4.2.5 No liability protection for ‘subjective bad faith’ or ‘not in good faith’ actions

As already mentioned, directors owe the company fiduciary duties of care and loyalty. Delaware courts determine whether the directors’ actions have met the standard of conduct imposed by their fiduciary obligations through the lens of a standard of review: the business judgement rule, the heightened standards of review (Revlon and Unocal) or the entire fairness standard. Exculpatory clauses may be raised, indifferently to the underlying standard of review, and this either at the earliest procedural stage or at trial, as Cornerstone and Emerald shows (see paragraphs 4.2.3. and 4.2.4 respectively). Only when a shareholder- claimant is able to successfully allege a non-exculpated claim under section 102(b)(7) – a claim implicating a breach of the duty of loyalty – would a director find himself in the danger zone. As I have discussed in paragraph 4.2.1, ‘good faith’ is an important condition of a director’s loyalty.1 If shareholders allege sufficient facts to support an inference that the directors’ actions were ‘not in good faith’, the directors concerned may not be protected under section 102(b)(7) DGCL. In this paragraph, I will explore the delicate distinction between ‘subjective bad faith’ actions, actions ‘not in good faith’ and actions ‘in good faith’ by making use of the Delaware Supreme Court’s decisions in Disney and Stone.

Disney2 was an important turning point. In reviewing whether Disney’s directors lacked good faith with regards to Ovitz’ employment and severance pay-out, the Delaware Supreme Court undertook to define categories of conduct which may constitute directors’ ‘bad faith’. Three categories of potential bad faith actions were construed. The first, ‘subjective bad faith’ involves actions motivated by an ‘actual intent to do harm.’ The second, actions taken ‘solely by reason of gross negligence and without any malevolent intent’ do not constitute bad faith but ‘lack of due care’, for which the director may be exculpated. The third, actions ‘not motivated by subjective bad intent’ but still ‘qualitatively more culpable than gross negligence’ are in bad faith insofar as they manifest an ‘intentional dereliction of duty, a conscious disregard for one’s responsibilities.’3 The first category of misconduct evidently constitutes a breach of loyalty and thus involves a non-exculpatory claim under section 102(b)(7). The second category of misconduct may only constitute a breach of due care for which the director may be exculpated. The third category of misconduct, which in Disney was distinctively qualified ‘not in good faith’, constitutes a breach of loyalty for which section 102(b)(7) expressly denies exculpation from monetary damages.

It is interesting to note that, in Disney, the Court qualified ‘intentional misconduct’ and a ‘knowing violation of law’ as actions involving ‘subjective bad faith’, whereas ‘intentional dereliction of duty, a conscious disregard for one’s responsibilities’ was behaviour performed ‘not in good faith’.4 It goes without saying that for both misbehaviours, the duty of loyalty is violated and thus, under these conditions, a director cannot rely on the exculpatory provision of 102(b)(7). Disney demonstrates, however, that claimants are not required to prove directors’ actual intent to do harm to the company in order to assert directors’ liability.

Disney’s ‘not in good faith’ standard was later applied in the context of oversight liability. In Stone, the claimants alleged that the defendant directors of a bank are personally liable because they did not excise their oversight responsibilities in good faith. The claimants asserted that the directors failed to prevent bank employees from violating criminal laws or from causing the company to incur significant financial liability or both.5 The Delaware Supreme Court followed the Disney reasoning for determining directors’ lack of good faith by requiring ‘intentional failure to act in the face of a known duty to act, demonstrating a conscious disregard for ones duties.’6 Importantly and consistent with Disney, the Court affirmed in Stone that the conditions for oversight liability accorded with those articulated in Caremark:

The Court then held that, in the absence of red flags, “only a sustained or a systematic failure of the board to exercise oversight – 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.”8 The allegations were ultimately found insufficient, resulting in dismissal for failure to establish a demand futility. The particular facts raised in the complaint could not create reasons to doubt whether the directors had acted in ‘good faith’ in exercising their oversight responsibilities.

Accordingly, Figure 3 visualises the treatment of non-exculpated claims under Disney and Stone.

The ‘not in good faith’ standard was also applied in a change of control context, where Lyondell’s board approved the transfer of control to Basell. The deal was characterised as an ‘absolute home run’ by Lyondell’s financial advisor, Deutsche Bank. Less than thirteen months after the closing of the merger in December 2007, Lyondell filed for bankruptcy. The board’s decision was reviewed under the Revlon standard.9 In Lyondell, the Chancery Court denied the directors’ summary judgment because the directors’ ‘unexplained inaction’ prevented the court from determining that they had acted in good faith.10 The Supreme Court reached a different outcome. First, the Delaware Supreme Court considered that bad faith could only be found if ‘a fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.’ Moreover, ‘in the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’11 Paramount in Lyondell is the Court’s emphasis that directors’ decisions must be reasonable, not perfect.12 ‘Instead of questioning whether disinterested, independent directors did everything that they (arguably) could have done to obtain the best sale price, the [trial court’s, TP] inquiry should have determined whether those directors utterly failed to attempt to obtain the best sale price.’13 Accordingly, only if directors knowingly failed to undertake – consciously disregarded – their responsibilities, hence acted not in good faith, would they breach their duty of loyalty and be liable.

In the recent Chen14 case, the director argued, while relying on Lyondell, that the claimants’ allegations were insufficient to support a non-exculpated duty of loyalty claim because they did not establish that the directors ‘consciously disregarded known obligations imposed by Revlon.’ The Chancery Court rejected this position and clarified that conscious disregard is not the only way to establish a non-exculpated claim against directors in a change of control transaction.15 Proper motive did however play a central role. In the specific Chen case, the court held that the claimants ‘did not contend that the directors consciously disregarded known duties.’ Instead, ‘[claimants] properly relied on another line of Delaware precedent,’ which provides that a fiduciary’s lack of good faith can be established by showing that he or she ‘intentionally’ acted with a purpose ‘other than advancing the best interests of the corporation.’16 Applying this standard, the Chen decision suggests that Occam’s directors could be found to be personally liable of monetary damages in circumstances where their conduct fell outside the range of reasonableness if there is sufficient evidence of some improper motive, even if that improper motive did not lead Occam’s directors to knowingly disregarding their responsibilities.17

Accordingly and as demonstrated in the cases above, exculpation will be denied when reviewing the applicability of exculpatory clauses only if the claimant sufficiently pleads facts supporting a rational inference that the director concerned acted in ‘bad faith’, that is in ‘subjective bad faith’ or ‘not in good faith’, where ‘subjective bad faith’ actions may concern actions motivated by an actual intent to do harm and a knowing violation of law,18 and actions ‘not in good faith’ may concern a knowing disregard of duty or failure to act in the face of a known duty19 and actions with improper motive which were not in the interest of the company.20 As the cases discussed in this paragraph show, a director acting under these conditions would violate his or her fiduciary duty of loyalty and will not be able to rely on the protection of section 102(b)(7) DGCL. Moreover, it can be deduced from these cases that directors’ good faith requirement in 102(b)(7) DGCL involves ‘subjective good faith’.