Delaware Courts and the Tolerance for Bad Faith: McPadden v. Sidhu

It was Delaware that invented waiver of liability provisions (Indiana preceded Delaware by changing the standard of fault for directors).  Delaware did so, not because of Van Gorkom, as most commentators suggest, but because of the so called "insurance crisis" and the need to encourage competent directors to serve.  The "insurance crisis" had little or nothing to do with the standard of care and the risk of director liability (the crisis arose primarily out of cyclical change in the insurance industry).  Nor was there anything but anecdotal evidence that competent directors were not serving because of fear of liability.  All of this is discussed at great length in the paper, Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.   

While waiver of liability provisions had little impact on the "insurance crisis" (something largely over by the time the law was adopted), it did provide a benefit to management by reducing the already small risk of liability for breach of the duty of care.  As the paper points out, all companies, Pepsi excepted, in the Fortune 100 have waiver of liability provisions and all of these companies waive liability to the fullest extent permitted. 

In Lyonell, a case discussed on this Blog, the Delaware Chancery Court threw commentators into a fit by suggesting that waiver of liability provisions might sometimes fail to protect a disinterested board of directors.  The Vice Chancellor in that case has assuaged all concerns by making it very clear that he intends to ultimately find the waiver of liability provision applicable and dismiss the plaintiff's case.

In McPadden v. Sidhu, 2008 Del. Ch. Lexis 123 (August 29, 2008), we see another consequence of the use of waiver of liability provisions.  In that case, the plaintiff managed to circumvent the ridiculous pleading standards imposed at the demand excusal stage by showing that the second prong of Aronson had been met.  This prong requires evidence that the presumption of the business judgment rule was rebutted.  In other words, plaintiffs must show that the board acted with at least gross negligence.  This is an extraordinarily difficult standard to meet at the pleading stage and one rarely found by the Delaware courts. 

But even with demand excusal, the plaintiff cannot necessarily move forward with his or her case.  Defendants can file a motion to dismiss, arguing that, even though the directors engaged in gross negligence, the behavior did not reach the level of bad faith.  As a result, the case must be dismissed under the waiver of liability provision.  The result is that a case meeting demand excusal standards is still  dismissed, with the plaintiff never allowed to engage in discovery.  This is exactly what happened in McPadden.

The case involved the sale of a subsidiary to the CEO, allegedly for an inadequate price.  As the opinion noted:  "The board's first step in the series of actions culminating in the sale of TSC to Dubreville was also its most egregious: tasking Dubreville with the sale process of TSC when the board knew that Dubreville was interested in purchasing TSC."  Although having done this, the board exercised little or no oversight of the sale process.  Again, according to the opinion:  "Despite having tasked a potential purchaser of TSC with its sale, the board appears to have engaged in little to no oversight of that sale process, providing no check on Dubreville's half-hearted (or, worse, intentionally misdirected) efforts in soliciting bids for TSC."  Even with the information, the board agreed to sell the subsidiary to the CEO for $3 million, despite having received a $25 million offer for the same subsidiary two  years earlier.  

Although having found at least gross negligence, the court nonetheless dismissed most of the case (save for one defendant) because of the applicability of the waiver of liability provision.  In other words, the conduct may have been gross negligence but it wasn't bad faith.    

• Thus, for the reasons explained above, the Director Defendants' actions, beginning with placing Dubreville in charge of the sale process of TSC and continuing through their failure to act in any way so as to ensure that the sale process employed was thorough and complete, are properly characterized as either recklessly indifferent or unreasonable. Plaintiff has not, however, sufficiently alleged that the Director Defendants acted in bad faith through a conscious disregard for their duties. Instead, plaintiff has ably pleaded that the Director Defendants quite clearly were not careful enough in the discharge of their duties--that is, they acted with gross negligence or else reckless indifference. Because such conduct breaches the Director Defendants' duty of care, this violation is exculpated by the Section 102(b)(7) provision in the Company's charter and therefore the Director Defendants' motion to dismiss for failure to state a claim must be granted.

In other words, the court characterizes the board's behavior with respect to a self interested transaction that may have involved the sale of the company's assets for a small fraction of their actual value, a transaction that was surrounded by warning sounds and evidence that something was amiss, as merely a failure of the duty of care.  Admittedly, in the aftermath of Disney, conscious disregard has generally been synonymous with almost complete inactivity in the face of a known duty or, as the court in McPadden noted, "the intentional dereliction of duty." But that is too cramped a view of the duty. 

Surely a board that is alleged to be consciously aware of warning sign after warning sign but disregards them and allows a self dealing transaction to go forward at potentially great harm to shareholders ought not to be exonerated from further examination through demand excusal.  Demand excusal would allow shareholders to engage in discovery and explore further the basis for the board's decisions.  Finding demand excusal would also have effectively imposed higher standards of behavior on boards of directors.  It would have sent a message to boards that, in order to avoid demand excusal in the future, additional steps and board involvement in conflict of interest transactions was necessary. 

But, of course, this is Delaware.  The desire the exonerate directors is too strong and too necessary under the race to the bottom theory of decision making.  It is, therefore, the use of waiver of liability to largely render inactionable a breach of the duty of loyalty.  It is also the use of waiver of liability to avoid setting standards of behavior for directors in conflict of interest transactions.  

Cases like these are evidence of the unwillingness of the Delaware courts to set adequate standards for director behavior.  Given these types of cases, is it really any great surprise that Congress has begun to preempt Delaware law, with provisions in SOX and the recent Bailout Bill taking such steps.