By James Hamilton, J.D., LL.M.
In a seminal landmark ruling, the Delaware Supreme Court has affirmed the Caremark standard for director oversight liability and ruled that the duty of good faith is a subsidiary of the duty of loyalty. Thus, the court answered the question it had reserved in the Walt Disney case by holding that the fiduciary duty to act in good faith is a duty that, unlike the duties of care and loyalty, cannot serve as an independent basis for imposing liability upon corporate officers and directors. (Stone v. Ritter, No. 93, 2006)
Although good faith had previously been described as part of a triad of fiduciary duties, along with due care and loyalty, the court made clear that 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 only do so indirectly.
In this derivative action that hinged on the futility of demand, the court held that, in the
absence of red flags, good faith in the context of corporate oversight must be measured by the directors’ actions to assure the existence of a reasonable internal system of information and reporting, and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome.
A corollary to the holding that good faith is not an independent duty is the fact that the 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.
With regard to Chancellor Allen’s ruling in Caremark, the court said that it 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.