The Delaware Supreme Court recently issued an 89 page decision upholding the Chancery Court’s ruling in favor of the Disney directors in the case of In Re the Walt Disney Company Derivative Litigation.  The matter arose from the Disney directors’ costly 1995 hiring and 1996 no-fault termination of former Disney President Michael Ovitz, which included a severance payout to Ovitz valued at approximately $130 million.  The court’s unanimous decision clarifies the business judgment rule, reaffirms the Delaware courts’ deference to directors who act in good faith and sets forth “best practices” for directors to follow.

Case History and Findings

The appeal arose from several Disney shareholders’ 1997 derivative actions on behalf of Disney in the Court of Chancery against Ovitz and various Disney directors in service at the time of Ovitz’s hiring and/or termination. The plaintiffs “claimed that the $130 million severance payout was the product of fiduciary duty and contractual breaches by Ovitz, and breaches of fiduciary duty by the Disney defendants, and a waste of assets.”  Following a trial, the Chancellor set forth a 174 page opinion, entering judgment in favor of the Disney directors and holding that “the director defendants did not breach their fiduciary duties or commit waste.”

On appeal, the appellants set forth claims of error against the Disney directors and Ovitz. With respect to the directors, the appellants claimed that the “Disney defendants breached their fiduciary duties to act with due care and in good faith by (1) approving [Ovitz’s employment agreement (the “OEA”)], and specifically, its [non-fault termination (“NFT”)] provisions; and (2) approving the NFT severance payment [of approximately $130 million] to Ovitz upon his termination—a payment that is also claimed to constitute corporate waste.”  The court noted “that the appellants do not contend that the Disney defendants are directly liable as a consequence of those fiduciary duty breaches.  Rather, appellants’ core argument is indirect, i.e., that those breaches of fiduciary duty deprive the Disney defendants of the protection of business judgment review, and require them to shoulder the burden of establishing that their acts were entirely fair to Disney.”  The appellants contended that the directors failed to carry their burden.  Alternatively, the appellants claimed that even if the business judgment presumptions applied, the Disney directors are nonetheless liable, because the NFT payout constituted corporate waste.

The court analyzed and rejected appellants’ business judgment and corporate waste claims.  Regarding the business judgment rule, the court summarized its findings as follows:

[T]he Court of Chancery correctly determined that the decisions of the Disney defendants to approve the OEA, to hire Ovitz as President, and then to terminate him on an NFT basis, were protected business judgments, made without any violations of fiduciary duty.  Having so concluded, it is unnecessary for the Court to reach the appellants’ contention that the Disney defendants were required to prove that the payment of the NFT severance to Ovitz was entirely fair.

Moreover, the court held that the appellants’ waste “claim does not come close to satisfying the high hurdle required to establish waste,” as the directors’ decisions “had a rational business purpose.”

The Business Judgment Rule and Duty of Good Faith

Under Delaware law, courts generally act under a presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.  Those presumptions can be rebutted if the plaintiff shows that the directors breached their fiduciary duty of care or of loyalty or acted in bad faith.  If that is shown, the burden then shifts to the director defendants to demonstrate that the challenged act or transaction was entirely fair to the corporation and its shareholders.”

The court provided conceptual guidance for determining what constitutes bad faith.  In its decision, the Delaware Supreme Court acknowledged that the duty of good faith, although increasingly recognized as “important,” has been “relatively uncharted” in Delaware jurisprudence.  The court therefore set forth “conceptual guidance” for directors, examining three categories of conduct that “are candidates for the ‘bad faith’ pejorative label:”

1. “The first category involves so-called ‘subjective bad faith,’ that is, fiduciary conduct motivated by an actual intent to do harm.  That such conduct constitutes classic, quintessential bad faith is a proposition so well accepted in the liturgy of fiduciary law that it borders on axiomatic.”

2. “The second category of conduct…involves lack of due care-that is, fiduciary action taken solely by reason of gross negligence and without any malevolent intent…”  According to the Delaware Supreme Court, this category, without more, does not amount to bad faith.

3. The third category falls between the first two and is categorized by “intentional dereliction of duty, a conscious disregard for one’s responsibilities.”

Gross negligence, without more, does not amount to bad faith but can be very costly.  The court held that the first and third categories of conduct, as listed above, constitute bad faith conduct.  In comparison, the second category (gross negligence without malevolent intent) does not constitute conduct in bad faith.  Thus, corporations may include appropriate provisions in their certificates of incorporation to exculpate directors from monetary liability arising from gross negligence.  See, e.g., Del. Gen. Corp. L. § 102(b)(7).  Although such exculpation is permitted, corporations should note that a director’s gross negligence can be very costly both in terms of dollars and reputation.  The Disney directors were in litigation for nearly 10 years prior to receiving the appellate decision in their favor, which presumably resulted in massive legal fees and related costs.  The case was also costly in terms of reputation to the individual directors, Ovitz and Disney.  The courts criticized the individual defendants for their actions and the case generated a great deal of publicity, much of which was unfavorable. 

Delaware law has yet to set forth an all-encompassing definition for good faith.  Although the Disney decision clarified the law regarding good faith, it did not set forth a firm definition or encompass the myriad of acts that may constitute good—or bad—faith.  Directors should be aware that other instances of failure to act in good faith may arise because of the fact specific nature of the inquiry.

Best Practices and Post-Disney Practical Advice

Recommendations for Directors in Compensation Settings

Although the Disney directors ultimately avoided liability, their failure to follow “best practices” ultimately precluded success on either a motion to dismiss or a motion for summary judgment, resulting in nearly ten years of litigation, culminating in a costly 37 day trial and requisite appeals.  To help directors avoid this result in the future, the court suggested “a helpful approach is to compare what actually happened here to what would have occurred had the committee followed a ‘best practices’ (or ‘best case’) scenario.”  The court stated:

In a “best case” scenario, all committee members would have received, before or at the committee’s first meeting on September 26, 1995, a spreadsheet or similar document prepared by (or with the assistance of) a compensation expert (in this case, Graef Crystal). Making different, alternative assumptions, the spreadsheet would disclose the amounts that Ovitz could receive under the OEA in each circumstance that might foreseeably arise.  One variable in that matrix of possibilities would be the cost to Disney of a non-fault termination for each of the five years of the initial term of the OEA.  The contents of the spreadsheet would be explained to the committee members, either by the expert who prepared it or by a fellow committee member similarly knowledgeable about the subject.  That spreadsheet, which ultimately would become an exhibit to the minutes of the compensation committee meeting, would form the basis of the committee’s deliberations and decision.

Had that scenario been followed, there would be no dispute (and no basis for litigation) over what information was furnished to the committee members or when it was furnished.  Regrettably, the committee’s informational and decision making process used here was not so tidy.  That is one reason why the Chancellor found that although the committee’s process did not fall below the level required for a proper exercise of due care, it did fall short of what best practices would have counseled.

As stated above, the Disney court recommends that directors, particularly in compensation settings, do the following:

• Request and receive information prepared by a compensation expert.  Such information should make different, alternative assumptions.  Among other things, the spreadsheet should disclose the amounts that the executive could receive under a hiring agreement in each circumstance that might foreseeably arise.

• Be sure that the expert’s findings are adequately explained to all committee/board members.  The contents of the spreadsheet should be explained to the compensation committee or board members, either by the expert who prepared it or by a fellow committee member similarly knowledgeable about the subject.

• Expert findings should be made an exhibit to meeting minutes.  The spreadsheet should ultimately become an exhibit to the minutes of the compensation committee meeting and should form the basis of the committee’s deliberations and decision.

General Post-Disney Practical Advice

In addition to the recommendations, above, related to compensation, the Disney opinion contains more general advice for directors to follow.

• Be aware and attentive to responsibilities.  Individual Board members should take an active role in important decisions, rather than rubber stamping deals fashioned by a CEO, president or other executives.  While delegation to management can be both permissible and appropriate, board members should take care to review management’s actions or recommendations, seek and obtain necessary information, and confront, or go against, management.

• Be adequately informed.  Directors should be active in seeking information and verifying information.  Directors should be sure to obtain relevant and reliable information rather than relying upon secondhand recollections.  For example, the Disney board should have asked for and received full expert proposals, and a complete copy of Ovitz’s employment agreement, at a minimum, prior to making a fully informed decision.  (Instead, the directors relied on a mere term sheet, and only half of the compensation committee received the expert’s recommendation.)

• Make sure that meeting minutes properly document the decision-making process.  In Disney, the court noted that a number of important issues were not adequately documented, creating what amounted to very costly uncertainty.  For example, the court noted that the grounds for which Ovitz could have received a non-fault termination were not, but should have been, documented.  To minimize such uncertainty, detailed minutes and memoranda should be taken, particularly where important decisions are being made.  Additionally, important matters should be discussed before the full board, or full committee, rather than in informal conversations.  Adequate notice of all meetings should be given to each board or committee member and background materials should be provided prior to meetings.  Additionally, legal advice provided to the board should be appropriately memorialized.  Finally, appropriate time should be devoted to important matters, and such time spent should be memorialized in the minutes.

• Each director must take individual responsibility for meeting his/her fiduciary duties.  While earlier Delaware cases examined the conduct of a board as a whole, Delaware courts increasingly are deciding fiduciary duty claims on a director-by-director basis.  The Disney opinion takes this individualized approach, providing a detailed analysis of each defendant director’s conduct in connection with Ovitz’s hiring and termination.  This approach emphasizes the fact that there is no safety in numbers—a director who breaches his or her fiduciary duties may yet be found liable even though every other director is found to have fulfilled his or her duties.  Each director should be cognizant of the need to take individual responsibility for becoming fully informed prior to voting on proposed action. 

• Boards should be “truly independent” of management.  There is a widespread recognition in the post-Sarbanes era of the need for independent directors on the corporate board; however, the Disney opinion takes director independence a step further by discussing the need for “truly independent” directors.  The Delaware courts were critical of the fact that many of the Disney directors were Eisner’s friends and acquaintances, and the chairman of the compensation committee was Eisner’s personal lawyer.  Boards dominated by these kinds of relationships may be subject to claims that directors breached their duties, particularly when senior management appears to have exceeded the bounds of its authority.  To the extent possible, therefore, boards should seek out independent director nominees.  Where friendships or familial relationships exist between board members and management, such individuals should take additional care to comply with their fiduciary duties and act in the best interests of the corporation, as courts will look at such relationships with additional scrutiny.

Of course, no list of suggestions can be all inclusive or serve to protect directors in all cases.  Nevertheless, we suggest that directors add the Disney suggestions to the general rules for good corporate governance, and where necessary, consult appropriate legal and tax advisors in order to limit exposure to costly and lengthy litigation.

If you have any questions or need assistance implementing the suggestions contained in the Disney opinion, or with general corporate guidance regarding director liability, please contact David Dreifus, Business Litigation Practice Group Leader, at ddreifus@poynerspruill.com or 919.783.2817.