1. Yesterday, Stephen Bainbridge noted the following, against the background of the Delaware Supreme Court's opinion in Lyondell Chemical Company v. Ryan (see post No. 24) and Eric Chiappinelli's reflections on this decision:
Here in Ryan, Justice Berger brings back some of Chancellor Allen's language about utter failure and I worry that such a standard might work its way into the standard for duty of loyalty liability in bad faith cases.
For example, when she first mentions the standard she writes (p.11), "We adopted the standard articulated ... in In re Caremark ... [now she quotes from Caremark:] only a sustained or systematic failure ... such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability." Likewise, she later writes (p.18), "Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty." Note the phrase, "and completely." Further on that page she quote a Chancery Court opinion that could lend support to this analysis: "[an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties." Does an extreme set of facts equate with a requirement that the plaintiff show that the directors not only intended to disregard their duties but did absolutely nothing? Finally (p.19) "[T]he inquiry should have been whether those directors utterly failed to attempt to obtain the best sales price." Note the words, "utterly failed." All this language might be seen as imposing liability for breach of the duty of loyalty via bad faith only when there is intent and when the directors completely fail to meet their duty or perhaps completely fail to take action.
This can't be the law. Intent is surely a requisite for finding bad faith and hence a duty of loyalty violation but there's no case law authority and no policy reason to impose an additional test of utter failure to meet the duty or take action. Surely a director is liable who intends not to meet the duty of loyalty by only a little bit.
Justice Berger has much language, though, that suggests the correct rule, as well, and I'm hopeful that courts will pick up on that language and not on the looser formulations quoted above.The use in recent bad faith opinions of terms like "completely" and "utter" does suggest that bad faith requires a showing of an intentional and utter failure on the board's part. It's hard to imagine sufficiently "egregious" facts to satisfy that standard. (AIG suggests that, in oversight cases, culpable participation may be necessary.)
Yet, that does appear to be the emerging standard. In his recent Citigroup decision, Chancellor William Chandler explained that "a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter." 964 A.2d 106, 125 (Del Ch 2009). As I explained in Caremark and Enterprise Risk Management, Chandler hewed closely to the "utter" and "completely" position.
In effect, bad faith may be in the process of becoming the functional equivalent of the so-caled [sic] egregious or irrational decision exception to the business judgment rule; i.e., a theoretical claim that in practice is an empty set.
2. What is missing in this interesting closing remark is that, at least under Delaware corporate law, the 'lack of any rational business purpose' element of the business judgment rule is not a stand alone concept, but is actually linked to the concept of bad faith (lack of good faith), meaning that this type of irrationality - typically framed in terms of 'waste' - is already considered indicative of bad faith (lack of good faith). Let me elaborate a bit on this; for practical reasons, I don't include references to footnotes in the quotes.
3. In Brehm v. Eisner, a Delaware Supreme Court opinion from 2000, then Chief Justice Veasey described the business judgment rule as follows:
The business judgment rule has been well formulated by Aronson and other cases. See, e.g., Aronson, 473 A.2d at 812 ("It is a presumption that in making a business decision the directors ... acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation."). Thus, directors' decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.
He also explained that:
[a]s for the plaintiffs' contention that the directors failed to exercise 'substantive due care', we should note that such a concept is foreign to the business judgment rule. Courts do not measure, weigh or quantify directors' judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only. Irrationality is the outer limit of the business judgment rule. Irrationality may be the functional equivalent of the waste test or it may tend to show that the decision is not made in good faith, which is a key ingredient of the business judgment rule.
One year later, Veasey further made clear in White v. Panic that:
[t]he standards for corporate waste and bad faith by the board are similar. To prevail on a waste claim or a bad faith claim, the plaintiff must overcome the general presumption of good faith by showing that the board's decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation's best interests.
This meant, also in view of Brehm v. Eisner, that as to waste:
[a]s a pratical matter, a stockholder plaintiff must generally show that the board "irrationally squander[ed]" corporate assets - for example, where the challenged transaction served no corporate purpose or where the corporation received no consideration at all. Under this standard, a corporate waste claim must if "there is any substantial consideration received by the corporation, and (...) there is a good faith judgment that in the circumstances the transaction is wortwhile." As we have observed, "courts are ill-fitted to attempt to weigh the 'adequacy' of consideration under the waste standard, or, ex post, to judge appropriate degrees of business risk." Thus, absent some reasonable doubt that the ICN board proceeded based on a good faith assessment of the corporation's best interest, the board's decisions are entitled to deference under the business judgment rule.
As Veasey remarked in his instructive 2005 article covering Delaware corporate case law in the 1992-2004 period, referring to the 'lack of any rational business purpose' element:
This objective component might more appropriately be understood as a requirement that objective indicators be used, as a matter of evidence, to assess the director's real (i.e., subjective) state of mind. Thus, if a court can discern no rational, objective basis for the director's asserted belief that a decision was in the corporation's best interest, the court can reasonably doubt the sincerity of the asserted belief.
4. The "utter failure" language used by the Delaware Supreme Court in Lyondell Chemical Company v. Ryan may have a sortlike function in Caremark (duty of oversight) and Revlon (in short: sale of control) situations, i.e., as an objective indicator - as a matter of evidence - to assess the director's subjective state of mind.
5. The above case law has led Chancellor Chandler to conclude in his 2005 opinion In re The Walt Disney Company Derivative Litigation that the "Delaware Supreme Court has implicitly held that committing waste is an act of bad faith", and in his recent In re Citigroup Inc. Shareholder Derivative Litigation opinion (see post No. 12) the following:
Delaware law provides stringent requirements for a plaintiff to state a claim for corporate waste, and to excuse demand on grounds of waste the Complaint must allege particularized fact that lead to a reasonable inference that the director defendants authorized "an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." The test to show corporate waste is difficult for any plaintiff to meet; indeed, "[t]o prevail on a waste claim ... the plaintiff must overcome the general presumption of good faith by showing that the board's decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation's best interests."
6. In this case, the Chancellor found a reasonable inference of waste. Although this has not yet resulted in a finding of liability (remember, this was the demand excused phase of the litigation), this does show that the "egregious or irrational decision exception to the business judgment rule" is in reality not an empty set; if it truly were, the court would also have dismissed this waste claim. Also compare, e.g., Vice-Chancellor Strine's 2007 opinion in Sample v. Morgan:
Although the test for waste is stringent, I believe that Sample has pled facts supporting a pleading-stage inference of waste. Claims of waste are sometimes misunderstood as being founded on something other than a breach of fiduciary duty. Conceived more realistically, the doctrine of waste is a residual protection for stockholders that polices the outer boundaries of the broad field of discretion afforded directors by the business judgment rule. The wording of the test implies as much, as it condemns as wasteful a transaction that is on terms so disparate that no reasonable person acting in good faith could conclude the transaction was in the corporation's best interest. When pled facts support an inference of waste, judicial nostrils smell something fishy and full discovery into the background of the transaction is permitted. In the end, most transactions that actually involve waste are almost found to have been inspired by some form of conflicting self-interest. The doctrine of waste, however, allows a plaintiff to pass go at the complaint stage even when the motivations for a transaction are unclear by pointing to economic terms so one-sided as to create an inference that no person acting in a good faith pursuit of the corporation's interests could have approved the terms.
7. So, concluding:
This is in line with what I concluded in post No. 24, discussing the Delaware Supreme Court's opinion in Lyondell Chemical Company v. Ryan. Violation of the good faith component of the duty of loyalty, to be derived from the circumstances of the case at hand, requires facts that are - from a culpability perspective - clearly more egregious than facts that justify a finding of a duty of care breach. This confirms that the 'lack of good faith' concept is to be applied quite narrowly, at least in the director liability setting. If there is no conflict of interests, and the company's charter has an exculpatory clause (the standard situation), it is terribly difficult for a plaintiff to succeed in a director liability proceeding on bad faith grounds in the absence of any clear direct evidence like memo's or e-mails; not just under the business judgment rule and in Caremark claims (duty of oversight), but also in a Revlon scenario. I discussed this more in detail in Judicial Review of Director Conduct - Under Dutch and Delaware Corporate Law, Deventer: Kluwer 2007, no. 19.c. UPDATE Stephen Bainbridge offers a nice response to this post, that you can find here.
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