3.7.3.1 Fiduciary duty violations onder corporate law, business judgment rule, duty of loyalty, duty of care

The source of the law on corporate fiduciary duty is the case law of the courts. Clear law on this subject has been developed by the Delaware Chancery Courts and the Delaware Supreme Court as most listed corporations are registered in Delaware and the Delaware judges, chosen on merit from experienced corporate lawyers. They write lucid opinions which are instructive for corporate lawyers and hence also for the whole US corporate world. Moreover, they take their decisions quickly. Director liability cases, usually derivative cases, start with a motion to dismiss. These motion cases are dealt with quickly in days, weeks or a few months. These decisions are important for the negotiations between parties. When the case does go to trial, i.e. the motion to dismiss failed, the procedure will take longer. The injunction cases, such as all the takeover cases, are dealt with in days or weeks, therefore very quickly.

The basis of Delaware and US corporate law is the business judgment rule, which protects directors in that the courts may not second-guess board decisions provided they are taken with (a) loyalty and (b) care. These two elements are therefore the only areas which the judge may review. Judges should not (even marginally) question the wisdom of the decision itself. This means that a plaintiff can win a case only if he proves (a) disloyalty or (b) insufficient care or (c) good faith in exercising loyalty and care.

The old cases that are often cited as business judgment cases are: Dodge v. Ford Motor Co. (1919)2

The board must develop and execute the strategy of the corporation in the following manner:

Below I discuss the duties of (a) loyalty and (b) care and also good faith, which can be classified onder the category of loyalty. To have a chance of winning a case a plaintiff must prove (a) disloyalty or (b) insufficient care.

The duty of loyalty is necessary because of the separation of management from ownership. The duty of loyalty has two elements, the negative element (no violation of trust of shareholders) and the positive element (subjective bona fides).

The fact that bona fides - good faith - falls under the duty of loyalty follows from cases such as Stone v. Ritter.5

While loyalty and care are taught as the two duties that judges always check in fiduciary cases, the terms "good faith" and "bad faith" appear very often, most recently in 2009, in the Citigroup case.6

The criterion of good faith also appears in the Delaware General Corporation Law,

 § 141(e): "directors are protected ... in relying in good faith upon records ... and information ..."

 § 145(a) and (b): directors can be indemnified "if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the corporation"

- § 102(b)(7): to protect directors from personal liability for gross negligence,7 but not "(i) for any breach of the director 's duty of

Loyalty …. (ii) for acts or omissions not in good faith (iii) under § 174 (wilful incorrect dividends, explanation author), (iv) improper personal benefit".

In Cede & Co. v. Technicolor, Inc. (1993),8 the Delaware Supreme Court announced for the first time that directors owe a "triad" of fiduciary duties, including not only the traditional duties of loyalty and care, but a third duty of good faith.

The term good faith appears in many Delaware decisions, before and after Technicolor. There have been many articles in law reviews about the question of the applicability of Section 102(b)(7) of the Delaware GCL, i.e. non-liability of directors for gross negligence if they have acted in good faith, as mentioned above.

Former Chief Justice Veasey does not really mind whether it is a separate fiduciary duty. In discussing whether a director with extra knowledge has a heightened liability, he takes the view that this is not always necessarily so, though if the director has any particular knowledge he should inform his fellow directors. Accordingly, Veasey does consider that "good faith" can be one of the elements when judging a director 's loyalty.9 In Stone v. Ritter (in 2006 after the retirement of Chief Justice Veasey), the Delaware Supreme Court made absolutely clear that "good faith" is important, but falls under the duty of loyalty.10

As for the definition of good faith it is clear that it draws much of its content from the directors' subjective state of mind. A sincere belief that one is acting in the best interests of the company is not enough. In addition, there must be some objective basis. Veasey says: "Directors must not act irrationally, irresponsibly, disingenuously, or so unreasonably that no reasonable director would accept the decision or conduct".11

This brings us back to the dut), of loyalty. Each director has the duty to be disinterested (no interest other than the corporation and shareholders) and independent. Disinterestedness means a director may not stand on both sides of a transaction, may not engage in self-dealing, may not be entrenched, may not have material advantage and, if he notices a corporate opportunity or a problem, must inform the whole board (positive requirement).

In cases of self-dealing or whenever the directors have an interest, the business judgment rule is not applicable to them. Instead, unless the transaction is approved by a disinterested majority of directors or shareholders, the burden of proof is on the directors to show that the transaction was intrinsically fair to the corporation.

In Aronson v. Lewis of 198412 a 4.7% stockholder, who was also CEO, secured for himself a lucrative employment contract by obtaining the approval of the other directors who, the plaintiff alleged, were under the control of the CEO stockholder. A special form of self-dealing occurs where a director exploits a corporate opportunity for himself and does not inform the full board. Independence means a director makes decisions independently under no pressure from third parties, e.g. the CEO or a major shareholder. "Directors must be able to debate and confer and not simply follow a dominant director". The directors were liable, because they had been entrenched by the CEO.

Oversight and supervision cases since Stone v. Ritter of 200613 fall under the category of loyalty. It is a duty of loyalty to have "due corporate information and reporting systems". Indeed the judicial standard for liability is loyalty, while the behavioural duty is care. But some experts classify oversight under care.14

According to Section 141(a) of the Delaware GCL, the business and affairs of the corporation will be managed by and under the direction of the board of directors.

The legal standard for liability applicable to a director's supervisory authority, was explained in Graham in 1963.16 "Directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong" ... "or unless he has recklessly reposed confidence in an obviously untrustworthy employee". These issues were addressed again in 1996 in Caremark17 a case also involving violations of federal law by employees. The Delaware Court of Chancery ruled: "It is important that the board exercise a good faith judgment that the corporation's information and reporting system is, in concept and design, adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations." "Duty to attempt in good faith to assume that a corporate information and reporting system ... exists." In the Caremark case there was also the test of subjective good faith as again in Gagliardi v. Trifoods International (Del. Ch. 1996).18

The Supreme Court of Delaware approved the court's decision in Caremark in 2006, in the case of Stone v. Ritter,19 holding director oversight liability in circumstances where "(a) the directors utterly failed to implement any reporting system or controls or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention. If the board fails to act in the face of obvious wamings, then the board's behaviour could suggest a reckless or intentional disregard of the duty of care. Such allegations could be sufficient to rebut the presumption of the business judgment rule."

So, in short, directors are not disloyal if there is an adequate system of controls and no red flags have been raised.

A basic principle is that directors owe fiduciary duties to their corporation and its shareholders to act in the best interests of the corporation and to show the loyalty and care in the management of the corporation's business that ordinarily careful and prudent men would use in handling their own affairs.20 The new cases of 2009 are Citigroup21 (motion to dismiss the case accepted because the directors, who had ensured that control systems were in place, should not be liable for failing to recognize the extent of a company's business risk) and A/G22 (motion to dismiss refused because a core group of directors had kept to themselves decisions about information systems that would put them on notice of fraudulent and criminal conduct and had not involved the other directors). These oversight cases are of great interest in these times of worry and concern about monitoring and risk management. Delaware makes a distinction between failing to recognize business risks while having reasonable information systems which do not lead to directors' liability and constructively failing to have systems to check fraudulent and criminal conduct, for which directors are liable.

The duty of care makes its appearance when it comes to decision making by the board. In Aronson v. Lewis of 198423 the directors rubber-stamped the decision of the CEO/shareholder, who awarded himself a lucrative contract. The directors were liable because they had been "entrenched" by the CEO and had not taken proper care when they made the decision.

Under the business judgment rule the courts accord directors a broad discretion in business decisions. Thus, in general, the courts will not second guess business decisions made in good faith by an independent and fully informed board. The test for whether a board is fully informed — and therefore has met its duty of care — is one of gross negligence (see Smith v. Gorkom,24 where the directors did nothing to inform themselves). The test of care is not whether the content of the board decision leads to a loss, but more the consideration of good faith or rationality of the process of decision making (Caremark25). However, when directors fail to exercise any business judgment this may possibly be a failure to act in good faith (Disney,26 where directors did exercise some business judgment).

Section 141(e) of the Delaware GCL repeats that directors are protected if they rely in good faith on the records of the corporation.27 Decisions with respect to how much information to obtain and from what sources are themselves business decisions: Cede & Co. v. Technicolor of 1993, in which case the Delaware Supreme Court found that the directors had not taken enough time to obtain sufficient information.28

The business judgment rule was given a different perspective in Cinerama v. Technicolor.29 The court found that the directors had not fully informed themselves in approving the merger transaction but despite the board's lack of full information, the merger was entirely fair. The Supreme Court upheld the Chancery Court's finding. The "entirely fair" solution is a different manner of not holding directors liable even if there was insufficient care. Besides, a corporation can in its articles of incorporation eliminate the liability of directors for the duty of care pursuant to Section 102(b)(7) of the Delaware GCL. This would not have protected directors from monetary liability in cases like Smith v. Van Gorkom of 1985,30 where they had been very sloppy. In fact, they did nothing at all to collect information, and were therefore liable. The elimination of liability only applies if there was no duty-of-disloyalty.

In Aronson of 198431 the board did collect information before taking a decision. The court applied the business judgment rule and declined to say that the decision taken was wrong. Self-imposed time limits could be an infringement on the duty of care if that means that the board could not collect sufficient information.

Disney was a case about the collection of information necessary to take a decision. The conclusion is that the board should not be sloppy in collecting information.