On June 8, 2006, the Delaware Supreme Court upheld the lower court’s decision in favor of the directors of The Walt Disney Company. Plaintiffs had claimed that the directors had breached their duty of care in approving an employment agreement with Michael Ovitz, which permitted Ovitz to receive a $140 million severance payment just 14 months after he joined the company. The lower court concluded that the defendant directors who had approved the terms of Ovitz’s employment agreement “did not act in bad faith, and were at most ordinarily negligent,” which was insufficient to constitute a breach of the duty of care. The Supreme Court held that the lower court’s “factual findings and legal rulings were correct and not erroneous in any respect.”

The Supreme Court’s decision addresses an area of Delaware corporate law that had been plagued by some uncertainty. Delaware Supreme Court has identified a “triad” of fiduciary duties governing the conduct of officers and directors: the duty of loyalty, the duty of care and the duty of good faith. In recent years, courts and commentators have questioned whether the duty of good faith is a standalone duty, or whether it is part of the two other duties of loyalty and care. For example, a director who acts disloyally clearly also is acting in bad faith. But is a director who acts with gross negligence — in other words, in breach of the duty of care — necessarily also in breach of the duty of good faith? The Supreme Court recognized that “the duty to act in good faith . . . to date is not a well-developed area of our corporate fiduciary law” and decided to provide “some conceptual guidance to the corporate community” on this subject.

The Supreme Court confirmed that the duty of good faith involves considerations separate and distinct from the duty of care. The Court observed that “conduct motivated by an actual intent to do harm” is a “quintessential” breach of the duty of good faith. Conduct “at the opposite end of the spectrum,” i.e., “action taken solely by reason of gross negligence and without any malevolent intent,” is not a breach of the duty of good faith. The Court noted that while “issues of good faith are (to a certain degree) inseparably and necessarily intertwined with the duties of care and loyalty,” in the “pragmatic, conduct-regulating legal realm which calls for more precise conceptual line drawing, the answer is that grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith.” This distinction, the Court explained, is significant because Delaware law distinguishes between good and bad faith breaches of the duty of care in applying the exculpation provisions of Section 102(b)(7) and the indemnification provisions of Section 145 of the Delaware General Corporation Law. Thus, exculpation and indemnification may be available if a director has committed grossly negligent conduct, but has not acted in bad faith. Finally, the Court confirmed that a conscious disregard of directorial duties is an act of bad faith, not just a breach of the duty of care, and thus outside the scope of protection offered by Section 102(b)(7) and, potentially, Section 145.

This decision should put to rest any doubt regarding the existence of the separate duty of good faith. It is safe to assume that plaintiffs will redouble their efforts to expand liability under this element in order to, among other things, avoid the potentially dispositive effect of exculpation from liability under Section 102(b)(7).

For further information, please contact John Stigi at (213) 617-5589.