March 26, 2009
Is the New "Bad Faith" an Empty Set in Delaware Fiduciary Law?
Posted by Gordon Smith

The Delaware Supreme Court finally issued its long-awaited opinion in Lyondell Chemical Company v. Ryan today. Remember, this is the case in which the directors of Lyondell Chemical Company were accused to breaching their fiduciary duties in connection with a sale of the company. The directors were admittedly independent and disinterested, but the plaintiff shareholders accused the directors of breaching their fiduciary duty of good faith by knowingly shirking their duties under Revlon. Vice-Chancellor Noble refused to grant the directors summary judgment because he wanted to know more facts about whether "the directors may have consciously disregarded their known fiduciary obligations in a sale scenario." (Ryan v. Lyondell Chemical Co., 2008 WL 2923427 (Del. Ch. 2008)).

In reference to that earlier decision, I expressed my frustration with the current state of Delaware law:

The problem with the decision is that [the defendants] can't get a lawsuit like this dismissed. But I don't see how you can pin that on Vice-Chancellor Noble. He is just taking direction from the Delaware Supreme Court.

Others, like Jeff Lipshaw, thought VC Noble was simply bootstrapping a duty of care claim into a non-exculpable duty of good faith claim. (Glom guest blogger Andrew Lund has written a paper about this possibility and how Delaware could more easily avoid it.) In its opinion today, the Delaware Supreme Court agreed with Jeff's assessment of the facts of this case: "At most, this record creates a triable issue of fact on the question of whether the directors exercised due care." (For Jeff's reaction to the opinion, see here.)

Importantly, this conclusion depends on a strikingly narrow understanding of "bad faith" in Delaware fiduciary law. In my first post on this case last August, I observed, "Disney and Stone now have defined 'bad faith' in a manner that does not require illegality or fraud (the traditional meanings of 'bad faith'), or disloyalty -- at least in the traditional sense of self-dealing. 'Bad faith' now has a more expansive meaning, that might include actions by directors who are admittedly independent and disinterested." While all of this remains true, it appears that the Delaware courts still have an extremely narrow view of bad faith. Steve Bainbridge described it this way earlier today: "Ryan ... goes a long way towards constricting the scope of bad faith claims to egregious and highly unusual sets of facts."

To understand how narrow "bad faith" has become, consider VC Noble's initial decision to deny summary judgment. That decision was motivated by a desire to gather more facts before determining that the directors here had not acted in bad faith. VC Noble was under the impression that directors could do something to fulfill their Revlon duties, but still knowingly fall short of doing enough. This is not an unreasonable view, though it would require a fair amount of precision to determine the difference between a care claim and a good faith claim. Chancellor Chandler made a similar point in a recent opinion in In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106 (Del.Ch. 2009):

It is almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the “right” business decision. In any investment there is a chance that returns will turn out lower than expected, and generally a smaller chance that they will be far lower than expected. When investments turn out poorly, it is possible that the decision-maker evaluated the deal correctly but got “unlucky” in that a huge loss-the probability of which was very small-actually happened. It is also possible that the decision-maker improperly evaluated the risk posed by an investment and that the company suffered large losses as a result.

Business decision-makers must operate in the real world, with imperfect information, limited resources, and an uncertain future. To impose liability on directors for making a “wrong” business decision would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second guessing is what the business judgment rule was designed to prevent, and even if a complaint is framed under a theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.

The Delaware Supreme Court wants to draw a brighter line in its opinion issued today:

If directors failed to do all that they should have under the circumstances [whether knowingly or negligently?], they breached their duty of care. Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty. (emphasis added)

And again:

Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price. (emphasis added)

The influence of Caremark is apparent here, and we know from experience that Caremark liability is almost unheard of in Delaware. Of course, Vice-Chancellor Strine recently found support for Caremark claims with respect to the former senior vice chairman of general insurance and former vice chairman of investments and financial services of AIG. See In re American Intern. Group, Inc., 2009 WL 366613 (Del.Ch.2009). In denying a motion to dismiss on this issue, VC Strine observed:

The Complaint fairly supports the assertion that AIG's Inner Circle led a -- and I use this term with knowledge of its strength -- criminal organization. The diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary. The proposition that Matthews and Tizzio, who the Complaint fairly alleges were directly knowledgeable of and involved in much of the wrongdoing, did not also know that AIG's internal controls were inadequate and too easily bypassed is not, for present purposes, an interpretation to ground a Rule 12(b)(6) dismissal order on. Indeed, for present purposes, it is inferable that even when Matthews and Tizzio were not directly complicitous in the wrongful schemes, they were aware of the schemes and knowingly failed to stop them.

This sort of behavior, if proved at trial, would easily support a finding of "bad faith" under the traditional standards. In other words, the Caremark version of bad faith would be unnecessary. And if the Delaware courts are serious about the standards articulated in Lyondell, I suspect plaintiffs will need facts like these to prevail on a claim of bad faith. So while boosters of the fiduciary duty of good faith had reason to rejoice after VC Noble's initial opinion, they will not be pleased with this latest directive from the Delaware Supreme Court.

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