There are four forms of corporate bad faith: intentional misconduct, knowing violation of law (Massey), violation of the duty of oversight (Caremark), and corporate waste. Each is a distinct theory of the case in a cause of action for “bad faith.” The four forms appear to be an archipelago of discrete rules fashioned for specific contexts and classified under the common moniker “bad faith.” But beneath the apparent discreteness of these rules is a unifying theory of bad faith that binds them in a cogent doctrine: The fiduciary rule of good faith in corporate law is an equitable gap filler—it is a residual, anti-evasion principle.
Anti-Evasion and First Order Principle of Bad Faith
Bad faith plugs major holes in the traditional fiduciary framework of care and loyalty. The duty of care encompasses the decision-making process, and the classic duty of loyalty encompasses an exacting but narrow spectrum of conflict-of-interest dealings. The doctrine of good faith functions as an equitable gap filler such that a fiduciary cannot evade liability for knowingly engaging in any wrongful act.
A helpful starting point is the laws of partnerships and LLCs. Noncorporate firms are contract-based entities, and their laws have adopted the contractual obligation of good faith and fair dealing into the standard of conduct. Even when contracting is central, good faith is a nonwaivable statutory-contract term and covers gaps that neither party anticipated at the time of organizational contracting. Corporate law is different. It has no concept of a contractual good faith. Because fiduciary duties are mandatory, corporate good faith is a tort-like fiduciary duty.
Despite the fundamental difference between contract and torts, there is a conceptual commonality: Both rules of good faith serve the same anti-evasion function, precluding a party from technically satisfying a narrower obligation while defeating the very purpose that obligation was designed to serve. Corporate good faith thus functions as a gap filler, not in contract but in equitable tort duty: The fiduciary duty of good faith is a residual, anti-evasion principle.
The four forms of bad faith are not an archipelago of discrete rules, but instead they are bound by a first-order principle, which is embodied in the statutory proscription of “intentional misconduct.” Subjective bad faith is the organizing principle and serves as the catch-all rule and incorporation of the anti-evasion principle. The other three forms of bad faith (Massey, Caremark, and waste) are derivative second-order rules, context-specific and addressing recurring forms of misconduct.
Knowledge of Wrong as Minimum Scienter
The doctrine of corporate bad faith can be confusing because lawmakers have applied so many different terms to describe conduct and scienter. We know them well: “subjective bad faith,” “intentional misconduct,” “knowing violation of law,” “actual intent to do harm,” “intentional dereliction of duty,” “utter failure,” “sustained or systematic,” “conscious disregard for one’s responsibilities,” and “purpose other than that of advancing the best interests of the corporation.” This cornucopia of language clouds more than clarifies.
The theory and practice would be better off decluttering this lexical stew into a simple principle. A theory of bad faith reduces the essential wrong as this: A fiduciary commits bad faith when she has knowledge, actual or constructive, of the wrongful nature of her act or omission. For example, if a fiduciary knowingly violates the law, disregards his compliance duty, engages in misconduct, or transacts an irrational deal, he indubitably commits bad faith. Knowledge is the minimum scienter required for all four forms of bad faith, and this scienter distinguishes conduct (such as negligence or bad decisions) from misconduct (knowing wrongdoing).
Public and Private Bad Faith
The taxonomy of bad faith and the minimum scienter of knowledge reveal important theoretical implications. The four forms of bad faith can be classified into two distinct types: private bad faith and public bad faith. The difference lies in the nature of the harm to the corporation.
Private bad faith principally protects against harm to the corporation’s economic interest. Public bad faith protects against harm to the corporation’s noneconomic interest. A corporation has a fundamental obligation to obey the rules of society. Any act that subverts this obligation harms the corporation in law. Public bad faith comprises Massey and Caremark. The nature of Massey is obvious. Caremark concerns the board’s oversight obligation as it is tethered to the rules of society, an obligation imposed by an external source of legal or law-endowed authority.
Summarized, the legal topology of bad faith is shaped by two factors: (1) the nature of the harm (private or public harm), and (2) the specificity of the rule (context-specific rules or residual catch-all rule).
Waste, Massey, and Caremark claims are context-specific forms of bad faith. Because waste occurs in the transactional context, it is a pure form of private bad faith. Because Massey and Caremark are anchored in external obligations, they are forms of public bad faith. Subjective bad faith is the catch-all rule and can remedy other instances of private or public bad faith.
Why does this private–public dichotomy matter at all? There are three reasons. (1) The dichotomy illuminates our understanding of the legal architecture of the bad faith, answering questions such as: What is the purpose and policy structure of the rule? How does the rule work? (2) The dichotomy is consequential at the level of practice because it should influence the theory of the case brought before a court. Differences in rules, categorized under the dichotomy, could produce different outcomes at the margin. (3) The dichotomy recognizes a public facet of a manager’s obligation through an internal duty under the fiduciary framework. It thus creates conceptual space for corporate ethics and social responsibility internally from within corporate law.
Category Errors and Corporate Litigation
The theory of bad faith can have pragmatic implications on corporate litigation at the margin. A specific example is Lyondell Chemical Co. v. Ryan. To escape the duty of care and exculpation, the plaintiff theorized the case as a Caremark violation. The Delaware Supreme Court recognized the potential viability of a bad faith claim under Caremark in the context of board oversight of an M&A deal. However, because Caremark is a form of public bad faith and an M&A deal is a private transaction, Caremark should not have applied in the Lyondell context as a matter of law.
Of course, I do not suggest that there is no bad faith theory of a failure of oversight. That cause of action lies in subjective faith: viz., a fiduciary knowingly failed to exercise his duty of oversight, which is a definition of misconduct. The practical difference between the two theories of the case—Caremark or subjective bad faith—is a difference in focus.
When Caremark is the theory of the case, the critical inquiry must be on the actus from which scienter is inferred: “utterly failed to implement any reporting or information system or controls” or “consciously failed to monitor or oversee its operations.” Only upon a complete failure (“utter” or “systematic”) can a court infer or impute knowledge from the act or omission. On the other hand, when subjective bad faith is the theory of the case, the critical inquiry must be the mens first—a fiduciary’s knowledge of the failure of oversight. A classic case of such failure and constructive knowledge thereof is the old chestnut Francis v. United Jersey Bank. Knowledge requires a level of confidence in the outcome that is “substantially” or “practically” certain. This difference in focus could produce a sliver of difference in results at the margin.
Public Bad Faith and Corporate Social Responsibility
The dichotomy between private and public bad faith also matters to demonstrate the link between corporate law and corporate social responsibility. Public bad faith is the legal principle that connects the corporation’s activities most directly to the public interest. This principle is no more remarkable than the idea that the corporation, as a creature of law and beneficiary of large legal–political endowments, must comply with the rules of society. This axiom of corporate law has near universal acceptance. Massey and Caremark embody this social obligation. Massey represents the smaller set of bad faith cases, which comports with the intuition that outright lawbreaking is relatively fewer. Caremark is the more consequential contested space.
The principle of public bad faith is already found in corporate law: Consistent with the rule of Caremark, the doctrine of good faith, per the duty–sanction framework of the fiduciary rule, may serve as a legal instrument for shareholder enforcement of obligations that the corporation owes to the public so long as those obligations are imposed on the corporation by an external source of legal or law-endowed authority. This principle of public bad faith simply reflects back the principle of Caremark as a limited incorporation of expressed political and democratic values into corporate fiduciary rule.
Concluding Thoughts
A unified theory of corporate bad faith exists. The heart of bad faith is not a series of discrete instrumental rules and standards that apply situationally in contextualized facts. At the core bad faith is the simple general principle of liability upon culpability: an actus (act or omission) coupled with a mens (state of mind). The doctrine of bad faith is fundamentally a residual principle, an anti-evasion rule that has spawned different rule forms. The rule has a legal topology, the dichotomy of private bad faith and public bad faith. The idea of public faith opens doctrinal space for the continued evolution of corporate responsibility to comply with law and law-endowed mandates in an ever more complex economies, markets, and social conditions.
Robert J. Rhee is John H. and Mary Lou Dasburg Professor of Law at the University of Florida Levin College of Law. This post is based on his paper, “A Theory of Corporate Bad Faith: The Legal Topology of Public and Private Bad Faith,” available here.