Good Faith Issues Present New Risks For Directors And Officers

Sunday, May 1, 2005 - 01:00



Untitled Document

Introduction

The corporate scandals of the new millennium
resulted in a host of high-profile
legislative and regulatory responses by,
among others, Congress, the Securities
and Exchange Commission and the
national securities exchanges. Fearful of
being marginalized by the incursion of
these entities into matters of corporate
governance, the Delaware courts may be
using the threat of enhanced exposure to
personal liability to incentivize directors
and officers to be more attentive to their
fiduciary duties.

Historically, fiduciary duties have been
characterized as having two components –
the duty of loyalty and the duty of care.
Recently, however, Delaware courts have
referred to a “triad” of fiduciary duties
consisting of loyalty, care and good faith.
Moreover, recent opinions in Delaware
indicate that conduct that traditionally
would have been thought to implicate
only the duty of care may be found to constitute
a breach of the duty of good faith.
This analytical shift is significant because
directors are typically exculpated, and
both directors and officers are typically
indemnified and insured, for breaches of
their duty of care, while exculpation and
indemnification are impermissible, and
insurance coverage exclusions may apply,
for conduct that constitutes bad faith.

The Traditional Duties Of Loyalty And Care

With regard to both decision-making
and oversight functions, the duty of loyalty
requires directors and officers to act
in the interests of the corporation and its
stockholders. Courts have described the
duty of loyalty as requiring corporate fiduciaries
to act in good faith and in the honest
belief that their actions are in the best
interests of the corporation and its stockholders.
Thus, the duty of loyalty has
always had a good faith component.

Although the concepts underlying the
duty of loyalty appear susceptible to
expansive interpretation, duty of loyalty
analyses have traditionally focused on
whether a financial conflict of interest was
present and, if so, whether the conflict was
mitigated through the use of a decisionmaking
process that included the
informed approval of disinterested and
independent directors or stockholders or,
alternatively, that the action or transaction
in question was entirely fair to the corporation
and its stockholders. Scant attention
was given to the good faith component of
the duty of loyalty in these analyses, and
the absence or appropriate mitigation of
any conflict of interest was generally outcome
determinative.

The duty of care is process oriented
and requires directors and officers to
inform themselves of all reasonably available
material information before making
corporate decisions. It also requires them
to oversee and monitor corporate employees
to ensure that they carry out their
responsibilities in furtherance of the corporation’s
interests and in compliance
with law.

With regard to the decision-making
function, the Delaware courts have held
that the standard for determining whether
a corporate fiduciary’s decision was suffi-
ciently informed is one of gross negligence.
Gross negligence in this context
has been described as reckless indifference
to or a deliberate disregard of corporate
interests. Conversely, with regard to
the oversight function, Delaware cases
suggest that the standard for determining
whether a corporate fiduciary has complied
with the duty of care may be one of
simple negligence. Simple negligence in
this context has been described as the failure
to use the amount of care that an ordinarily
careful and prudent person would
use in similar circumstances.

The Recent Judicial Focus On Good Faith

Despite the recent judicial focus on
good faith, the Delaware courts have not
provided a definition of the term. Apparently,
as with Justice Potter Stewart’s
approach to identifying obscenity, the
Delaware courts will know good faith (or
bad faith) when they see it.

In Cede & Co. v. Technicolor, Inc., 634
A.2d 345 (Del. 1993), the Delaware
Supreme Court invented, without explanation,
a “triad” of duties consisting of
loyalty, care and good faith. Initially, this
articulation appeared to reflect only a
change in semantics, because both Technicolor
and subsequent Delaware cases
equated the newly-christened duty of
good faith with the pre-existing duty of
loyalty. For example, in quoting from its
earlier holding in Barkan v. Amsted Industries,
Inc
., 567 A.2d 1279 (Del. 1989), the
court in Technicolor added this clarifying
bracketed language: “A board’s actions
must be evaluated in light of the relevant
circumstances to determine if they were
undertaken with due diligence [care] and
good faith [loyalty].” Technicolor, 634
A.2d at 368 n.36.

Several post-Technicolor opinions of
the Delaware Chancery Court have been
critical of an analytical construct that
would recognize a duty of good faith separately
from the duty of loyalty. For example,
in Nagy v. Bistriar, 770 A.2d 43 (Del.
Ch. 2000), Vice Chancellor Strine
observed that “[i]f it is useful at all as an
independent concept, the good faith iteration’s
utility may rest in its constant
reminder (1) that a fiduciary may act disloyally
for a variety of reasons other than
personal pecuniary interest; and (2) that,
regardless of his motive, a director who
consciously disregards his duties to the
corporation and its stockholders may suffer
a personal judgment for monetary
damages for any harm he causes.” Id. at
49 n.2.

At first blush, the proposition that there
may exist a level of inattention to managerial
responsibilities that transcends
mere negligence or gross negligence and
raises loyalty concerns hardly seems
shocking. However, the logical boundaries
of this proposition as an analytical
construct are disturbingly unclear.
Because negligence by directors and offi-
cers is always likely to be inconsistent
with the best interests of the corporation
and its stockholders, a robust analytical
filter is needed to prevent the wholesale
conversion of duty of care claims into
duty of loyalty (or good faith) claims.

In Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959
(Del. Ch. 1996), the court addressed allegations that Caremark’s board
had breached its fiduciary duties by failing to adequately supervise Caremark
employees. Because no duty of loyalty issues were presented, the court nominally
engaged in a duty of care analysis. However, because Caremark’s certificate
of incorporation eliminated the directors’ personal liability for carerelated
acts to the extent permitted by Section 102(b)(7) of the Delaware General Corporation
Law (the “DGCL”), the allegations would be actionable only if the
directors’ conduct constituted bad faith. In this regard, the Caremark
court opined that “only a sustained or systematic failure of the board
to exercise oversight – such as an utter failure to attempt to assure
that a reasonable information and reporting system exists – will establish
the lack of good faith that is a necessary condition to liability.” Id.
at 971. The Caremark court further noted that “[s]uch a test of liability
– lack of good faith as evidenced by sustained or systematic failure of
a director to exercise reasonable oversight – is quite high.” Id.

In Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch.
2003), the court analyzed allegations that the directors of The Walt Disney
Company breached their fiduciary duties in connection with their approval of
the employment of Michael Ovitz as Disney’s president, and their implicit
approval of his subsequent termination. The plaintiff alleged that, within a
14-month timeframe, Mr. Ovitz’s employment and severance arrangements
cost Disney more than $140 million. The plaintiff further alleged that Disney’s
board failed to receive any relevant documents or presentations regarding these
arrangements, failed to ask any questions about the details of Mr. Ovitz’s
salary, stock options or severance package and failed to consider the possible
cost of Mr. Ovitz’s termination. The directors contended that, at most,
the plaintiff had alleged breaches of the duty of care, and as a result, the
directors were shielded from liability under Disney’s certificate of incorporation.
Noting that it is rare for a court to impose liability on directors for a breach
of the duty of care, the Disney court concluded that the facts alleged did not
implicate merely negligent or grossly negligent conduct, but instead suggested
a knowing and deliberate indifference to a potential risk of harm to the corporation.
In this regard, the court held that where a director consciously ignores his
duties to the corporation, resulting in economic injury to its stockholders,
the director’s actions are either not in good faith or involve intentional
misconduct, and therefore are not protected by the limitations on liability
contemplated by Section 102(b)(7) of the DGCL. (It is important to note that
this controversial decision was reached in response to a motion to dismiss the
complaint for failure to state a cause of action, and therefore did not constitute
a decision on the merits. At the time of this writing, no decision has been
reached in the trial of this case.)

In Official Committee of Unsecured Creditors of Integrated Health Services,
Inc. v. Elkins
, No. Civ. A. 20228-NC, 2004 WL 1949290 (Del. Ch. Aug. 24,
2004), the plaintiff alleged that the directors of Integrated Health Services
breached their fiduciary duties in approving a series of executive compensation
and loan arrangements. Finding that the arrangements had been approved by a
majority of disinterested directors, the court dismissed the plaintiff’s
claims relating to the duty of loyalty. The court then focused on whether the
challenged actions were authorized with the intentional and conscious disregard
to the directors’ duties necessary to state a claim not subject to exculpation
as authorized by Section 102(b)(7) of the DGCL. In this regard, the court noted
that, in analyzing whether an action was taken with intentional and conscious
disregard of directors’ duties, it is necessary to determine that the
action is beyond unreasonable, and that it is in fact irrational. Emphasizing
that allegations of nondeliberation are different from allegations of inadequate
deliberation, the court held that compensation decisions that were allegedly
made without any consideration, deliberation or advice from an expert stated
claims suffi- cient to survive the defendants’ motion to dismiss.

Taken at face value, the standards of good faith articulated in Disney
and Integrated Health Services do not appear to be unduly worrisome
for directors and offi- cers who make a genuine effort to attend to their managerial
responsibilities. It is unclear, however, whether these relatively deferential
standards will withstand future efforts by plaintiffs to impose liability for
care-related conduct.

Conclusion

Both as a matter of good practice and in order to minimize the possibility
of being found to have acted in bad faith, directors and officers should perform
their duties in a conscientious manner. When making decisions, directors and
officers should identify and consider in a deliberate manner the rationale for
any proposed action or transaction, the alternatives thereto and the relative
advantages and disadvantages of each. When relying on professional advisers,
directors should seek to be informed about the advisors’ competence and
the care with which they were selected. Directors should also seek to determine
whether any director, member of management or professional adviser has any conflict
of interest or other impediment to objectivity in connection with any proposed
action and, if so, take appropriate steps to assure that the decision- making
process is not tainted. Finally, and importantly, directors and officers should
assure that their decisions are documented carefully and with suffi- cient detail
to reflect the care with which they were

Mark E. Betzen is a partner in the Dallas
office of Jones Day. Jeffrey D. Litle
is an associate in the firm's Columbus
office. A longer version of this article
originally appeared in The Corporate
Compliance & Regulatory Newsletter,
January 2005, published by Law Journal
Newsletters, ALM.