United States: Delaware Supreme Court Affirms Business Judgment Safe Harbour by Ruling in Favour of Disney Directors

In a highly anticipated decision, the Delaware Supreme Court has unanimously affirmed a lower court’s ruling that the board of directors of The Walt Disney Company did not breach its fiduciary duties or act in bad faith in the hiring and subsequent termination of former president, Michael Ovitz, despite the board’s failure to adhere to corporate governance best practices. In so ruling, the Court addressed two subjects of special interest to those affected by Delaware corporate law: the duty of good faith and best practices for board committees.

The Disney shareholder plaintiffs claimed, among other things, that certain directors breached their fiduciary duties in approving Ovitz’s employment agreement, which ultimately provided him with a $140 million severance package after only 14 months of employment. The Court noted that the board’s conduct—and especially that of the compensation committee, which reviewed Ovitz’s proposed employment agreement and recommended that the board approve it—fell "significantly short of the best practices of ideal corporate governance." Nevertheless, the Court ruled that the board’s decision to approve the employment agreement, to hire Ovitz as president of Disney and then to terminate him on a no-fault basis (which obligated Disney to pay $140 million in severance) were protected by the business judgment rule and did not constitute bad faith.

The Court confirmed that under Delaware corporate law, directors owe a duty of good faith distinct from the duties of care and loyalty. However, the Court acknowledged that this duty "is not a well-developed area of corporate fiduciary law." With a view to offering some "conceptual guidance to the corporate community," the Court identified three categories of fiduciary behavior that potentially constitutes bad faith:

• Subjective bad faith. A fiduciary who acts with actual intent to do harm unquestionably violates the duty of good faith.

• Gross negligence. On the other side of the spectrum is the "fiduciary action taken solely by reason of gross negligence and without any malevolent intent." Here, the Court unequivocally stated that gross negligence, standing alone, "does not and cannot constitute a breach of the fiduciary duty to act in good faith."

• Conscious disregard. Falling between the first two categories is the conduct described in the lower court’s definition of bad faith, the "intentional dereliction of duty … or conscious disregard for [the fiduciary’s] responsibilities." Such conduct violates the duty of good faith as long as it exceeds mere inattention or failure to be informed of the facts material to a fiduciary’s decision.

The Court declined to fashion a "definitive and categorical definition of the universe of acts that would constitute bad faith," or determine whether "the fiduciary duty to act in good faith is a duty that, like the duties of care and loyalty, can serve as an independent basis for imposing liability upon corporate officers and directors…" However, the Court held that the Disney directors’ actions did not constitute subjective bad faith, nor rise to the level of intentional dereliction. Accordingly, the directors were entitled to the protection of the business judgment rule.

Under most Canadian corporate statutes, the directors expressly have a duty to act "honestly and in good faith with a view to the best interests of the corporation." While not binding on a Canadian court, the Disney decision is clearly relevant to an interpretation of the duty of good faith.

The Court held that the Disney board’s compensation committee process for reviewing and ultimately recommending approval of Ovitz’s employment agreement fell far short of best practices. The Court focused on the committee’s failure to document in the minutes the work done by committee members outside the committee’s official meetings to inform themselves of the agreement’s terms and conditions before recommending approval. Although the directors’ process fell short of best practices, the Court held that the directors did not breach their duty of care.

The Court suggested that litigation could have been avoided if the compensation committee had followed better procedures; the Court then went on to describe a best practices scenario for considering Ovitz’s proposed agreement. Before their first meeting, the committee members would have received a spreadsheet prepared by (or with the assistance of) an executive compensation expert that set forth the amounts that Ovitz could receive in each circumstance that may foreseeably arise. The contents of the spreadsheet would be explained to the committee members, either by the expert who prepared it or by a knowledgeable committee member. That spreadsheet, which ultimately would become an exhibit to the minutes of the meeting, would form the basis of the committee’s deliberations and decision. Following these procedures would leave no room for litigation over what information was furnished to the committee members, when it was furnished or how the committee deliberated.

In short, the lesson for compensation committees—and by implication for any board of directors or its committees—is that process matters. Although the courts ultimately vindicated the Disney directors, it took nearly 10 years of litigation and required a lengthy trial. Trials not only increase legal costs, but are unpredictable given the court’s need to make evidentiary and credibility determinations. Although this decision sets a high threshold for establishing a breach of the duty of good faith, it would be far better and more cost-efficient for boards of directors to establish and adhere to best practices and procedures and, thus, avoid costly and unpredictable litigation. This recommendation is equally applicable to Canadian boards of directors and their committees.