In all aspects of corporate life—from creation to expansion and from restructuring to demolition—experts are available to advise directors, managers, shareholders, financiers, and other participants. In particular, directors often rely on, for example, accounting firms to review financial statements, attorneys to assess the legality of dividends, compensation consultants to assess the fairness of bonuses, rating agencies to rate debt, investment banks to advise on transactions, and a variety of analysts.
Corporate laws typically contain “reliance provisions,” which entitle directors and, sometimes, officers to rely on experts and, therefore, avoid liability, as long as certain requirements are met. In my article, I focus on Section 141(e) of the Delaware General Corporation Law, according to which directors are entitled to rely on the advice of experts as long as they believe that the advice was within the expert’s professional competence, the expert was selected with reasonable care, and reliance is in good faith.
Good faith, as one would imagine, is the most important but also the trickiest requirement. In Section 141(e), unlike under, say, Australian law, there is no requirement to make an independent inquiry into the reports submitted by experts. However, under the groundbreaking decision of Smith v. Van Gorkom, the board is “entitled to good faith, not blind reliance.” In my article, I argue that Delaware court opinions are particularly useful in understanding the concept of good faith in Section 141(e). According to these holdings, bad faith entails the conscious disregard of duties or otherwise clearly egregious behavior, and does not extend to instances in which one “should have known” the consequences of the behavior at issue. In addition, in the Caremark case the Delaware Court of Chancery substantially narrowed the oversight duties of boards, ruling that a “sustained or systematic” failure to monitor is required for liability.
Clearly, directors are not required to familiarize themselves with the substance of the reports they receive and act as experts in accounting, finance, or the law. If, of course, they consciously disregard their duties or systematically fail to monitor red flags, the reliance defense is inapplicable. Furthermore, they do not act in good faith if they learn through, for example, their own expertise or an employee’s tip that the advice is incorrect, or if they accept only favorable advice and reject other opinions.
Section 141(e) does not come into play as often as one might imagine. Directors are often shielded from personal liability by the business judgment rule, the Section 102(b)(7) exculpatory clause, indemnification, and D&O insurance, among other things. Nevertheless, Section 141(e) can be useful for a director in the context of conflicted transactions or gross negligence in the information gathering process when there is no Section 102(b)(7) protection. While this is the case in ordinary business decisions, different standards apply in the context of change of control transactions. These standards apply even if the conditions for properly relying on experts are met.
The good faith requirement in Section 141(e) does not, of course, cover all circumstances. In determining whether reliance on experts is reasonable, a court should weigh all relevant information, especially the expertise of the director, the magnitude and nature of the misbehavior, the expert selection process, and the efforts to understand the expert’s opinion.
This post comes to us from Alexandros Rokas, adjunct lecturer at the Aristotle University of Thessaloniki. It is based on his paper, “Reliance on Experts from a Corporate Law Perspective,” available here.