How to Define "Bad Faith" for a Board
Bad faith conduct in the boardroom is the fiduciary version of kryptonite; of Samson with shorn locks. Evidence of bad faith can rob the board of its traditional protections against breach of duty: the business judgment rule; exculpatory and indemnification protections provided through corporate bylaws, insurance policies, and statute; the ability to overcome preliminary motions in litigation; and the general deference afforded decisions of an informed and well-intentioned board. It’s a concept with which the attentive board will want to be familiar.
But a practical definition of bad faith conduct can be elusive; judicial decisions rarely describe it in terms of specific examples. Often, they speak to conduct that doesn’t constitute bad faith, as opposed to conduct that does. Perhaps that’s because the standard for proving bad faith conduct is so high that it’s hard to find judicially sanctioned examples. That makes it fairly tough for the corporate counsel, when asked to describe what might constitute “bad faith” in a specific context.
Inquiring minds—and board members—want to know, and offering up examples of good faith conduct won’t help those who quite reasonably seek a better understanding of the fiduciary foul lines.
The in-house counsel’s “desktop definition” of bad faith will include Lyondell v. Ryan and Stone v. Ritter-type themes: e.g., “failure to act in the face of a known duty to act”; and the “conscious disregard” of the duties to be reasonably informed of the business and its risks, and to exercise reasonable oversight. Pretty serious stuff, indeed—but practically, what action (or inaction) actually reaches this level? On what basis may counsel reasonably warn client boards on the real risks of problematic conduct?
So, it’s quite the “yellow highlighter moment” when a series of unrelated Delaware and federal decisions, all released within the last several months, separately tackle the question of conduct that rises (or falls, depending upon your perspective) to the egregious level of bad faith—with all of its implications. These new cases will certainly help corporate counsel offer meaningful guidance to board members who want to know where the “third rail” of director conduct might be located. So, they may be worth a five-minute board briefing, at the very least.
One of these decisions arose in the context of the board’s consideration of a proposed sale of the company. Another arose in the context of the exercise of the board’s Caremark obligations. And a third arose in the context of the financial demise of a well-known health care facility. Collectively, these cases offer a platform from which corporate counsel can have more substantive, practical conversations with the board on conduct that might trip the “bad faith” wire—and that which might not.
In re Novell, Inc. S’holder Litig
With In re Novell, Inc. S’holder Litig, it was substantive allegations in the context of a sale process that the board unfairly favored one bidder over another. Here, the Delaware Court of Chancery denied a motion to dismiss a shareholder derivative action that alleged that the Novell board acted in bad faith by allowing the sale of Novell to another company. Specifically, the plaintiffs alleged that the board provided the ultimate purchaser with information about competing bids without doing the same for another bidder. Had it done so, it was possible that the other bidder may have increased its own offer for the company. Citing Stone v. Ritter, the Court stated that bad faith could arise in the context of a sale of the business where the board acted with a purpose other than pursuing shareholder interests by seeking the best sale price. While the Court expressed uncertainty as to whether an actual breach of duty had occurred, it acknowledged that it was reasonably conceivable on the basis of the pleadings that a breach (i.e., preferential treatment of bidders) had occurred.
Rich v. Chong
With Rich v. Chong, it was the board’s indifference to its Caremark compliance oversight obligations with respect to evidence of financial irregularities. The underlying controversy was a series of accounting errors that served to undermine the credibility of the company’s financial statements. The Court of Chancery denied a motion to dismiss a shareholder derivative action for two substantive reasons. First, the Court determined that the plaintiff had pled facts that presented a reasonable doubt that the board acted in good faith to the plaintiff’s initial litigation demand. The Court referred to “well pled allegations” that the board had chosen to abandon the special committee it had initially formed to investigate the cause and effect of the accounting errors. Second, the Court determined that the plaintiff had stated a claim for bad faith violation of the compliance oversight duty because of evidence that the company lacked any meaningful internal controls, and failed to exercise any oversight of its operations in China. It also noted that even had such controls been in place, the board failed to monitor those controls, despite an awareness of the accounting errors, and failed to act to prevent further problems.
Along with the Court’s recent Puda Coal decision, Rich v. Chong also highlights the risk that resignation from the board of a troubled company to avoid liability may be viewed as bad faith conduct.
With Lemington Home, it was the board’s “outrageous” indifference to evidence that senior management was failing to perform its duties. The controversy arose from the financial demise of a historically prominent nonprofit home for the aging in the African-American community of Pittsburgh. Lemington Home had, over a period of time, encountered substantial difficulties, leading to insolvency in 1999, and eventual closure of the home and commencement of voluntary Chapter 11 bankruptcy proceedings. The breach of fiduciary duty and deepening insolvency actions were commenced by the official committee of unsecured creditors.
In the instant case, the federal district court determined that sufficient evidence existed to support jury verdicts against officers and directors that included compensatory and punitive damages, on the grounds that they violated their duty of care owed to Lemington Home and contributed to the organization’s deepening insolvency. Critical to the decision to award punitive damages were facts that indicated that the directors (a) took no action to remove the executive director even though they knew she was not sufficiently performing her job; (b) took formal public action to close Lemington Home, contrary to the advice of bankruptcy counsel who had told them that such action would harm the value and viability of the home; (c) never chose to seek bids from nursing home turnaround firms; and (d) did not create a “due diligence book” for potential purchasers.
These decisions combine to give corporate counsel a more practical basis from which to advise the board on conduct that might arise to the level of “bad faith”. It’s always important to lay the foundation by referencing the core Lyondell/Stone concepts of “failure to act” and “conscious disregard”. But these recent decisions allow a more meaningful message to be delivered.
Corporate counsel can now say, “Here’s how that definition was applied in a bunch of new cases,” to a board that may have favored one potential purchaser over another in a sale process; to a board that walked away from its Caremark compliance oversight duty; or to a board that was asleep at the switch when it came to retaining—in the face of potential insolvency—a nonperforming CEO. Those are the kind of “real world” examples that are more likely to get the board’s attention, and to gain their appreciation for why counsel is bringing up the issue.
Michael W. Peregrine is a partner in the law firm McDermott Will & Emery. He advises corporations, officers, and directors on issues related to corporate governance and fiduciary duties. Mr. Peregrine’s views do not necessarily reflect the views of McDermott Will & Emery or its clients. Mr. Peregrine wishes to thank his partner, Robert A. Schreck Jr. for his contributions to this column.