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Good Faith in Delaware After Stone v Ritter

Gordon Smith's post Good Faith, Care, and Loyalty in Delaware is an excellent capsule analysis of the recent Delaware cases affecting the doctrine of good faith and its relationship to the traditional duties of care and loyalty, with special application to oversight cases. More on this subject to come.

Update: I discuss the facts and what I regard as the key legal issues in Stone v Ritter, which is the case motivating Gordon's comments, in my post Stone v Ritter: Directors Caremark Oversight Duties. In this post, let me just say a few words about the portion of the opinion dealing with the "duty" of good faith.

Status of Good Faith as an Independent Basis for Liability

Stone appears to put to rest any remaining question as to whether acting bad faith is an independent basis of liability under Delaware corporate law, stating that “although good faith may be described colloquially as part of a ‘triad’ of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty.  Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly.” 911 A.2d at 370. This will greatly disappoint those corporate law scholars who have sought to create a separate fiduciary duty of good faith.

On the other hand, this holding may not matter all that much. After all, the Stone court makes clear that acts taken in bad faith breach the duty of loyalty. As a result, instead of being split out as a separate fiduciary duty, good faith has been subsumed by loyalty. Given the definition of bad faith adopted in Disney and confirmed in Stone, this result seems acceptable. Recall that a “failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” In re Walt Disney Co. Deriv. Litig.,906 A.2d 27, 67 (Del.2006). It was hard to imagine a case in which that definition would be satisfied without an accompanying violation of the duty of loyalty.

In sum, as I commented over at Gordon's blog:

Putting good faith under the duty of loyalty means there will be liability for acting in bad faith, even though good faith is not an independent fiduciary duty. Looks like a compromise to me between those who wanted to elevate good faith to being part of a triad of duties and those who did not, with the former losing as a matter of form, and the latter losing as a matter of substance. But lord only knows, given the Del Sup Ct's recent performance.

Remedial Aspects

If I'm right about the compromise struck in Stone, an interesting question is presented as to the remedy available against defendant directors who act in bad faith. The duty of loyalty traditionally focused on cases in which the defendant fiduciary received an improper financial benefit. Accordingly, the traditional remedy was to strip that benefit away from the defendant. In related party transactions whose terms are unfair to the corporation, for example, the transaction may be voided. Where a defendant usurps a corporate opportunity, the corporation gets a constructive trust on the opportunity.

By subsuming good faith into the duty of loyalty, however, Stone presents the prospect of loyalty cases in which the defendant received no financial benefit. E.g., a compensation case, in which the defendant board of directors consciously disregarded its fiduciary duties in setting the CEO's pay. In such cases, the traditional remedy is inapt. There is no transaction to be voided or a res to be seized.

Instead, as with the duty of care, acts in bad faith presumably give rise to monetary liability. In turn, such a remedy presumably requires a showing of causation. After all, if we're to recover the amount by which the defendant harmed the corporation, presumably we need to show that the defendant's conduct in fact harmed the corporation.

To be sure, in Technicolor, the Delaware Supreme Court held that causation was not an element of the duty of care claim, but that decision made no sense. At one point in the long-running Technicolor saga, Chancellor Allen ruled that plaintiff Cinerama could not prevail on its duty of care claims because it had failed to prove a financial injury caused by the Technicolor board’s alleged misfeasances. In so holding, Allen relied on Barnes v. Andrews, 298 F. 614 (S.D.N.Y. 1924), in which Learned Hand held that a shareholder-plaintiff must show not only a breach of the duty of care, but also that the performance of the director’s duties would have avoided a loss. In other words, plaintiff must prove causation.

The Delaware Supreme Court reversed, bizarrely opining it to be “a ‘mystery’ how the [Chancery] court discovered the Barnes case and then based its decision on Barnes.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 370 (Del. 1993). Perhaps Chancellor Allen found the Barnes case by glancing at virtually any major corporate law text. If so, such a glance would have demonstrated that Barnes was (and still is) routinely cited as the leading authority for the well-accepted proposition that “the undoubted negligence of directors may not result in liability if the plaintiff cannot show that the negligence proximately caused damages to the corporation.” Robert C. Clark, Corporate Law 126 (1986). Even the Emanuel’s law outline in print at the time cited Barnes for the proposition that “the traditional tort notions of cause in fact and proximate cause apply in [the duty of care] context”! Steven Emanuel, Corporations 128 (1989). Ditto the corporation law nutshell in print at the time Technicolor was decided, which likewise cited Barnes as “the leading case” for this proposition. Robert W. Hamilton, The Law of Corporations (3d ed. 1991). The true mystery thus is how the Delaware supreme court failed to discover Barnes’ well-established status in corporate law jurisprudence. To be sure, the Barnes issue does not come up very often, but that is only because duty of care cases that reach the damages phase of litigation are so few and far between.

Technicolor’s rejection of Barnes has had troubling systemic implications. Under Technicolor, once plaintiff rebuts the business judgment rule by proving a breach of the duty of care (which you will recall itself puts the cart before the horse), the defendants have the burden of establishing “entire fairness.” The court thus conflated the duties of care and loyalty. See generally Michael P. Dooley, Fundamentals of Corporation Law 249-54 (1995). (For a careful demonstration that Technicolor’s importation of entire fairness into the duty of care was a doctrinal novelty, see Lyman Johnson, Rethinking Judicial Review of Director Care, 24 Del. J. Corp. L. 787, 799-801 (1999). Johnson concludes there is “no clear and reasoned prior authority” supporting Technicolor in this respect. Id. at 801.)

Corporate law’s “sweeping grant of authority to the board is, of course, subject to the overarching normative constraint that the directors exercise their authority with the intention of benefiting the shareholders and not themselves.” Dooley at 250. Where directors have conflicted interests, accountability necessarily trumps the principle of deference to board decisions. Consequently, courts review loyalty claims under a most exacting standard. In the classic case of Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983), for example, the court described the entire fairness standard as placing on the defendant directors the burden of proving, subject to “careful scrutiny by the courts,” “their utmost good faith and the most scrupulous inherent fairness of the bargain.” This exacting burden is justified, inter alia, because knowledge of facts necessary to prove the nature and extent of self-dealing typically are peculiarly within the possession of the defendants.

The concept of entire fairness, however, has little relevance to a duty of care case like Van Gorkom or Technicolor. In the first place, the relevant factual issues go not to fairness but to negligence and errors of judgment, which are precisely the sorts of issues the business judgment rule was intended to prevent courts from addressing. In the second place, invocation of entire fairness carries with it important remedial implications. In Weinberger, the court had authorized the use of “any form of equitable or monetary relief as may be appropriate, including rescissory damages” in loyalty cases. By conflating the loyalty and care analyses, Technicolor extends this broad grant of remedial authority to care claims, with bizarre consequences. Rescissory damages make sense in a loyalty case like Weinberger, because the wrongdoer was also the beneficiary of the wrongdoing. The goal in such cases thus should be to ensure that the wrongdoer retains neither its ill-gotten gains nor their tainted fruits. Dooley at 256.

In a care case like Technicolor, however, an award of rescissory damages would have the effect of ordering the defendant directors to return a benefit that they never received. By definition there are no ill-gotten gains to be recouped.

The same considerations apply to claims alleging a breach of the "duty" of good faith that do not involve an improper benefit to the defendant(s). Barnes thus should govern such cases. By subsuming good faith into the duty of loyalty, however, Stone makes it conceptually harder to require causation, while simultaneously leaving the task of crafting appropriate remedies conceptually difficult.