confusingly, however, the Delaware standard articulated by the Court of Special Appeals did not deal with springing legal duties at all but, rather, the Delaware court’s standard of judicial review with regard to allegations that directors breached fiduciary duties owed directly to stockholders under Delaware common law in any circumstance. In short, the open-ended holding of Shenker and its progeny injected deep uncertainty into the business world of Maryland corporations and their boards of directors, as well as their counsel.  

The confusion wrought by Shenker was ultimately corrected by the Maryland General Assembly. In 2016, through House Bill 354 (then codified as Chapter 171 of the Laws of Maryland 2016), the General Assembly unanimously confirmed that the codified standard of conduct replaced all prior articulations of director duties, fiduciary or otherwise, under Maryland law and clarified the reach of Section 2-405.1(c) (formerly subsection (a)). House Bill 354 represented the culmination of a six-year effort by the Business Law Section of the Maryland State Bar Association and its legislative sponsors to correct the problems caused by Shenker. House Bill 354 involved two major changes: (1) it added new subsection (i) to Section 2-405.1; and (2) it deleted old subsection (g), which had provided “[n]othing in this section creates a duty of any director of a corporation enforceable otherwise than by the corporation or in the right of the corporation.” House Bill 354 reflected compromise to preserve an implied objection to former Section 2-405.1(g) in Shenker, while reestablishing that Section 2-405.1 alone governs director conduct. New subsection (i) now states that Section 2-405.1 is the “sole source” of duties of a director to the corporation and the stockholders of the corporation, resolving one of the ambiguities created by Shenker and its progeny. Thus, the 2016 amendments to the statute eliminated the distinction, believed to be unique among the states, between managerial and non-managerial acts created by the Court of Appeals in Shenker, resolved the surrounding confusion, and clarified that Section 2-405.1 is the sole source of a director’s duties. See Bill Carlson and Scott R. Wilson, The Director Duties Bill: Amendments to Section 2-405.1 of the Maryland General Corporation Law, Md. Bus. Journal, Vol. 49, at 41 (September/October 2016) at 41.

Section 2-405.1(c) continues to provide, as former Section 2-405.1(a) did, that “[a] director of a corporation shall act: (1) In good faith; (2) In a manner the director reasonably believes to be in the best interests of the corporation; and (3) With the care that an ordinarily prudent person in a like position would use under similar circumstances.” New (as of 2016) Section 2-405.1(i) further provides that Section 2-405.1:

  1. Is the sole source of duties of a director to the corporation or the stockholders of the corporation, whether or not a decision has been made to enter into an acquisition or a potential acquisition of control of the corporation or enter into any other transaction involving the corporation; and 
  2. Applies to any act of a director, including an act as a member of a committee of the board of directors.

(Emphasis added.)  Consequently, there are no legal, fiduciary, or other duties owed by a director of a Maryland corporation to the corporation or its stockholders other than those statutory duties arising under the standard of conduct articulated in Section 2-405.1 and any claim against a director by a stockholder must accord with all other subparts of 2-405.1 that underscore deference to the business judgment of directors (i.e., 2-405.1(d)–(h)). 

Thus, a cause of action for “breach of fiduciary duty” against a director of a Maryland corporation does not exist under Maryland law. Since 1976 the cause of action for behavior that in Delaware and other common law jurisdictions would constitute a breach of fiduciary duty has been correctly styled as a breach of the standard of conduct. Indeed, whatever claims for a breach of common law fiduciary duties survived the adoption of 2-405.1 in 1976 and were recognized by Shenker in 2009, were extinguished on October 1, 2016the effective date of the amendments to Section 2-405.1.

Notwithstanding all of the foregoing, Eastland Food almost entirely ignores Section 2-405.1 of the MGCL. Despite considerable effort by the bar and the confirmation and correction by the General Assembly, the Eastland Food opinion not only ignores the impact and significance of the 2016 amendments, which obviate much of the court’s analysis, but also reduces the entire statute to a “see also” citation following the now significantly curtailed (if not superseded) Shenker opinion. 256 Md. App. at 527–29. In doing so, Eastland Food ignores the actions of the General Assembly in both 1976 and 2016. By ignoring Section 2-405.1 and the General Assembly’s unanimous 2016 amendments, the Maryland Appellate Court follows an entirely inapt framework to analyze the causes of action in the underlying complaint. At this moment of consequence, the Supreme Court of Maryland should explicitly recognize that any claim by a stockholder, whether direct or derivative, against a director for acts by that director relating to the corporation or its stockholders must be grounded in a breach of Section 2-405.1(c), subject to all of the presumptions and limitations of that statute.  

Following such holding, the analysis of the both the first and second causes of action in Eastland Food, viewed through proper application of Section 2-405.1(c) of the MGCL and sounding in a breach of the same, becomes much more straightforward: (i) if brought on behalf of the corporation, did the appellee-stockholder satisfy Maryland’s demand requirement; and (ii) if “yes” or if the cause of action is a direct cause of action, did the appellee-stockholder plead sufficient facts to defeat the presumption of Section 2-405.1(g) and, accepting all allegations as true, establish that acts by directors constitute a breach of the standard of conduct of Section 2-405.1(c)? The entire discussion of “de facto dividends,” which is itself unsound and deeply flawed (e.g. under Maryland law a “distribution” may only be authorized by the board of directors subject to the limitations in Section 2-311conversely, salaries and other compensation are often set by officers and do not carry the same limitations or penalties), becomes irrelevant to this analysis and to the review of the trial court’s grant of the appellant’s motion to dismiss. We express no view as to whether the appellee-stockholder’s claims should survive this analysis, but further observe that the Maryland Appellate Court also failed to apply the presumption of Section 2-405.1(g). See Hanks, Maryland Corporation Law §§ 606B notes 195-96, 6.09.

The Presumption of Section 2-405.1(g) Applies to All Stockholder Actions Against Directors

For generations, courts have deferred to the business judgment of directors of corporations formed in Maryland and elsewhere through an initial presumption and standard of review known at common law as the business judgment rule. Following national debate as to whether adoption of the Model Business Corporation Act standard of conduct unintentionally and adversely impacted application of the common law business judgment rule, Maryland adopted the statutory business judgment presumption. Hanks, Maryland Corporation Law § 6.09 (“The presumption of Section 2-405.1(g) in favor of a director’s acts was added by the General Assembly in 1999” and “[a]ccordingly, it may now be said that the business judgment rule . . . has been codified by the Maryland legislature.”) Today, that statute provides as follows: “An act of a director of a corporation is presumed to be in accordance with subsection (c) of this section.” MGCL § 2-405.1(g).

In dicta in Shenker and again in Eastland Food, without citation to any binding precedent or persuasive legal authority, first writing for the then-Court of Appeals of Maryland and subsequently for the Appellate Court of Maryland, Judge Harrell concluded that “[i]f the plaintiff demonstrates that he or she has suffered the alleged injury directly … the business judgment rule does not apply.” Shenker, 411 Md. at 345; see also Eastland Food, 256 Md. App. at 529. This legal conclusion has no basis in fact or law. 

As an initial matter, any novel rejection of the business judgment rule based upon whether a cause of action is direct or derivative misapprehends the role and decision-making process of a board of directors. When a board of directors acts, whether the impact of its act is felt by the corporation or the stockholders directly is rarely (if ever) a consideration; indeed, the mere question of whether alleged harm resulting from director action results in harm to the corporation (and stockholders only indirectly) or to stockholders directly produces vigorous debate and motions practice even after the fact. See Waller v. Waller, 187 Md. 185, 189–90 (1946). To afford deference to acts of a director where harm is alleged to have impacted the corporation, but not the same deference if it is established that purported harm directly impacted stockholders, is unsound at best. This interpretation is not the law in the State of Maryland or in any other jurisdiction of which we are aware. 

Pursuant to Section 2-405.1 of the MGCL, the business judgment of a board of directors of a Maryland corporation is entitled to deference whether an act results in harm to the corporation or its stockholders. Stated otherwise, whether a claim is direct or derivative has no bearing on the availability of the presumption of compliance with Section 2-405.1(c). This result is not a question for the common law, but a relatively straightforward question of statutory interpretation. As Section 2-405.1(c) is the “sole source” of the legal duties owed by a director of a Maryland corporation to “the corporation or to its stockholders,” there is no room to conclude that subsection (g) does not apply to direct claims, and, therefore, Section 2-405.1(g) of the MGCL applies to both direct and derivative claims.  

* * *

Eastland Food represents a moment for Maryland corporate law where a course correction is required. Maryland courts have from time to time gotten the details wrong (e.g., the MGCL uses the term “stockholder” to define an owner of stock in a Maryland corporation and opinions all too often employ the term “shareholder”), but (at least until Shenker) Maryland courts were always correct on the “big” issues. Indeed, the Court of Appeals of Maryland has grappled with difficult issues and developed sound and well-reasoned results that have helped to establish Maryland as one of the leading jurisdictions for formation of New York Stock Exchange-listed public companies. E.g., Werbowsky v. Collomb, 362 Md. 581 (2001); Parish v. Maryland & Virginia Milk Producers Ass’n, 250 Md. 24 (1968) (pre-dating the adoption of Section 2-405.1); Waller v. Waller, 187 Md. 185 (1946). The corporate bar, both within and without Maryland, is watching yet again. Our hope is that the Supreme Court of Maryland corrects the hazardous course improvidently charted by Eastland Food.

 

[1] Among the pre-1976 miasma of competing and inconsistent (and, one may imagine, bewildering) standards for director conduct and liability were “strict and faithful discharge of duty”—Booth v. Robinson, 55 Md. 419, 436-37 (1881); “skill and reasonable care”, suggesting simple negligence—Fisher v. Parr, 92 Md. 245, 265 (1901); “gross or culpable negligence”—Carrington v. Basshor, 118 Md. 419, 442–43 (1912); non-conflicted “good faith”—Wight v. Heublein, 238 F. 321, 324 (4th Cir. 1916); “illegal, fraudulent, ultra vires or grossly negligent acts”—Matthews v. Headley Chocolate Co., 130 Md. 398, 404 (1931); “reasonable skill and care,” “ordinarily skillful and prudent men”—Pritchard v. Myers, 174 Md. 66, 77 (1938); “proof of fraud”—Williams v. Salisbury Ice Co., 176 Md. 13, 23 (1939); fraud, illegality, or ultra vires—Warren v. Fitzgerald, 189 Md. 476, 491 (1948); “gross or culpable negligence”—Parish v. Maryland & Va. Milk Producers Ass’n, 250 Md. 24, 74 (1968). See James J. Hanks, Jr., Maryland Corporation Law § 6.07C, note 244. 

___________

Opinions and conclusions in this article are solely those of the authors unless otherwise indicated. The information contained in this article is general in nature and is not offered and cannot be considered as legal advice for any particular situation.