United States: Delaware Supreme Court Affirms Chancery Court’s Disney Decision - Lessons Learned

In June 8, 2006, the Supreme Court of the State of Delaware issued its decision in the case of In Re: The Walt Disney Company Derivative Litigation, No. 411/2005, affirming the Chancery Court’s August 2005 determination (after trial) that the Disney directors did not breach their fiduciary duties with respect to the hiring and termination of Michael Ovitz, nor in connection with his termination compensation package.

On appeal, the plaintiffs’ core argument was that breaches of fiduciary duty by the Disney defendants (i.e., through either grossly negligent actions or actions not performed in good faith) deprived the defendants of the benefit of the business judgment rule and thus required such defendants "to shoulder the burden of establishing that their acts were entirely fair to Disney," which the plaintiffs argued the Disney defendants had failed to do. The law presumes that directors’ business decisions are made on "an informed basis, and in the honest belief that the action taken was in the best interest of the company." These presumptions can be rebutted by a showing that the directors breached their fiduciary duty of care, of loyalty, or their duty to act with good faith.

The court analyzed and rejected the plaintiffs’ claims that the Disney defendants breached their fiduciary duties to act with due care and in good faith by (1) approving the Ovitz employment agreement (including, specifically, its non-fault termination provisions), (2) electing Ovitz as Disney’s President, and (3) approving the non-fault termination severance payment to Ovitz upon his termination—a severance payout of $130 million that plaintiffs also claimed constituted corporate waste. The court concluded that:

In addition, the Court said that the non-fault termination provisions of the employment agreement did not constitute waste because there was a rational business purpose for them (i.e., an inducement to Ovitz to leave his lucrative private company to join the public Disney company).¹

This latest and definitive decision in this protracted Disney litigation serves to underscore recommendations and insights contained in the December 2005 report of a blue ribbon commission of the National Association of Corporate Directors (NACD) [see our report of February 8, 2006: "National Association of Corporate Directors’ Report on ‘Director Liabilities: Myths, Realities, and Prevention’"]. Among other things, the NACD report attempted to address the "new liability landscape" for corporate directors and it suggested that recent cases, such the Chancery Court’s 2005 Disney decision (which was on appeal to the Delaware Supreme Court at the time), demonstrated that:

1. The business judgment rule has not been undermined;
2. A director’s "level of good faith in applying his expertise" is the proper basis for liability and not the director’s mere status as an expert;
3. Each director will be judged on the basis of whether his or her conduct was undertaken in good faith (i.e., "without an intentional disregard of known responsibilities"); and
4. Striving to meet evolving, aspirational, best practice standards of conduct does not expose directors to a higher standard of review as to their business judgments.

In addition to concluding this long-running case, the Delaware Supreme Court’s recent pronouncement in Disney that the "Chancellor’s factual findings and legal rulings were correct and not erroneous in any respect"² also clearly supports the conclusions and recommendations of the NACD blue ribbon commission, which advocated the adoption of aspirational best practice standards of conduct by corporate boards that can help them avoid claims that they have not met their fiduciary duties.

More importantly, the Supreme Court’s 89 page Disney decision further illuminates our understanding of the directors’ new litigation landscape by providing additional important guidance about governance best practices in the context of the business judgment rule and directors’ separate and distinct duties of care and good faith under it.

With respect to the duty of care, the Disney Court’s primary focus was on the Chancellor’s determination that the Disney compensation committee members (who, according to the committee charter, were responsible for establishing and approving the compensation of the CEO and the President) had not failed to exercise due care in approving the Ovitz employment agreement, which contained the non-fault termination provisions. The plaintiffs claimed that the committee members had not adequately informed themselves about the full magnitude of the potentially enormous payout to Ovitz under the non-fault termination provisions of the employment agreement. In concluding that the trial record adequately supported the Chancellor’s conclusion, the Court thought it would be helpful to compare what actually happened to what would have occurred had the Disney compensation committee followed a best practice or "best case" approach. In doing so, the Court provided the following generally applicable guidance:

1. all compensation committee members would have received, before or at the committee’s first meeting, a spreadsheet or similar document prepared by (or with the assistance of) a compensation expert;
2. the spreadsheet would contain different, alternative assumptions in order to disclose the amounts that Ovitz could receive under the employment agreement in each foreseeable circumstance that might arise, including, among other possibilities, the cost to Disney of a non-fault termination for each of the five years of the initial term of the employment agreement;
3. the contents of the spreadsheet would be explained to the committee members, either by the expert who prepared it (which may be the better course of action under the circumstances) or by a fellow committee member similarly knowledgeable about the subject; and
4. the spreadsheet (that included disclosure, in a single document, of the estimated value of the accelerated options in the event of a non-fault termination after one year) would become an exhibit to the minutes of the compensation committee meeting, and would form the basis of the committee’s deliberations and decision.

Even though the compensation committee’s informational and decision-making process was, according to the Court, regrettably untidy, falling short of what best practices would have counseled, the committee’s process did not fall below the level required for a proper exercise of due care. However, the Court’s guidance provides hope and comfort to other corporations seeking not only to avoid liability but also to avoid, or minimize exposure to, Disney-like litigation. The Court suggests that had the above best case 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" and there would not have been the same need, as occurred in Disney, to rely so heavily on the trial testimony of various witnesses to establish the facts as to what did or did not occur with respect to spreadsheets that were prepared for the compensation committee meetings.³

In addressing the duty of good faith as a separate and distinct duty for purposes of applying the business judgment rule presumptions to the decisions of the compensation committee and the remaining Disney directors, the Supreme Court found no substantive difference between the Chancery Court’s pre- and post-trial definitions of bad faith. Dismissing plaintiffs’ arguments to this effect as "plainly wrong," the Supreme Court examined the Chancery Court’s 2003 definition of bad faith as a conscious and intentional disregard of responsibilities, "adopting a ‘we don’t care about the risks’ attitude…." In 2005, the Chancellor stated the definition somewhat differently as an "intentional dereliction of duty, a conscious disregard for one’s responsibilities." According to the Supreme Court, both formulations express the same concept, although in slightly different language.

In addressing plaintiffs’ argument that the Chancellor’s standard of bad faith in either event was legally incorrect, the Court offered that "some conceptual guidance to the corporate community may be helpful." In the Court’s view, the duty to act in good faith, while playing a prominent role in the Disney case, is still not yet a well-developed area of corporate fiduciary law. Finding it unwise and unnecessary to provide a fixed definition, the Court, in providing its guidance, explained that "at least three different categories of fiduciary behavior are candidates" for the bad faith label. These are: (i) subjective bad faith, referring to conduct motivated by an intent to do harm, (ii) grossly negligent action taken without malevolent intent and (iii) intentional dereliction of duty or a conscious disregard of one’s responsibilities.

The court found it axiomatic that the first candidate category of conduct (i.e., conduct motivated by an intent to do harm) involves and characterizes an extreme example of bad faith.

At the other extreme was the grossly negligent conduct without malevolent intention. Without more, the court held, grossly negligent conduct alone (which is sufficient to breach the duty of care) cannot amount to bad faith as a legal matter because such a determination would render the duty of good faith indistinguishable from the duty of care. The Supreme Court explained that the two duties are legally separate and distinct as found in protections provided to directors by Delaware statutes that permit corporations in their articles of incorporation to "exculpate their directors from monetary damage liability for a breach of the duty of care" but not for "acts or omissions not in good faith." Further, Delaware statutory law provides that a director or officer of a corporation can be indemnified for liability related to a violation of the duty of care, but not for a violation of the duty to act in good faith. The Court found that conflating the duty of care with the duty to act in good faith would not only blur their distinction but also ignore the intent of the legislature to afford directors and other corporate agents these statutory liability protections.

The third candidate category was one that the Court decided fell between the two extremes discussed above. In analyzing the Chancery Court’s standard of intentional dereliction of duty or a conscious disregard of one’s responsibilities, the Supreme Court concluded that the category effectively captured behavior where directors are not conflicted by self-interest (which would violate the duty of loyalty) yet engage in behavior that is qualitatively more culpable than gross negligence (which without more could only violate the duty of care). The vehicle for protecting against such behavior is the fiduciary duty to act in good faith that the plaintiffs had failed to prove had been violated in the Disney case. The Court found that the plaintiffs had effectively conceded that they did not have proof of bad faith sufficient to meet the Chancellor’s definition. Plaintiffs’ argument that the failure of the Disney directors to act with due care was also a violation of the duty to act in good faith necessarily failed because the two duties were separate and distinct. Furthermore, even if plaintiffs had been correct that gross negligence was equivalent to bad faith, the plaintiffs had failed, as discussed above, in the eyes of both the Chancellor and the Supreme Court, to establish that the Disney defendants had acted in a grossly negligent manner.

Accordingly, the Court’s guidance instructs directors to guard against not only the extreme of intentional harm to corporate interests but also against acts and omissions that would suggest an intentional dereliction of duty or a conscious disregard of responsibilities such as a sustained or systematic failure of the board to exercise oversight, by, for instance, failing to assure that there exists a reasonable corporate information and reporting system. See, In re Caremark Int’l Derivative Litig., 698 A.2d 959, 971 (Del. Ch. 1996).

The Delaware Supreme Court’s June 8, 2006 decision in the case of In Re: The Walt Disney Company Derivative Litigation provides an opportunity to revisit the recent analysis and recommendations from the NACD, which the Disney court supports and supplements, regarding the liability of corporate directors, the continuing viability of the business judgment rule, the appropriate understanding of the duties of due care and good faith, and the benefit of corporate governance best practices. In this regard, the Disney lessons regarding directors being aware and attentive to their duties and responsibilities, and adequately informed in connection with matters that are before them for decision, including the use of, and reliance upon, actual reports, spreadsheets, appropriate experts and other sources, as well as proper documentation in the minutes, suggest renewed attention to the NACD recommendations that directors should take the following actions.

• Ensure that they are free from conflict and that their independence is uncompromised. They should assume and carry out their duties meaningfully and responsibly. They should assure that their fellow directors are well-qualified persons of integrity; that the board has the skill sets it needs to oversee management’s performance effectively; and that senior management is comprised of persons of integrity who set the right ethical tone overall and specifically for improving corporate governance.
• Be diligent and attentive to all board matters, avoid self-dealing and be strict in observing and adhering to procedures for addressing conflicts of interest.
• Understand the business, financial and competitive environments, the systems of controls and compliance, the culture, financial statements and the business strategies and risks faced by the companies that they serve, in addition to understanding their own general and specific legal obligations and fiduciary duties as directors.

• Pay special attention to the board agenda and the flow of information to the board; attend meetings well-prepared to engage actively in board deliberations, with an attitude of healthy skepticism and constructive criticism when necessary; insist on timely receipt of and read drafts of financial reports and public filings and ask questions about anything that is not clear or that causes concern; and insist that management circle back to issues decided or discussed for updates and progress reports.

• Insist on regular executive sessions without management to consider the quality of the management team and to discuss other important issues about which the board is being asked to act.

• Understand every item, transaction, or public filing put before the board for approval and ask management and auditors for appropriate assurances and representations regarding the integrity of reporting and the processes relied upon.

• In reviewing registration statements, prospectuses and the public filings that they incorporate, and discuss within the board and with management, the auditor and with counsel whether there are any additional steps that directors should take to assure themselves of the accuracy of documents filed with the SEC, whether there are any unusual aspects, close calls or other problems with particular disclosures and whether there are potential red flags that may not be apparent to non-experts.

• As to any issue or transaction that involves a potential conflict for a member of management, a director or a controlling stockholder.