January 03, 2007
Good Faith, Care, and Loyalty in Delaware
Posted by Gordon Smith

Later today, I will participate on the "Teaching Disney" panel. Last night, I had dinner with Justice Jack Jacobs, who wrote the Disney opinion. He also joined Justice Holland's opinion in Stone v. Ritter, in which the Delaware Supreme Court held that "good faith" was part of the duty of loyalty. What motivated the Court to decide Stone in the way it did?

According to Justice Jacobs, this was the Court's attempt to clarify some doctrinal points and to distance "good faith" from the duty of care. In light of that latter goal, the Court's decision to embrace Chancellor Allen's classic language from Caremark as one standard for measuring bad faith may seem strange because that case was expressly about the duty of care. The second sentence of Caremark reads: "The suit involves claims that the members of Caremark's board of directors (the 'Board') breached their fiduciary duty of care to Caremark in connection with alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers."

References to the duty of care are sprinkled throughout the case, which mentioned loyalty only once: "The complaint thus does not charge either director self-dealing or the more difficult loyalty-type problems arising from cases of suspect director motivation, such as entrenchment or sale of control contexts." Nevertheless, in Stone v. Ritter the Court associates Caremark with the duty of loyalty:

It is important, in this context, to clarify a doctrinal issue that is critical to understanding fiduciary liability under Caremark as we construe that case. The phraseology used in Caremark and that we employ here – describing the lack of good faith as a "necessary condition to liability" – is deliberate. The purpose of that formulation is to communicate that 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." [citing Guttman v. Huang, 823 A.2d 492, 506 n. 34 (Del.Ch.2003).] It follows that because a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.

How did the Court get from point A to point B? The key is Leo Strine's opinion in Guttman. In that case, Strine tied the notion of "good faith" to loyalty. He focused on this oft-quoted paragraph from Caremark:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or 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. Such a test of liability--lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight--is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

Notice the repeated reference to "good faith." According to Strine, Chancellor Allen was really talking about the duty of loyalty:

Although the Caremark decision is rightly seen as a prod towards the greater exercise of care by directors in monitoring their corporations' compliance with legal standards, by its plain and intentional terms, the opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith.

The footnote quoted in Stone v. Ritter reads in whole as follows:

A director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation's best interest. For this reason, the same case that invented the so-called "triad[ ]" of fiduciary duty, see Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del.1993) ("Cede II"), also defined good faith as loyalty. See In re Gaylord Container Corp. S'holders Litig., 753 A.2d 462, 475 n. 41 (Del.Ch.2000) (explaining the origins of this oddment of our law, i.e., the "triad[ ]").

It does no service to our law's clarity to continue to separate the duty of loyalty from its own essence; nor does the recognition that good faith is essential to loyalty demean or subordinate that essential requirement. There might be situations when a director acts in subjective good faith and is yet not loyal (e.g., if the director is interested in a transaction subject to the entire fairness standard and cannot prove financial fairness), but there is no case in which a director can act in subjective bad faith towards the corporation and act loyally. The reason for the disloyalty (the faithlessness) is irrelevant, the underlying motive (be it venal, familial, collegial, or nihilistic) for conscious action not in the corporation's best interest does not make it faithful, as opposed to faithless.

The General Assembly could contribute usefully to ending the balkanization of the duty of loyalty by rewriting § 102(b)(7) to make clear that its subparts all illustrate conduct that is disloyal. For example, one cannot act loyally as a corporate director by causing the corporation to violate the positive laws it is obliged to obey. See 8 Del. C. § 102(b)(7)(ii). Many recent events have only emphasized the importance of that obvious component of the duty of loyalty. But it would add no substance to our law to iterate a "quartet" of fiduciary duties, expanded to include the duty of "legal fidelity," because that requirement is already a subsidiary element of the fundamental duty of loyalty. The so-called expanded "triad [ ]" created by Cede II, I respectfully submit, is of no greater utility.

This is a fine enough argument, though I have a hard time understanding why it would be necessary in 2006. In the most recent Disney opinion, the Delaware Supreme Court effectively distinguished the "duty of good faith" from the "duty of care": "grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith." Why was it necessary to take the additional step of placing the "duty of good faith" under the "duty of loyalty," especially after Chancellor Chandler and Justice Jacobs had taken such pains to define the "duty of good faith"?

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