Acting badly . . .but without bad faith: recent court cases compel a new urgency by directors to ensure against any process failings when making critical decisions.

• Author: Raymond, Doug
• Position: LEGAL BRIEF

OVER 20 YEARS AGO, the case of Smith v. Van Gorkom sent shock waves through board-rooms across the country. In that case, the Delaware Supreme Court held that directors may be personally liable for damages in a stockholder law-suit if they were negligent in carrying out their duties. In response, and to reassure directors and potential directors that they had freedom to take appropriate actions without the fear of personal liability for innocent mistakes, the Delaware legislature adopted the Directors Liability Act (DLA), which has become part of the Delaware General Corporation Law.

The DLA permits a Delaware corporation, through a provision in its certificate of incorporation, to eliminate the personal liability of directors, as so long as it does not limit their liability for breach of the duty of loyalty, or for bad faith, intentional misconduct, or transactions from which directors derived an improper personal benefit. Recent Delaware court cases have raised new and disturbing doubts as to the effectiveness of the liability protection provided by the DLA exculpatory clauses.

In recent cases from the Delaware Chancery Court and the Federal Bankruptcy Court, the plaintiffs alleged that the boards of companies being sold had improperly delegated primary negotiating authority to an officer of the company, the sales were negotiated and finalized within a very short time frame, and neither a market check of the price nor a serious review of other potential alternatives had been performed by the boards. Those findings are remarkably similar to the situation 20 years ago in Smith v. Van Gorkom.

Although there were no allegations of self-interest or lack of independence, the courts found that the alleged process failures in the current cases themselves raised questions as to whether the directors had failed to act in good faith.

The focus on good faith differentiates the current cases from the situation 20 years ago. The DLA was intended to protect directors against liability for a breach of the duty of care. However, the DLA does not permit exculpation for acts or omissions not taken in good faith. Based on this exception, the courts found in the current cases that the exculpatory clauses in the corporations' charters did not protect the directors from having to defend themselves at trial.

However, in two subsequent decisions, and in further action in one of the cases described above, the Delaware Chancery Court judges have signaled that they...