A few recent Delaware cases had cast doubt on the protections afforded to directors of a Delaware corporation. More recent decisions, however, seem to indicate that protections for directors of a Delaware corporation are alive and well.

These decisions focus on the fiduciary duties owed by a director of a Delaware corporation and the protections afforded to directors by the business judgment rule.1

FIDUCIARY DUTY GENERALLY

Every director of a Delaware corporation must discharge his or her duties in good faith, and in a manner the director reasonably believes to be in the best interests of the corporation. These concepts have been translated into two basic duties: duty of care and duty of loyalty. In addition, Delaware corporate law permits a Delaware corporation to have a provision in its charter that eliminates the personal liability of a director to the corporation or its stockholders for monetary damages for a breach of fiduciary duty as a director, except for:

  • any breach of the director's duty of loyalty to the corporation or its stockholders;
  • acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; or
  • any transaction from which the director derived an improper personal benefit.

This exculpatory provision, which most Delaware corporations have adopted, eliminates the personal liability of directors for monetary damages for breach of duty of care, but not for breach of duty of loyalty. As a result, much of Delaware fiduciary litigation is focused on claims of a breach of the duty of loyalty or lack of good faith, a component of such duty, not a breach of the duty of care.

However, in the context of injunctive relief, both fiduciary duties may be implicated.

TYPES OF FIDUCIARY CASES

Delaware director fiduciary litigation has principally involved two types of cases.

  • Transactional cases – involving the board taking action, typically in the context of a takeover.
  • Oversight cases – involving inaction by the board in which directors are alleged to have breached their fiduciary duty by failing to properly oversee the operations of a company.

DOW CHEMICAL

Although Dow Chemical (Del. Ch. Civ. No. 4349-CC (Jan. 11, 2010)) did not make new law, it did reaffirm the protections afforded to directors of a Delaware corporation in both the transactional and oversight contexts. The case involved shareholder litigation surrounding the acquisition by Dow Chemical Company of Rohm & Haas Company (R&H).

In July 2008, after a vigorous auction process by R&H, the Dow board approved a merger agreement to purchase R&H for almost $19 billion. Because of the intense bidding and competition for the deal, the Dow board approved the acquisition without traditional "outs" for Dow, most notably a financing contingency. The merger agreement did contain, however, a number of protections for R&H to make sure the transaction closed. As a result of the turmoil in the financial markets between the time the agreement was signed and its expected closing date, Dow was unable to obtain the necessary financing. Accordingly, Dow refused to close and R&H filed suit for specific performance. On the eve of trial, the lawsuit settled and Dow acquired R&H on April 1, 2009, on substantially altered (and less rich to R&H) financial terms.

Transactional Fiduciary Duty Claims

The Dow shareholders' principal complaint was that the directors breached their fiduciary duty by entering into the merger agreement without traditional "outs," particularly a financing contingency. The court analyzed the breach of fiduciary claims on the approval of the merger under the standard set forth in Aronson v. Lewis, which provides that plaintiffs must plead particularized facts that raise reasonable doubt that either (a) a majority of the directors who approved the transaction were disinterested and independent or (b) the transaction was the product of the board's good faith, informed business judgment.

The court then analyzed the two prongs. For the first prong, plaintiffs would have to show that a least half the Dow board was not disinterested and independent. Disinterested "means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit that devolves upon the corporation or all stockholders generally." "Independence means that a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences." The court rejected arguments that any of the directors were interested. As a result, the court held that independence need not be considered.

The court then considered the second prong of Aronson – that there was reason to deny defendants the protection of the business judgment rule. To do so, plaintiffs had to plead particularized facts sufficient to raise reasonable doubt that (a) the action was taken honestly and in good faith or (b) the board was adequately informed in making the decision. The court stated that there was no real evidence that the board was not adequately informed. In fact, the court noted that the plaintiffs' real issues were with the substance of the board's decisions, not the process the board followed. The court stated that substantive second-guessing of the merits of a business decision is precisely the kind of inquiry that the business judgment rule prohibits.

The court similarly rejected arguments that the directors did not act in good faith. "To show that a disinterested and independent board acted outside the bounds of business judgment, plaintiffs must show that directors acted in bad faith." The court then cited the recent Delaware Supreme Court decision in Lyondell Chemical for the proposition that "[i]n the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties."

In Lyondell, the Delaware Supreme Court reviewed its jurisprudence on what constitutes bad faith. At one end of the spectrum is "subjective bad faith" – conduct motivated by actual intent to do harm – which clearly constitutes bad faith. At the opposite end of spectrum is lack of due care – i.e., gross negligence without any malevolent intent. Gross negligence, without more, does not constitute bad faith. A third (intermediate) category is intentional dereliction of duty or conscious disregard for one's responsibilities. In some cases, this type of misconduct may be treated as violation of the fiduciary duty to act in good faith. To prevail on such a charge, however, plaintiffs would have to show that the directors completely and utterly failed to attempt to meet their duties. Finding that this extreme standard was not met, the Dow court dismissed the claim that the defendant directors breached their fiduciary duties by approving the R&H merger.

Oversight Fiduciary Duty Claims

Plaintiffs in Dow also brought breach of fiduciary duty oversight claims, alleging that the board failed to detect a variety of alleged wrongs, including bribery. Because Dow had adopted a charter provision eliminating directors' liability for monetary damages for a breach of the duty of care, plaintiffs had to plead particularized facts showing bad faith (i.e., breach of the duty of loyalty) in order to establish a substantial likelihood of personal liability.

In re Caremark Int'l provided that directors could be liable for a failure to monitor only if there is 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. Another case, Stone v. Ritter, made clear that director oversight liability is based on the concept of good faith imbedded in the duty of loyalty. Bad faith is a necessary condition to director oversight liability. Imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities, such as by failing to act in the face of a known duty to act.

The court then analyzed the facts in Dow and found that even if there may have been wrongdoing at the company, there were no facts that would lead to the conclusion that the board should have had cause for suspicion to the level required to sustain a failure to supervise claim. Accordingly, the court also dismissed those charges.

PRACTICE POINTS

Delaware case law consistently demonstrates that board process and recordkeeping, as well as director independence, are crucial in combating breach of fiduciary claims. Accordingly, boards should be conscious of the following points:

  • Process is very important.
  • Board should keep good records of its deliberations and matters considered.
  • Board should engage legal and financial advisors and, as appropriate, other advisors.
    • Advisors should be independent.
  • Board should be actively involved in the process.
    • Board should get regular updates from individuals involved in negotiations, as well as from its advisors.
  • Board needs to be independent and disinterested.
    • If not, Board should create special committee of disinterested directors.
    • Committee should be authorized to retain its own independent financial and legal advisors.

Footnote

1. The business judgment rule is a principle that defers to the decision-making process of the directors themselves. Absent evidence of self-dealing, conflict of interest, bad faith or fraud, directors of a corporation are presumed to have exercised their business judgment in the best interests of the corporation. A court will not second-guess board decisions with 20-20 hindsight or substitute its judgment for that of the board.

Cozen O'Connor's corporate and other business attorneys work regularly with clients in assessing director liability and fiduciary duty issues. For more information, please contact Richard J. Busis (Philadelphia, 215.665.2756, rbusis@cozen.com).

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.