When a dispute erupts into litigation between a corporation and one of its investors, the corporation will likely seek to invoke the attorney-client privilege to prevent the investor from accessing otherwise relevant communications between the corporation’s board of directors and its counsel. However, according to a recent decision by the Delaware Court of Chancery, the attorney-client privilege may not shield such materials from production to the investor in situations where the director wears two hats because of affiliation with the investor. Corporations governed by Delaware law should familiarize themselves with this decision to ensure that privileged information is properly protected from disclosure.
In Hyde Park Venture Partners Fund III, L.P. et al. v. FairXchange, Inc., C.A. No. 2022-0344-JTL (March 9, 2023), the corporation in question, FairXchange, Inc. (FairXchange), sought to withhold communications between its board of directors and FairXchange’s counsel from production to two of its investors (the Funds). The Funds had been represented on FairXchange’s board of directors by a director who was also a manager of the Funds. When a third party offered to purchase FairXchange, the Board member affiliated with the Funds opposed the proposed sale (preferring a process where the company would seek other strategic alternatives), while the remaining directors favored pursuing the offer. The remaining directors then took steps to remove FairXchange’s representative from the board, and following such director’s removal by the requisite stockholder vote, the board unanimously approved the sale. After the sale closed, the Funds then brought an appraisal proceeding against FairXchange. When the Funds sought the production of pre-sale communications between the board and its attorneys during the discovery phase of the proceeding, the corporation objected on the grounds of attorney-client privilege.
The Chancery Court rejected FairXchange’s privilege claim and ordered the corporation to produce the attorney-client communications to the Funds. The Court explained that Delaware had adopted the so-called “joint client rule,” whereby members of a corporation’s board of directors are each considered joint clients of the corporation’s attorneys. According to the Court, such joint clients are each “within the circle of confidentiality” and, therefore, cannot assert a privilege against one another concerning advice sought from counsel relevant to their service to the corporation. A corporation, therefore, cannot have a reasonable expectation of confidentiality that excludes a member of its board. If a director is removed from the board, that director is excluded from the “circle” from that point forward. But the former director remains within the circle as to advice received from counsel before the former director’s removal.
Moreover, where an investor in the corporation is represented by a director on the board, the investor’s designee is presumed to share information with the investor because, according to the Court, humans “ha[ve] only one brain [and] cannot partition their brains so that they only use particular knowledge for particular purposes.” For this reason, the Court held, the corporation similarly cannot have a reasonable expectation of confidentiality that excludes an investor represented by a member of the board of directors.
While the Court held that the corporation was required to produce the privileged material to the Funds, the material remains privileged as to the rest of the world. But it cannot be withheld from another party “within the circle of confidentiality” established by the joint representation.
The Chancery Court clarified that corporations have options if they wish to exclude particular directors (or the investors they represent) from the “circle of confidentiality” concerning certain legal communications. Corporations can do so by contract, typically via a confidentiality agreement laying out limitations to a director’s or investor’s right to receive or access information. They can do so by appointing (openly and with the excluded director’s knowledge) a special committee not including the excluded director, which could then retain its own counsel and enjoy confidentiality only within its own ranks. Or they can do so by advising the excluded director that an adversity of interest exists between the director and the corporation, such that the director can no longer rely upon the advice of the corporation’s counsel with respect to the matters related to the adversity.
Notably, the Chancery Court recognized that Federal courts generally apply a different rule to this circumstance: the so-called “entity rule.” Under this approach, directors are treated as agents of the corporation, and the corporation, not the directors, holds the privilege. When a director resigns or is removed from the board, the former director has no claim to privileged material that she may have previously accessed during her period serving as a director.
Simply put, corporations governed by Delaware law (or potentially subject to Delaware law) should consider how the Chancery Court’s recent decision in Hyde Park could impact their ability to maintain the confidentiality of attorney-client communications if relations with a director or the investor she represents turn adverse. Taking some reasonable precautions in advance – such as through the execution of a fulsome confidentiality agreement – may avoid a negative outcome down the road.