United States: Practical Tips for Directors Post-"Disney"

On June 8, 2006, the Delaware Supreme Court issued an opinion ending nearly 10 years of shareholder derivative litigation against the directors of The Walt Disney Company. In its opinion, the Supreme Court upheld in all respects the September 2005 decision of the Delaware Chancery Court in which the Chancery Court found, after a several-week trial, that the Disney directors had not breached their fiduciary duties of care, loyalty and good faith in connection with their approving the employment and – only 14 months later – the no-fault termination of Michael Ovitz, at a cost of approximately $130 million to Disney. (For a summary of the facts of the Disney case and the rulings of the Delaware Chancery Court, see Goodwin Procter’s October 3, 2005 Public Company Advisory entitled "Practical Steps for Directors to Consider After Disney," by clicking on the 'Next Page' link at the foot of this article.

While the implications of the Disney decision on corporate governance will be debated for years to come, there are several practical steps that directors should undoubtedly consider in the wake of the Disney saga:

• Create a Record of Director Diligence. The Delaware Supreme Court made clear in Disney that Delaware law does not judge directors on the basis of whether they have complied with "the best practices of ideal corporate governance." Rather, Delaware law gives directors broad latitude – even if a board’s conduct is less than perfect, Delaware law will defer to (and not second-guess) the board’s business judgment under the Business Judgment Rule. The Business Judgment Rule presumes that in making a business decision the board acted on an informed basis, in good faith, and in the reasonable belief that the action taken was in the corporation’s best interests. Directors can lose the protection of the Business Judgment Rule, however, where a plaintiff can demonstrate – for example – that the directors did not adequately inform themselves of all material information before making a material business decision. If the Business Judgment Rule presumption is lost, directors must prove that the decision they made was "entirely fair" to the corporation, a significant hurdle to clear. It is thus imperative that directors create a record of adequate diligence when they make decisions that could have material financial consequences for the corporation and its shareholders. The Disney directors did just enough for the court to get comfortable that they had considered "all material information," but directors cannot assume that a court reviewing their own conduct will come out the same way. For that reason, written materials that the directors will be asked to consider and act on should be provided to the directors as far in advance of the meeting at which they take action as reasonably possible. Meetings also should run as late or as long as necessary, and be scheduled as frequently as necessary, to permit adequate consideration and discussion of all important topics. A record of frequent and lengthy meetings is good evidence of a diligent effort by directors to be adequately informed.

• Minutes Should Reflect Active Board Involvement and Questioning. The Disney lawsuit was filed after the plaintiffs had demanded that Disney make available to them under Delaware law access to the minutes of its board and board committee meetings. Had those minutes reflected more extensive discussion and deliberation of the issues relating to Ovitz’s employment, it is possible that the litigation might not have been filed or, at least, might have been derailed under the Business Judgment Rule before a lengthy and expensive trial. For example, the original Delaware Chancery Court opinion noted that "it would have been extremely helpful to the Court if the minutes had indicated . . . that the discussion relating to the Ovitz Employment Agreement was longer and more substantial than the discussion relating to the myriad of other issues brought before the compensation committee that morning." Minutes (including minutes of executive sessions) should be thoughtfully prepared in order to make clear that the board or committee members actively considered important issues, asked questions about those issues in an effort to inform themselves "of all material information reasonably available to them," and appropriately deliberated about those issues before reaching a decision. In addition, minutes should reflect that board and committee members received and had an opportunity to consider important agreements or other documents on which board/committee action was required. Minutes, however, should not be so detailed as to become cannon fodder for plaintiffs’ lawyers who do not have the corporation’s best interests in mind. The board should also make sure to monitor and follow up on important issues identified in the minutes – flagging such issues and then not resolving them will work to an unfriendly lawyer’s advantage.

• Ensure That Your Company’s Charter Includes an "Exculpation" Provision. Section 102(b)(7) of the Delaware Code and similar law in other states allow corporations to adopt charter provisions that eliminate a director’s liability for money damages for breach of fiduciary duty, provided the breach does not involve (among other things) disloyalty or "bad faith." After the Delaware Supreme Court’s Disney decision, having such an "exculpation" provision has become more valuable than ever before. This is because the Supreme Court narrowly interpreted "bad faith" to require either a deliberate intent to harm one’s company or an "intentional dereliction of duty, a conscious disregard for one’s responsibilities." The Court made clear that careless – or even grossly negligent – conduct is not "bad faith." As such, a shareholder plaintiff will not be able to recover money damages from a director who is protected by a Section 102(b)(7) exculpation provision even if that director has been so lax in his or her diligence efforts as to be deemed "grossly negligent."

• The Disney Court Provided a Recipe for Avoiding Liability. While not requiring the Disney directors to adhere to a "best practices" standard of corporate governance, the Delaware Supreme Court did outline the following "gold standard" steps that compensation committees can take when making compensation decisions that the Court said will provide "no basis for litigation": (i) all committee members would receive, before or at the committee’s first meeting, a spreadsheet or similar document prepared by (or with the assistance of) a compensation expert; (ii) the spreadsheet would disclose the amounts that the officer would receive under the employment agreement in each foreseeable circumstance; (iii) 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; (iv) the spreadsheet would form the basis of the committee’s deliberations and decision; and (v) the spreadsheet would ultimately become an exhibit to the minutes of the compensation committee meeting. "Had this scenario been followed" by the Disney board, the Court stated, "there would be no dispute (and no basis for litigation) over what information was furnished to the committee members or when it was furnished."

• The Nature and Materiality of the Transaction Make a Difference. Directors should keep in mind that their actions will be scrutinized more strictly where the decisions being challenged are material from a financial point of view. The more significant the decision the directors are being asked to make, the more likely that decision will be a magnet for litigation. In addition, directors should not forget that in Delaware and certain other states, special rules may apply to certain acquisition transactions – for example, a decision to sell the company or a controlling interest in the company. In those situations, the board may be required not simply to have made a good faith, informed business judgment, but to have obtained the best price available for shareholders under the circumstances.

• Review Your Company’s D&O Insurance Program and Directors’ Indemnification and Advancement Rights. Litigation challenging compliance with a director’s fiduciary duties can be very expensive, and often can last many years. For that reason, directors should know how much directors and officers’ liability insurance is available in the event of a lawsuit, and what that insurance will cover (and not cover). Perceived deficiencies in coverage should be addressed promptly. Having an attorney expert in such matters review this coverage can be extremely valuable. In addition, ask whether your company’s by-laws or charter provides for mandatory advancement of legal expenses and indemnification in the event of litigation. All insurance policies have deductibles, and a director or officer must look to his or her company for payment of legal expenses before coverage is triggered (or if coverage is exhausted). Mandatory advancement means that a director or officer will not have to wait until the conclusion of litigation to have his or her legal fees paid. Having a separate indemnification agreement that supplements or supersedes whatever rights are otherwise provided by the bylaws/ charter can also be useful in plugging holes and providing superior protection for directors.

• Don’t Forget to Use Common Sense. Boards cannot do their job without delegating many tasks to management for implementation, but directors should nonetheless insist on understanding what management has done and why. Directors should regularly ask management about significant customer, market or business trends, changes in accounting policy, and operational or financial challenges to help ensure that the company’s financial reporting is accurate and not misleadingly incomplete. Directors should be especially diligent when signing off on registration statements for public stock offerings. As the securities litigation against the WorldCom outside directors has demonstrated, reliance on management to "get it right" may not be enough, and it is in a director’s best interests to create a record that shows that the directors actively probed a company’s outside and inside auditors and did more than simply rely on management. Perhaps most important, don’t ignore what your gut is telling you when something seems too good to be true – common sense and good judgment is your best guide to good board practice.

For further discussion of these and other practical steps for avoiding director liability, please see the article by Goodwin Procter partners Brian E. Pastuszenski and Inez H. Friedman-Boyce entitled "Reducing Director Liability Risks," which was recently published in the January/February 2006 issue of The Corporate Board available at http://www.goodwinprocter.com/getfile.aspx?filepath=/Files/publications/pastuszenski_friedman-boyce_1_06.pdf.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.