The Defining Role of Good Faith

The Harvard Program on Corporate Governance has issued a new discussion paper entitled “Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law.” Co-authored by Leo E. Strine, Jr., who is Vice Chancellor of the Delaware Court of Chancery and Senior Fellow of the Program of Corporate Governance, and by Lawrence A. Hamermesh, R. Franklin Balotti and Jeffrey M. Gorris, the paper examines the role of good faith in corporate law, and its use as the key element in defining the state of mind that must motivate a loyal fiduciary. Employing an historical, etymological, and policy-oriented analysis, the authors address the particular question of whether the obligation of directors to act in good faith is a separate, free-standing fiduciary duty, or a core aspect of the duty of loyalty.

In the paper, the authors outline their views as follows:

We conclude, consistent with the Delaware Supreme Court’s recent decision in Stone v. Ritter, that in the American corporate law tradition, the basic definition of the duty of loyalty is the obligation to act in good faith to advance the best interests of the corporation. What this article also shows is that the duty of loyalty has traditionally been conceived of as being much broader than the duty to avoid acting for personal financial advantage. The duty of loyalty also precludes acting for unlawful purposes, and affirmatively requires directors to make a good faith effort to monitor the corporation’s affairs and compliance with law.

The authors analyze arguments in favor of a free-standing duty of good faith separate from the duty of loyalty. While conceding the importance and enduring relevance of the duty of good faith, the authors see no basis to conclude that the traditional place of good faith — as the definition of a loyal state of mind — should be altered. Doing so to make room for such a separate duty would add confusion not clarity, the authors argue. In so stating, the authors acknowledge and discuss circumstances when the duty of loyalty remains most difficult to apply.

The paper also emphasizes a critical policy implication resulting from Stone v. Ritter – “that an independent director who is accused of having failed in her monitoring duties may only be held liable if a court finds that she breached her duty of loyalty by consciously failing to make a good faith effort to comply with her duty of care.” The authors explain that “by requiring a finding of bad faith before imposing liability on an independent director, the corporate law, as explicated by Stone, protects the policy interests underlying the business judgment role from erosion.”

The paper is available here.