Director liability for bad judgment and bad faith: the business judgment rule and many states' 'director shield statutes' protect corporate directors from liability for breaching their fiduciary duty to shareholders. But recent court decisions have opened the door to claims based on bad faith for conscious nonfeasance.

Like a football team, a corporation depends for success on sound management and judgment. When a team picks the wrong quarterback in the draft, the decision can doom its fans to years of frustration and disappointment. Corporate blunders, of course, can have vastly more serious consequences. They can cause huge financial losses and even the demise of the corporation through bankruptcy or a bargain-basement acquisition by a rival.

Although football fans can do little more than gripe about a team's misfortunes, people harmed by corporate stupidity or hubris may have legal claims they can bring in court. Shareholders can file derivative suits against directors and officers on behalf of the injured corporate entity. And if a company slips into the zone of insolvency, creditors or a bankruptcy trustee may have direct claims against the same defendants for failing to adequately preserve and salvage the value remaining in the foundering corporate vessel. (1)

Given the number of bad corporate decisions that the media report every day, such lawsuits should be almost as common as divorces or fender-bender cases. Why aren't they? Because most corporate missteps are the kind of day-to-day business decisions with which courts are loath to meddle.

For example, if XYZ Delivery Co. spends $2 million on Ford trucks when $1.9 million would have bought more reliable and efficient Chevys, that's not something for the law to fix. But if one of the directors pushed the purchase at a board meeting because it benefited his Ford dealership, and he never disclosed the conflict, the story might change. Without such an extreme and obvious breach of a fiduciary duty, however, actions against inept directors usually fail.

Because Delaware courts traditionally have taken the lead in developing corporate law, this article focuses on Delaware statutes and decisions. The conceptual framework described will likely have some bearing in most other jurisdictions, which often look to Delaware precedent.

Delaware courts have historically described a corporate director's fiduciary duties as a triad: due care, loyalty, and good faith. (2) But determining what these three terms mean, how they differ from each other, and how they should be applied to assess liability has never been either clear or simple. For example, how could a director act in bad faith and still be loyal? Or disloyally divert a corporate opportunity to himself or herself and not be acting in bad faith? Or knowingly fail to perform his or her duties and be either loyal or acting in good faith? The conceptual morass is large and deep.

The Delaware General Corporation Law provides that a corporation's board of directors bears the primary responsibility for company governance. (3) The judge-made business judgment rule (BJR) expands on the statute by safeguarding the power of the board of directors from judicial scrutiny. (4)

The policy underlying the rule suggests that courts should generally avoid second-guessing the business judgment of corporate decision-makers, no matter how wrongheaded. The concern is that if courts regularly scrutinize inherently risky business transactions, judicial oversight will deter directors from serving on boards and taking necessary chances. Building on this justification, Delaware courts apply the BJR as a general "presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company." (5)

Smith v. Van Gorkom 

In 1985, judicial scrutiny of director conduct reached its apogee with the Delaware Supreme Court's decision in Smith v. Van Gorkom, now a staple of most law school courses on the law of corporations. (6) The case arose when the Trans Union Corp. board of directors hastily approved a poorly documented cash-out merger. Anxious to sell, Trans Union's chief executive officer and chairman of the board of directors, Jerome Van Gorkom, personally negotiated the merger with a group controlled by Chicago business leader Jay Pritzker.

Van Gorkom submitted the deal to the board of directors after a brief oral presentation lasting less than two hours. At the board meeting, he failed to disclose that many people in the company's senior management opposed the transaction. And Trans Union's chief financial officer did not mention that he was unaware of the merger deal until the morning of the meeting. Famously, Van Gorkom executed the final agreement while at the opera and delivered it to Pritzker without any of the directors reviewing it. Shareholders brought a class action seeking, among other things, monetary damages from individual directors.

Surprisingly, the Delaware Supreme Court held that the Trans Union directors--inside and outside directors--violated their fiduciary duty of due care, exposing them to personal liability for money damages. The court imposed liability despite the absence of evidence of any board member's self-dealing, disloyalty, or bad faith.

The court reasoned that "a director's duty to exercise an informed business judgment is in the nature of a duty of care, as distinguished from a duty of loyalty. Here, there were no allegations of fraud, bad faith, or self-dealing, or proof thereof." (7) The court held that the directors failed to fully inform themselves of all the relevant information that was reasonably available before approving the merger. In the court's opinion, the directors' omissions constituted "gross negligence," overcoming the presumption of the BJR. (8)

Before Van Gorkom, the general consensus among corporate lawyers was that a Delaware court would not hold a director personally liable for a business transaction unless it included intentional wrongdoing or presented a conflict of interest, breaching the director's duty of loyalty. (9) But in the wake of that ruling, a corporate board's decision-making process was potentially subject to far more probing judicial oversight. Van Gorkom triggered a wild spate of hand-wringing about whether worthy candidates would be afraid to accept appointments to corporate boards. (10)

Unfortunately for plaintiffs, heightened judicial scrutiny of the boardroom was short-lived. The significance of Van Gorkom lies less in altered liability for breaches of the duty of due care than in the legislative firestorm the case prompted. Only months after the Delaware Supreme Court's ruling, the state's general assembly passed a law that allows companies to exculpate directors from money damages arising from certain breaches of fiduciary duty. (11)

The exculpatory statute permits corporations to limit or eliminate directors' personal liability for either negligent or grossly negligent conduct by explicitly exculpating them in the corporation's certificate of incorporation. The protection does not extend to officers who are not themselves directors. And the statute's applicability to claims brought by creditors is uncertain. Although no case appears to address the issue, adoption of the permissible liability limitation might be viewed as a waiver by shareholders; but how could they waive the rights of others?

While a severe limitation, the law is not a complete liability shield. In particular, it does not apply to breaches of the duty of loyalty, acts or omissions not in good faith, intentional misconduct or a knowing violation of the law, or transactions contaminated by serf-interest. Also, the law's exculpatory provisions apply only to monetary damages. They don't stop plaintiffs from seeking injunctive relief to block a transaction or other available remedies.

The Delaware Supreme Court has held that the exculpatory statute constitutes an affirmative defense. (12) A director seeking to assert its protection bears the burden of showing that his or her conduct is not excepted from the statute. (13) But if a director successfully asserts the statutory protection, then recovery of money damages is precluded. If a plaintiff seeks money damages and successfully rebuts the presumption of the BJR by alleging a breach of the duty of due care, the victory will be pyrrhic and short-lived. The statute will necessitate dismissal of the action. To avoid such an unhappy outcome, a plaintiff would have to allege well-pleaded facts that implicate a breach of the duty of loyalty or the duty of good faith.

Perhaps most important, the law does not define "good faith." Might a plaintiff argue that the total lack of due care in a case like Van Gorkom was a manifestation of bad faith? Is it bad faith for a director to agree to serve on a board and oversee a corporation's affairs and then to act without making any effort to obtain adequate information? See below for some interesting recent history on these questions.

A return to due care?

Last year, 21 years after Van Gorkom, the Delaware Supreme Court made the link between due care and bad faith, reopening the door a crack to potential liability for due-care breaches. Fittingly for an area of the law plagued with fantastical twists of reasoning, the decision came in the Walt Disney Co. Derivative Litigation, which has produced multiple opinions. (14) This litigation arose from a golden-parachute provision in an executive compensation contract.

In 1995, Disney's CEO, Michael Eisner, approached Hollywood powerbroker Michael Ovitz to join Disney's senior management team. During contract negotiations, Ovitz obtained an extravagant termination clause. At the time, only Eisner and two others were aware of the terms of the agreement.

Disney issued a press release announcing Ovitz's hiring, and six weeks later, the corporation's compensation committee approved the agreement with less than an hour of discussion. Doesn't this sound a little--maybe a lot--like Van Gorkom?

After beginning work, Ovitz clashed with several people in senior management, and Disney terminated him in 1996, but not for cause. Thus, Ovitz was entitled to a severance package valued at more than $130 million. Disney shareholders brought a derivative action against Ovitz and the directors who approved his employment agreement.

The case made two trips to the Delaware Supreme Court. Initially, the court of chancery dismissed the action for failure to plead facts sufficient to support the alleged causes of action. The supreme court affirmed the chancery court's decision but gave the plaintiffs leave to file an amended complaint. (15)

When the court of chancery considered the amended complaint, the chancellor allowed the action to proceed, finding that the plaintiffs had sufficiently alleged a breach "of the foundational directoral obligation to act honestly and in good faith." (16) In a posttrial opinion, Disney IV, the court of chancery concluded that the defendant directors had not breached any fiduciary duties, but the chancellor reaffirmed his previous determination that allegations of a violation of the fiduciary duty of good faith could state a claim under Delaware law.

The chancellor wrote:

   Upon long and careful consideration, I am
   of the opinion that the concept of intentional
   dereliction of duty, a conscious disregard
   for one's responsibilities, is an appropriate (although
   not the only) standard for determining
   whether fiduciaries have acted in
   good faith. Deliberate indifference and inaction
   in the face of a duty to act is, in my
   mind, conduct that is clearly disloyal to the
   corporation. It is the epitome of faithless
   conduct.

      The good faith required of a corporate
   fiduciary includes not simply the duties of
   care and loyalty, in the narrow sense ... but
   all actions required by a true faithfulness
   and devotion to the interests of the corporation
   and its shareholders. (17)

Therefore, in the court's opinion, the duty of good faith requires directors not only to refrain from acting against the interests of the corporation, but also to take action when the best interests of the corporation demand it.

The Delaware Supreme Court, in Disney V, adopted the chancery court's formulation of the requirement to act in good faith, while supplying additional justification. (18) The court reasoned that the term "bad faith" potentially represents at least three different categories of conduct.

The first is subjective bad faith--that is, fiduciary conduct undertaken with an actual intent to harm the interests of the corporation. This category of bad faith is well known in Delaware corporate law and hardly novel or controversial.

The second category involves breaches of the duty of care--negligence without malevolent intent. The court found, however; that the scheme of director liability in Delaware could not support labeling negligence as bad faith:

   The conduct that is the subject of due care
   may overlap with the conduct that comes
   within the rubric of good faith in a psychological
   sense, but from a legal standpoint
   those duties are and must remain
   quite distinct. Both our legislative history
   and our common law jurisprudence distinguish
   sharply between the duties to exercise
   due care and to act in good faith,
   and highly significant consequences flow
   from that distinction....

      To adopt a definition of bad faith that
   would cause a violation of the duty of care
   automatically to become an act or omission
   "not in good faith" would eviscerate the protections
   accorded to directors by the General
   Assembly[ ] .... " (19)

After staking out the limits of the definition of bad faith, and seeming to pull back from including within its ambit any failure to take due care, the court observed that the characterization of the conduct at issue in the Disney litigation did not fit cleanly within either of the two categories of wrongful conduct it had analyzed. The court concluded that the chancellor's definition constituted an intermediate category--that is, intentional nonfeasance--which is bad faith under the law. But is this not failure to take due care, at least at some level, perhaps akin to gross negligence?

The court summarized by quoting the chancellor:

   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. There maybe other
   examples of bad faith yet to be proven or alleged,
   but these three are the most salient. (20)

The duty of loyalty

Following Disney V, the question remained whether a breach of the duty of good faith (maybe by not exercising due care) alone established liability for damages. In Stone ex rel. AmSouth Bancorporation v. Ritter, the Delaware Supreme Court clarified that the doctrine of good faith is a "necessary condition to liability" but not an independent foundation for liability. (21)

It reasoned, "[A] failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability. The failure to act in good faith may result in liability because the requirement to act in good faith 'is a subsidiary element,' i.e., a condition, 'of the fundamental duty of loyalty.'" (22) The court suggested two doctrinal consequences of this formulation:

   First, 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. The second doctrinal
   consequence is that the fiduciary duty
   of loyalty is not limited to cases involving a
   financial or other cognizable fiduciary conflict
   of interest. It also encompasses cases
   where the fiduciary fails to act in good faith. (23)

This new formulation of loyalty and good faith is neither intellectually clear nor consistent. Some have argued that distinctions among the duty of care, the duty of loyalty, and the requirement of good faith are to a large degree rhetorical. (24)

At a practical level, the triad of fiduciary duties often covers similar instances of wrongdoing. The continuing doctrinal ambiguity has prompted one commentator to argue:

   The Delaware legislature should establish
   by statute that monetary liability may not be
   imposed on corporate directors for breach
   of the "duty of care," but that monetary liability
   may be imposed for breach of the
   "duty of loyalty," defined to include cases involving
   financial conflicts of interest, other
   improper personal benefits, conscious
   malfeasance, and conscious nonfeasance. (25)

Whatever the ambiguity, and perhaps precisely because of it, the new conception of good faith as a fundamental element of the duty of loyalty arguably provides a viable basis for recovery when a director fails to act in the face of a known duty.

While Delaware law is widely followed, lawyers representing clients with claims against corporate directors or officers should research both cases and statutes in the relevant jurisdiction. Despite the developments in Disney, plaintiff lawyers should not plead a case solely in terms of a breach of the duty of care, and certainly not a mere negligent breach of this duty. Even if the facts essentially show gross negligence with no self-dealing or obvious acts of bad faith, the case should be couched in terms of loyalty and bad faith along with due care.

The law of director liability has long foreclosed many meritorious claims, and Disney has certainly not changed the landscape radically. But it has opened some new vistas and provided plaintiffs the opportunity to turn the law in a more favorable direction.

Postscript on officer liability

Despite the common assumption that the BJR applies equally to directors and officers, some commentators suggest that the case law does not necessarily support its application to officers, noting that traditional policy justifications for the BJR do not apply to corporate officers in the same way. (26) In particular, officer recruitment is not much compromised by a lower standard for liability because of the widespread use of incentive compensation, and officers have a more direct relationship with the daily workings of the corporation, which may make them more knowingly culpable and thus liable. When claiming against officers--especially those who are not directors--lawyers should not assume that statutes and common law decisions about director liability will necessarily apply. Some states do not include officers in their shield statute, for example, and the distinction is easily justified on policy grounds.

People deeply familiar with the day-to-day operation of a corporation should be held to a higher standard of care than outside directors whose knowledge is less detailed and whose contact is more episodic.

Notes

(1.) See Bert Black et al., Recovering for the Wrongful Death of a Company, TRIAL 20 (June 2006). Creditors or a trustee might also have claims against accountants, lawyers, bankers, or others who have harmed a company through a breach of various duties. The present article focuses only on claims against directors.

(2.) See e.g. Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). (3.) Del. Code Ann. tit. 8, [section] 141 (Lexis 2007).

(4.) See Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (Del. 1981).

(5.) Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000).

(6.) 488 A.2d 858 (Del. 1985) (en banc), superseded by statute as stated in Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001). Van Gorkom's ubiquity is underscored by Professor Lawrence Hamermesh's essay explaining his "unique decision" not to teach the case. Lawrence A. Hamermesh, Why I Do Not Teach Van Gorkom, 34 Ga. L. Rev. 477, 477 (2000).

(7.) 488 A.2d at 872-73.

(8.) Id. at 873-74.

(9.) See Joseph W. Bishop Jr., Sitting Ducks and Decoy Ducks: New Trends in the Indemnification of Corporate Directors and Officers, 77 Yale LJ. 1078, 1099 (1968) ("The search for cases in which directors of industrial corporations have been held liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very small number of needles in a very large haystack.").

(10.) See e.g. Daniel R. Fischel, The Business Judgment Rule and the Trans Union Case, 40 Bus. Law. 1437, 1453-55 (1985) (the biggest losers in Van Gorkom were shareholders and the reputation of Delaware corporate law).

(11.) Del. Code Ann. tit. 8, [section] 102(b)(7) (Lexis 2007).

(12.) Emerald Partners, 787 A.2d at 91-92.

(13.) Id.

(14.) For a summary of the principal decisions in the Disney litigation, see Sarah Helene Duggin & Stephen M. Goldman, Restoring Trust in Corporate Directors: The Disney Standard and the "New" Good Faith, 56 Am. U.L. Rev. 211, 215 n. 14 (2006).

(15.) Brehm v. Eisner, 746 A.2d 244, at 267 (Del. 2000).

(16.) In re Walt Disney Co. Derivative Litig. (Disney II), 825 A.2d 275, 291 (Del. Ch. 2003).

(17.) In re Walt Disney Co. Derivative Litig. (Disney IV), 907 A.2d 693, 755 (Del. Ch. 2005) (emphasis in original), aff'd, 906 A.2d 27 (Del. 2006).

(18.) In re Walt Disney Co. Derivative Litig. (Disney V), 906 A.2d 27, 64 (Del. 2006).

(19.) Id. at 65.

(20.) Id. at 67 (quoting Disney IV, 907 A.2d at 755-56) (emphasis added).

(21.) 911 A.2d 362, 369 (Del. 2006).

(22.) Id. at 369-70 (quoting Guttman v. Huang, 823 A.2d 492, 506 n. 34 (Del. Ch. 2003)).

(23.) Id. at 370.

(24.) See e.g. Sean J. Griffith, Good Faith Business Judgment: A Theory of Rhetoricin Corporate Law Jurisprudence, 55 Duke L.J. 1 (2005).

(25.) Christopher M. Bruner, Good Faith, State of Mind, and the Outer Boundaries of Director Liability in Corporate Law, 41 Wake Forest L. Rev. 1131, 1177 (2006).

(26.) See e.g. Lyman P.Q. Johnson, Corporate Officers and the Business Judgment Rule, 60 Bus. Law. 439 (2005).

BERT BLACK is a partner at Lockridge Grindal Nauen in Minneapolis. ROBERT L. WHITENER was a clerk with the firm before graduating recently from the University of Minnesota Law School. After taking the bar examination in July, he will join the New York office of Shearman & Sterling as an associate.