Commentary: Midway directors not guilty of fraud

The legal action brought by aggrieved shareholders in Midway Games against Midway directors over the collapse of the company has concluded with a victory for the Midway directors.  This case shows once again the dangerous fallout that can emerge from the collapse of any business.  Read on…

The background is that certain shareholders in Midway Games (developer of Mortal Kombat) commenced US legal proceedings claiming that certain of Midway Games directors concealed the truth about the financial condition of the company (source: Gamesindustry.biz).  These shareholders, who lost millions when Midway Games entered insolvency proceedings in February 2009 and was subsequently sold for a fraction of its previous value, argued that the directors had deliberately kept the shareholders and the public in the dark regarding Midway’s financial condition in order to profit from their sale of their own Midway shares.  The directors in question were former CEO David Zucker, Thomas Powell (chief financial officer), Steven Allison (chief marketing officer), James Boyle (controller) and Miguel Iribarren (senior vice president, publishing).

However, a US District Court has now ruled in favour from the Midway directors, finding that they had not “said or did anything more than publicly adopt a hopeful posture that [Midway’s] strategic plans would pay off…” and, in any event, “such preening for the financial press is classic puffery”.

This case exemplifies the rule of thumb that when any business fails, both the creditors and the shareholders will look for someone to blame in order to try to recoup as much of their losses as possible.  A strategy frequently adopted is to go after those persons or entities with the deepest pockets and/or who had a say in the management of the company – quite frequently, the directors of a company will meet both of these criteria.

It helps that directors generally are held to a high standard of conduct regarding their management of a company, especially where that company is in financial difficulty.  Under English law (and most common law jurisdictions that we can think of), directors have a strict duty to act in the best interests of the company and not to act for their own private profit.  For example, this has previously been held to mean that directors cannot take up commercial opportunities that the company has rejected (unless of course the company gives a clear ok to the director).  The directors also have a duty to monitor the financial performance of a company and, if it is apparent that the company is or may become insolvent in the near future (i.e. it is no longer able to meet its debts as they fall due and/or its liabilities are greater than its assets) then the directors should think very seriously about stopping trading altogether.  It is a criminal offence for directors to permit the company to keep trading when there is no realistic prospect of the company recovering on its own, or to continue trading where they know that the company cannot recover.  If the directors breach any of those duties, then in principle they could face both civil and criminal legal action against them personally, including demands to pay monies back to the company.

Of course, all that just deals with the relationship between the director and his/her company.  What about shareholders?  This is a more difficult question, because as a very general rule shareholders’ direct relationship is with the company in which they own shares, not its directors.  However, there may be some ways around this.  For a start, it may be possible (depending on the laws of the jurisdiction in question) for the shareholders to step into the shoes of the company for the purpose of asserting a claim against the directors (called a ‘derivative claim’).  Or it may be possible for the shareholders to fund the company to make a claim itself against the directors.  Or the shareholders may able to argue some direct relationship between them and the directors which entitles them to assert a direct action against the directors.

Whatever the precise legal form of the shareholders’ claim, any such claim would face the usual problems with litigation: it is costly, risky and time-consuming and – far more often than not – there is no guarantee of success however strong one’s case may seem at the outset.  In some jurisdictions, difficult claims may be easier to bring than others – in England and Wales for example the loser generally has to pay the winner’s legal costs, which can be a significant disincentive to bring a speculative claim.  Other jurisdictions can be more ‘claimant-friendly’. 

Anyway, a few practical points to sum up:
(i) when a business goes under, people who lose out can be very inventive in deciding who to go after.

(ii) directors are particular targets and should consider taking legal advice about their duties and responsibilities as soon as it becomes possible that the company may be entering a difficult financial condition or even insolvency.  This advice need not be expensive, but it may help them to avoid personal liability if things get really bad…

[Image source: Wikipedia – http://en.wikipedia.org/wiki/File:MKDL.PNG]

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