In a case involving allegations of unusually egregious conduct by directors of a Delaware corporation, the Delaware Court of Chancery in Kandell v. Niv, C.A. No. 11812-VCG (Del. Ch. Sept. 29) (Glasscock, V.C.) found that directors of FXCM, Inc. faced a substantial likelihood of liability for demand futility purposes on a claim alleging that they knowingly allowed FXCM to engage in an illegal business practice, despite the lack of allegations suggesting that the directors were ever explicitly notified that the practice was illegal.

Background

FXCM, Inc. is a global foreign exchange (FX) trading services company that derives a majority of its revenue from providing retail trading services to individuals. Prior to 2016, FXCM maintained a policy of guaranteeing that it would not pursue claims against its customers for negative equity on their accounts—i.e., any losses that exceeded their initial investments—and that FXCM would instead absorb any such losses (the policy). The policy, which was allegedly responsible for a significant portion of FXCM's revenue, was embodied in FXCM's client agreements and conspicuously touted in a press release, on FXCM's website, and on social media.

While the policy was in effect, however, the Commodity Futures Trading Commission (CFTC) expressly prohibited such a practice under Regulation 5.16, which provides that no FX dealer may “represent that it will, with respect to any retail foreign exchange transaction in any account carried by a retail foreign exchange dealer … guarantee such person against loss [or] limit the loss of such person.” The CFTC's stated purposes for adopting Regulation 5.16 included protecting FX companies from extreme volatility in the currency market and ensuring that they remain financially viable by not agreeing to absorb their customers' losses.

In January 2015, following the Swiss National Bank's announcement of its plan to decouple the Swiss franc from the Euro, the Swiss franc rapidly appreciated against the Euro, causing immediate, exorbitant losses for FXCM customers who had invested long on the Euro and short on the Swiss franc. Because the extreme volatility led to illiquidity in the market, FXCM could not issue stop orders to prevent the losses until its customers had already accumulated negative equity balances of upwards of $276 million—an amount for which, under the Policy, FXCM was responsible.

Plaintiff's Derivative Claim

In the aftermath of this debacle, plaintiff, a stockholder of FXCM, brought a derivative action against directors of FXCM, alleging, among other things, that they breached their fiduciary duties by allowing FXCM to engage in an illegal business practice. Ruling on a motion to dismiss for failure to make a demand, the Court assessed whether demand was excused because the defendants faced a substantial likelihood of liability on this claim.

The Court's Holding

As a threshold matter, the court noted that, “while a Delaware corporation may pursue diverse means to make a profit, it remains subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue lawful business by lawful acts.” Thus, a fiduciary that knowingly causes the company to pursue profits in an illegal manner is in breach of the duty of good faith.

Turning to the issue at hand, because the court found that the facts adequately established the defendants' awareness of both the policy and regulation 5.16, its analysis boiled down to determining whether the plaintiff had pleaded sufficient facts—for purposes of satisfying the plaintiff-friendly motion to dismiss standard—to demonstrate that the defendants knew that the policy violated regulation 5.16.

Defendants argued that the facts alleged were insufficient to establish the requisite bad faith scienter, in large part because, despite FXCM openly touting the policy for several years, the CFTC did not enforce regulation 5.16 against FXCM until it brought a complaint against the company in 2016, and thus there were no facts suggesting the directors were previously on notice that the policy was illegal. Nonetheless, acknowledging Delaware's high standard for pleading bad faith, the court found that regulation 5.16 clearly prohibited the business practices represented by the policy, thus leading to a strong inference that the directors knew the policy violated regulation 5.16. The court's finding was bolstered by the fact that regulation 5.16 was designed to prevent the precise type of “excessive trading risk” that ultimately “crippled” FXCM. The court therefore concluded that the defendants faced a substantial likelihood of liability on the bad faith claim, and the motion to dismiss the claim was denied.

Practical Implications

The Kandell decision is unlikely to reflect a shift in Delaware's approach to assessing bad faith claims, which are notoriously difficult to plead, or the heightened “substantial likelihood of liability” standard. In delivering its decision, the court was careful to “emphasize that this case presents a highly unusual set of facts,” and distinguished the situation at hand from other less clear-cut scenarios, where a company may be in violation of a more complex or nuanced law, or have a more ambiguous company policy that is not as blatantly illegal. In those types of scenarios, the court clarified, “something more would need to be pleaded to invoke scienter.” The court's opinion thus does not suggest that directors necessarily need to adopt more stringent compliance measures following this decision.

Nor does the opinion lower the high bar in Delaware for pleading bad faith claims. Rather, the court's holding suggests that under particularly unique and egregious circumstances where directors knowingly adopt a policy or practice that, in addition to being a crucial component of the company's business, clearly violates a straightforward and pervasive law, the court is willing to permit a bad faith claim to move forward against those directors, even if the specificity of the allegations may not in other contexts be adequate to establish the requisite scienter. The decision, more than anything, reflects that the court will have zero tolerance for directors who, even in an effort to boost the revenue of the company for the benefit of its stockholders, knowingly violate the law.

Timothy R. Dudderar, a partner at Potter Anderson & Corroon, focuses his practice on corporate and alternative entity litigation. Daniyal M. Iqbal, a Potter Anderson associate, practices primarily in corporate and commercial litigation in the Delaware Court of Chancery.

Potter Anderson & Corroon

In a case involving allegations of unusually egregious conduct by directors of a Delaware corporation, the Delaware Court of Chancery in Kandell v. Niv, C.A. No. 11812-VCG (Del. Ch. Sept. 29) (Glasscock, V.C.) found that directors of FXCM, Inc. faced a substantial likelihood of liability for demand futility purposes on a claim alleging that they knowingly allowed FXCM to engage in an illegal business practice, despite the lack of allegations suggesting that the directors were ever explicitly notified that the practice was illegal.

Background

FXCM, Inc. is a global foreign exchange (FX) trading services company that derives a majority of its revenue from providing retail trading services to individuals. Prior to 2016, FXCM maintained a policy of guaranteeing that it would not pursue claims against its customers for negative equity on their accounts—i.e., any losses that exceeded their initial investments—and that FXCM would instead absorb any such losses (the policy). The policy, which was allegedly responsible for a significant portion of FXCM's revenue, was embodied in FXCM's client agreements and conspicuously touted in a press release, on FXCM's website, and on social media.

While the policy was in effect, however, the Commodity Futures Trading Commission (CFTC) expressly prohibited such a practice under Regulation 5.16, which provides that no FX dealer may “represent that it will, with respect to any retail foreign exchange transaction in any account carried by a retail foreign exchange dealer … guarantee such person against loss [or] limit the loss of such person.” The CFTC's stated purposes for adopting Regulation 5.16 included protecting FX companies from extreme volatility in the currency market and ensuring that they remain financially viable by not agreeing to absorb their customers' losses.

In January 2015, following the Swiss National Bank's announcement of its plan to decouple the Swiss franc from the Euro, the Swiss franc rapidly appreciated against the Euro, causing immediate, exorbitant losses for FXCM customers who had invested long on the Euro and short on the Swiss franc. Because the extreme volatility led to illiquidity in the market, FXCM could not issue stop orders to prevent the losses until its customers had already accumulated negative equity balances of upwards of $276 million—an amount for which, under the Policy, FXCM was responsible.

Plaintiff's Derivative Claim

In the aftermath of this debacle, plaintiff, a stockholder of FXCM, brought a derivative action against directors of FXCM, alleging, among other things, that they breached their fiduciary duties by allowing FXCM to engage in an illegal business practice. Ruling on a motion to dismiss for failure to make a demand, the Court assessed whether demand was excused because the defendants faced a substantial likelihood of liability on this claim.

The Court's Holding

As a threshold matter, the court noted that, “while a Delaware corporation may pursue diverse means to make a profit, it remains subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue lawful business by lawful acts.” Thus, a fiduciary that knowingly causes the company to pursue profits in an illegal manner is in breach of the duty of good faith.

Turning to the issue at hand, because the court found that the facts adequately established the defendants' awareness of both the policy and regulation 5.16, its analysis boiled down to determining whether the plaintiff had pleaded sufficient facts—for purposes of satisfying the plaintiff-friendly motion to dismiss standard—to demonstrate that the defendants knew that the policy violated regulation 5.16.

Defendants argued that the facts alleged were insufficient to establish the requisite bad faith scienter, in large part because, despite FXCM openly touting the policy for several years, the CFTC did not enforce regulation 5.16 against FXCM until it brought a complaint against the company in 2016, and thus there were no facts suggesting the directors were previously on notice that the policy was illegal. Nonetheless, acknowledging Delaware's high standard for pleading bad faith, the court found that regulation 5.16 clearly prohibited the business practices represented by the policy, thus leading to a strong inference that the directors knew the policy violated regulation 5.16. The court's finding was bolstered by the fact that regulation 5.16 was designed to prevent the precise type of “excessive trading risk” that ultimately “crippled” FXCM. The court therefore concluded that the defendants faced a substantial likelihood of liability on the bad faith claim, and the motion to dismiss the claim was denied.

Practical Implications

The Kandell decision is unlikely to reflect a shift in Delaware's approach to assessing bad faith claims, which are notoriously difficult to plead, or the heightened “substantial likelihood of liability” standard. In delivering its decision, the court was careful to “emphasize that this case presents a highly unusual set of facts,” and distinguished the situation at hand from other less clear-cut scenarios, where a company may be in violation of a more complex or nuanced law, or have a more ambiguous company policy that is not as blatantly illegal. In those types of scenarios, the court clarified, “something more would need to be pleaded to invoke scienter.” The court's opinion thus does not suggest that directors necessarily need to adopt more stringent compliance measures following this decision.

Nor does the opinion lower the high bar in Delaware for pleading bad faith claims. Rather, the court's holding suggests that under particularly unique and egregious circumstances where directors knowingly adopt a policy or practice that, in addition to being a crucial component of the company's business, clearly violates a straightforward and pervasive law, the court is willing to permit a bad faith claim to move forward against those directors, even if the specificity of the allegations may not in other contexts be adequate to establish the requisite scienter. The decision, more than anything, reflects that the court will have zero tolerance for directors who, even in an effort to boost the revenue of the company for the benefit of its stockholders, knowingly violate the law.

Timothy R. Dudderar, a partner at Potter Anderson & Corroon, focuses his practice on corporate and alternative entity litigation. Daniyal M. Iqbal, a Potter Anderson associate, practices primarily in corporate and commercial litigation in the Delaware Court of Chancery.