How to Define "Bad Faith" for a Board

Bad faith conduct in the boardroom is the fiduciary version of kryptonite; of Samson with shorn locks. Evidence of bad faith can rob the board of its traditional protections against breach of duty: the business judgment rule; exculpatory and indemnification protections provided through corporate bylaws, insurance policies, and statute; the ability to overcome preliminary motions in litigation; and the general deference afforded decisions of an informed and well-intentioned board. It’s a concept with which the attentive board will want to be familiar.

But a practical definition of bad faith conduct can be elusive; judicial decisions rarely describe it in terms of specific examples. Often, they speak to conduct that doesn’t constitute bad faith, as opposed to conduct that does. Perhaps that’s because the standard for proving bad faith conduct is so high that it’s hard to find judicially sanctioned examples. That makes it fairly tough for the corporate counsel, when asked to describe what might constitute “bad faith” in a specific context.

Inquiring minds—and board members—want to know, and offering up examples of good faith conduct won’t help those who quite reasonably seek a better understanding of the fiduciary foul lines.

The in-house counsel’s “desktop definition” of bad faith will include Lyondell v. Ryan and Stone v. Ritter-type themes: e.g., “failure to act in the face of a known duty to act”; and the “conscious disregard” of the duties to be reasonably informed of the business and its risks, and to exercise reasonable oversight. Pretty serious stuff, indeed—but practically, what action (or inaction) actually reaches this level? On what basis may counsel reasonably warn client boards on the real risks of problematic conduct?

So, it’s quite the “yellow highlighter moment” when a series of unrelated Delaware and federal decisions, all released within the last several months, separately tackle the question of conduct that rises (or falls, depending upon your perspective) to the egregious level of bad faith—with all of its implications. These new cases will certainly help corporate counsel offer meaningful guidance to board members who want to know where the “third rail” of director conduct might be located. So, they may be worth a five-minute board briefing, at the very least.

One of these decisions arose in the context of the board’s consideration of a proposed sale of the company. Another arose in the context of the exercise of the board’s Caremark obligations. And a third arose in the context of the financial demise of a well-known health care facility. Collectively, these cases offer a platform from which corporate counsel can have more substantive, practical conversations with the board on conduct that might trip the “bad faith” wire—and that which might not.

In re Novell, Inc. S’holder Litig

With In re Novell, Inc. S’holder Litig, it was substantive allegations in the context of a sale process that the board unfairly favored one bidder over another. Here, the Delaware Court of Chancery denied a motion to dismiss a shareholder derivative action that alleged that the Novell board acted in bad faith by allowing the sale of Novell to another company. Specifically, the plaintiffs alleged that the board provided the ultimate purchaser with information about competing bids without doing the same for another bidder. Had it done so, it was possible that the other bidder may have increased its own offer for the company. Citing Stone v. Ritter, the Court stated that bad faith could arise in the context of a sale of the business where the board acted with a purpose other than pursuing shareholder interests by seeking the best sale price. While the Court expressed uncertainty as to whether an actual breach of duty had occurred, it acknowledged that it was reasonably conceivable on the basis of the pleadings that a breach (i.e., preferential treatment of bidders) had occurred.

Rich v. Chong