For the second time in five months the Delaware Supreme Court has spoken, en Banc, about the duty of good faith. In June 2006 the court, in In re The Walt Disney Company Derivative Litigation (New Developments discussion here), defined bad faith, and by implication good faith. The court left open the question whether a breach of the duty of good faith is a viable claim for relief separate from a breach of the duty of care or loyalty. Now, in Stone v. Ritter (listen to the oral argument here), the court has held that the duty of good faith is a component of the duty of loyalty, not a separately litigable claim. It also changed the framework for analyzing a Caremark claim and may presage a constriction of the duty of care. Gordon Smith, Francis Pileggi, and Elizabeth Nowicki all have posts on Stone.
The plaintiffs in Stone brought a derivative suit against the directors of AmSouth Bancorporation. AmSouth had paid $50 million in fines and penalties for failing to file suspicious activity reports. The branch employees who should have filed the reports not only did not do so but did not report the facts upward in the corporation. The directors did not know, and had no reason to know, that reports should have been filed. The plaintiffs sought relief on a Caremark theory (casebook page 410): that the defendants utterly failed to implement a monitoring system. The Chancellor dismissed the complaint, and the Supreme Court affirmed, on the ground that no basis for a Caremark claim existed thus the directors could not be personally liable so demand on the board was not futile.
Justice Holland noted that AmSouth has a § 102(b)(7) exculpatory provision so the directors’ liability must be predicated on a breach of either the duty of good faith or the duty of loyalty. He looked at Caremark, and Disney to understand a claim of lack of oversight. Justice Holland focused on the many references to “good faith” in Caremark and asserted that they were consonant with Disney’s understanding of the definition and role of good faith. Then he answered the question Disney left open:
[A] failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of 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’. … [A]lthough good faith may be described colloquially as part of a ‘triad’ of fiduciary duties that includes the duties of care and loyalty the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. … [T]he fiduciary duty of loyalty is not limited to cases involving a … conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith.
Finally, Justice Holland affirmed what had been generally assumed: Caremark, including the standard of review (casebook page 426-27), governs the board’s duty to monitor. However, he went on to say that Caremark liability “requires a showing that the directors knew that they were not discharging their fiduciary obligations”. That’s a significant change in Caremark jurisprudence.
This case is surprising. It was argued in July, just after Disney came down, before
This case essentially reverses Disney’s conception of good faith. Where Disney all but held that good faith is a separate fiduciary duty, Stone makes clear that good faith is a component of the duty of loyalty. This is what the Court of Chancery (and several commentators, including me) has been saying for years, in the face of the Supreme Court’s insistence that good faith is a separate part of a triad of good faith, loyalty, and care.
Another important aspect of Stone is that Caremark is reconceptualized. Chancellor Allen decided Caremark, and discussed a board’s obligation to monitor, strictly as an aspect of the duty of care. That is, it is part of a board’s duty to be informed. A few Court of Chancery opinions, notably Guttman v. Huang by Strine, VC, suggest that the standard for finding liability under Caremark is so high that only intentional actions will suffice, which transmutes Caremark into a duty of loyalty claim. Stone, without any acknowledgment that it was choosing to redefine a Caremark claim from care to loyalty, did so. This has the effect of removing Caremark claims from the ambit of § 102(b)(7) provisions.
Let me dilate a moment on the connection between good faith
and the duty of loyalty. The traditional incantation of the fiduciary duties of
care and loyalty in
Pedagogically, what does this mean? First, my casebook, on pages 400-402 asks whether there is a separate duty of good faith. The answer now is clearly no. Good faith is part of the duty of loyalty. Second, Caremark, casebook page 410, needs to be moved from Chapter 12 (Duty of Care), to Chapter 11 (Duty of Loyalty), probably to page 394. This is so not because Caremark itself is different but because Stone has shifted the focus in a Caremark inquiry from board information to board intent. Third, the duty of care is becoming increasingly constricted. The casebook at page 421 asks whether there is a duty of care. When I wrote that I was being provocative, picking up on an idea Chancellor Allen floated. After Stone, though, and its approval of Guttman, it is clear to me that the duty of care may, in fact, be or become chimerical. Fourth, Note 1 on page 426 needs to be rewritten to reflect the change in conceiving Caremark and moved perhaps to page 437.
I worry that the court’s approach in Disney and Stone will
make matters worse. In my view, the