The Disney Decision

On August 9, 2005, the Delaware Court of Chancery issued its decision in the closely followed In re Walt Disney Co. Derivative Litigation, No. 15452 (Del. Ch. Aug. 9, 2005). Following a 37- day trial, the court entered judgment in favor of the director-defendants and against the stockholder-plaintiffs on all counts. The Court’s detailed and carefully reasoned opinion held that even Boards such as Disney’s, which "[fall] significantly short of the best practices of ideal corporate governance," are still entitled to the protections of the business judgment rule and cannot be monetarily liable provided they make decisions in good faith, "untainted by selfinterest", and "on an informed basis . . . and in the honest belief that the action taken was in the best interest of the company [and its shareholders]."

The case involved alleged breaches of fiduciary duty by Disney’s directors in connection with the hiring of Michael Ovitz as president of Disney in 1995, approval of the terms of the employment agreement provided to him and the termination of Ovitz a little more than a year later. The employment agreement’s termination provisions provided Ovitz "roughly $38 million in cash" and the immediate vesting of 3 million options to purchase Disney shares if he was terminated without cause. Ovitz was subsequently terminated without cause in 1996, receiving tens of millions of dollars in severance after only fourteen unsuccessful months on the job. The Court found that Ovitz was terminated after it was determined that "[t]o everyone’s regret, . . . Eisner [Disney’s CEO] was unable to work well with Ovitz," but that Ovitz had not committed gross negligence or malfeasance and therefore could not be terminated for cause.

In a detailed 175 page decision, Chancellor William B. Chandler, III held that each of Disney’s directors, including Eisner, Eisner’s personal attorney, who served as chairperson of the compensation committee, and each of Disney’s outside directors, "fulfilled his or her obligation to act in good faith and with honesty of purpose." The court reaffirmed the applicability of the business judgment rule and embraced the long-established rule that courts should not discourage risk-taking – which the court called "the essence of business" – by using "perfect hindsight" to second-guess decisions by disinterested and independent directors who act on an informed basis and in good faith, even when those decisions go "awry, spectacularly or otherwise."

At the same time, the court observed that Disney’s directors were "taken on a wild ride, and most of it was in the dark" and that "there are many aspects of defendants’ conduct that fell significantly short of the best practices of ideal corporate governance." The Court also noted that "the actions (and the failures to act) of the Disney board that give rise to this lawsuit took place ten years ago," before "the Enron and WorldCom debacles, and the resulting legislative focus on corporate governance," and that "applying 21st century notions of best practices in analyzing whether those decisions were actionable would be misplaced." The court took pains to repeatedly make clear that "[u]nlike ideals of corporate governance, a fiduciary’s duties [of due care and loyalty] do not change over time" and that "Delaware law does not – indeed, the common law cannot – hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices. . . ."

The decision clarifies the legal standards to be applied to the actions (or failures to act) of directors of Delaware corporations. The decision makes clear that the traditional protections provided by the business judgment rule and exculpatory "raincoat" provisions enacted pursuant to 8 Del. C. § 102(b)(7) remain viable, despite recent suggestions by commentators and the media that they have been eroded in the wake of Enron, WorldCom and other corporate scandals. The Court also reconfirmed that only conduct exhibiting "reckless indifference to or a deliberate disregard of the whole body of stockholders’ [interests] or that are without the bounds of reason" (internal quotations omitted), violate the duty of care. At the same time, while leaving some doubt, the Court seemed to suggest that there was no independent duty of good faith, but rather that the obligation to act in good faith overarches all fiduciary duties and "is inseparably and necessarily intertwined with the duties of care and loyalty." Finally, the Court rejected the idea that egregious carelessness or even recklessness were sufficient to establish the absence of good faith necessary to eliminate the protections against monetary liability provided by Section 102(b)(7) exculpatory clauses. Rather, the Court held that "§102(b)(7), on its face, seems to equate bad faith with intentional misconduct." Thus, only deliberate or intentional breaches of the duty of care could support monetary liability if a corporation has enacted an exculpatory charter provision pursuant to Section 102(b)(7).

This article discusses the impact of the Disney decision on the potential liability of directors of Delaware Corporations and the lessons to be learned from the Court’s review of the mistakes and missteps of the Disney board in the Ovitz affair.

I. The Business Judgment Rule

The business judgment rule is a common-law doctrine which protects directors from liability claims by or on behalf of the corporation or its shareholders challenging the wisdom of corporate actions taken in good faith on an informed basis. More accurately, the "business judgment rule" is a presumption employed by Courts that business decisions made by disinterested and independent directors are made on an informed basis and with a good faith belief that the decision will serve the best interests of the corporation.¹ If the rule applies, the business decisions of directors "will not be disturbed if they can be attributed to any rational business purpose. A court under such circumstances will not substitute its own notions of what is or is not sound business judgment."² Thus, "[t]he rule operates to preclude a court from imposing itself unreasonably on the business and affairs of a corporation."3

In Disney, the Court confirms the continuing vitality of the business judgment rule. In this regard, the Court emphasizes the importance of this rule because "the essence of business is risk." The Court states that "[f]iduciaries who act faithfully and honestly on behalf of those whose interests they represent are indeed granted wide latitude in their efforts to maximize shareholders’ investments" and expressly rejects the notion that courts should assess liability "based on the ultimate outcome of decisions taken in good faith by faithful directors or officers."

The Court also confirmed that this presumption applies in the absence of evidence of fraud, bad faith or self-dealing on the part of the directors, and that plaintiffs must – in the first instance – rebut the presumption by establishing that the directors did not act in good faith in the honest belief that their actions were in the best interest of the Corporation and its shareholders. Otherwise, the "redress for failures that come from faithful management" must "come from the markets, through the action of shareholders and the free flow of capital, not from this Court."

The Court followed the recent trend of cases, including Emerging Communications,⁴ in which liability determinations must be made on a director-by-director basis. This continues the departure from the approach taken twenty years ago in Smith v. Van Gorkom,⁵ which analyzed the conduct of the board of directors as a whole in determining whether the protections of the business judgment rule applied. Finally, where a director fails to act (i.e., a director has not exercised business judgment), the Court states that the business judgment rule does not apply, but concludes that, as discussed below, conduct must still be grossly negligent to breach a director’s duty of care.

II. The Duty of Care

The Court’s analysis of the directors’ fiduciary duties focuses almost exclusively upon whether the directors breached their duty of care when they approved the hiring of Ovitz, the terms of his employment agreement and his subsequent termination. The Court notes that "the duty of loyalty ‘mandates that the best interest of the corporation and its shareholders take[ ] precedence over any interest possessed by a director, officer or controlling shareholder and not shared by stockholders, generally.’" The Court found that no director – other than Ovitz – had any financial interest in Ovitz’s hiring, the terms of his employment or his firing, and that plaintiffs could not, therefore, establish any breach of the duty of loyalty. With respect to Ovitz, the Court found that he owed no duty of loyalty prior to his employment and therefore did not breach any such duty in negotiating or accepting his employment agreement, and that he played no role in determining the basis for his termination or in Disney’s decision to make the payment required for a termination without cause. Accordingly, his receipt of the severance payment also did not breach his duty of loyalty.

The Court reconfirms the traditional definition of the duty of care as requiring directors to "use that amount of care which ordinarily careful and prudent men would use in similar circumstances" but makes clear that ordinary negligence does not constitute a violation of the duty of care. Rather, the Court concludes that a violation of the duty of care requires that "the directors’ actions are grossly negligent." The Court then defined gross negligence as a "reckless indifference to or a deliberate disregard of the whole body of stockholders’ [interests] or actions which are without the bounds of reason."

Indeed, quoting former Chancellor Allen’s seminal Caremark decision, the Court holds that "whether a judge or jury, considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through ‘stupid’ to ‘egregious’ or ‘irrational,’ provides no ground for director liability. . . ." The Court goes on to catalogue the deficiencies in the process employed by what it describes as a "stacked" board consisting of CEO Michael Eisner’s "friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally. . . ." Throughout the opinion, the Court repeatedly stresses the importance of "truly independent directors" who are not merely a CEO’s hand picked "yes men", and who must, "where appropriate," be willing to stand up to, and question the CEO and management.

The Court repeatedly criticizes Eisner for "fail[ing] to keep the board as informed as he should have" and "stretch[ing] the outer boundaries of his authority as CEO by acting [to hire Ovitz] without specific Board direction or involvement." The Court notes that "the only logical way for [a] corporation to operate is that everyday governance should be ‘under the direction’ of the board of directors rather than ‘by the board’" and that "[a]s a general rule, a CEO has no obligation to continuously inform the board of his actions as CEO, or to receive prior authorization for those actions." According to the Court, this delegation of day to day operational authority to the CEO, however, is not a license to "act in a unilateral manner" and the Court notes that "a reasonably prudent CEO (that is to say, a reasonably prudent CEO with a board willing to think for itself and assert itself against the CEO when necessary)" would not, as Eisner did, push the "outer boundaries of his authority", leaving all – or a significant majority – of his directors "in the dark" about significant corporate actions – even those delegated to him – until called upon to ratify his actions.

Nevertheless, the Court concludes that, while "Eisner’s failure to better involve the board in the process of Ovitz’s hiring, usurping that role for himself . . . does not comport with how fiduciaries of Delaware corporations are expected to act," they did not violate his duty of care and were not taken in bad faith because Eisner "subjective[ly] belie[ved] that those actions were in the best interests of the Company. . . ." Accordingly, the Court found that none of these mistakes demonstrated that Eisner was either grossly negligent or acting in bad faith in connection with Ovitz’s hiring. Instead, the Court concluded that Eisner was acting in good faith in his belief that he was "acting swiftly and securing Ovitz as Disney’s President would be in Disney’s best interest notwithstanding the high cost of Ovitz."

Similarly, while the Court criticized members of the board for not doing more to inform themselves concerning Ovitz’s employment agreement or involving themselves more in the process, the Court nevertheless held that they were not grossly negligent and they were not consciously and intentionally disregarding their duties. The Court specifically criticized the compensation committee’s approval of Ovitz’s compensation package as failing to comport with the best corporate governance practices. In this regard, the Court noted that it would have been better if someone other than Eisner’s personal attorney, though head of the compensation committee, had negotiated the terms of Ovitz’s employment agreement for Disney. The Court suggested that "although not legally beholden to Eisner", the chairman of the compensation committee (along with the other outside directors) was not "truly independent" and suffered from "sycophantic tendencies," and that he (and they) "kowtow[ed] [to Eisner] in regard to Ovitz’s hiring" rather than objectively and critically assessing Eisner’s proposal. The Court also stated that the compensation committee should have verified Ovitz’s income at the time he was hired, rather than just relying on Ovitz’s attorney’s statement, and the committee should have more fully investigated Ovitz’s background. In addition, the Court criticized the two other members of the compensation committee, who participated in just one phone call regarding Ovitz’s compensation package and never reviewed Ovitz’s actual contract or met with the compensation consultant hired by management before they voted to approve Ovitz’s compensation package. The court was also critical of the compensation committee meeting at which Ovitz’s employment agreement was approved, which lasted approximately an hour, and where five other topics were discussed for an unspecified period of time. The Court, however, concluded that despite the fact that the actions of these compensation committee members may have appeared "casual or uninformed," they did not breach their fiduciary duties, because none of the directors on the compensation committee were grossly negligent and none acted in bad faith. The Court concluded that each "knew what he needed to know, did for the most part what he was required to do, and that [each] thought he was doing the best he could to advance the interests of the Company."

The Court also determined that the board was not grossly negligent or acting in bad faith when it elected Ovitz as Disney’s president. The Court was satisfied that the directors were informed of who Ovitz was, how he would fit into the Disney organization and the key terms of his employment agreement, and thus, properly exercised their business judgment when electing Ovitz. The Court again concluded that many aspects of Ovitz’s hiring by the board reflected the absence of ideal corporate governance, reiterating that the standards used to measure the conduct of fiduciaries under Delaware law do not require adherence to best corporate governance practices, but rather an absence of gross negligence, bad faith or self-dealing. The Court also emphasizes the importance of meeting minutes, and criticized Disney on several occasions for failing to keep good records of its board and compensation committee’s meetings, which in many cases failed to shed any light on who was present, what topics were discussed or how much time was devoted to the hiring of Ovitz.

Finally, the Court concluded that under Disney’s bylaws and certificate of incorporation, the board was not required to vote to terminate Ovitz, and that Eisner and Disney’s general counsel did not usurp the board’s authority when Eisner terminated Ovitz without cause. Moreover, the Court found that the board was informed of, and supported, Eisner’s decision to fire Ovitz without cause. As a result, the board did not breach any fiduciary duty by permitting Eisner to terminate Ovitz without a board vote. Once again, the Court criticized Eisner’s conduct with respect to the decision to terminate Ovitz, noting for instance, that the absence of any written legal analysis supporting the decision to terminate Ovitz without cause did not violate the duty of care, but was not model behavior.

III. Good Faith and The Protections of Section 102(b)(7) Charter Provisions

Recently, some courts and commentators have suggested that an independent fiduciary duty of good faith exists. Indeed, Plaintiffs, in Disney, argued that good faith qualified as a separate fiduciary duty. While the Court acknowledges that there is an open question as to whether the duty of good faith constitutes an independent fiduciary duty, its decision appears to reject plaintiffs’ argument that good faith is such an independent fiduciary duty. Rather, the Court notes that a director must "act in good faith," and concludes issues of good faith are "inseparably and necessarily intertwined with the duties of care and loyalty." The Court’s decision nevertheless focuses on what it means to "act in good faith" because – like many Delaware corporations – Disney has, as permitted by 8 Del. C. § 102(b)(7), enacted a provision in its certificate of incorporation which exculpates its directors from monetary liability for breaches of their duty of care unless those actions were "not in good faith." In recent years, commentators have suggested that the protection from liability that these exculpatory provisions were intended to create has been eroded by decisions suggesting that reckless conduct (or even less culpable conduct) could be considered not to be in good faith and therefore beyond the protection of Section 102(b)(7). The Court squarely rejects any such lower standard, holding that only deliberate, intentional action (or inaction) which a director knows to be against the interests of the corporation can constitute bad faith, holding that, "§ 102(b)(7), on its face appears to equate bad faith with intentional misconduct."

In this regard, the Court defines bad faith as "authorizing a transaction for some purpose other than a genuine attempt to advance corporate welfare or when the transaction is known to constitute a violation of applicable positive law." The Court holds that the appropriate standard for determining bad faith is whether a director showed an "intentional dereliction of duty" or "a conscious disregard for one’s responsibilities."

The Court also states that a "deliberate indifference and inaction in the face of a duty to act" is disloyal to the corporation. Furthermore, the Court confirms that bad faith can "be the result of any emotion that may cause a director to intentionally place his own interests, preferences or appetites before the welfare of the corporation, including greed, hatred, lust, envy, revenge. . .shame or pride." The Court specifically notes that ignorance by itself does not constitute bad faith. The Court, therefore, expressly rejects the arguments that bad faith can be shown by recklessness, extreme carelessness or gross negligence. Thus, absent intentional, deliberate or conscious misconduct, the Court finds that the protections provided by Section 102(b)(7) charter provisions continue to preclude monetary liability for breaches of the duty of care.

IV. Lessons to Learn From Disney

Noting that "best practices of corporate governance include[s] compliance with fiduciary duties [but] compliance with fiduciary duties . . . is not always enough to meet or to satisfy what is expected by best practices of corporate governance," the Court identified many instances where the Disney directors failed to comply with the minimum standards of best corporate governance practices even though those lapses did not rise to the level of a breach of any fiduciary duties, noting that "many lessons of what not to do can be learned from defendant’s conduct here." Indeed, while not sufficient to impose liability, the conduct criticized as "ordinary negligence" by the Court provides useful lessons for how boards can seek to meet the "[a]spirational ideals of good corporate governance practices . . . that go beyond the minimal legal requirements" the Court found were satisfied by the Disney board.

First, directors must take an active interest in the management of the business. They should not permit the CEO to "enthrone[] himself as the omnipotent and infallible monarch of his [own] personal Magic Kingdom." The board should also not permit the CEO to act unilaterally (or with a small inner circle) to make significant decisions, only bringing them to the board for ratification when they are "as a practical matter . . . a ‘done deal’". While the court acknowledges that the Board should not attempt to manage the "everyday governance" of a corporation, and logically must delegate responsibility to management, the Disney decision indicates that "blank check" delegation and "sycophantic" deference to even a successful CEO is not appropriate. Thus, while the board may delegate power to the CEO, it must define carefully the limits of that delegated power and should insist on being kept informed by management, especially concerning actions that approach the limits of that delegated authority. The board also must be prepared to "think for itself and assert itself against the CEO when necessary." In other words, it must learn to say "no." Indeed, the Court warns that it is "precisely in this context – the imperial CEO or controlling shareholder with a supine or passive board -- that concepts of good faith may prove highly meaningful. . . . Good faith may serve to fill [the] gap and ensure that the persons entrusted by shareholders to govern Delaware corporations do so with an honesty of purpose and with an understanding of whose interests they are there to protect".

Second, directors should use all the resources available to them to obtain and verify information critical to significant decisions. Directors should actively question management and regularly seek from them any information that seems pertinent to their oversight of the business or the specific decisions before the board. Similarly, the board should avail itself of the right to retain its own independent experts (including, where appropriate, legal counsel) to provide advice and analysis. It should be noted that the board can rely on the advice of such experts, but that the recommendations of an expert need not be followed if the board in its business judgment determines not to do so. Moreover, while the law allows directors to rely upon management and experts, where it is possible easily to confirm the information provided by these experts or by management or request supporting backup materials, directors should do so. Similarly, where the underlying documents for a proposed transaction are available, directors should review them rather than rely upon on term sheets or summary descriptions, and experts should be asked to make formal presentations to the board or relevant committee where directors can question them directly, rather than rely upon management’s summary of their conclusions.

Finally, the Court’s opinion suggests the importance of well-prepared minutes and legal opinions. The absence of any documentation that Disney’s legal counsel (inside or outside) had considered whether Ovitz could be terminated for cause thereby avoiding the massive termination payment and the vague and unclear minutes of the meeting approving Ovitz’s employment agreement contributed to the uncertainty surrounding whether the directors fulfilled their fiduciary duties. In contrast, well-prepared minutes and memoranda presented to the board by management and the board’s advisors may demonstrate (without a costly trial) that the directors carefully considered their options before embarking upon approving a challenged course of action.

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