Bad Faith and Exculpating Gross Negligence: McPadden v. Sidhu

In McPadden v. Sidhu, No. 3310-CC, 2008 Del. Ch. LEXIS 123 (Del Ch. Aug. 29, 2008), the Delaware Court of Chancery held the board of directors of i2 Technologies, Inc. (“i2”) grossly negligent in the sale of Trade Services Corporation (“TSC”). The exculpatory provision in the certificate of incorporation, however, shielded the board from liability but the officer who coordinated the sale did not have the same protection.

In June 2005, i2 sold TSC, a wholly owned subsidiary, to Trade Services Holdings, LLC (“TCH”) for $3 million. i2’s board gave authority to Anthony Duberville (“Duberville”), an officer of i2, to manage the sale. In carrying out the sale, Duberville only contacted three potential buyers, none of which were competitors of TCS. Most notably, Duberville did not contact the sister companies VisionInfoSoft and Material Express.com (VIS/ME), which had previously offered to pay upwards of $25 million for TSC. Both Duberville and the i2’s board of directors knew about the VIS/ME offer.

Just prior to the board’s decision to sell TSC, i2’s investment banker Sonenshine Ventures presented a revised valuation memorandum that changed TSC’s value from $6 to $10.8 million to a much lower figure of $3 to $7 million. Duberville was TCH’s principle owner at the time of the offer for TSC, and i2’s board of directors knew of his relationship. Two years after the sale, VCH resold for $25 million. Plaintiffs claimed, among other things, that i2’s board of directors and Duberville breached fiduciary duties of care and loyalty.

The Chancery Court found the board knew or reasonably should have known about Duberville’s relationship with TCH, the previous offer from VIS/ME for $25 million, and the dramatic differences in the Sonenshine Venture memorandums. The court held that plaintiff’s pleadings cast doubt about the board’s business judgment because these facts were “so obvious that the board’s failure to consider it was grossly negligent.” This doubt sufficiently demonstrated demand futility for the plaintiff’s derivative action.

i2’s certificate of incorporation contained an exculpatory provision, as authorized by Delaware code § 102(b)(7), limiting liability of i2’s directors. Grossly negligent conduct, which breaches the duty of care, is exculpable under § 102(b)(7). Gross negligence is “conduct that constitutes reckless indifference or actions that are without the bounds of reason.” The court found i2’s board careless in overseeing Duberville’s selling of TSC, and therefore grossly negligent. The board’s gross negligence breached their duty of care, but the § 102(b)(7) provision exculpated the board from liability. Some conduct, such as bad faith, is never exculpable under § 102(b)(7). The court noted that the Delaware Supreme Court has carved out “intentional dereliction of duty or the conscious disregard for one’s responsibilities” as bad faith. Plaintiffs in the present case did not demonstrate the board consciously disregarded their duties, as required for bad faith. Because the exculpatory clause limits liability for the board’s breach of the duty of care, shown by the board’s gross negligence, the board was not liable.

Like a board of directors, officers owe the same duties of care and loyalty, but are not protected under § 102(b)(7) exculpatory provisions. The court held Duberville’s actions demonstrated triable violations of these duties. Additionally, the court held that the plaintiff’s claims of unjust enrichment, through Duberville’s manipulative conduct to gain the letter of intent to sell TSC to VCH, were valid. The court therefore denied the defendant’s motion to dismiss and plaintiffs may continue their suit against Duberville for breach of fiduciary duties and unjust enrichment.

The primary materials for this post are available on the DU Corporate Governance web site.