Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (Introduction) (Part 1)
It is traditional to attribute to the board of directors a duty of care and loyalty (with good faith a subcategory of loyalty). Violations of the duty of care typically involve allegations of mismanagement (and resulting harm to shareholders) in circumstances that do not involve conflicts of interest.
For all intents and purposes, the duty of care no longer exists in any meaningful way. Back in the days of Van Gorkom, there was some notion that boards had to meet a minimum standard of behavior to fulfill their fiduciary obligations under the duty of care. Van Gorkom is no longer good law, in fact or in practice, having effectively been reversed by Disney. Moreover, the presence of waiver of liabilty provisions has eliminated any hope of damages whenever a breach does occur. The ubiquitous nature of the provisions has been chronicled in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.
The approach is unfortunate but has a certain logic. In cases without a conflict of interest, it can be assumed that the board for the most part acted in a way that it thought was in the best interests of shareholders. In those circumstances, liability arises not because of a suspect motive but because of inadequate information or deliberation. Imposing liability in those circumstances could cause boards to act in a slower, more bureacratic fashion or may encourage them to become risk averse. It is possible that these harms outweigh the benefits of elevating the board's standard of behavior.
The same reasoning is not, however, applicable to the duty of loyalty. Where a conflict of interest exists in the approval process, there is always a risk that the final terms will not be in the best interests of shareholders but in the best interests of the fiduciary with the conflict. Heightened standards seek to reduce the risk that this will occur. Moreover, loyalty transactions are only a small part of the board's activities. Thus, while they may result in a slower process, they will not affect a significant number of board decisions.
Despite these concerns, the courts in Delaware have gradually weakened the duty of loyalty. It does not apply, for example, where the benefits are shared pro rata among shareholders. This is the case despite the fact that even a shared transaction can be a result of a conflict of interest and be disadvantageous to the company or minority shareholders.
Similarly, executive compensation involves a clear conflict of interest when paid to someone who also serves on the board. Nonetheless, the courts have found that the duty of loyalty is rendered inapplicable if the compensation is approved by a board consisting of a majority of independent directors. The approach ignores the presence of the conflict of interest in the decision making process and treats independent directors as if they were truly independent, an often questionable assumption. See Returning Fairness to Executive Compensation.
The latest blow to the duty of loyalty came in In re El Paso Securities Litigation. The court found sufficient allegations to establish a number of conflicts of interest in the merger approval process. Yet when it came time to impose sanctions, the court acknowledged that a suit for damages was unlikely to be an adequate remedy but declined to issue any injunction. The result, as we will discuss in the upcoming posts, was a violation without remedy.
Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.