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The Delaware "Bad Faith" Dilemma: The Problem And A Possible Solution

Posted In Directors

Introduction
A recent Delaware Court of Chancery decision has generated much discussion over whether disinterested directors may be held liable for approving a transaction that appeared reasonable to them and their advisors. Indeed, by holding that the directors may have acted in “bad faith,” the decision seemed to some to be a threat to the core principles embodied in the business judgment rule. That rule protects directors from being second guessed by courts long after the business decision has been made. These concerns are overstated. This article will: (1) outline the background to the current controversy over “bad faith” in Delaware, (2) predict how the Delaware Supreme Court will clarify the Delaware law of “bad faith” and (3) suggest a possible solution to address lingering concerns over director liability for disinterested business decisions.

The “Problem”
For many years Delaware limited director liability for disinterested business decisions to those decisions properly held to be grossly negligent. This high standard seemed adequate to protect directors from inappropriate judicial second guessing. Then in 1985, Smith v. Van Gorkom held a board was grossly negligent. Many commentators felt Van Gorkom demonstrated the inability of courts to understand what should constitute gross negligence. The Delaware Legislature promptly responded to Van Gorkom by adopting Section 102(b)(7) of the Delaware General Corporation law. That new statute permitted Delaware corporations to include a provision in their certificate of incorporation that immunized directors for even grossly negligent decisions. Section 102(b)(7) has its exceptions, however. One of those is that actions “not in good faith” lose the statutory protection from liability.

As might be expected, if directors could not be successfully sued for actions “in good faith,” it was only a matter of time before plaintiffs filed claims alleging directors had acted in “bad faith”.

Bad Faith
Bad faith remained largely undefined until 2005. After much debate regarding whether good faith was an independent fiduciary duty and what exactly constitutes good (and bad) faith, Chancellor Chandler defined bad faith as an “intentional dereliction of duty, a conscious disregard for one’s responsibilities” and a “[d]eliberate indifference and inaction in the face of a duty to act.” The Delaware Supreme Court then set out three different categories of fiduciary behavior that might deserve the “bad faith pejorative label.” The first, fiduciary conduct motivated by an intent to do harm, was aptly labeled “subjective bad faith” The second category involves “fiduciary action taken solely by reason of gross negligence and without any malevolent intent,” a lack of due care. The court decided, however, that gross negligence without more does not constitute bad faith, and thus does not breach the duty of loyalty. The third category is the Chancellor’s definition of bad faith, as intentional dereliction of duty, a conscious disregard for one’s responsibilities. In Stone v. Ritter, the court further stated bad faith is a “fail[ure] to act in the face of a known duty to act, thereby demonstrating a conscious disregard for [one’s] responsibilities,” and thus not exculpated under § 102(b)(7).

Section 102(b)(7) and Its Interpretations
Section 102(b)(7)(ii) expressly denies exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” Justice Jacobs wrote “[b]y its very terms [this] provision distinguishes between ‘intentional misconduct’ and a ‘knowing violation of law’ (both examples of subjective bad faith) on the one hand, and ‘acts … not in good faith,’ on the other.” For example, a fiduciary who “intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties” does so in bad faith. Thus the court seems to require an element of intent in this third example of bad faith.

Since the courts seemed to require intent as a necessary element of bad faith many commentators found the recent decision in Ryan v. Lyondell to be incorrect for lack of evidence of intentional acts or omissions by the board. Eric Chiappinelli, Dean of the Creighton University Law School, pointedly states the decision lacks Stone’s requirement of intent. “To be liable under Stone, the plaintiff must show that the defendants knew they were not discharging their fiduciary duties.” In summary, Mr. Chiappinelli states,  

if the claim is one of duty of loyalty rather than care, a plaintiff must show either that the directors were interested, or not independent, or that they intended their actions (or lack of actions) to violate a known duty. It is that analysis that is missing [in Ryan].

Another commentator stated the 2006 decisions in Stone and Disney, “indicated intent was required for breach of good faith to exist. ‘What [Vice Chancellor] Noble seems to be doing here [in Ryan] is deciding it is a much lower standard.’” The “intent” requirement was not only indicated, but expressly set out in the Chancery’s Disney opinion. The court stated, “[i]ndeed, §102(b)(7) on its face seems to equate bad faith with intentional misconduct” and cites to section 102(b)(7)(ii). Also in Disney, the court categorizes intentional misconduct and a knowing violation of law as subjective bad faith, which as defined above includes the element of intent. In fact, conscious is defined as “[i]ntentionally conceived or done; deliberate.” And knowingly is synonymous with deliberate.

Yet, the Stone opinion did not use the word intent when it upheld the standard for bad faith. The court stated in part: “imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations” and “[w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” The Ryan court in applying this standard concluded, “the directors … walked into a potential liability trap with their eyes wide open: they knew the Company was ‘in play,’ they knew what the proper discharge of their fiduciary obligations in connection with a sale of control demanded, and yet they appear, on the limited record before the Court, to have done nothing to prepare for the possible sale.” The court’s application of Stone seems to give bad faith a more expansive meaning that might include liability for independent and disinterested directors who possess knowledge of a duty to act but fail to act, regardless of their subjective intent.

Critics have also noticed the stark contrast between Ryan and two recent Chancery court decisions. The Harvard Law School Blog cites McPadden v. Sidhu and In Re Lear Corporation as “reaffirm[ing] the high bar required to prove that directors have breached their duty of loyalty via ‘bad faith conduct’ that cannot be exculpated.” The author further notes, [w]hile the allegations in McPadden “appear considerably more egregious than those alleged in [Ryan], Chancellor Chandler finds that the complaint alleges actions that were recklessly indifferent or unreasonable but fails to allege that the directors ‘acted in bad faith through a conscious disregard for their duties.’” The court concluded that the directors were exculpated by section 102(b)(7) and granted the directors motion to dismiss. Vice Chancellor Strine states in his Lear opinion that “a very extreme set of facts would seem to be required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.” In Lear the shareholders alleged that the directors acted in bad faith by agreeing to a “No-Vote Termination Fee” in exchange for additional merger consideration “while knowing that the price increase would likely not be sufficient to attract a majority vote in favor of the transaction.” The court held that the complaint “failed to create an inference of mere negligence or gross negligence, much less the ‘far more difficult task of stating a non-exculpated duty of loyalty claim.’” The court next focuses on the difficulties directors face when confronted with a valuable opportunity: 

Boards may have to choose between acting rapidly to seize a valuable opportunity without the luxury of months, or even weeks, of deliberation-such as a large premium offer-or losing it altogether. Likewise, a managerial commitment to timely decision making is likely to have systemic benefits but occasionally result in certain decisions being made that, with more time, might have come out differently. Courts should therefore be extremely chary about labeling what they perceive as deficiencies in the deliberations of an independent board majority over a discrete transaction as not merely negligence or even gross negligence, but as involving bad faith.

The court further warns in a footnote that “not all situations governed by Revlon have a strong sniff of disloyalty that was present in the original case.” Vice Chancellor Strine explains that the more common cases that raise Revlon duties “simply involve the question of whether the board took enough time to market test a third-party, premium generating deal, and there is no allegation of self interested bias.” Therefore, absent “an illicit directorial motive and the presence of a strong rationale for the decision taken (to secure the premium for stockholders) makes it difficult for a plaintiff to state a loyalty claim.” The Vice Chancellor seems to clarify the necessity of intent and reject the expansive definition of bad faith applied in the Ryan decision.

The Supreme Court Will Clarify Bad Faith
The Delaware Supreme Court recently took the highly unusual step of accepting an interlocutory appeal in the Ryan v. Lyondell case. The Supreme Court did so even after Vice Chancellor Noble had declined to certify such an appeal and had issued an extensive additional decision clarifying his prior opinion and limiting it to the odd facts presented by its procedural status as a summary judgment decision. That the Supreme Court acted notwithstanding the Court of Chancery’s clarification of Ryan v. Lyondell suggests it will further speak to what constitutes “bad faith.” It seems likely the Supreme Court will require that a complaint alleging “bad faith” conduct by directors also contain some specific factual support for that allegation.

To meet this test, “bad faith” complaints must allege facts that suggest the board is guilty of some sort of “intentional dereliction of duty” or “conscious disregard” of duty. Exactly what sort of conduct meets that test remains to be seen. However, one explanation may be found in scholarly definitions of intentional conduct as including either: (1) a deliberate purpose to cause a specific bad consequence (similar to the “subjective bad faith” discussed in Disney) or (2) a belief or knowledge that a given bad consequence is substantially certain to result from that conduct. As the Supreme Court noted previously, the first type of bad faith is unlikely to occur in a board of truly disinterested directors.

However, two circumstances may lead to the second type of conduct constituting “bad faith” under the current case law. First, a board of directors that has received clear warnings of threats to their corporation but still fails to act may be guilty of bad faith. In a sense, the Caremark line of decisions illustrates this example of bad faith claims.

Second, if a board knows it has a specific fiduciary duty because of the circumstances it faces, that board may also be guilty of bad faith if its actions do not try to carry out that duty. “Try to” is the key operative word here. A board that tries to do its duty but acts negligently is not guilty of bad faith.

The obvious difficulty with these formulations of “bad faith” conduct (or lack of action) is that they are vague enough to leave room for doubt as to their scope. Ryan v. Lyondell is an example of this problem. What the board in that case apparently missed is that it had fiduciary duties under the Revlon decision that it failed to address. One may well ask how was the board to know Revlon applied to them, particularly when the scope of Revlon is still debated. Of course, as the court was dealing with a summary judgment motion, the application of Revlon was presumably known by the board and that is why the case was not dismissed.

This problem of a lack of full understanding of a board’s duties will continue to exist. The question then is whether there is a possible solution.

Avoiding Intentional Wrongdoing Claims
If the test of intentional conduct amounting to bad faith is a failure to at least address a fiduciary duty, then one possible way to pass that test is to obtain advice that board conduct (or inaction) is consistent with its fiduciary duties. This advice-of-counsel defense has successfully been used in other contexts to avoid liability for allegedly intentional torts. Patent law and tortious interference with business relations law are just two examples where reliance on an attorney’s advice is a defense to some claims where intentional conduct is an element of the cause of action.

Ryan suggests that directors must be cautious when confronting unusual corporate actions or any corporate action not in the normal course of its business. Directors should seek the advice of counsel when undertaking any unusual corporate action. Counsel will advise directors of the applicable law, legal obligations and the effects of action or inaction. Such advice will allow directors to defend any allegation of intentional wrongdoing by waiving attorney client privilege and revealing the steps taken in good faith reliance on that advice. This course of action will make it difficult for plaintiffs to establish a claim that the directors failed to act or consciously disregarded their responsibilities.

Edward M. McNally and Patricia A. Winston
Morris James LLP