Director Liability on the Table

In a separate, but possibly equally important case, a Delaware judge has allowed a derivative lawsuit brought by shareholders against The Walt Disney Co., Disney's board of directors and Michael Ovitz, a former president of Disney, to enter the discovery phase and proceed toward trial.

“[T]he facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision,” wrote Judge William B. Chandler III of the Delaware Chancery Court. Among other things, the suit focuses on the much-publicized $140 million severance package awarded to Ovitz after he left Disney. The Walt Disney Co. Derivative Litig., Consolidated Civil Action No. 15452.

John Olson, a partner in the Washington office of Los Angeles-based Gibson, Dunn & Crutcher, believes these cases are a “wake-up call to directors,” and are meant to tell them that they must make informed decisions. These cases may only add to the already increasing pressure on board members to scrutinize more closely corporate officers and financial statements in light of the scandals that have swept through corporate America during the past 2 years.

The Sarbanes-Oxley Act of 2002 informs all employees of a company – not just directors – that they cannot sit back and assume that all is going well, says Louis Bevilacqua, a partner at New York's Cadwalader, Wickersham & Taft.

Bevilacqua says that proposed reforms by the Securities and Exchange Commission will require that directors function in an independent manner and be mandated to exercise more active oversight of a company than they have in the past.

Personal Benefit

Under Delaware law – and the laws of most other states – board members are protected under the business-judgment rule, meaning that even if the company suffered a monetary loss as a result of a board decision, the board would not be liable as long as the board acted in good faith. Judges have typically held directors and officers liable for breaching their duty of loyalty toward a company only if they derived personal benefit from a transaction, says Olson.

Trace was comprised of insider directors, and, according to Olson, Sweet's ruling shows that a director can be held liable for inaction, because ultimately directors are responsible to all the shareholders, not just the majority shareholder, which, in this case, was Cogan, who was also their boss.

Highlighting the misplaced faith that two of the directors had in Cogan, Sweet wrote, “[they] appear to argue that they took no action because they believed that Cogan was good for the loans. … Because it was Trace's money, however, their duty to Trace required them to go beyond such simplistic assumptions.”

Professor John Coffee of Columbia University Law School says that the Trace case is important because it not only tells officers what their roles are, but it also tells directors that they can be held liable even for decisions that they did not make.

Robert A. Meister, a partner at Piper Rudnick and counsel for three defendants in the Trace case, says the ruling will have a negative effect: “The decision to impose a very large financial liability on directors and officers who didn't benefit will impair a corporation's ability to find qualified directors and officers, and particularly general counsel,” Meister says. He said his clients will appeal Sweet's ruling.

Breach Of Loyalty?

In the Disney suit, the plaintiffs contend that Disney's board of directors breached their duties of good faith and loyalty by allowing Ovitz to negotiate his contract directly with his close friend, Disney CEO Michael Eisner. The plaintiffs are also suing Ovitz, claiming he negotiated his stock options while also serving as president, and therefore, according to Chandler's ruling, “had a duty to negotiate honestly and in good faith so as not to advantage himself at the expense of the Disney shareholders.”

According to the terms of his contract, Ovitz was entitled to a severance package of almost $140 million under a nonfault termination agreement, despite his poor performance over the course of his 1 year of service.

“In short order, Ovitz wanted out, and, once again, his good friend Eisner came to the rescue, agreeing to Ovitz's request for a nonfault termination,” wrote Chandler.

“The court is saying that directors have to show that they had knowledge of all facts related to compensation,” states Steven Schulman, partner at New York's Milberg Weiss Bershad Hynes & Lerach who represents the plaintiffs.

John Spelich, vice president for corporate communications at Disney, believes that the current corporate climate has resulted in people viewing Chandler's opinion as more than just a ruling on a motion to dismiss.

Professor Charles Elson, head of the Weinberg Center for Corporate Governance at the University of Delaware, says the Disney case shows a major change. “There has been a paradigm shift in Delaware from allowing independence to enforcing oversight,” he said. “This would not have happened 10 years ago.” These cases could add to a trend.

Following the wave of financial scandals, potential board members began asking more questions of companies, including examining their books more closely, and are thinking twice before accepting a board position, says Joe Goodwin, president of The Goodwin Group, an executive search firm. Goodwin believes that this sense of caution is linked to Sarbanes-Oxley, which, he believes, lowered the standards necessary for shareholders to take action against a company.

As a result, he says, “people are turning down board positions that they would have taken 3 to 5 years ago.”

Impact On D&O Insurance

Rulings imposing liability on directors also could have major implications for directors' and officers' insurance. According to Tony Galban, vice president and underwriting manager at Chubb Specialty Insurance, premiums this year will rise 100% for publicly held companies and 20% to 30% for privately held companies.

“We are looking more carefully at board composition and performance before issuing coverage for public and private companies,” says Galban. He also says that Chubb has rejected companies that are “out of step with modern-day expectations.”

Two recent court decisions could have an impact on the future liability of directors at public and private companies.

In a federal court in New York, Marshall S. Cogan, former CEO and chairman of Trace International Holdings, a privately held company that is now bankrupt, and several of Trace's board members were recently found liable for more than $40 million in damages. Pereira v. Cogan, No. 00 Civ. 619 (S.D.N.Y.).

In a rare ruling for either a public or private company, Senior Judge Robert W. Sweet, after a bench trial in May, found board members liable for breaching their fiduciary duties of loyalty and care through their inaction by allowing, among other things, Cogan to unilaterally raise his salary and take loans for himself. Sweet also found that the directors never took steps to prevent Cogan from liquidating Trace, and by this inaction, failed to fulfill their roles as monitors of the company.

In a separate, but possibly equally important case, a Delaware judge has allowed a derivative lawsuit brought by shareholders against The Walt Disney Co., Disney's board of directors and Michael Ovitz, a former president of Disney, to enter the discovery phase and proceed toward trial.

“[T]he facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision,” wrote Judge William B. Chandler III of the Delaware Chancery Court. Among other things, the suit focuses on the much-publicized $140 million severance package awarded to Ovitz after he left Disney. The Walt Disney Co. Derivative Litig., Consolidated Civil Action No. 15452.

John Olson, a partner in the Washington office of Los Angeles-based Gibson, Dunn & Crutcher, believes these cases are a “wake-up call to directors,” and are meant to tell them that they must make informed decisions. These cases may only add to the already increasing pressure on board members to scrutinize more closely corporate officers and financial statements in light of the scandals that have swept through corporate America during the past 2 years.

The Sarbanes-Oxley Act of 2002 informs all employees of a company – not just directors – that they cannot sit back and assume that all is going well, says Louis Bevilacqua, a partner at New York's Cadwalader, Wickersham & Taft.

Bevilacqua says that proposed reforms by the Securities and Exchange Commission will require that directors function in an independent manner and be mandated to exercise more active oversight of a company than they have in the past.

Personal Benefit

Under Delaware law – and the laws of most other states – board members are protected under the business-judgment rule, meaning that even if the company suffered a monetary loss as a result of a board decision, the board would not be liable as long as the board acted in good faith. Judges have typically held directors and officers liable for breaching their duty of loyalty toward a company only if they derived personal benefit from a transaction, says Olson.

Trace was comprised of insider directors, and, according to Olson, Sweet's ruling shows that a director can be held liable for inaction, because ultimately directors are responsible to all the shareholders, not just the majority shareholder, which, in this case, was Cogan, who was also their boss.

Highlighting the misplaced faith that two of the directors had in Cogan, Sweet wrote, “[they] appear to argue that they took no action because they believed that Cogan was good for the loans. … Because it was Trace's money, however, their duty to Trace required them to go beyond such simplistic assumptions.”

Professor John Coffee of Columbia University Law School says that the Trace case is important because it not only tells officers what their roles are, but it also tells directors that they can be held liable even for decisions that they did not make.

Robert A. Meister, a partner at Piper Rudnick and counsel for three defendants in the Trace case, says the ruling will have a negative effect: “The decision to impose a very large financial liability on directors and officers who didn't benefit will impair a corporation's ability to find qualified directors and officers, and particularly general counsel,” Meister says. He said his clients will appeal Sweet's ruling.

Breach Of Loyalty?

In the Disney suit, the plaintiffs contend that Disney's board of directors breached their duties of good faith and loyalty by allowing Ovitz to negotiate his contract directly with his close friend, Disney CEO Michael Eisner. The plaintiffs are also suing Ovitz, claiming he negotiated his stock options while also serving as president, and therefore, according to Chandler's ruling, “had a duty to negotiate honestly and in good faith so as not to advantage himself at the expense of the Disney shareholders.”

According to the terms of his contract, Ovitz was entitled to a severance package of almost $140 million under a nonfault termination agreement, despite his poor performance over the course of his 1 year of service.

“In short order, Ovitz wanted out, and, once again, his good friend Eisner came to the rescue, agreeing to Ovitz's request for a nonfault termination,” wrote Chandler.

“The court is saying that directors have to show that they had knowledge of all facts related to compensation,” states Steven Schulman, partner at New York's Milberg Weiss Bershad Hynes & Lerach who represents the plaintiffs.

John Spelich, vice president for corporate communications at Disney, believes that the current corporate climate has resulted in people viewing Chandler's opinion as more than just a ruling on a motion to dismiss.

Professor Charles Elson, head of the Weinberg Center for Corporate Governance at the University of Delaware, says the Disney case shows a major change. “There has been a paradigm shift in Delaware from allowing independence to enforcing oversight,” he said. “This would not have happened 10 years ago.” These cases could add to a trend.

Following the wave of financial scandals, potential board members began asking more questions of companies, including examining their books more closely, and are thinking twice before accepting a board position, says Joe Goodwin, president of The Goodwin Group, an executive search firm. Goodwin believes that this sense of caution is linked to Sarbanes-Oxley, which, he believes, lowered the standards necessary for shareholders to take action against a company.

As a result, he says, “people are turning down board positions that they would have taken 3 to 5 years ago.”

Impact On D&O Insurance

Rulings imposing liability on directors also could have major implications for directors' and officers' insurance. According to Tony Galban, vice president and underwriting manager at Chubb Specialty Insurance, premiums this year will rise 100% for publicly held companies and 20% to 30% for privately held companies.

“We are looking more carefully at board composition and performance before issuing coverage for public and private companies,” says Galban. He also says that Chubb has rejected companies that are “out of step with modern-day expectations.”