Boardroom "Best" Practices are Changing: The Need to Demonstrate "Good Faith"

In the wake of Enron and other corporate scandals, courts reviewing alleged violations of fiduciary duties are probing further into directors' actions (and inactions). Courts are giving further definition to a duty of "good faith," and directors who violate this duty may lose their rights to indemnification by the corporation and the benefit of corporate charter provisions that limit director liability. This article reviews briefly the increased scrutiny being applied by courts, including the recent emphasis on the good faith duty, and suggests ways for directors to protect themselves.

The Business Judgment Rule and Fiduciary Duties

One of the bedrock principles of corporate law is the "business judgment rule," under which courts are reluctant to second-guess the decisions of a properly functioning board. Courts have declined to apply the business judgment rule, however, where directors have breached their fiduciary duties. Delaware courts generally have focused on the duties of care and loyalty. In recent cases, courts have also reviewed the duty of good faith, but it has not always been clear whether this duty is separate or merely a subset of the duty of care or loyalty.

The Duty of Care

The duty of care has been described by Delaware courts as the duty of directors to "inform themselves, prior to making a business decision, of all material information reasonably available to them" and to "act with requisite care in the discharge of their duties." Cases finding a violation of the duty of care have been relatively rare and usually arise where the board fails in a fairly obvious manner to give enough time to consider a critical decision. For example, in a leading Delaware case, decided in 1985, the Delaware Supreme Court found that directors had violated this duty when they approved a merger of the corporation at a hastily convened, two-hour meeting, without receiving information required to make an informed decision.

The Duty of Loyalty

The duty of loyalty under Delaware law essentially requires that "the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director ... and not shared by the shareholders generally." Duty of loyalty cases generally have involved some allegations of self-dealing, and are not dealt with in this article.

Increasing Emphasis on the Duty of Good Faith

Delaware courts for many years have recognized good faith as one of a director's "triad" of fiduciary duties. Until recently, however, there has not been substantial case law addressing the requirements of this duty. Several recent decisions suggest that the duty of good faith can be an extension of the activities commonly associated with the duty of care, although a violation of the duty of good faith entails much more significant risk to directors. These cases have emphasized that directors must act in good faith and on an informed basis in order to receive the benefit of the business judgment rule. These cases also suggest that a violation of the duty of good faith will be found where the board fails to apply minimum levels of diligence, such as through a "sustained and systematic failure ... to exercise oversight" as was found in the Abbott case described below.

Implications for Personal Liability

A violation of the duty of good faith, or another finding that a director did not act in good faith, can result in personal liability risks for the director beyond those posed by a simple violation of the duty of care or the duty of loyalty. Delaware and many other states have adopted protective provisions (in Delaware, found in Section 102(b)(7) of the General Corporation Law) that allow corporations to eliminate or limit the personal liability of directors for monetary damages for breach of fiduciary duties by adopting certain language (referred to as "exculpatory" provisions) in their certificates of incorporation. These protective provisions, however, typically do not apply to acts or omissions not in good faith or involving intentional misconduct, so that the exculpatory provisions effectively are limited to duty-of-care violations. Similarly, Delaware and other states do not allow a corporation to indemnify directors for actions that were not taken in "good faith." Insurance policies also may have exclusions for actions taken in bad faith.

Best Practices of the Board

In this judicial environment, we think it is more important than ever that directors look to the suggestions that courts have made concerning the level of conduct necessary to discharge their fiduciary duties, including the emerging duty of good faith. The following suggestions are intended to be illustrative, rather than comprehensive. The actual steps a board (or committee) should take will depend upon the circumstances, including the nature of the matters to be acted upon.

  • Be proactive. One key lesson is that directors must be proactive. A director that sees, or should see, actions that may harm the corporation, and fails to act, or acts without sufficient information, may be deemed to have failed to meet his or her duty to act in good faith. It is not enough to confirm that company management is aware of and claims to be responding to key issues--the board must fulfill its duty to supervise management on those issues. Directors should ask questions about important matters, even if the matters are not on the agenda.
  • Obtain and review material information. Directors must always act on an informed basis. While business circumstances typically do not allow "perfect" information to be developed, directors should strive to obtain all material information reasonably available to them.
  • Receive and review relevant materials prior to the meeting. Directors should receive and review prior to the meeting an agenda and copies of all relevant documentation.

Legal documents are often lengthy, and directors must have the opportunity to understand them.

  • Review final (or close-to-final) versions of proposed agreements. To the extent possible, directors should receive final or substantially final versions of any proposed agreements. If the version presented is not in substantially final form, the board should consider meeting again on the agreement, or establishing limits on the revisions that can be made without returning to the board for further approval.
  • Consult with experienced legal counsel. Many boards have legal counsel attend all meetings. The board needs to understand in advance the legal implications of material decisions, including the different consequences of alternative courses of action.
  • Seek the advice of experts. Directors should consult with experts where appropriate. It is better if the board engages the expert, rather than uses an expert engaged by management, particularly when acting on issues where management has a conflict of interest, such as compensation and benefit plans for senior executives.
  • Take sufficient time for discussion and deliberation at board meetings. Directors must act deliberately. The amount of time required for a particular discussion depends on the issue to be discussed. It is important to provide each board member with enough time to present his or her views and to ask questions. Multiple meetings may be required.
  • Consider alternatives. Directors should consider alternatives to proposed courses of action. Sometimes one alternative may be to not do anything, but the record should show that the directors considered the consequences of the failure to act.
  • Document the process; record adequate minutes. Board and committee meeting minutes should reflect the deliberative process of the directors. While a detailed account of the questions asked and the issues discussed is not necessary, some indication of the length and nature of the discussion is warranted. Even where the board ultimately resolves to take no action, the record should reflect the board's effort and time in reviewing the issue.

Recent Cases

Two recent cases illustrate the courts' increasing emphasis on the duty of good faith.

In its March 2003 Abbott Laboratories decision,[1] the Seventh Circuit Court of Appeals (assuming for procedural reasons that the facts alleged by the plaintiffs were true) noted that the Abbott directors had received repeated warnings over a six-year period that some of Abbott's processes were in violation of FDA regulations. The board did not take any action to address the alleged violations. Ultimately, the FDA's investigation of the violations resulted in a $100 million fine, and an agreement to halt manufacturing of, and to destroy inventory of, certain products until compliance could be proved.

The court, applying Illinois law (which generally follows Delaware law on these matters), found that there was a "sustained and systematic failure of the board to exercise oversight," that was "intentional in that the directors knew of the violations of law, [and] took no steps ... to prevent or remedy the situation...." Accordingly, the court found that the directors' actions fell outside the protection of the business judgment rule.

In its May 2003 Walt Disney Company decision,[2] the Delaware Chancery Court (assuming for procedural reasons that the facts alleged by the plaintiffs were true) noted that the compensation committee and board of directors had spent little, or no, time reviewing the initial employment arrangement and subsequent severance arrangement (valued at approximately $140 million) for Michael Ovitz as the president of Disney, and instead allowed Michael Eisner, described as a close personal friend of Ovitz, to conduct the negotiations and finalize arrangements.

The court believed that the directors had not "merely [been] negligent or grossly negligent," but also had "failed to exercise any business judgment [or] make any good faith attempt to fulfill their fiduciary duties." The court held that the 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." The court distinguished the alleged facts from the situation where directors "in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance" to the corporation. If the board "had taken the time or effort to review ... [its] options, perhaps with the assistance of expert legal advisors," then the business judgment rule might have protected the board's actions. Such conduct, the court found, falls outside the protection of the business judgment rule.

In both of the above cases, the courts also found that the directors were not entitled to the protection of the corporations' respective exculpatory provisions.


Footnotes

1) In re Abbott Laboratories Derivative Shareholders Litigation, 325 F.3d 795 (7th Cir. 2003).

2) In re The Walt Disney Company Derivative Litigation, C.A. No. 15452, 2003 Del. Ch. LEXIS 52 (May 28, 2003).