New Developments

Delaware Court of Chancery on Caremark duty of loyalty

The Delaware Court of Chancery has held that two directors breached their duty of loyalty by failing to meet their Caremark obligations. In ATR-Kim Eng Financial Corp. v. Araneta, Araneta controlled 90% of a corporation and was one of the three directors. After a falling out with his childhood friend Arnaiz, who’s ATR owned the remaining 10%, Araneta transferred the corporation’s assets to his own children for no consideration.

Vice Chancellor Strine had no difficulty finding Araneta liable. The interesting part of the opinion concerns the other two directors, Berenguer (Araneta’s niece and the CFO) and Bonilla. They were completely overborne by Araneta and readily admitted that they did nothing as directors. It appears that no board meetings were held. Vice Chancellor Strine found that they violated their duty of loyalty by failing to implement a reporting or monitoring system as required by Caremark. It has several characteristically Strinian phrases.

Pedagogically, this case and Stone v. Ritter will probably replace Caremark (casebook pp. 410, 426-27, 443-44). Between them they show that the duty to monitor is a loyalty issue and they also discuss the standard of review. The facts of Araneta are more accessible and interesting than those of Caremark. Since Stone v. Ritter torques Caremark rather considerably, it would be hard to keep Caremark itself as a teaching case. Perhaps it will be less confusing to students if we refer to the duty to monitor as the Loyaltymark duty.

Francis Pileggi (here), Steve Bainbridge (here), and Gordon Smith (here) all have discussions of Araneta.

Delaware Supreme Court on good faith (again) and the duties of care and loyalty

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 Holland, Berger, and Jacobs, JJ. At some point it was referred to the court en Banc, but I haven’t been able to find the order doing so. The oral argument contains no hint that a discussion of good faith or Disney was involved.

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 Delaware is that a director must act, “on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the corporation”. In 1993, the Delaware Supreme Court first indicated that good faith might be a duty coequal to care and loyalty. Vice Chancellor Strine joined the issue in In re Gaylord Container Corp. in 2000. In footnote 41 he asserted that good faith was a subsumed under the duty of loyalty, citing to two law review articles, the main one of which was by me. He reinforced that view in later cases, most notably in Guttman at footnote 34. Disney made clear, at least in my view, that good faith was a separate duty (see my discussion of Disney earlier on this site). I thought footnote 112, which left open the question Stone answers, was a way for the pro-Chancery justices (including Justice Jacobs, Disney’s author, and a pro-Chancery justice) to satisfy the colleagues who insisted that good faith is a separate duty while at the same time eviscerating that holding by hinting that a claim for breach of the separate duty of good faith isn’t a valid claim for relief. It seems that now the court is prepared to be even bolder. It is clear that Stone is a capitulation to Vice Chancellor Strine and other Court of Chancery judges who saw good faith as an aspect of the duty of loyalty.

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 Delaware preference for stability may impede a clear understanding of the law. Over 20 years ago the court got itself into serious problems because, in my view, it refused to acknowledge that it had recently misspoken. Back then, the error was Pogostin v. Rice, which held, without much discussion, that the business judgment rule applied in takeovers. The next year the court faced Unocal and, rather than admit that Pogostin was ill advised, it hewed to the position that the BJR, rather than entire fairness, applies in takeovers. That forced the court to invent intermediate scrutiny, which has been somewhat protean, but basically has wavered between being essentially entire fairness and being the business judgment rule. I wish the court in Stone had simply said, we were wrong in Disney, good faith is simply a part of the duty of loyalty. I hope the court’s circumlocution will not generate as much misunderstanding as Unocal has done.

New York trial court on director duties to other directors and officers

The Supreme Court of New York has held that a corporate director does not have a duty of care or duty of loyalty that runs to the corporation’s other directors or officers. In New York v. Grasso, Grasso, an officer of the New York Stock Exchange, Inc., a not for profit corporation, was sued by the Attorney General for receiving improper compensation. Grasso impleaded McCall, a director and the chair of the compensation committee. One of Grasso’s theories was that any improper compensation was caused by McCall’s negligent misrepresentation to Grasso. Grasso alleged that McCall, as director and compensation committee chair, had a special relationship of trust and confidence with him.

Justice Ramos held that predicates for a negligent misrepresentation claim include a duty of care owed by defendant to plaintiff and a special relation of trust and confidence between the two. McCall had an arm’s length relationship with Grasso concerning Grasso’s compensation, not a special relationship of trust and confidence.

This is clearly correct and might best be seen as a reminder to directors and officers that their loyalty and care obligations run to the entity and not to other directors and officers.