Stefan Padfield sent along this email:
Just got around to reading your excellent post analyzing the possible claims against the H-P board. If you have a moment, I'd be interested to hear how you think Cede fits in the picture at this point. In other words, the last paragraph of your post seems to put a lot of weight on the difficulty the plaintiffs would have proving loss, but doesn't Cede shift the burden to defendants before that?
Great question. In my article The Convergence of Good Faith and Oversight, I explain that:
In Stone v. Ritter, 911 A.2d 362 (Del. 2006), two important strands of Delaware corporate law converged; namely, the concept of good faith and the duty of directors to monitor the corporation’s employees for law compliance. As to the former, Stone puts to rest any remaining question as to whether acting bad faith is an independent basis of liability under Delaware corporate law, stating that “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. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly.” 911 A.2d at 370. Nevertheless, this holding may not matter much, because the Stone court makes clear that acts taken in bad faith breach the duty of loyalty. As a result, instead of being split out as a separate fiduciary duty, good faith has been subsumed by loyalty. In this sense, Stone looks like a compromise between those scholars and jurists who wanted to elevate good faith to being part of a triad of fiduciary duties and those who did not, with the former losing as a matter of form, and the latter losing as a matter of substance.
As to the duty of oversight, Stone confirmed former Chancellor William Allen’s dicta in Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), that the fiduciary duty of care of corporate directors includes an obligation for directors to take some affirmative law compliance measures. In Stone, the Delaware Supreme Court confirmed “that Caremark articulates the necessary conditions for assessing director oversight liability.” Stone, 911 A.2d at 365.
But what is this Cede of which Stefan speaks? It is the Delaware Supreme Court's decision in Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 368-69 (Del. 1993), which I refer to as Technicolor. Back to the article:
... in Technicolor, the Delaware Supreme Court held that causation was not an element of the duty of care claim,[1] a ruling that the court presumably will extend to the good faith context, but that decision made no sense. At one point in that Jarndyce-like saga, Chancellor Allen ruled that plaintiff Cinerama could not prevail on its duty of care claims because it had failed to prove a financial injury caused by the Technicolor board’s alleged misfeasances.[2] In so holding, Allen relied on Barnes v. Andrews,[3] in which Learned Hand held that a shareholder-plaintiff must show not only a breach of the duty of care, but also that the performance of the director’s duties would have avoided a loss.[4] In other words, plaintiff must prove causation.
In an opinion by Justice Horsey, the Delaware Supreme Court reversed, opining it to be “a ‘mystery’ how the [Chancery] court discovered the Barnes case and then based its decision on Barnes.”[5] Perhaps Chancellor Allen found the Barnes case by glancing at virtually any major corporate law text. If so, such a glance would have demonstrated that Barnes was routinely cited as the leading authority for the well-accepted proposition that “the undoubted negligence of directors may not result in liability if the plaintiff cannot show that the negligence proximately caused damages to the corporation.”[6] Even the Emanuel’s law outline in print at the time cited Barnes for the proposition that “the traditional tort notions of cause in fact and proximate cause apply in [the duty of care] context,”[7] as did the corporation law nutshell in print at the time Technicolor was decided, which likewise cited Barnes as “the leading case” for this proposition.[8] The true mystery is why Justice Horsey failed to discover Barnes’ well-established status in corporate law jurisprudence.
Technicolor’s rejection of Barnes has had troubling systemic implications. Under Technicolor, once plaintiff rebuts the business judgment rule by proving a breach of the duty of care (which itself puts the cart before the horse[9]), the defendants have the burden of establishing “entire fairness.”[10] The court thus conflated the duties of care and loyalty.[11]
Corporate law’s “sweeping grant of authority to the board is, of course, subject to the overarching normative constraint that the directors exercise their authority with the intention of benefiting the shareholders and not themselves.”[12] Where directors have conflicted interests, accountability necessarily trumps the principle of deference to board decisions and, consequently, courts review loyalty claims under a most exacting standard.[13] In the classic case of Weinberger v. UOP, Inc.,[14] for example, the court described the entire fairness standard as placing on the defendant directors the burden of proving, subject to “careful scrutiny by the courts,” “their utmost good faith and the most scrupulous inherent fairness of the bargain.”[15]
The concept of entire fairness, however, has little relevance to either a duty of care case or one involving bad faith. First, as noted above, the relevant factual issues go not to fairness but to errors of judgment and resulting damages. Second, invocation of entire fairness carries with it important remedial implications. In Weinberger, the court had authorized the use of “any form of equitable or monetary relief as may be appropriate, including rescissory damages” in loyalty cases. By conflating the loyalty and care analyses, Technicolor extended this broad grant of remedial authority to care claims, with bizarre consequences. Rescissory damages make sense in a loyalty case like Weinberger, because the wrongdoer was also the beneficiary of the wrongdoing. The goal in such cases thus should be to ensure that the wrongdoer retains neither its ill-gotten gains nor their tainted fruits.[16] In a care case, however, an award of rescissory damages would have the effect of ordering the defendant directors to return a benefit that they never received. By definition, there are no ill-gotten gains to be recouped.
The same considerations apply to claims alleging a breach of the “duty” of good faith that do not involve an improper benefit to the defendant(s). Barnes thus should govern such cases. By subsuming good faith into the duty of loyalty, however, Stone makes it doctrinally even more difficult to require causation, while simultaneously creating a conceptually difficult task of crafting appropriate remedies.
As such, Stefan's got a perfectly correct critique; namely, that causation seems not to be an element of the Delaware claims discussed in my earlier post, although it damned sure ought to be. Even the great Homer nods, and this is one area where the Delaware Supreme Court definitely nodded off.
I suspect that the Delaware courts would have fixed this problem to restore a requirement that plaintiff show a causal link between the breach and damages but for the fact that actual monetary liability is so rare. The net effect of the doctrinal high barriers to care/oversight liability, exclupatory clauses, and settlements means that courts almost never get to the point of actually having to award damages for a breach of the duty of care.
[1] Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 368-69 (Del. 1993).
[2] Cinerama, Inc. v. Technicolor, Inc., 1991 WL 111134 at *3 (Del. Ch. 1991), rev’d sub nom., Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993).
[3] 298 F. 614 (S.D.N.Y. 1924).
[4] Cinerama, 1991 WL 111134 at *3.
[5] Technicolor, 634 A.2d at 370.
[6] Robert C. Clark, Corporate Law 126 (1986).
[7] Steven Emanuel, Corporations 128 (1989).
[8] Robert W. Hamilton, The Law of Corporations (3d ed. 1991).
[9] See supra note 25.
[10] Technicolor, 634 A.2d at 361.
[11] See generally Michael P. Dooley, Fundamentals of Corporation Law 249-54 (1995) (criticizing Technicolor). For a careful demonstration that Technicolor’s importation of entire fairness into the duty of care was a doctrinal novelty, see Lyman Johnson, Rethinking Judicial Review of Director Care, 24 Del. J. Corp. L. 787, 799-801 (1999). Johnson concludes there is “no clear and reasoned prior authority” supporting Technicolor in this respect. Id. at 801.
[12] Dooley, supra note 177, at 250.
[13] See supra notes 49-50 and accompanying text.
[14] 457 A.2d 701 (Del. 1983).
[15] Id. at 710.
[16] Dooley, supra note 177, at 256.
