Editor’s Note: This post is by Scott J. Davis of Mayer Brown LLP.
Michael Torres, who is my colleague at Mayer Brown LLP, and I have written a paper titled Directors’ Monetary Liability for Actions or Omissions Not in Good Faith, based on a paper we submitted to the Ray Garrett Jr. Corporate and Securities Law Institute at Northwestern Law School. It has long been established that damages are available against directors when they engage in self-dealing or similar actions in situations in which they have a conflict of interest. Few issues in U.S. corporate law, however, are as controversial as whether directors should be exposed to damages for their actions or omissions in situations in which they do not have a conflict of interest. Advocates of such damages awards argue that they are appropriate in extreme cases of directorial misconduct and an important deterrent to future misconduct. Opponents of such awards argue that courts cannot reliably distinguish between extreme cases of misconduct and routine cases of negligence, and that well-qualified persons will not serve as directors if they are exposed to this type of monetary liability.
Since the enactment of section 102(b)(7) of the Delaware General Corporation Law, it has been clear that directors could still be responsible for damages for breaches of the duty of loyalty involving conflicts of interest – for example, being on both sides of a transaction to which the corporation was a party – and could not be held liable for money damages for breaching their duty of care, even if they were grossly negligent. The question was whether there was any real-world basis for imposing damages on directors in situations in which they did not breach their duty of loyalty on conflict of interest grounds.
Beginning in the middle 1990s with the Caremark decision, the Delaware courts answered that question in the affirmative by making it clear that certain conduct of directors who did not have a conflict of interest could constitute acts or omissions not in good faith that would expose them to damages. As the law has developed, there has been no bright line rule defining such conduct. Consequently, there is no shortcut to examining the cases decided inside and outside of Delaware in determining where the law now stands. Most of these cases were brought as derivative lawsuits, and the reported decisions were issued in deciding defendants’ motions to dismiss because of the plaintiffs’ failure to make a demand on the company’s board of directors. We briefly analyze a number of these decisions, dividing them into cases in which the directors are accused of failing to act and therefore violating their duty of oversight and cases in which the directors are accused of acting improperly. We reached the following conclusions from this analysis:
1. The courts are anxious to limit monetary liability for bad faith to situations in which directors knowingly countenanced wrongdoing or knowingly engaged in wrongful conduct. The test laid down in Stone v. Ritter, 911 A.2d 362 (Del. 2006), for bad faith oversight is that the directors knew that they were not discharging their obligations of oversight because they utterly failed to implement any reporting or information system or controls or, having implemented such a system or controls, consciously failed to monitor or oversee their operations. The test for bad faith action laid down in In re the Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006), is intentional dereliction of duties or a conscious disregard of one’s responsibilities. Thus, the case law, in both the oversight and the action situations, indicates that bad faith has a mens rea requirement: bad faith requires scienter, i.e., an illicit state of mind. Anything less is no more than gross negligence, which Disney defined as not bad faith.
2. However, the line between bad faith and negligence or gross negligence can be blurry, especially in merger or sale cases. It is arguably difficult to distinguish between the bad faith conduct of the director held liable in In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. 2004), for permitting an unfair transaction and the director in Gesoff v. IIC Industries, Inc, 902 A.2d 1130 (Del. Ch. 2006), or the directors in McPadden v. Sidhu, 964 A.2d 1262 (Del. Ch. 2008), who permitted unfair transactions but were exonerated because their conduct, while negligent or grossly negligent, did not rise to bad faith. It is possible that Emerging Communications is an anomaly because lawsuits challenging directors’ good faith, absent a conflict of interest, in merger and sale transactions have been mostly unsuccessful. See, in addition to Gesoff and McPadden, In re Lear Corporation Shareholder Litigation, 2008 WL 5704774 (Del. Ch. 2008), and Lyondell Chemical Company v. Ryan, 2009 WL 790477 (Del. 2009).
3. McCall v. Scott, 239 F.3d 808 (6th Cir.), amended on denial of rehearing, 250 F.3d 997 (6th Cir. 2001), and In re Abbott Laboratories Derivative Shareholder Litigation, 325 F.3d 795 (7th Cir. 2001), suggest (admittedly based on a small sample) that courts outside of Delaware may be more inclined to allow oversight claims to proceed than Delaware courts are. Indeed, Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003), Stone v. Ritter, Desimone v. Barrrows, 924 A.2d 908 (Del. Ch. 2007), Wood v. Baum, 953 A.2d 136 (Del. 2008), and In re Citigroup Inc. Shareholder Litigation, 964 A.2d 106 (Del. Ch. 2009), are all Delaware cases in which oversight claims were dismissed, with AIG Consolidated Derivative Litigation, 965 A.2d 763 (Del. Ch. 2009), being a counterexample.
4. The courts appear to be drawing a distinction between directors’ oversight or actions resulting in bad business decisions that did not result in illegality or fraud and those that did. In the former case the courts tend not to find bad faith. See Citigroup, Gesoff, Disney, McPadden, Lear and Lyondell. In the latter case the courts will find bad faith if the complaint supplies particularized allegations of a knowing failure of oversight or knowing misconduct. See McCall, Abbott, AIG, Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), and In re Tyson Foods Consolidated Shareholder Litigation, 919 A.2d 563 (Del. Ch. 2007). The courts are concerned that the availability of damages for bad faith not lead to directors being second-guessed for business decisions that were merely wrong.
The paper is available here.