Courts Turn Up Corporate Heat

The litigation in Disney concerned the hiring and termination by Disney of Michael Ovitz, who was alleged to have received in excess of $140 million for little more than one year of allegedly ineffective service. Plaintiff stockholders brought a derivative action against Disney's directors alleging that those directors breached their duties to the corporation, both in connection with the decision to hire Ovitz and award him an excessively lucrative contract, as well as in their handling of Ovitz's subsequent termination.

On an initial motion to dismiss, the Complaint was dismissed with leave granted to replead. Thereafter, plaintiffs were granted the right to take certain discovery, allowing them to amend their complaint by adding specific allegations of director inaction in connection with the decisions regarding Ovitz. Among other things, the amended Complaint alleged that the directors had each spent less than an hour reviewing Ovitz's possible hiring; that neither the directors nor the Compensation Committee had reviewed the actual draft employment agreement; that the directors had failed to evaluate the details of Ovitz's salary or his severance arrangements; that no expert had been retained to provide information about comparable contracts; and that after authorizing Disney's CEO, Michael Eisner, to negotiate directly with Ovitz, Disney's directors never asked to review, or otherwise received, the final terms of Ovitz's contract.

The amended Complaint alleged a similar (to use the words of the Delaware Court of Chancery) “ostrich-like approach” regarding Ovitz's subsequent termination, which was effected on a no-fault basis, thereby triggering huge payouts to Ovitz notwithstanding that he had spent only about a year in his position with the company. The Complaint alleged that the directors had chosen “to remain invisible in the process,” that the directors never sought to consider whether a termination could be effected based on “fault,” which would have resulted in a much smaller severance payment and that the directors blindly allowed Eisner to hand over to his personal friend, Ovitz, more than $38 million in cash, as well as three million stock options.

The Chancery Court, while acknowledging its reluctance to second guess the decisions of independent directors, held that the facts alleged “belie any assertion that [the Disney directors] exercised any business judgment or made any good faith attempt to fulfill the fiduciary duties owed to Disney and its shareholders.”

In addition, the court held that the directors' alleged inaction would, if proven, take them outside of the protections afforded by the exculpatory provision found in Disney's charter under Section 102(b)(7) of the Delaware General Corporation Law. The court summarized the plaintiffs' claim: “[T]he facts alleged in the new complaint suggest that the defendant directors consciously disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision.” The court also went on to explain that “[w]here a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either 'not in good faith' or 'involve intentional misconduct'.” Thus, the Court of Chancery concluded that plaintiff's allegations fell outside of the liability waiver provided for by Disney's charter.

In Abbott, the plaintiffs alleged that the independent directors on Abbott's Board of Directors took no action during a 6-year period in which the Food and Drug Administration repeatedly served notice of safety violations on Abbott's major divisions. Similar to the holding is Disney, the United States Court of Appeals for the Seventh Circuit found that:

.”..six years of noncompliance, inspections, [FDA] Warning Letters, and notice in the press, all of which then resulted in the largest civil fine ever imposed by the FDA and the destruction and suspension of products which accounted for approximately $250 million in corporate assets, indicate that the directors' decisions to not act was not made in good faith and was contrary to the best interests of the company.”

As a result, the court, despite the presence in Abbott's charter of an exculpatory provision, reversed the lower court decision to dismiss plaintiffs' complaint because “plaintiffs' complaint … alleged 'omissions not in good faith' and 'intentional misconduct' concerning 'violations of law,' which conduct falls outside the exemption and cannot be determined at the pleading stage.”

Equally noteworthy from the perspective of corporate directors is the decision of the United States District Court for the Southern District of New York in Trace. More alarming than the other two cases, Trace was not a decision on a motion to dismiss, but rather reflects an adjudication of personal liability against outside directors following a bench trial. Specifically, the court held that the directors of a privately-held corporation had “clearly abdicated their duties” with respect to the declaration of dividends and the approval of lucrative compensation packages. As the court explained, “the mere fact that [the CEO] had successfully spearheaded extremely lucrative deals for [the corporation] in the relevant years … is insufficient to justify a blind vote in favor of compensation that may or may not be commensurate with those given to similarly situated executives.” Noting the self-interest of the CEO, the close relationships of the Board members to the CEO, and the complete lack of any exercise of diligence in the performance of the directors' duties, the court found that the directors had breached their duties of loyalty to the corporation, which, according to the court, “vitiated” the directors argument that they were shielded from liability under the company's exculpatory charter provision. The court also held that the directors failure to inform themselves and deliberate in a meaningful manner before voting on the matters in question “results in a finding that they breached their duty of care….”

The common thread in all these cases is that the failure of the directors to proactively supervise and challenge management was contrary to the best interests of the corporation and established a lack of good faith and, in the case of Trace, also breached the duty of loyalty. Thus, these cases signal that directors will not be shielded from liability by exculpatory charter clauses where it can be demonstrated that they have consciously disregarded their duties to the corporation. Put another way, to benefit from the protections of the business judgment rule and exculpatory charter provisions, directors cannot abdicate their decision-making function on material corporate issues to the corporation's management, but rather must be able to demonstrate that they have taken the time to pass on material decisions for the corporation, and that they have done so having educated themselves as to the relevant issues.

Although these recent holdings are clearly reason for some additional concern on the part of outside directors, there is no reason to believe that independent board members who can demonstrate the requisite level of diligence will not continue to be fully protected by the business judgment rule and the exculpatory provisions in their company's charter, even when their decisions turn out, with the benefit of 20 x 20 hindsight, to have been bad ones. What these decisions do highlight is that courts have ratcheted up the level of scrutiny that board actions will receive. It is therefore increasingly important in the current environment for directors to act with independence, diligence and vigilance to ensure that they are positioned to make informed decisions on material corporate issues. Generally speaking, directors who obtain the information necessary to take, or refrain from taking, an action, insist that management present material matters to the board, devote ample time to consider relevant information and obtain, where helpful, the advice of counsel and/or other experts, will continue to be afforded the protections of the business judgment rule and exculpatory charter provisions. Board minutes should accurately record the decision-making process of the board, even where the decision is to take no action at all, to help protect directors from potential claims that they have abdicated their duties.

Conclusion

In our view, these decisions reflect the same approach that has been taken by Congress in the Sarbanes-Oxley legislation and by the SEC in the implementing regulation. Directors, and particularly non-management directors, are now expected to exercise a degree of vigilance and diligence that keeps them more in touch with the daily operations of the corporations on whose boards they serve. The public spotlight has been turned on outside directors and their public corporations as never before. The message is really rather simple: the job of the corporate director is not to rubber stamp or accept at face value the actions of management, but to safeguard the interests of shareholders by actively questioning management and demanding reasonable justifications for their actions.

The highly publicized accounting scandals at Enron, WorldCom and other large corporations have prompted a concerted legislative and regulatory response from Congress, the Securities and Exchange Commission (SEC), and the national securities exchanges. While there has been little in the way of legislative reaction at the state level, several recent court decisions reflect that state corporate law is not immune from the impact of these scandals. Using existing judicial doctrine, but applying it in a fashion that appears to indicate an increasing toughness with respect to corporate directors and officers who do not live up to their obligations, the judiciary has turned up the heat on corporate fiduciaries.

This heightened level of scrutiny is highlighted in several recent court decisions: In Re The Walt Disney Company Derivative Litigation, C.A. No. 15452 (Del. Ch. May 28, 2003), In Re Abbott Laboratories Derivative Shareholders Litigation, 325 F.3d 795 (7th Cir. March 28, 2003) and John S. Pereira, as Trustee of Trace International Holdings, Inc. and Trace Foam Sub, Inc. vs. Marshall S. Cogan et al., 294 B.R. 449 (S.D.N.Y. May 7, 2003). Significantly, each of these decisions potentially limits the scope of the protections provided to directors by the business judgment rule, as well as the protections afforded by “exculpatory” provisions that are expressly provided for by state corporate statutes in order to shield directors from liability for breaches of their duty of care. Under these exculpatory provisions, director liability can generally be limited only to those actions constituting 1) a breach of the duty of loyalty (eg, a theft of corporate opportunity or an improper self-dealing transaction), or 2) acts or omissions that are not in good faith or which involve intentional misconduct or a knowing violation of the law.

As discussed below, these cases suggest that directors must take their responsibilities seriously in the post-Enron era. The business judgment rule and exculpatory provisions in a company's charter will continue to protect directors against liability for a decision taken in good faith that turns out to be a mistake. However, these protections will not be available to directors who fail to inform themselves adequately when authorizing corporate action turns out to be ill-advised, or who fail to take action when presented with evidence of corporate impropriety.

The litigation in Disney concerned the hiring and termination by Disney of Michael Ovitz, who was alleged to have received in excess of $140 million for little more than one year of allegedly ineffective service. Plaintiff stockholders brought a derivative action against Disney's directors alleging that those directors breached their duties to the corporation, both in connection with the decision to hire Ovitz and award him an excessively lucrative contract, as well as in their handling of Ovitz's subsequent termination.

On an initial motion to dismiss, the Complaint was dismissed with leave granted to replead. Thereafter, plaintiffs were granted the right to take certain discovery, allowing them to amend their complaint by adding specific allegations of director inaction in connection with the decisions regarding Ovitz. Among other things, the amended Complaint alleged that the directors had each spent less than an hour reviewing Ovitz's possible hiring; that neither the directors nor the Compensation Committee had reviewed the actual draft employment agreement; that the directors had failed to evaluate the details of Ovitz's salary or his severance arrangements; that no expert had been retained to provide information about comparable contracts; and that after authorizing Disney's CEO, Michael Eisner, to negotiate directly with Ovitz, Disney's directors never asked to review, or otherwise received, the final terms of Ovitz's contract.

The amended Complaint alleged a similar (to use the words of the Delaware Court of Chancery) “ostrich-like approach” regarding Ovitz's subsequent termination, which was effected on a no-fault basis, thereby triggering huge payouts to Ovitz notwithstanding that he had spent only about a year in his position with the company. The Complaint alleged that the directors had chosen “to remain invisible in the process,” that the directors never sought to consider whether a termination could be effected based on “fault,” which would have resulted in a much smaller severance payment and that the directors blindly allowed Eisner to hand over to his personal friend, Ovitz, more than $38 million in cash, as well as three million stock options.

The Chancery Court, while acknowledging its reluctance to second guess the decisions of independent directors, held that the facts alleged “belie any assertion that [the Disney directors] exercised any business judgment or made any good faith attempt to fulfill the fiduciary duties owed to Disney and its shareholders.”

In addition, the court held that the directors' alleged inaction would, if proven, take them outside of the protections afforded by the exculpatory provision found in Disney's charter under Section 102(b)(7) of the Delaware General Corporation Law. The court summarized the plaintiffs' claim: “[T]he facts alleged in the new complaint suggest that the defendant directors consciously disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision.” The court also went on to explain that “[w]here a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either 'not in good faith' or 'involve intentional misconduct'.” Thus, the Court of Chancery concluded that plaintiff's allegations fell outside of the liability waiver provided for by Disney's charter.

In Abbott, the plaintiffs alleged that the independent directors on Abbott's Board of Directors took no action during a 6-year period in which the Food and Drug Administration repeatedly served notice of safety violations on Abbott's major divisions. Similar to the holding is Disney, the United States Court of Appeals for the Seventh Circuit found that:

.”..six years of noncompliance, inspections, [FDA] Warning Letters, and notice in the press, all of which then resulted in the largest civil fine ever imposed by the FDA and the destruction and suspension of products which accounted for approximately $250 million in corporate assets, indicate that the directors' decisions to not act was not made in good faith and was contrary to the best interests of the company.”

As a result, the court, despite the presence in Abbott's charter of an exculpatory provision, reversed the lower court decision to dismiss plaintiffs' complaint because “plaintiffs' complaint … alleged 'omissions not in good faith' and 'intentional misconduct' concerning 'violations of law,' which conduct falls outside the exemption and cannot be determined at the pleading stage.”

Equally noteworthy from the perspective of corporate directors is the decision of the United States District Court for the Southern District of New York in Trace. More alarming than the other two cases, Trace was not a decision on a motion to dismiss, but rather reflects an adjudication of personal liability against outside directors following a bench trial. Specifically, the court held that the directors of a privately-held corporation had “clearly abdicated their duties” with respect to the declaration of dividends and the approval of lucrative compensation packages. As the court explained, “the mere fact that [the CEO] had successfully spearheaded extremely lucrative deals for [the corporation] in the relevant years … is insufficient to justify a blind vote in favor of compensation that may or may not be commensurate with those given to similarly situated executives.” Noting the self-interest of the CEO, the close relationships of the Board members to the CEO, and the complete lack of any exercise of diligence in the performance of the directors' duties, the court found that the directors had breached their duties of loyalty to the corporation, which, according to the court, “vitiated” the directors argument that they were shielded from liability under the company's exculpatory charter provision. The court also held that the directors failure to inform themselves and deliberate in a meaningful manner before voting on the matters in question “results in a finding that they breached their duty of care….”

The common thread in all these cases is that the failure of the directors to proactively supervise and challenge management was contrary to the best interests of the corporation and established a lack of good faith and, in the case of Trace, also breached the duty of loyalty. Thus, these cases signal that directors will not be shielded from liability by exculpatory charter clauses where it can be demonstrated that they have consciously disregarded their duties to the corporation. Put another way, to benefit from the protections of the business judgment rule and exculpatory charter provisions, directors cannot abdicate their decision-making function on material corporate issues to the corporation's management, but rather must be able to demonstrate that they have taken the time to pass on material decisions for the corporation, and that they have done so having educated themselves as to the relevant issues.

Although these recent holdings are clearly reason for some additional concern on the part of outside directors, there is no reason to believe that independent board members who can demonstrate the requisite level of diligence will not continue to be fully protected by the business judgment rule and the exculpatory provisions in their company's charter, even when their decisions turn out, with the benefit of 20 x 20 hindsight, to have been bad ones. What these decisions do highlight is that courts have ratcheted up the level of scrutiny that board actions will receive. It is therefore increasingly important in the current environment for directors to act with independence, diligence and vigilance to ensure that they are positioned to make informed decisions on material corporate issues. Generally speaking, directors who obtain the information necessary to take, or refrain from taking, an action, insist that management present material matters to the board, devote ample time to consider relevant information and obtain, where helpful, the advice of counsel and/or other experts, will continue to be afforded the protections of the business judgment rule and exculpatory charter provisions. Board minutes should accurately record the decision-making process of the board, even where the decision is to take no action at all, to help protect directors from potential claims that they have abdicated their duties.

Conclusion

In our view, these decisions reflect the same approach that has been taken by Congress in the Sarbanes-Oxley legislation and by the SEC in the implementing regulation. Directors, and particularly non-management directors, are now expected to exercise a degree of vigilance and diligence that keeps them more in touch with the daily operations of the corporations on whose boards they serve. The public spotlight has been turned on outside directors and their public corporations as never before. The message is really rather simple: the job of the corporate director is not to rubber stamp or accept at face value the actions of management, but to safeguard the interests of shareholders by actively questioning management and demanding reasonable justifications for their actions.