Directorial Abdication and the Taxonomic Role of Good Faith in Delaware Corporate Law
36 Pages Posted: 24 Apr 2007 Last revised: 10 Apr 2008
History has a way of repeating itself. The Delaware Supreme Court stated in 1963 in Graham v. Allis-Chalmers Manufacturing Company that a director owes the corporation the duty of care of an ordinarily careful and prudent person in similar circumstances. In an important 1984 clarification, the court articulated in Aronson v. Lewis the important business judgment rule limitation that it is presumed that in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. However, soon thereafter in its 1985 Smith v. Van Gorkom decision, the Delaware Supreme Court imposed supposedly ruinous liability on directors for a duty of care violation involving a failure to properly investigate and determine a fair merger price of their public company. The Delaware legislature swiftly enacted permissive legislation in 1986, essentially permitting the articles to eliminate monetary damages for directorial duty of care violations. The Delaware business judgment rule had been inadequate to protect the directors, placing the future of directors, and therefore corporate governance, in serious doubt. Who would serve facing catastrophic personal liability? But statutory exculpation provided theoretical limits rooted in the exculpatory language itself. Rather than directly eliminating liability for duty of care violations, the statute stated a general rule of no liability subject to important exceptions.
First, monetary liability for duty of loyalty violations could not be eliminated, that not being the object of the statute. But director loyalty seemingly caused little difficulty in most cases, at least where the directors had no significant personal interest in the outcome of a particular transaction. Since the 1939 Guth v. Loft, Inc. case, Delaware loyalty infractions almost always involved improper personal pecuniary gain. Second, acts or omissions not in good faith could also not be eliminated.
A director must act or fail to act with a pure heart in the best interests of the corporation. But a pure heart may not be realistic when coupled with an empty mind. Matters seemed manageable until the Delaware Supreme Court suggested in 1993, in Cede & Co. v. Technicolor, that a fiduciary duty "triad" existed, including care, loyalty, and good faith. While the business judgment rule "presumed" good faith, adequate allegations of bad faith could overcome both the business judgment rule and statutory exoneration, as well as provide an independent basis of liability.
In 1996, matters remained under control when the Delaware Supreme Court decided In re Caremark International, Inc. Derivative Litigation, articulating that only "systemic" failures to exercise oversight responsibility in the face of known problems establish a prerequisite lack of good faith. Troubled waters lie ahead. The reason? As a duty independent of care and loyalty, good faith was at once both inarticulate and difficult to apply. In its 2001 decision in Emerald Partners v. Berlin, the Delaware Supreme Court attempted to reconcile the pretrial implications of the interaction of the Aronson business judgment rule, statutory exculpation, and the triad by requiring an entire fairness hearing on cases overcoming the Aronson business judgment rule before considering the resulting further effects of statutory exculpation. However, a 1996 derivative suit litigation filed by Brehm, a shareholder of the Walt Disney Corporation, was beginning its tortuous journey through the Delaware Chancery and Supreme Courts. The case alleged that the Disney directors had breached their fiduciary duties in approving both a lucrative employment agreement with Michael Ovitz and a later no-fault termination of his employment. Some fourteen disappointing months later, Ovitz parted company with Disney, with approximately $140 million. Mercifully, the case ended in 2006 with a shareholder loss in In re Walt Disney Company Co. Derivative Litigation.
The Delaware Supreme Court valiantly attempted to make sense of the role of good faith in the triad. Acknowledging the Chancery Courts connection between bad faith and loyalty, Justice Jacobs articulated three potential categories of bad faith in the post-exculpatory world: (i) actionable subjective bad faith involving a subjective intent to harm the corporation; (ii) nonactionable duty of care involving only gross negligence; and (iii) actionable intentional dereliction of duty or conscious disregard for duty (abdication). Soon after Disney, the Delaware Supreme Court closed the door on the "abdication" role for good faith near the end of 2006 in Stone v. Ritter. In an en banc decision, the Delaware Supreme Court finally conflated the "triad" and stated that good faith in abdication cases in the Disney and Caremark sense is a "subsidiary element" of the duty of loyalty. While good faith may be doctrinally described as part of a triad of duties articulated in the exculpatory statute, it is not a basis of independent duty. At the same time, the court acknowledged that the duty of loyalty is no longer confined to cases involving a personal financial interest. By freeing loyalty to assume a more natural role, including those involving bad faith, this Article suggests that the Delaware Supreme Court has simplified the law while making it more predictable.
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