The Delaware Supreme Court has finally delivered its 91 page opinion in RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION, No. 411, 2005, C.A. No. 15452, June 8, 2006.
There were few surprises in a well crafted, and conservative, decision. The Court was careful not to break new ground. It also resisted the numerous attempts by counsel for both sides to play fast and lose with the opinions of the Chancery Court and to sneak new and sometimes marvelously odd arguments into the litigation at the last minute. The examples are everywhere in the opinion.
The most interesting portion of the opinion was the ten pages or so (Pages 66-75 of the opinion) in which the Supreme Court began to plot the more or less definitive outlines of the separable fiduciary duty of "good faith." It explained this effort by noting that "Because of the increased recognition of the importance of good faith, some conceptual guidance to the corporate community may be helpful. For that reason we proceed to address the merits of the appellants’ second argument." (Slip op. at 67).
The Court differentiated between three broad categories of behavior as bases for the imposition of breach of good faith liability. The "first category involves so-called “subjective bad faith,” that is, fiduciary conduct motivated by an actual intent to do harm." (Slip op. at 67) is clearly the sort of conduct that will sustain a claim for breach of good faith duty (citing with approval McGowan v. Ferro, 859 A.2d 1012, 1036 (Del. Ch. 2004) (“Bad faith is ‘not simply bad judgment or negligence,’ but rather ‘implies the conscious doing of a wrong because of dishonest purpose or moral obliquity...it contemplates a state of mind affirmatively operating with furtive design or ill will.’”) (quoting Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1119, 1208, n. 16 (Del. 1993)).
The second category of conduct--gross negligence--is not a basis for claims of breaches of good faith, at least without more. (Slip op. at 67-68). It is in connection with this point--the distinction between gross negligence, on the one hand, and bad faith, on the other, that the Court attempts some guidance. (Slip op. at 68-72). It draws on statutory sources for the construction of the distinction--principally Del. Code Sections 1032(b)(7) and 145, concluding on the basis of the distinctions drawn in those provisions between care and good faith that: "Section 145, like Section 102(b)(7), evidences the intent of the Delaware General Assembly to afford significant protections to directors (and, in the case of Section 145, other fiduciaries) of Delaware corporations.108 To adopt a definition that conflates the duty of care with the duty to act in good faith by making a violation of the former an automatic violation of the latter, would nullify those legislative protections and defeat the General Assembly’s intent." (Slip op. at 71).
None of this is particularly novel. And the Court had been working its way to a formal statement of these understandings for years. Much more interesting, I think, is the last category--the one drawn from the Chancellor's analysis of the peculiar nature of the derelictions of the Board in the approval of the Ovitz Employment Agreement and its termination a year later: "This third category is what the Chancellor’s definition of bad faith—intentional dereliction of duty, a conscious disregard for one’s responsibilities—is intended to capture. The question is whether such misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith. In our view it must be, for at least two reasons."(Slip op. at 72). First, the Curt recognized that some conduct that was neither comfortably classifiable as a breach of the duty of loyalty (for lack of appropriate levels of self interest or domination) or as a breach of the duty of care (because the judgment was terrible but the formalities of decionmaking was even barely sufficient)--precisely the case in the Ovitz matter--ought to be actionable as well. "Cases have arisen where corporate directors have no conflicting self-interest in a decision, yet engage in misconduct that is more culpable than simple inattention or failure to be informed of all facts material to the decision. To protect the interests of the corporation and its shareholders, fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed." (Slip op. at 72-73). Thus, in a sense, the statutory distinctions between good faith and care ought to lead, at least in some cases, to the imposition of liability for breach of duty--the duty to be understood as that of "good faith" in contradistinction to those of care and loyalty. The Court explained it this way:
"[T]he legislature has also recognized this intermediate category of fiduciary misconduct, which ranks between conduct involving subjective bad faith and gross negligence. Section 102(b)(7)(ii) of the DGCL expressly denies money damage exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” By its very terms that provision distinguishes between “intentional misconduct” and a “knowing violation of law” (both examples of subjective bad faith) on the one hand, and “acts...not in good faith,” on the other. Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for “acts...not in good faith” must encompass the intermediate category of misconduct captured by the Chancellor’s definition of bad faith." (Slip op, at 74).
More importantly, it noted that neither its discussion, nor that of the Chancery Court, defined the universe of breach of good faith claims. "To engage in an effort to craft (in the Court’s words) “a definitive and categorical definition of the universe of acts that would constitute bad faith” would be unwise and is unnecessary to dispose of the issues presented on this appeal." (Slip op. at 75).
The Supreme Court has effectively declared open season for lawyers seeking to bring cases to flesh this now important and unexplored aspect of fiduciary duty. Indeed, the Court was very careful to note, in footnote 112 of the opinion that "we do not reach or otherwise address the issue of whether the fiduciary duty to act in good faith is a duty that, like the duties of care and loyalty, can serve as an independent basis for imposing liability upon corporate officers and directors. That issue is not before us on this appeal." (Slip op. at 75).
There thus is likely to be much more litigation on the way. I suspect that this basis of liability, defining an important area of actionable conduct lying between loyalty (self-interest) and care (gross negligence), will prove a more fertile ground for litigation than even the traditional breaches of the duty of loyalty or care. Good faith claims may provide plaintiffs’ with a greater ability to avoid the difficulties of proof in duty of loyalty cases while avoiding the statutory limits of liability (especially Section 102(b)(7) waivers) for duty of care cases.
Development of the notion of “good faith” in the conduct of corporate affairs will have a number of collateral effects on corporate governance. One of the most important is the utility of this form of fiduciary duty for solidifying the notion of the autonomy of corporations, that is of corporations as entities separate from that of the shareholders who own interests in them. A duty of good faith can suggest a duty owed to the entity directly rather than to the shareholders. While the Delaware courts traditionally have been very sloppy about distinguishing between the interests of the shareholders (embracing a contractarian view of corporations as an aggregate of property in the hands of its shareholders) and that of the corporation itself (embracing an institutionalist view of corporations as an entity independent of its shareholders), there is an intimation in the discussion that good faith is grounded in the relationship of director to the corporation itself, rather than to the aggregate interests of shareholders directly. It will be interesting to see if this line of reasoning is also expanded as the Court works its way through the developing doctrine.
The case, then, ends the long journey of the Ovitz Employment Agreement as the foundation of conventional fiduciary duty law. To that extent the case is interesting as confirmation of fairly conventional and well-established principles of Delaware law. The case is far more interesting for the way in which it opens the door to a new chapter ion the development of fiduciary duty. Not only will this prove a fertile area for litigation, but also it may well affect the way in which federal regulatory authorities respond in the context of the federal securities laws. More on that in the future.
There were few surprises in a well crafted, and conservative, decision. The Court was careful not to break new ground. It also resisted the numerous attempts by counsel for both sides to play fast and lose with the opinions of the Chancery Court and to sneak new and sometimes marvelously odd arguments into the litigation at the last minute. The examples are everywhere in the opinion.
The most interesting portion of the opinion was the ten pages or so (Pages 66-75 of the opinion) in which the Supreme Court began to plot the more or less definitive outlines of the separable fiduciary duty of "good faith." It explained this effort by noting that "Because of the increased recognition of the importance of good faith, some conceptual guidance to the corporate community may be helpful. For that reason we proceed to address the merits of the appellants’ second argument." (Slip op. at 67).
The Court differentiated between three broad categories of behavior as bases for the imposition of breach of good faith liability. The "first category involves so-called “subjective bad faith,” that is, fiduciary conduct motivated by an actual intent to do harm." (Slip op. at 67) is clearly the sort of conduct that will sustain a claim for breach of good faith duty (citing with approval McGowan v. Ferro, 859 A.2d 1012, 1036 (Del. Ch. 2004) (“Bad faith is ‘not simply bad judgment or negligence,’ but rather ‘implies the conscious doing of a wrong because of dishonest purpose or moral obliquity...it contemplates a state of mind affirmatively operating with furtive design or ill will.’”) (quoting Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1119, 1208, n. 16 (Del. 1993)).
The second category of conduct--gross negligence--is not a basis for claims of breaches of good faith, at least without more. (Slip op. at 67-68). It is in connection with this point--the distinction between gross negligence, on the one hand, and bad faith, on the other, that the Court attempts some guidance. (Slip op. at 68-72). It draws on statutory sources for the construction of the distinction--principally Del. Code Sections 1032(b)(7) and 145, concluding on the basis of the distinctions drawn in those provisions between care and good faith that: "Section 145, like Section 102(b)(7), evidences the intent of the Delaware General Assembly to afford significant protections to directors (and, in the case of Section 145, other fiduciaries) of Delaware corporations.108 To adopt a definition that conflates the duty of care with the duty to act in good faith by making a violation of the former an automatic violation of the latter, would nullify those legislative protections and defeat the General Assembly’s intent." (Slip op. at 71).
None of this is particularly novel. And the Court had been working its way to a formal statement of these understandings for years. Much more interesting, I think, is the last category--the one drawn from the Chancellor's analysis of the peculiar nature of the derelictions of the Board in the approval of the Ovitz Employment Agreement and its termination a year later: "This third category is what the Chancellor’s definition of bad faith—intentional dereliction of duty, a conscious disregard for one’s responsibilities—is intended to capture. The question is whether such misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith. In our view it must be, for at least two reasons."(Slip op. at 72). First, the Curt recognized that some conduct that was neither comfortably classifiable as a breach of the duty of loyalty (for lack of appropriate levels of self interest or domination) or as a breach of the duty of care (because the judgment was terrible but the formalities of decionmaking was even barely sufficient)--precisely the case in the Ovitz matter--ought to be actionable as well. "Cases have arisen where corporate directors have no conflicting self-interest in a decision, yet engage in misconduct that is more culpable than simple inattention or failure to be informed of all facts material to the decision. To protect the interests of the corporation and its shareholders, fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed." (Slip op. at 72-73). Thus, in a sense, the statutory distinctions between good faith and care ought to lead, at least in some cases, to the imposition of liability for breach of duty--the duty to be understood as that of "good faith" in contradistinction to those of care and loyalty. The Court explained it this way:
"[T]he legislature has also recognized this intermediate category of fiduciary misconduct, which ranks between conduct involving subjective bad faith and gross negligence. Section 102(b)(7)(ii) of the DGCL expressly denies money damage exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” By its very terms that provision distinguishes between “intentional misconduct” and a “knowing violation of law” (both examples of subjective bad faith) on the one hand, and “acts...not in good faith,” on the other. Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for “acts...not in good faith” must encompass the intermediate category of misconduct captured by the Chancellor’s definition of bad faith." (Slip op, at 74).
More importantly, it noted that neither its discussion, nor that of the Chancery Court, defined the universe of breach of good faith claims. "To engage in an effort to craft (in the Court’s words) “a definitive and categorical definition of the universe of acts that would constitute bad faith” would be unwise and is unnecessary to dispose of the issues presented on this appeal." (Slip op. at 75).
The Supreme Court has effectively declared open season for lawyers seeking to bring cases to flesh this now important and unexplored aspect of fiduciary duty. Indeed, the Court was very careful to note, in footnote 112 of the opinion that "we do not reach or otherwise address the issue of whether the fiduciary duty to act in good faith is a duty that, like the duties of care and loyalty, can serve as an independent basis for imposing liability upon corporate officers and directors. That issue is not before us on this appeal." (Slip op. at 75).
There thus is likely to be much more litigation on the way. I suspect that this basis of liability, defining an important area of actionable conduct lying between loyalty (self-interest) and care (gross negligence), will prove a more fertile ground for litigation than even the traditional breaches of the duty of loyalty or care. Good faith claims may provide plaintiffs’ with a greater ability to avoid the difficulties of proof in duty of loyalty cases while avoiding the statutory limits of liability (especially Section 102(b)(7) waivers) for duty of care cases.
Development of the notion of “good faith” in the conduct of corporate affairs will have a number of collateral effects on corporate governance. One of the most important is the utility of this form of fiduciary duty for solidifying the notion of the autonomy of corporations, that is of corporations as entities separate from that of the shareholders who own interests in them. A duty of good faith can suggest a duty owed to the entity directly rather than to the shareholders. While the Delaware courts traditionally have been very sloppy about distinguishing between the interests of the shareholders (embracing a contractarian view of corporations as an aggregate of property in the hands of its shareholders) and that of the corporation itself (embracing an institutionalist view of corporations as an entity independent of its shareholders), there is an intimation in the discussion that good faith is grounded in the relationship of director to the corporation itself, rather than to the aggregate interests of shareholders directly. It will be interesting to see if this line of reasoning is also expanded as the Court works its way through the developing doctrine.
The case, then, ends the long journey of the Ovitz Employment Agreement as the foundation of conventional fiduciary duty law. To that extent the case is interesting as confirmation of fairly conventional and well-established principles of Delaware law. The case is far more interesting for the way in which it opens the door to a new chapter ion the development of fiduciary duty. Not only will this prove a fertile area for litigation, but also it may well affect the way in which federal regulatory authorities respond in the context of the federal securities laws. More on that in the future.
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