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The Omnipresent Specter of the Duty of Good Faith

Do Directors Have Reason to Worry?

November 1, 2005, Michael B. Tumas, Mark A. Morton, David S. Phillips


In four recent decisions -- Disney I,[2] Integrated Heath Services,[3] Emerging Communications,[4] and Disney II[5] -- the Delaware courts have explored the nature of a director's duty to act in good faith.  While these cases suggest an increased focus by the Delaware courts on this duty, collectively they still have not fully articulated the contours of the duty of good faith.  This article will attempt to summarize the case law concerning the duty of good faith, and to make some general observations about the circumstances in which there may be a risk that the duty will be violated.  The article concludes that the duty of good faith continues to function as a "safety valve" to capture conduct by disinterested directors that is aberrational or that amounts to an abdication of their duty to oversee the business affairs of the corporation.

Fiduciary Duties Generally.

In carrying out their central responsibilities, directors have an unyielding fiduciary duty to protect the interests of the corporation and to act in the best interests of the corporation's stockholders.[6]  Traditionally, those fiduciary duties were characterized as duties of due care and of loyalty.  More recently, however, the Delaware Supreme Court clarified that this unyielding fiduciary responsibility involves a "triad" of duties:[7]

  • The duty of due care requires that directors act in a fully-informed manner and with the requisite level of care dictated by the particular circumstances.
  • The duty of loyalty requires that directors act unselfishly; the best interests of the corporation and its stockholders must take precedence over any interest possessed by a director personally and not shared by the stockholders generally.
  • The duty of good faith was recognized as a distinct directorial duty in Cede & Co. v. Technicolor, Inc.[8]  The duty of good faith requires that directors act honestly, in the best interest of the corporation, and in a manner that is not knowingly unlawful or contrary to public policy.   Since that time, however, its contours have not been fully developed.[9]

    The Delaware Supreme Court has emphasized that this tripartite "fiduciary duty does not operate intermittently but is the constant compass by which all director actions for the corporation and interactions with its stockholders must be guided." [10]

The Increasing Significance of the Duty of Good Faith.

One of the reasons for an increased focus on the duty of good faith appears to be the availability of damages as a remedy against directors who are found to have acted in bad faith.  Many Delaware corporations have taken advantage of the benefits of  Section 102(b)(7) of the Delaware General Corporation Law (the "DGCL") which authorizes corporations to include in their certificates of incorporation a provision eliminating or limiting directors' liability for breach of the fiduciary duty of due care.[11]  Section 102(b)(7), however, expressly provides that directors cannot be protected from liability for either actions not taken in good faith or breaches of the duty of loyalty.[12]

Because corporate governance reforms initiated by stock exchanges (and, in some cases, mandated by the Sarbanes-Oxley Act) have required public companies to populate their boards with a predominance of independent directors, duty of loyalty cases may be more difficult to pursue.[13]  Thus, plaintiffs may be encouraged to explore duty of good faith claims as an alternative rationale for recovery against directors.[14]

A finding of a lack of good faith has profound significance for directors not only because they may not be exculpated from liability for such conduct, but also because a pre-requisite to eligibility for indemnification under Section 145 of the DGCL is that the directors have acted "in good faith."[15]  Accordingly, a director who is found not to have acted in good faith not only is exposed to personal liability, but also may be denied indemnification from the corporation for any judgment or expenses.  In contrast, it is at least theoretically possible that a director who has been found to have breached his or her duty of loyalty could be found to have acted in good faith and, therefore, be eligible for indemnification of expenses (and, in non-derivative cases, amounts paid in judgment or settlement) by the corporation.[16]

Thus, in cases involving decisions made by directors who are disinterested and independent with respect to a transaction (and, therefore, the duty of loyalty is not implicated), the duty of good faith provides an avenue for asserting claims of personal liability against the directors.  Moreover, these claims, if successful, create barriers to indemnification of amounts paid by directors in judgment or settlement.[17]

Renewed Focus on Good Faith

Renewed attention is being given to directors' duty of good faith in the wake of numerous corporate governance scandals.  This attention originally was heightened by statements by sitting members of the Delaware judiciary, who have spoken of good faith as a potential avenue for plaintiffs seeking to challenge decisions made by facially disinterested and independent boards of directors.  Disney I and II, IHS and Emerging Communications are further evidence of the increased focus on the duty of good faith.[18]

Delaware Case Law Discussing the Duty of Good Faith.

Early Cases.  The concept of "good faith" found expression in early Delaware case law.  However, because the modern business judgment rule had not yet been fully developed, the concept of good faith was simply stated as a prerequisite to a court's deference to a board's decision, which would only be disregarded in cases of "fraud."

Thus, in Bodell v. General Gas & Electric Corp.,[19] the Delaware Supreme Court stated that it would defer to board decisions unless they were tainted by fraud, "actual or constructive, such as improper motive or personal gain or arbitrary action or conscious disregard of the interests of the Corporation and the rights of its stockholders."

The use of "fraud" to describe the absence of good faith was also found in Allied Chemical & Dye Corp. v. Steel & Tube Co. of America.[20]  In denying a motion to enjoin a sale of assets, the Court reasoned that "so long as the [alleged] inadequacy of price may reasonably be referred to as an honest exercise of sound judgment, it cannot be denominated as fraudulent."  Id. at 494.

A similar analysis was employed in Allaun v. Consolidated Oil Co.,[21] which involved a challenge to the adequacy of consideration for a sale of assets:

The disparity must be sufficiently great to indicate that it arises not so much from an honest mistake in judgment concerning the value of the assets, as from either improper motives underlying the judgment of those in whom the right to judge is vested or a reckless indifference to or a deliberate disregard of the interests of the whole body of stockholders including of course the minority.

Bad Faith as Overcoming the Business Judgment Rule.

Since the development of the business judgment rule, Delaware courts have  characterized aberrational conduct that was sufficiently egregious or "irrational" so as to justify overcoming the deference normally accorded to informed decisions by disinterested directors as having been taken in "bad faith."

Chancellor Allen's analysis of a claim of bad faith conduct by disinterested directors in In re RJR Nabisco, Inc. Shareholders Litig.[22] provides some guidance as to the type of conduct that might constitute a breach of the duty of good faith.  The decision also illustrates the difficulty courts have in divining subjective motivation (good faith or bad faith) from objective facts, and suggests that conduct must be fairly egregious in order to rise to the level of "bad faith."

In RJR, plaintiffs sought to enjoin the closing of a pending tender offer that was to be followed promptly by a merger.  No member of the board appeared to have an interest in the transaction.  In asserting an alleged breach of the duty of good faith, plaintiffs argued that the directors' were inappropriately motivated to favor one bidder even if it allegedly meant not getting the best available transaction for the corporation's shareholders.  The directors' financial advisors had told the directors that the two competing offers were substantially equivalent in value.  The plaintiffs argued that if the directors had been properly motivated, they would have sought to break the tie between the two bidders instead of accepting the non-management offer.[23]

The Court determined that the fact that the board was faced with what it could reasonably believe were bids that were essentially equivalent from a financial point of view was a relevant circumstance is assessing its good faith in acting as it did.[24]  The Court also found it especially relevant that the directors had been placed under severe time constraints by the non-management bidder (they had been given thirty minutes to accept the bid on pain of its being withdrawn.).  Chancellor Allen concluded:  "In the light of these circumstances, the decision not to attempt to break the tie but to accept one of the bids at that point and thus avoid the risk of the loss of that bid – no matter that my personal view might be that the risk was rather small – can in no event be seen as justifying an inference that those who made such a choice must have had some motivation other than the honest pursuit of the corporation's welfare."[25]  The Chancellor also determined that the decision to prefer the non-management bid could not be viewed "as so beyond the bounds of reasonable judgment as to raise an inference of bad faith….; the judgment reached does not, as indicated, appear so far a field as to raise a question of the motivation of the board."[26]

Chancellor Allen's analysis of good faith attempted to harmonize the "fraud" cases with those focusing on the rationality of a board's decision:

True irrationality is unlikely to be encountered when boards of directors of large enterprises act deliberately, after receiving the advice of professionals…  It might be suggested that in such a setting, action that obviously is not 'rationally' designed to maximize corporate or shareholder interests, is best understood as a 'rational' breach of the duty to proceed in the good faith pursuit of appropriate interests.[27]

So viewed, the limited substantive review that the business judgment rule contemplates "(i.e., is the judgment under review 'egregious' or 'irrational' or 'so beyond reason,' etc.) really is a way of inferring bad faith." [28]

In re J.P. Stevens & Co., Inc. Shareholders Litig.[29] represents another articulation of an analysis in which a court pointed to "irrational" conduct as evidence of improper motivation that might also be characterized as having been taken in bad faith.

The Court noted that the policy of the business judgment rule prevents substantive review of the merits of a business decision made in good faith and with due care.  "A court may, however, review the substance of a business decision made by an apparently well motivated board for the limited purpose of assessing whether that decision is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith."[30]  The Court remarked that this "escape hatch" language has been variously stated in Delaware case law:  "egregious" decisions are said to be beyond the protections of the business judgment rule, as are decisions that cannot "be attributed to any rational business purpose," or decisions that constitute "a gross abuse of discretion."[31]

In contrast, the decision of the Court of Chancery in In re Holly Farms Corp. Shareholders Litig.,[32] illustrates a judicial reluctance to infer improper motives from even aberrational conduct.  In Holly Farms, a potential bidder for, and certain stockholders of, a target corporation sought a preliminary mandatory injunction to enjoin the effectuation of the asset option lock up, termination fee and expense reimbursement provisions contained in a merger agreement.  They also sought to compel the corporation to redeem a stock rights plan.  The essence of the claim was that the board did not conduct an auction of the company and therefore failed to attempt to maximize shareholder value upon the sale of the corporation.[33]

The Court concluded that a preliminary injunction was warranted because the board did not utilize proper procedures designed to maximize the value of the corporation after the board decided to sell it.  The Court found that the board did not make a serious effort to negotiate with another bidder who had expressed interest nor did it encourage that bidder to put its best offer on the table.  Especially significant to the Court was the fact that the board refused to tell that bidder in the face of direct questioning whether the corporation was to be sold.[34]

The Court concluded:

Even if the Board thought it was acting in good faith, the sale process itself was so substantially flawed that the Board's actions, considering all the facts and circumstances, were not likely to have maximized the value of the corporation for its shareholders and, therefore, its actions cannot be viewed as being rational.[35]

There may be some theoretical appeal to the proposition that unless a court can ascertain some subjective intention by a board to do wrong, a facially objective board should be given unfettered leave to conduct an auction as it pleases or displeases.  I, however, have seldom been able to ascertain the subjective intent of board members except by reviewing the objective effect of their acts and I do not believe that it is possible for a court to meaningfully review an auction except by reviewing the objective procedures used.[36]

Finally, Cinerama, Inc. v. Technicolor, Inc.,[37] the Delaware Supreme Court articulated good faith as one of a "triad" of fiduciary duties, the others being due care and loyalty.  While the Court did not articulate in that case the standard by which good faith would be measured, the Court did cite Allaun, supra, which spoke in terms of "improper motivation," or "reckless indifference" to the interests of all stockholders as being necessary to overcome a court's natural deference to board decision making authority.

Post-Cinerama Cases.

In In re Caremark Intern. Inc. Derivative Litig.,[38] the Court approved a proposed settlement of claims that members of the board breached their fiduciary duty of care in connection with alleged violations by company employees of federal and state laws and regulations.  Specifically, the claim was that the directors allowed a situation to develop and continue that exposed the corporation to enormous legal liability and that in so doing they violated a duty to be active monitors of corporate performance.  While the claim was framed as involving due care, the Chancellor's articulation of the standard for proving a breach of that duty (at least in cases involving the "duty to monitor" performance) was expressed in terms of good faith:

  • 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.[39]

The Court found that the breach of duty of care claim was extremely weak because the record did not support the conclusion that the defendants either lacked good faith in the exercise of their monitoring responsibilities or consciously permitted a known violation of law by the corporation to occur.[40]

In Strassburger v. Earley, 752 A.2d 557 (Del. Ch. 2000), a minority shareholder brought a derivative action claiming the board breached its fiduciary duty by arranging for the corporation to repurchase 83% of its outstanding stock, resulting in the transfer of control to the corporation's president.  The Court subjected the repurchase transactions to entire fairness review because the controlling stockholders and the directors stood on both sides of the transaction.  However, in the course of his analysis, Vice Chancellor Jacobs engaged in a discussion of individual director culpability that may provide some guidance in distinguishing breaches of the duty of good faith from breaches of the duties of loyalty or due care.

Focusing first on the duty of loyalty, the Court found that the two directors nominated by one of the former controlling stockholders were not themselves unjustly enriched and did not otherwise obtain a personal benefit at the shareholders' expense.  "Nor is there evidence that the two directors conspired with [the president] in the sense that they acted intentionally and in bad faith (emphasis added) to enable him wrongfully to benefit at the corporation's expense."  Nonetheless, the Court found that they had breached their duty of loyalty in approving the repurchases:

  • Their sin was not one of venality, but rather, of indifference to their duty to protect the interests of the corporation and its minority shareholders.  Stated differently, because their primary loyalty was to the interest of their employer, Triton [the controlling stockholder], in exiting [the corporation], [these two directors] were willing to subordinate those interests to [the president's].  The inevitable consequence was that [the two directors] gave priority to Triton's interest, and ignored their fiduciary obligation as [the corporation's] directors to assure that all [the corporation's] stockholders would be treated fairly.[41]

In analyzing the conduct of a director who was unaffiliated with either the former controlling stockholder or the president, Vice Chancellor Jacobs again equated bad faith with intentional conduct injurious to the corporation.  The Court defined bad faith as deliberate action to benefit the majority stockholders at the expense of the minority[42] and found that the director had not acted in bad faith.  "Rather, [a]t best, [his] belief that he was furthering the interests of all [the corporation's] shareholders was misguided, and at worst, it was misinformed, i.e., was not the product of due care."[43]

Thus, as in Caremark, the Court in Strassburger set a high standard for a finding of bad faith by an otherwise disinterested and independent director.

The Disney I Opinion.

In the Disney I opinion, Chancellor Chandler refused to grant a motion to dismiss a complaint seeking to hold the directors of The Walt Disney Company personally liable for damages to Disney allegedly arising out of the hiring and termination of Michael Ovitz as Disney's President.  While the finding that the complaint adequately alleged facts overcoming the business judgment rule protection of a disinterested board of directors[44] is unusual, Chancellor Chandler's opinion is consistent with the views expressed in the cases and commentary that preceded it suggesting that "bad faith" will only be found in fairly egregious circumstances.

The amended complaint in the Disney I case alleged complete director abdication of authority on a subject of importance to the corporation;  the hiring and firing of its President.  The complaint alleged that, when Mr. Ovitz was hired, the Compensation Committee and the Board paid scant attention to the terms of his employment, leaving the details instead to be negotiated by Mr. Ovitz and his "close friend," Michael Eisner, Disney's Chief Executive Officer.  The complaint alleged that neither the Compensation Committee nor the full Board reviewed any drafts of the employment agreement, spent very little time on it at their respective meetings, and failed to obtain expert advice concerning the reasonableness of the generous terms granted to Mr. Ovitz.[45]  Moreover, while the final agreement differed materially from the terms summarized for the Compensation Committee, in particular regarding termination, no further Board or Committee discussion occurred.[46]  With respect to Mr. Ovitz's termination, the complaint alleged that the Board took a similar "ostrich-like approach."[47]  Indeed, the complaint alleged there was no input from or review by either the Compensation Committee or the full Board of the terms of his departure, even after the termination arrangement was publicly disclosed and after the payout thereunder was accelerated by one month, and notwithstanding that Board approval was allegedly required for these actions.  Instead, the Board "chose to remain invisible in the process."[48]  The Chancellor focused on the willfully neglectful nature of the Board's conduct in denying the motion to dismiss.  Indeed, he stated that the business judgment rule might have applied if "the board had taken the time or effort to review [its] options, perhaps with the assistance of expert legal advisors."  However, the allegations, if true, "imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss."[49]  Accordingly, those claims were sufficient to survive a motion to dismiss:

Specifically, plaintiff's claims are based on an alleged knowing and deliberate indifference to a potential risk of harm to the corporation.  Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either "not in good faith" or "involve intentional misconduct."[50]

The IHS Decision.

In IHS, relying upon the good faith standard set forth in the Disney I decision, Vice Chancellor Noble refused to grant a motion to dismiss certain portions of a complaint seeking to hold certain IHS directors liable for damages to the Company arising out of certain compensation arrangements with senior management, including loan and loan forgiveness programs notwithstanding the fact that all of the challenged transactions were approved by the majority of a board consisting of disinterested independent directors.  In refusing to dismiss certain of the claims, the Vice Chancellor initially focused on whether the Board took any deliberative action at all with respect to the challenged transactions. In several instances, the complaint alleged that the Compensation Committee's approval of certain loans to management and the forgiveness of others and the Board's ratification of such conduct occurred without any review whatsoever.  The Court refused to dismiss those claims on the basis that such facts, if true, would imply that a Board "consciously and intentionally disregarded [its] responsibilities."[51]

In other instances, it was alleged that the Compensation Committee relied on letters and advice from the very officer that was to receive the benefit of the compensation arrangement.  In refusing to dismiss claims based upon such alleged conduct, the Vice Chancellor noted that "while there may be instances in which a board may act with deference to corporate officers' judgments, executive compensation is not one of those instances."[52]

In IHS, unlike Disney, the amounts in dispute were relatively small -- $2 million in comparison to the $145 million transaction in Disney.  Notwithstanding the difference in the magnitude of the compensation under scrutiny by the Court, the Vice Chancellor held that the same principles apply.  If a board of directors acts with a knowing indifference to its duties, its actions will be denied the protection of a Section 102 (b)(7) charter provision.[53]

The Emerging Communications Decision.

Unlike the Disney I decision and IHS, the decision in Emerging Communications is a decision on the merits after trial, not a decision on whether, if true, the allegations of a complaint are sufficient to survive a motion to dismiss.  Emerging Communications involved a challenge to a two step "going private" transaction of the publicly held shares of Emerging Communications, Inc. ("ECM") by its majority stockholder at a price of $10.25 per share.  The suit involved both a statutory appraisal action and a class action alleging breach of fiduciary duty.  The Court found entire fairness to be the applicable standard of review and found further that the interested merger was not entirely fair to the minority stockholders of ECM.  As a result of this finding, the Court turned to identifying the nature of the breaches of fiduciary duty -- whether of care, loyalty or good faith -- in order to determine which, if any, of the director defendants was liable for money damages in light of ECM's Section 102 (b)(7) charter provision.  In finding that several of the directors had breached their fiduciary duty of loyalty and/or good faith, the Court employed "the 'and/or' phraseology because the Delaware Supreme Court has yet to articulate the precise differentiation between the duties of loyalty and good faith."[54]

In finding that one particular director breached his duty of loyalty and/or good faith, the Court held a director who was by profession a former investment advisor to a higher standard because of his expertise.  While the Court found that it did not need to definitively determine the director's mindset, it found that his conduct was either motivated by a deliberate judgment to further his personal business over that of the minority or that he "consciously and intentionally disregarded" his responsibility to safeguard the minority from the risk, of which he had unique knowledge, that the transaction was unfair.[55]  Thus it appears that in making a determination as to whether a director acted in good faith, the courts may hold financially sophisticated directors to a higher standard.

The Disney II Decision.

As in Emerging Communications, Disney II is a decision on the merits after trial.  Following the Disney I decision, the plaintiffs pursued the claims against the Disney directors arising out of the approval of the employment and severance agreement with, and the termination of, Michael Ovitz.  After a thirty-seven day trial, the Delaware Court of Chancery rendered its much anticipated opinion on August 9, 2005.  The Court of Chancery analyzed in detail all the evidence and arguments and concluded that the defendant directors did not breach their fiduciary duties or commit waste in connection with the hiring and termination of Michael Ovitz.  As a result, judgment was entered in favor of defendants on all counts.

On the issue of good faith, the Court recognized that the Delaware case law has not provided clear guidance on the issue of whether a separate fiduciary duty of good faith exists.  Although not wholly remedying that lack of clarity, the Chancellor suggested that the concept of good faith is not an independent duty, in and of itself, but an overarching concept inherent in a fiduciary's duties of due care and loyalty:

  • Fundamentally, the duties traditionally analyzed as belonging to corporate fiduciaries, loyalty and care, are but constituent elements of the overarching concepts of allegiance, devotion and faithfulness that must guide the conduct of every fiduciary.  The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty, in the narrow sense that I have discussed them above, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders.[56]

Accordingly, the Court noted that the presumption of the business judgment rule could be overcome if a plaintiff proves an act of bad faith by a preponderance of the evidence.  The Court refused, however, to "create a definitive and categorical definition of the universe of acts that would constitute bad faith" because, to do so, would "misconceive how…the concept of good faith operates in our common law of corporations."[57]  However, the Court provided a non-exclusive list of examples of acts of bad faith, each of which contains an element of intent.  In particular, the Chancellor noted that a failure to act in good faith may be shown where a fiduciary:

  • "intentionally acts with a purpose other than that of advancing the best interests of the corporation;"
  • "acts with the intent to violate applicable positive law;" or
  • "intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties."[58]

In applying the facts of the case, the Court concluded that the Disney Board did not act in bad faith in connection with the hiring of Ovitz and the approval of his compensation arrangement.  Although repeatedly chastising the Board members for not acting in accordance with best practices, the Court refused to find that the conduct of the directors amounted to a breach of duty.  Although Michael Eisner did not act in accordance with best practices because he failed to keep the Board as informed as he should have and stretched the bounds of his authority by acting without specific Board direction in hiring Ovitz, the Court found that Eisner, nevertheless, acted in good faith and in the best interests of the Company.  With respect to the remaining Board members who ultimately approved Ovitz's hiring, the Court found that the record did not support a finding that they intentionally shirked or ignored their duties.  The Court also concluded, among other things, that Eisner did not act in bad faith when he decided to terminate Ovitz.  In particular, the Court found that Eisner, as the Chief Executive Officer, had the authority to terminate Ovitz and that the Board was not required to act in connection with that termination.[59]

In reaching those conclusions, the Chancellor relied upon the business judgment rule.  The Chancellor noted that "the greatest strength of Delaware's corporation law" – and the business judgment rule in particular – is the fact that corporate fiduciaries, although held to "a high standard in fulfilling their stewardship over the assets of others," are granted "wide latitude in their efforts to maximize shareholders' investments" when they act "faithfully and honestly on behalf of those whose interests they represent."

Differentiating between the role of the Court to provide a remedy for breaches of fiduciary duty and the role of the market to provide a remedy for bad business decisions, the Court reasoned as follows:

  • Even where decision-makers act as faithful servants, however, their ability and the wisdom of their judgments will vary.  The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, and not from this Court.  Should the Court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decision-makers would necessarily take decisions that minimize risk, not maximize value.  The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike.  That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary abilities, but within the boundaries of those duties are free to act as their judgment and duties dictate, free of post hoc penalties from a reviewing court using perfect hindsight.  Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased.[60]

The Court's decision in Disney II thus reaffirms the importance of the business judgment rule and provides at least some additional guidance to directors and officers with respect to the elusive concept of good faith.

In addition, while the Court made clear that Delaware law does not hold fiduciaries liable for a failure to comply with corporate governance "best practices" prevailing at the time a corporate decision is taken,[61] the Court also indicated in dicta instances in which, in its view, The Walt Disney Company board failed to comply with the best practices of ideal corporate governance, in the hope that the opinion "may serve as guidance for future officers and directors — not only of The Walt Disney Company, but of other Delaware corporations."[62]  Practical points from Disney II for fiduciaries to consider in assessing their continuing compliance with the duty of care and, to the extent implicated by an intentional or conscious failure to satisfy the duty of care, good faith, include:

Consultation between an executive and board members, or among board members, that occurs on an individual basis and outside of a formal board or committee meeting is less helpful than consultation in the context of a formal meeting.  Informal consultation on an individual basis results in members of the board or committee being unevenly informed.[63]  Also, informal consultation outside of a formal meeting is largely undocumented, leaving the board with an insufficient record to establish that proper deliberation and care with respect to a matter occurred.  Analogously (though not a consideration in Disney), where action is taken by a board pursuant to unanimous written consent in lieu of a meeting, care should be taken to properly document that the directors acted in an informed manner.
A board should continually assess potential conflicts of interest in the performance by officers and other board members of their respective duties.  While the Court expressly found that Mr. Eisner's twenty-five year friendship with Mr. Ovitz did not prevent him from being disinterested in his negotiation of the transactions between Mr. Ovitz and The Walt Disney Company, a failure of other board members to consider and evaluate whether it was appropriate for Mr. Eisner to act as one of the company's lead negotiators in the matter could be relevant in determining whether the other board members were exercising adequate oversight of the process.
Adequate time should be allotted at scheduled board meetings for consideration of material matters.  In this case, the Disney compensation committee met for only one hour to consider the Ovitz employment agreement along with four other matters.  Also, board meeting minutes should be detailed enough that it is later possible for the board to establish, or a neutral fact finder to determine, the approximate length of time spent considering a matter of importance.
•Every board member needs to be able to establish his or her own fulfillment of fiduciary duties.  Delaware courts will evaluate compliance, and liability, on an individual by individual basis.[64]  While it is neither realistic nor desirable that an entire board or committee conduct negotiations on behalf of a corporation, directors taking the early lead in negotiations need to keep other members of the board informed of the substance of such negotiations, and communicate all material information to them for their consideration before action is taken.
The taking of action by an executive with respect to a matter prior to formal board action gives rise to an inference that the board's later approval is a mere "rubber stamp" of the executive's action.  While execution of an employment letter agreement by Mr. Ovitz and Mr. Eisner on behalf of the company prior to board approval was not legally binding upon the company, this action, coupled with the public announcement of Mr. Ovitz' hiring, placed inappropriate pressure on the board to approve this action.[65]
All board or committee members should have the opportunity to review written materials regarding an important action prior to their decision.  Where the action involves execution of an agreement on behalf of the corporation, although not strictly required, the directors should ideally review the agreement itself.  At a minimum, they should review a written summary of the agreement's material terms.[66]
Where further negotiation of an agreement results in a material change in the terms most recently reviewed by the board, these changes should be clearly communicated to the board prior to taking of action on behalf of the corporation.
Reliance on the advice of experts or outside counsel, including care in the selection of experts, should be properly documented.  The expert's advice should ideally be memorialized in writing.  In the Opinion, the Court was critical of board members' failure to document in writing legal advice they received concluding that Mr. Ovitz could not be terminated for "cause" as defined in his employment agreement, which would have allowed the company to avoid the large severance obligations that, in part, gave rise to the lawsuit.[67]  It is helpful to the record to have an expert relied upon present at the board of committee meeting at which the action is considered, though not strictly required.[68]


The duty of good faith requires that a director be motivated to act in the best interests of the corporation and its stockholders.  While, therefore, the Court's review is of the board's subjective motivation, objective facts necessarily will be utilized to infer such motivation.  Like a duty of care analysis, such review likely will focus on the process by which the board reached the decision under review.  Consistent with earlier articulations of the level of conduct necessary to infer bad faith (or irrationality), more recent case law, including the recent Disney, IHS and Emerging Communications decisions, suggests that only fairly egregious conduct will rise to the level of "bad faith."  Nevertheless, as these decisions evidence, given the recent emphasis on director oversight, and in light of the recent wave of corporate scandals, the Delaware courts may be more willing to seriously consider claims of bad faith by otherwise disinterested directors who are alleged to have abdicated their responsibilities or acted in a manner contrary to their professed rationale.  At present, however, Delaware courts continue to be extremely reluctant to impose liability on disinterested directors who make even modest attempts to fulfill their duty to make informed decisions regarding matters of importance to the corporation.  Only time will tell whether this reluctance will continue.


[1] Mr. Tumas and Mr. Morton are partners in Potter Anderson & Corroon LLP, Wilmington, Delaware, and Mr. Phillips is an associate in the Atlanta office of Jones Day.  Portions of this article are drawn from materials prepared by other attorneys with Potter Anderson & Corroon, including John F. Grossbauer, Michael K. Reilly and Nancy N. Waterman and have been used in other presentations and continuing legal education programs.  The views expressed in this article are those of the authors and not necessarily those of their respective firms.

[2] In re The Walt Disney Company Deriv. Litig., 825 A.2d 275 (Del. Ch. 2003) (hereinafter "Disney I").

[3] Official Committee of Unsecured Creditors of Integrated Health Services, Inc. v. Elkins, et al., C.A. No. 20228, Noble, V.C., (Del. Ch. August 24, 2004) (hereinafter "IHS").

[4] In re Emerging Communications, Inc. S'holders Litig., C. A. 16415, Jacobs, J. (sitting by designation) (May 3, 2004, revised June 4, 2004) (hereinafter "Emerging Communications").

[5] In re The Walt Disney Company Deriv. Litig., C. A. No. 15452, Chandler, C. (Del. Ch. August 9, 2005) (hereinafter "Disney II").

[6] E.g., Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985); Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939).

[7] Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001) (citing Malone v. Brincat, 722 A.2d 5, 10 (1998)); Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993); McMullin v. Beran, 765 A.2d 910, 917 (Del. 2000).

[8] 634 A.2d 345, 361 (Del. 1993).

[9] Despite the Delaware Supreme Court opinions suggesting that directors have a separate duty of good faith, the Court of Chancery has not yet fully embraced this conclusion in its own decisions.  (See discussion of Disney II below.

[10] Malone, 722 A.2d at 10.

[11] 8 Del. C. § 102(b)(7).  It should be noted, however, that Section 102(b)(7) does not authorize corporations to eliminate personal liability of a director to persons, such as creditors of the corporation, other than the corporation and its stockholders.  E.g., Pereira v. Cogan, 2001 WL 24357 (trustee in case brought under Chapter 7 of bankruptcy code not barred by Section 102(b)(7) from bringing duty of care claim against directors on behalf of creditors) and Steinberg v. Kendig (In re Ben Franklin Retail Stores, Inc.), 2000 WL 28266 (same).

[12] Specifically, Section 102(b)(7) authorizes the inclusion in a certificate of incorporation of:

  • A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director:  (i) For any breach of the director's duty of loyalty to the corporation or its stockholders;  (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;  (iii) under § 174 of this title [dealing with the unlawful payment of dividends or unlawful stock purchase or redemption]; or (iv) for any transaction from which the director derived an improper personal benefit….

8 Del. C. § 102(b)(7).

[13] See Aronson v. Lewis, 473 A.2d 805 (Del. 1984) (demand required prior to initiating derivative suit unless majority of board is interested or the decision was not the "product of a valid exercise of business judgment").

[14] All but seven states (Florida, Indiana, Missouri, Ohio, Nevada, West Virginia and Wisconsin) authorize a corporation incorporated under its respective corporate statute to include in its charter exculpatory provisions similar to those adopted pursuant to Section 102(b)(7) of the DGCL.  Eighteen such states (Alabama, Arizona, Arkansas, Georgia, Hawaii, Idaho, Iowa, Maine, Michigan, Mississippi, Montana, Nebraska, New Hampshire, New Mexico, South Dakota, Utah, Vermont and Wyoming) have provisions that follow more closely Model Business Corporation Act Section 2.02(b)(4), which does not enumerate acts or omissions not taken "in good faith" as one of the items for which directors may not be exculpated, making it less likely that directors in these jurisdictions will be subjected to "good faith" claims as a means of avoiding such exculpatory provisions.  The remaining states follow Delaware in excluding acts or omissions not taken in "good faith" from matters for which directors may be protected.  It remains to be seen, however, whether courts in these jurisdictions will follow Delaware’s lead in defining "good faith" in a manner that allows plaintiffs to pursue "good faith" claims based upon allegations of reckless conduct or conscious disregard for duties.  At this writing, the authors are aware of only one court that has adopted a similar analysis.  See In Re: Abbott Laboratories Derivative Shareholders Litigation, 325 F.3d 378 (7th Cir. 2003) (applying Illinois law, court held that exculpatory provision adopted pursuant to Section 2.10(b)(3) of Illinois Business Corporation Act did not preclude claim where plaintiffs alleged omissions to act in good faith).

[15] 8 Del. C. §§ 145(a) and (b).

[16] See Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) (directors found to have acted in good faith but nevertheless breached their duty of loyalty).

[17] The availability of directors and officers liability insurance also may be brought into question by a finding of bad faith.  Policies often contain exclusions that could be cited by carriers as a basis for denying coverage.

[18] Then Chief Justice Veasey, in remarks made in a roundtable discussion of CEO compensation, focused on the duty of good faith as offering a theory that potential plaintiffs might successfully present, at least at the pleading stage.  (Useem, Overpaid CEOS?  Try Suing the Paymasters, Fortune (Dec. 19, 2002).  Vice Chancellor Strine sounded a similar theme in a recent Business Lawyer article.  In that article, the Vice Chancellor explored how the Enron debacle might exert pressure on courts to look more carefully at whether directors have made a good faith effort to accomplish their duties.  (Strine, Derivative Impact?   Some Early Reflections on the Corporation Law Implications of the Enron Debacle, 57 Bus. Law. 1371 (Aug. 2002) (hereinafter "Strine").

[19] 140 A.2d 264, 267-68 (Del. 1920).

[20] 120 A. 486 (Del. Ch. 1923). 

[21] 147 A. 257, 261 (Del. Ch. 1929).

[22] 1989 WL 7036, *14-15 (Del. Ch. Jan. 31, 1989).

[23] Id. at *15-16.

[24] Id. at *17.

[25] Id. at *17 (citing In re J.P. Stevens & Co., Inc. Shareholders Litig., 542 A.2d 770, 780, at n.5).

[26] Id. at *18.

[27] Id. at *21.

[28] Id. at *22, n.13 (Del. Ch. 1989) (citing Allied Chemical & Dye Corp. v. Steel & Tube Co., 120 A. 486, 494 (Del. Ch. 1923); Allaun v. Consolidated Oil Co., 147 A. 257, 261 (Del. Ch. 1929)).

[29] 542 A.2d 770 (Del. Ch. 1988).

[30] Id. at 780-81 (emphasis in the original).

[31] Aronson v. Lewis at 805 ("egregious" decisions); Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) (no rational purpose); Warshaw v. Calhoun, 221 A.2d 487 (Del. 1966) (gross abuse of discretion).  See also Kaplan v. Goldsamt, 380 A.2d 556, 567 (Del. Ch. 1977); Gimbel v. The Signal Companies, 316 A.2d 599, 610 (Del. Ch. 1974) ("inadequacy … so gross as to display itself as a badge of fraud"); Marks v. Wolfson, 188 A.2d 680, 685 (Del. Ch. 1963) ("price … for the sale of … assets was so clearly inadequate as constructively to carry the badge of fraud").

[32] 1988 WL 143010 (Del. Ch. Dec. 30, 1988).

[33] 1988 WL 143010, at *1, 3-4.

[34] Id. at *5.

[35] Id. at *5 (emphasis added).

[36] Id. at *9 (emphasis added).

[37] 634 A.2d 345 (Del. 1993).

[38] 698 A.2d 959 (Del. Ch. 1996).

[39] Id. at 971 (emphasis added).

[40] Id. at 972.  In an article published in 2002, Vice Chancellor Strine offered the following assessment of Caremark: 

  • That opinion is most often cited to emphasize the duty of directors to exercise due care in monitoring the corporation's compliance with legal standards—including standards of fair disclosure of the corporation's financial health.  But Caremark also suggests that directors should only be held personally liable for a failure to monitor if their laxity in oversight was so persistent and substantial that it evidences bad faith. 

Strine, 57 Bus. Law at 1386 (citation omitted) (footnote omitted).

The Vice Chancellor then posited how plaintiffs' lawyers might use this standard in the post-Enron environment: 

  • [O]ne can see how plaintiffs' lawyers might approach 'duty to monitor' cases somewhat differently in the near future.  They might well ask courts to infer not only that audit committee members did not know enough about their company's financial and accounting practices, but also that the committee members knew that their inadequate knowledge disabled them from discharging their responsibilities with fidelity.  Stated crudely, the court will be called on to conclude that a director who is conscious that he is not devoting sufficient attention to his duties in not acting in good faith, and is therefore not entitled to exculpation from damages liability. 

Id. at 1394 (acknowledging that courts will deal sensitively with arguments of this kind and err on the side of directors when close questions arise). 

[41] Id. at 581 (emphasis in the original).

[42] Id. at 582.

[43] Id.

[44] The Disney I opinion discussed above focused on an amended complaint filed by plaintiffs after their initial complaint was dismissed for failure to adequately plead breaches of fiduciary duty.  Brehm v. Eisner, 746 A. 2d 244 (Del. 2000).  The Supreme Court's decision expressly found that a majority of the Disney board (including Michael Eisner) was disinterested in the challenged transaction, and prohibited plaintiffs from relitigating that issue.  Thus, plaintiffs were required to plead facts sufficient to overcome the presumption of the business judgment rule.

[45] The Chancellor expressly noted that the discussion of Mr. Ovitz's hiring took up one and a half pages in the fifteen pages of minutes of the meeting at which it was approved, and much of that discussion centered on a "finder's fee" to be paid to another director.  Disney I, Mem. Op. at 23.

[46] The Court found that the fact that Mr. Ovitz began employment with Disney and began to serve on its Board before his contract was finalized rendered the contract a self-dealing transaction between the Company and him, thus precluding dismissal of Mr. Ovitz from the case.  Id. at 29 – 30.

[47] Id. at 26.

[48] Id. at 27.

[49] Id. at 28.

[50] Id. at 29 (quoting DGCL § 102 (b) (7)).

[51] IHS, slip op at 32.

[52] Id. at 31.

[53] In his opinion in IHS, Vice Chancellor Noble made it clear that he views a finding of bad faith as a violation of either the duty of care or the duty of loyalty, and not as a separate duty independent of due care and loyalty.  Id. at 23-24.

[54] Emerging Communications, slip op. at 106 n.184.

[55] Id. at 109.

[56] Disney II, slip op. at 36.

[57] Id.

[58] Id.

[59] An appeal of the Court of Chancery's Disney II decision is pending before the Delaware Supreme Court.

[60] Disney II, slip op. at 4-5.

[61] Disney II slip. op. at page 2.

[62] Id. slip. op. at page 5.

[63] Id. slip. op. at page 96.

[64] Id. at page 109 (liability of directors must be determined on an individual basis because the nature of their breach and whether they are exculpated can vary by director).

[65] Id. at 136, 137 (Eisner obtained no consent from board before agreeing to hire Ovitz, agreeing to substantive terms of his employment or issuing a press release).

[66] Id. at 154 (review and discussion of full text of then-existing draft employment agreement not required).

[67] Id. at page 71.

[68] Id. at 154 (formal presentation by expert at compensation committee "better course of action" but not required).