Duty of Loyalty (anti-theft; self- dealing; competition.

Duty to act loyally to the principal s benefit)-compels the fiduciary to refrain from self-interested behavior that constitutes a wrong to the beneficiary; Duty of Care (engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law )- duty to work non-negligently. Duty of Disclosure- affirmative duty to disclose economically significant information, without being asked Rest 3d of agency: Agency- is the fiduciary relationship that arises when one person (a principal ) manifests assent to another person (an "agent") that the agent shall act on the principal's behalf and subject to the principal's control, and the agent manifests assent or otherwise consents so to act. DL (Cardozo): Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place.Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the disintegrating erosion of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court. Board of directors: Shareholder agreement may eliminate the board of directors or restrict the discretion or powers of the board of directors MBCA 7.32(a)(1) Types of directors: inside directors = employees; outside directors = non-employees; independent directors =non-employees without substantial ties to the corporation; disinterested directors = directors without a financial interest in the relevant transaction Fiduciary limits on setting meetings: General Principle: directors must act in the interests of shareholders, not for the purpose of entrenchment. Two situations: 1. Setting the date: boards are given broad discretion; 2. Changing the date: courts want specific evidence of shareholder benefit Fiduciary duties fill gaps left by the statute and organizational documents (charter and bylaws) Enron: why gatekeepers failed: - Insufficient deterrence- Conflicts of interest - Market irrationality - Pressure from managers - Insufficient competition Why managers failed: 1. American corporate governance relies heavily on the board of directors - State corporate law grants vast authority to the board of directors. 2. Enron had 14 directors; 2 were insiders (Lay and Skilling) - Audit committee chair was the Dean of Stanford s Graduate School of Business 3. Directors supervise officers - Officers have incentives to cheat - Board did not prevent cheating (a. Approved conflict transactions; b. Waived Enron s code of conduct) -Inadequate disclosure by Enron s officers - Complex accounting issues - Conflicts of interest (financial ties) - Insufficient time and other resources - Structural bias Insufficient deterrence - Cognitive bias (e.g., commitment bias) Why Stockholders failed? - Complacency with the bubble market; AND Insufficient information Sarbanes-Oxley: Assumption: failure was structural. 1. Regulate the gatekeepers (- Public Company Accounting Oversight Board - Auditor and audit committee independence - Attorney and analyst regulation); 2. Regulate the managers (- Independence standards for boards - Certification requirements - Codes of ethics); 3. Regulate the trading of shares (New disclosure requirements) Gagliardi: - [I]n the absence of facts showing self-dealing or improper motive, a corporate officer or director is not legally responsible to the corporation for losses that may be suffered as a result of a decision that an officer made or that directors authorized in good faith. - [The business judgment rule] in effect provides that where a director is independent and disinterested, there can be no liability for corporate loss, unless the facts are such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty. - Rationale for BJR: 1. Shareholders want their portfolio companies to take risks - They are protected through diversification; 2. Directors have little upside from risky decisions - Liability would create significant downside; 3. Chancellor Allen: - Obviously, it is in the shareholders' economic interest to offer sufficient protection to directors from liability for negligence, etc., to allow directors to conclude that, as a practical matter, there is no risk that, if they act in good faith and meet minimal proceduralist standards of attention, they can face liability as a result of a business loss. Corp DC: Act with the care of an ordinarily prudent person! - Good faith decisions = directors protected from liability EXCEPT IF - Directors are conflicted or ; - Directors have improper motive; - Duty of care procedures = no director liability for losses = ASSUMING THE TRANSACTION WAS a. Lawful; b. Within the corporation s powers; c. Authorized (-By a corporate fiduciary ; - Acting in good faith ; - In pursuit of a corporate purpose) Under BJR Court will Defer to actions by directors taken in good faith! Comparison: Duty of Care (Act with care of ordinary prudent person) : - Standard of conduct; - Directors are target audience; - Goal is to encourage good process. BJR (defer to actions of directors taken in good faith)- Standard of liability; - Judges are target audience; - Goal is to encourage risk taking BJR: Policy Rational- Goal 1: Encourage directors to consider risky strategies (Reason: - Shareholders want directors to take risks because of the potential for higher profit (shareholders are protected from risk through diversification) - Incentive: Limit potential personal liability of directors (otherwise risks have mostly downsides for directors) - Decision Guide: Courts should avoid second-guessing directors ). 2. Policy Goal 2: Encourage informed decisions (discourage sloppy procedures) Incentive: - Allow personal liability in some cases; - Decision Guide: Directors should follow minimum procedures; - Rule - Courts should not review substance of boards decisions unless the decision-making process is unsound Triggers for Review: Breach of Duty of Care- Facts suggest a failure to gather requisite information - Apply gross negligence standard Breach of Duty of Loyalty: Facts suggest a conflict of interest; - Apply duty of loyalty standards; - Special situations; - Oversight cases lack of board decision; - Mergers and acquisitions Basic fiduciary duties: Duty of Care/Good Faith: acting on informed basis and in a deliberate manner Duty of Loyalty: acting without self-interest (financial or otherwise) Grades of deference: BJR- Enhanced scrutiny- entire fairness. Caremark: Standard of Conduct: - exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility. - only 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 exits will establish the lack of good faith that is a necessary condition to liability. Why Caremark was a big deal? - The specter of potential liability for cases in which low-level employees had caused great harm to corporations even if the prospect is remote set off shock waves in boardrooms - The response was to implement compliance programs - Is Caremark really about loyalty or care? Disney: Why Bad faith? - DGCL 102(b)(7)(b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: (7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law What is Bad Faith? A. Traditional corporate law: - Illegal; - Fraudulent; - Ultra vires B. Bad faith as substantive due care : - Allen: theoretical possibility of liability for egregious decisions ; - Veasey: Due care in the decisionmaking context is process due care only C. Bad faith as irrationality - Veasey: Irrationality may tend to show that the decision is not made in good faith BJR: Aronson v. Lewis (1984) - Presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Rebutting the BJR: Before Trial: - Allege facts sufficient to support a finding that the board of directors violated the duty of care, the duty of loyalty, or the duty of good faith; But: the Delaware Supreme Court has held that where a corporation has an exculpatory provision and the plaintiffs file a complaint that contains only a duty of care claim, the court will dismiss the compaint because the plaintiffs cannot recover monetary damages from the defendants. Or, stated another way, to survive a motion to dismiss, a complaint must allege a breach of the duty of loyalty or the duty of good faith. At Trial: Prove facts sufficient to support a finding that the board of directors violated the duty of care, the duty of loyalty, or the duty of good faith (Emerald Partners: "If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule operates to provide substantive protection for the directors and for the decisions that they have made.")

If BJR is rebutted: Before Trial: complaint withstands a motion to dismiss At Trial: A. Burden shifts to the defendants to show that the challenged transaction was entirely fair; B. What if plaintiff's case rested solely on a breach of the duty of care and corporation has an exculpatory provision? When entire fairness is the applicable standard of judicial review, this Court has held that injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair. A fortiori, the exculpatory effect of a Section 102(b)(7) provision only becomes a proper focus of judicial scrutiny after the directors' potential personal liability for the payment of monetary damages has been established. Accordingly, although a Section 102(b)(7) charter provision may provide exculpation for directors against the payment of monetary damages that is attributed exclusively to violating the duty of care, even in a transaction that requires the entire fairness review standard ab initio, it cannot eliminate an entire fairness analysis by the Court of Chancery. Forms of disloyal conduct: Competition- employee engages in direct competition with the employer ; Misappropriation - of the employer s profits, property, or business opportunities; Disclosure - breaches employers confidences and discloses or uses confidential information; Two Employers - Intentionally acts adversely to interests of one employer for the benefit of another employer. Self-Dealing: Self-dealing occurs when the corporation enters into a transaction with a director - Varied transactions ranging from sale of property to provision of services - May be direct or indirect (indirect includes transactions with relatives, other entities in which the director has a financial interest, and interlocking directorates) - Includes cases where executive determines her own compensation - Fundamental principle is that the decision making process is tainted - Two possible solutions: cleanse the process or look at substance What is bad faith Three candidates: 1. Subjective bad faith = actual intent to do harm - That such conduct constitutes classic, quintessential bad faith is a proposition so well accepted in the liturgy of fiduciary law that it borders on axiomatic. ; 2. Lack of due care - The conduct that is the subject of due care may overlap with the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct. 3. Intentional dereliction of duty, a conscious disregard for one's responsibilities - Fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed. - Section 102(b)(7) distinguishes between intentional misconduct and a knowing violation of law (both examples of subjective bad faith) on the one hand, and acts ... not in good faith, on the other. Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for acts ... not in good faith must encompass the intermediate category of misconduct captured by the Chancellor's definition of bad faith. Stone v. Ritter: - Delaware Supreme Court embraces Caremark and connects it to Disney - Key Disney passage on bad faith: A failure to act in good faith may be shown where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties - Holland: This behavior is fully consistent with, the lack of good faith conduct that the Caremark court held was a necessary condition for director oversight liability. - Huh? Caremark was supposed to be about unconsidered inaction - Implications: - Good faith is a subsidiary element of the duty of loyalty - Although 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. - The fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. New Caremark: Holland: We hold that Caremark articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith. Disney: Lack of Good Faith - Intentional failure to act in the face of a known duty to act - Demonstrates a conscious disregard for his/her duties Stone v. Ritter: Good faith is a subsidiary element of the duty of loyalty. Good faith does not establish an independent fiduciary duty .Duty of loyalty - Cases involving a financial or other cognizable fiduciary conflict of interest - Cases where the fiduciary fails to act in good faith New Caremark: Director Oversight Liability (KNOWLEDGE): 1. Imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations; 2. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith 2 OPTIONS - Directors utterly failed to implement any reporting or information system or controls OR - Directors implemented a system or controls BUT consciously failed to monitor or oversee its operations - thus disabling themselves from being informed of risks or problems requiring their attention Aronson v. Lewis (1984)- Presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. BJR: Before Trial: - Plaintiffs Must Allege facts sufficient to support a finding that the board of directors violated the duty of care or the duty of loyalty PLUS financial loss - If successful, complaint withstands a motion to dismiss At Trial: - Plaintiffs Must Prove facts sufficient to support a finding that the board of directors violated the duty of care or the duty of loyalty - If successful, Burden shifts to the defendants to show that the challenged transaction was entirely fair DGCL 144(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director's or officer's votes are counted for such purpose, if: (1) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or(2) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the shareholders; or(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.Leslie, Partners must treat each other with utmost good faith and loyalty. - Was there a legitimate business purpose for actions. - Maj: yeas there was a business purpose, minority said: it could be done in a less harmful manner. - Rule: need to balance business purpose with possibility of doing it in a less harmful manner.Gagliardi: As a general rule: individual directors are not responsible for bad decisions and business losses, as far as they did not acted in a bad faith. Smith, Duty of care and business j.r. in a context of fundamental transaction.Directors breach their fiduciary duty to their stockholders by: 1. their failure to inform themselves of all information reasonably available to them and relevant to their decision to recommend a merger; 2. by failure to disclose all material information such as a reasonable stockholder would consider important in deciding whether to approve the offerIf it is uninformed decision- cannot use BJR. What is gross negligence.Caremark, Failure to monitor. If directors knew or should have known that employees are violating the law and did not take good faith efforts to prevent or stop it.If there is a systematic failure to exercise monitoring individual directors can be liable. If there was a breach of duty of care and directors do at least something- it is ok. The standard to defend the directors/board is very low. The board must do at least something.Shareholders sued, board settled by providing some additional oversight. If they establish a system but did not Creating compliance system alone does not mean that there is no need to monitor the compliance. proximate cause must be shown by P. Disney, The role of good faith. Where it fits with duty of loyalty.Rule 109 in DE.Court: directors did not breach their duty of care.4 factors of bad faith.Due care and bad faith are separate grounds for denying BJR review.Stone v. Ritter, The role of good faith.Good faith is not a separate fiduciary duty, but just a subsidiary of duty of loyalty.Breach of duty of care: Systematic failure to monitor is breach as well.There must be knowledge to have a breach.If director knows they breach duty of care it is in itself a breach of duty of loyalty.Duty of care is something to influence behavior. Duty of loyalty- entire fairness standard.