Why 102(b)(7) Matters

I wanted to follow up on an earlier post, Triggering Revlon with Nonconvertible Debt.  In the last paragraph of that post I noted that Lyondell reminds us that good faith claims are very hard to win.  Stefan Padfield (Business Law Prof Blog) wrote me to remind me that the presence of an optional 102(b)(7) provision in the certificate is what is really motivating the good faith litigation.

It's Friday, and the last day of exams in many places, so it's probably worth quickly walking through why 102(b)(7) matters and the role it's playing in many of these cases, like Binks.

In Van Gorkom the court found directors had breached their duty of care when - among other things - they approved a merger agreement without adequately informing themselves of the agreement's contents.  The directors in that case had to pay damages.   The response to this decision was swift.  Delaware adopted Sec. 102(b)(7) which permits corporations to include provisions eliminating monetary damages for director for any breach of fiduciary duty.   This limitation on personal liability is subject to certain conditions.  A corporation may not eliminate liability for any of the following:  

(i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit.

This language basically tells you that with a 102(b)(7) provision in its certificate there are no monetary damages for Van Gorkom-like violations of the duty of care. Where there is only a care claim at stake and where plaintiffs are only seeking monetary damages, then courts will permit defendants to raise 102(b)(7) as an affirmative defense and will dismiss these cases at the earliest possible moment.

Now, the drafters 102(b)(7) could have just said a corporation may only eliminate liability for monetary damages for any violation of the director's duty of care, but they didn't.  What they did was create some unintended ambiguities that created an opportunity for creative plaintiff counsel to bring new claims.  In this case, the language that does not permit exculpation of acts not in good faith became a license for new claims.  The plaintiff’s strategy in the face of a 102(b)(7) provisions was to take an act by an otherwise independent and informed board that should by all rights be a care claim and convert it into a claim for which there might be the prospect of monetary damages.  By arguing that directors acted in bad faith, it might be possible to convert a care claim into a claim for damages.  Plaintiffs made that argument with gusto.  

However, in Stone v Ritter, the court started to put the brakes on such claims by endorsing Caremark and placing these good faith claims clearly in the realm of the duty of loyalty.  

In Lyondell, the plaintiffs again made an argument that an otherwise independent board had violated its fiduciary duties when it agreed to sell the company.  Plaintiffs argued that the board’s failure was not one of care, but that they had acted in bad faith.  Had this argument won the day, the action would have survived summary judgment and what would otherwise be an exculpable care claim would have been converted to a loyalty claim for which monetary damages would be available. 

The court in Lyondell recognized that there may be some violations of a director’s duty of care – for example a failure to act in the face of a known duty – that can rise to the level of acts not in good faith.  However, in order to make the magical conversion from an exculpable care claim to a non-exculpable loyalty claim, the facts must be extreme.  That’s where the court’s language “utter failure” comes into play.   To convert a care claim to a loyalty claim, a board would have to utterly fail to act in the face of a known duty. 

It’s hard to utterly fail.  I mean, you really have to try.  Think about how malleable the Revlon standard is.  There is no single blueprint to guide a board on how to fulfill their obligations under Revlon.  In the face of several reasonable alternatives, a court is not going to step in and tell an informed and disinterested board that it picked the wrong one.  It’s hard to imagine how a well-advised board would ever run afoul of Revlon's reasonableness standard to such a degree that it utterly fails.  I guess it could happen, but it’s not going to happen very often.

Is it Summer already?

-bjmq