Of Mice and Men: The Business Judgment Rule After The <i>Disney </i>Decision

Last month, we discussed the Delaware Court of Chancery decision in In re The Walt Disney Co. Derivative Litigation, 2005 WL 2056651 (Del. Ch. Aug. 9, 2005), a case that had drawn intense media attention (The case currently is on appeal to the Delaware Supreme Court.) We noted that the severance package given Disney president Michael Ovitz amounted to approximately $140 million in cash and vested stock options, which was paid to Ovitz upon the termination of his employment under a “no-fault” termination provision in his employment agreement. The court found that no Disney board member was liable for violating his or her fiduciary duties with respect to the hiring, and then the firing after a little more than 1 year, of Michael Ovitz. Now the question is: What has been learned? We continue the article with a discussion of fiduciary conduct.

A Primer on the Standards Governing Fiduciary Conduct

In holding that determinations of director liability for breach of fiduciary duty must be made on a director-by-director basis rather than by viewing the board as a whole, the Disney decision follows a line of recent Delaware cases, including In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. May 3, 2004, revised June 4, 2004). As stated in In re Emerging Communications, Inc. Shareholders Litigation, director liability “must be determined on an individual basis because the nature of their breach of duty (if any), and whether they are exculpated from liability for that breach, can vary for each director.”

The Business Judgment Rule

In its central holding, the Disney court reaffirmed the presumption of the business judgment rule — that directors are presumed to act on an informed basis and to honestly believe their actions are in the best interests of the company and its shareholders. The “redress for failures that arise from faithful management,” the court stated, “must come from the markets, through the action of shareholders and the free flow of capital, and not from this court. Should the court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decision-makers would necessarily take decisions that minimize risk, not maximize value.”

The court explained that to overcome the presumption of the business judgment rule, thereby shifting the burden of proof to the director defendants to demonstrate that the challenged transaction was “entirely fair” to the corporation and its shareholders, a plaintiff must demonstrate either that the directors breached their fiduciary duties, or acted in bad faith. As explained in greater detail below, the court found that the plaintiffs failed to show that any of the Disney directors breached their fiduciary duties or acted in bad faith. Consequently, the presumption of the business judgment rule applied and protected the directors from a finding of liability.

In analyzing the potential liability of the Disney board members, the court discussed at length Eisner's authority under Disney's certificate of incorporation and bylaws to fire a subordinate executive officer, and found that the Disney board was not required to act in connection with Ovitz's termination or the decision to terminate without cause (even though this triggered the severance payment obligation). Although the Disney certificate of incorporation and by-laws give the Board the right to remove any officer at any time with or without cause, the court found the Board's right to be non-exclusive and noted that the by-laws grant the Chairman and CEO “the general and active management, direction and supervision over the business of the corporation and over its officers” [emphasis added]. Therefore, the CEO also possessed the right to remove inferior officers and, with respect to the directors other than Eisner and Litvack, no member of the board of directors breached his or her fiduciary duties or acted in bad faith because there was no duty to act. The business judgment rule was not relevant because without a duty to act there could not be a breach of fiduciary duty.

As to Litvack, the court found that despite certain “less astute moments” during the course of events at Disney, his ultimate conclusions that: 1) board authorization was not required to approve Ovitz's termination or the payment of the severance package; and 2) Ovitz could not or should not be terminated for cause, were protected by the business judgment rule because he was adequately informed and acted in good faith for what he believed were the best interests of Disney. Similarly, Eisner's actions with respect to the Ovitz termination were protected by the business judgment rule, as the plaintiffs had failed to demonstrate Eisner either acted in bad faith or breached his fiduciary duties.

The Duty of Due Care

In determining whether any director breached his fiduciary duties to Disney, the court focused almost exclusively on the duty of due care. The other fiduciary duty under Delaware law, the duty of loyalty, was implicated in the case only insofar as the court analyzed whether Ovitz breached such duty in connection with his termination and the related severance payment. The court found that because Ovitz did not abuse or manipulate the corporate process by which the termination was granted, he did not breach his duty of loyalty to Disney. Rather, the “corporation imposed an unwanted transaction upon him” in which he played no part in either the decision to terminate his employment or the decision to do so without cause.

The court reconfirmed that the duty of due care requires directors to “use that amount of care which ordinarily careful and prudent men would use in similar circumstances” and “consider all material information reasonably available” in making the business decision. The court also reconfirmed that to find a breach by directors of the duty of care, a plaintiff must demonstrate gross negligence (as opposed to ordinary negligence) with respect to the directors' processes. Similarly, the court held that for inaction to constitute a breach of the duty of due care, the inaction must be so great so as to constitute gross negligence or must demonstrate a “lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight.”

Because no Disney director (including Eisner) was determined to have acted in a grossly negligent manner, no director violated the duty of due care under Delaware law.

The Duty of Good Faith

While the court seemingly rejected the position that an independent duty of good faith existed under Delaware law, it found the concept of good faith central to its ruling and suggested it is an overarching umbrella under which the more specific fiduciaries duties of care and loyalty reside and that it is “inseparably and necessarily intertwined with the duties of care and loyalty.” Although the court acknowledged there is no fixed and immutable rule for determining whether conduct satisfies or violates the duties of care and loyalty, it stated that an “intentional dereliction of duty, a conscious disregard for one's responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith. Deliberate indifference and inaction in the face of a duty to act is, to my mind, conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct.”

Because no Disney director acted with bad intent (or consciously failed to act with the knowledge that such director was under a duty to act), no director was found to have acted in bad faith. The court also addressed the issue of good faith as it relates to Section 102(b)(7) of the Delaware General Corporation Law, which permits corporations to include in their certificate of incorporation a provision providing directors with protection from personal monetary liability except for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of the law.” Disney, like most Delaware corporations, includes such a provision in its certificate of incorporation. Because the court set such a high standard for an action to be “not in good faith,” to lose the safe-harbor protection of Section 102(b)(7), a director must be found to have acted intentionally “with a purpose other than that of advancing the best interests of the corporation” or “with the intent to violate applicable law” or to have “intentionally fail[ed] to act in the face of an affirmative duty to do so, demonstrating a conscious disregard for his duties.”

The Lessons of Disney

The Disney court reaffirmed the business judgment rule's presumption that directors act on an informed basis and honestly believe their actions are in the best interests of the company and its shareholders and the difficulty plaintiffs face in overcoming that presumption. Nonetheless, the court's analysis suggests that corporate executives, boards of directors, and their counsel should carefully consider whether existing processes and procedures require fine-tuning to minimize the risk that future conduct will result in liability. Among the key issues to consider are the following:

Communicate with the Board and Avoid Pre-Empting the Board's Decision-Making Process

The court was harshly critical of Eisner's actions, describing them as having stretched the outer boundaries of CEO authority as he “enthroned himself as the omnipotent and infallible monarch of his personal Magic Kingdom.” Eisner's failure to involve the board in the decision-making process, and his premature issuance of a press release (which placed pressure on the board to consent to the Ovitz hiring decision and the compensation package) were found to have constituted significant lapses from appropriate standards of conduct. Nevertheless, because of his “subjective belief” that his actions were in the best interests of the Company, Eisner was found to have acted in good faith and without gross negligence.

Board Members Should Stay Active

The court made clear that “sycophantic” deference to a CEO is not appropriate. The court commented that the Disney board of directors was “stacked” with friends and acquaintances of Eisner who were “certainly more willing to accede to his wishes and support him unconditionally than truly independent directors.” The court noted that in the context of an environment of a powerful CEO or controlling shareholder combined with a passive board “the concept of good faith may prove highly meaningful” to “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”.

Reliance on Experts and Counsel

The court found it helpful to the director defendants that they relied upon the advice of an executive compensation consultant in negotiating Ovitz's compensation package. Section 141(e) of the Delaware General Corporation Law protects reliance by directors upon such experts. The case that the board was making an informed business decision would have been bolstered by a formal presentation by such expert at a compensation committee or board meeting and having the expert available at the meeting to respond to questions. The court also looked favorably on Eisner's reliance on Disney's general counsel on whether Ovitz could be fired for cause and whether he needed to seek board consent to take such action. With respect to Litvack, the court found, that his determination not to obtain a formal opinion from outside counsel was made in good faith, as he believed that such an opinion would not be helpful and involving more people in the termination process would increase the potential for news of the impending termination to leak out. Although the court ultimately agreed as a substantive matter with Litvack's conclusions and held that he was adequately informed and arrived at such conclusions in good faith, a more prudent course would have been to have reached his conclusions in consultation with outside counsel and to have obtained some written advice stating outside counsel's agreement.

Documentation of Process

Proper recordation of meetings (including the simple fact that such meetings have taken place) will go a long way in demonstrating that directors are complying with their duty of due care. Corporations should also consider including a description of the basis for board action in the minutes and referencing any prior meetings in which the board action was discussed.

Clarify Authority in Certificate of Incorporation and Bylaws

The Disney court's conclusion that Eisner had the requisite authority to terminate Ovitz without board consent and that the board did not breach its duty of due care because it did not have a duty to act, depended heavily on the court's reading of the Disney certificate of incorporation and bylaws. Corporations would be well served to review their certificate of incorporation and bylaws to clarify the scope of authority of executive officers.

Consider the Materiality of the Decision

Whether board inaction constitutes “gross negligence” depends in part on whether the transaction or matter is “material” to the corporation. Therefore, the court's conclusion that the $140 million severance payment to Ovitz was not material to Disney helped to insulate the directors from liability. The court went to significant lengths to distinguish this case from a prior Delaware case, Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), which involved a board acting on a proposed merger agreement in a flawed process consisting of a single 2-hour board meeting, called on short notice and without presentation of any documentation, to discuss and deliberate on and approve the sale of the company — an unquestionably material transaction. As the materiality of the decision increases, the court is likely to judge more harshly whether directors were sufficiently informed of all material information and adequately considered the proposed action.

Last month, we discussed the Delaware Court of Chancery decision in In re The Walt Disney Co. Derivative Litigation, 2005 WL 2056651 (Del. Ch. Aug. 9, 2005), a case that had drawn intense media attention (The case currently is on appeal to the Delaware Supreme Court.) We noted that the severance package given Disney president Michael Ovitz amounted to approximately $140 million in cash and vested stock options, which was paid to Ovitz upon the termination of his employment under a “no-fault” termination provision in his employment agreement. The court found that no Disney board member was liable for violating his or her fiduciary duties with respect to the hiring, and then the firing after a little more than 1 year, of Michael Ovitz. Now the question is: What has been learned? We continue the article with a discussion of fiduciary conduct.

A Primer on the Standards Governing Fiduciary Conduct

In holding that determinations of director liability for breach of fiduciary duty must be made on a director-by-director basis rather than by viewing the board as a whole, the Disney decision follows a line of recent Delaware cases, including In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. May 3, 2004, revised June 4, 2004). As stated in In re Emerging Communications, Inc. Shareholders Litigation, director liability “must be determined on an individual basis because the nature of their breach of duty (if any), and whether they are exculpated from liability for that breach, can vary for each director.”

The Business Judgment Rule

In its central holding, the Disney court reaffirmed the presumption of the business judgment rule — that directors are presumed to act on an informed basis and to honestly believe their actions are in the best interests of the company and its shareholders. The “redress for failures that arise from faithful management,” the court stated, “must come from the markets, through the action of shareholders and the free flow of capital, and not from this court. Should the court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decision-makers would necessarily take decisions that minimize risk, not maximize value.”

The court explained that to overcome the presumption of the business judgment rule, thereby shifting the burden of proof to the director defendants to demonstrate that the challenged transaction was “entirely fair” to the corporation and its shareholders, a plaintiff must demonstrate either that the directors breached their fiduciary duties, or acted in bad faith. As explained in greater detail below, the court found that the plaintiffs failed to show that any of the Disney directors breached their fiduciary duties or acted in bad faith. Consequently, the presumption of the business judgment rule applied and protected the directors from a finding of liability.

In analyzing the potential liability of the Disney board members, the court discussed at length Eisner's authority under Disney's certificate of incorporation and bylaws to fire a subordinate executive officer, and found that the Disney board was not required to act in connection with Ovitz's termination or the decision to terminate without cause (even though this triggered the severance payment obligation). Although the Disney certificate of incorporation and by-laws give the Board the right to remove any officer at any time with or without cause, the court found the Board's right to be non-exclusive and noted that the by-laws grant the Chairman and CEO “the general and active management, direction and supervision over the business of the corporation and over its officers” [emphasis added]. Therefore, the CEO also possessed the right to remove inferior officers and, with respect to the directors other than Eisner and Litvack, no member of the board of directors breached his or her fiduciary duties or acted in bad faith because there was no duty to act. The business judgment rule was not relevant because without a duty to act there could not be a breach of fiduciary duty.

As to Litvack, the court found that despite certain “less astute moments” during the course of events at Disney, his ultimate conclusions that: 1) board authorization was not required to approve Ovitz's termination or the payment of the severance package; and 2) Ovitz could not or should not be terminated for cause, were protected by the business judgment rule because he was adequately informed and acted in good faith for what he believed were the best interests of Disney. Similarly, Eisner's actions with respect to the Ovitz termination were protected by the business judgment rule, as the plaintiffs had failed to demonstrate Eisner either acted in bad faith or breached his fiduciary duties.

The Duty of Due Care

In determining whether any director breached his fiduciary duties to Disney, the court focused almost exclusively on the duty of due care. The other fiduciary duty under Delaware law, the duty of loyalty, was implicated in the case only insofar as the court analyzed whether Ovitz breached such duty in connection with his termination and the related severance payment. The court found that because Ovitz did not abuse or manipulate the corporate process by which the termination was granted, he did not breach his duty of loyalty to Disney. Rather, the “corporation imposed an unwanted transaction upon him” in which he played no part in either the decision to terminate his employment or the decision to do so without cause.

The court reconfirmed that the duty of due care requires directors to “use that amount of care which ordinarily careful and prudent men would use in similar circumstances” and “consider all material information reasonably available” in making the business decision. The court also reconfirmed that to find a breach by directors of the duty of care, a plaintiff must demonstrate gross negligence (as opposed to ordinary negligence) with respect to the directors' processes. Similarly, the court held that for inaction to constitute a breach of the duty of due care, the inaction must be so great so as to constitute gross negligence or must demonstrate a “lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight.”

Because no Disney director (including Eisner) was determined to have acted in a grossly negligent manner, no director violated the duty of due care under Delaware law.

The Duty of Good Faith

While the court seemingly rejected the position that an independent duty of good faith existed under Delaware law, it found the concept of good faith central to its ruling and suggested it is an overarching umbrella under which the more specific fiduciaries duties of care and loyalty reside and that it is “inseparably and necessarily intertwined with the duties of care and loyalty.” Although the court acknowledged there is no fixed and immutable rule for determining whether conduct satisfies or violates the duties of care and loyalty, it stated that an “intentional dereliction of duty, a conscious disregard for one's responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith. Deliberate indifference and inaction in the face of a duty to act is, to my mind, conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct.”

Because no Disney director acted with bad intent (or consciously failed to act with the knowledge that such director was under a duty to act), no director was found to have acted in bad faith. The court also addressed the issue of good faith as it relates to Section 102(b)(7) of the Delaware General Corporation Law, which permits corporations to include in their certificate of incorporation a provision providing directors with protection from personal monetary liability except for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of the law.” Disney, like most Delaware corporations, includes such a provision in its certificate of incorporation. Because the court set such a high standard for an action to be “not in good faith,” to lose the safe-harbor protection of Section 102(b)(7), a director must be found to have acted intentionally “with a purpose other than that of advancing the best interests of the corporation” or “with the intent to violate applicable law” or to have “intentionally fail[ed] to act in the face of an affirmative duty to do so, demonstrating a conscious disregard for his duties.”

The Lessons of Disney

The Disney court reaffirmed the business judgment rule's presumption that directors act on an informed basis and honestly believe their actions are in the best interests of the company and its shareholders and the difficulty plaintiffs face in overcoming that presumption. Nonetheless, the court's analysis suggests that corporate executives, boards of directors, and their counsel should carefully consider whether existing processes and procedures require fine-tuning to minimize the risk that future conduct will result in liability. Among the key issues to consider are the following:

Communicate with the Board and Avoid Pre-Empting the Board's Decision-Making Process

The court was harshly critical of Eisner's actions, describing them as having stretched the outer boundaries of CEO authority as he “enthroned himself as the omnipotent and infallible monarch of his personal Magic Kingdom.” Eisner's failure to involve the board in the decision-making process, and his premature issuance of a press release (which placed pressure on the board to consent to the Ovitz hiring decision and the compensation package) were found to have constituted significant lapses from appropriate standards of conduct. Nevertheless, because of his “subjective belief” that his actions were in the best interests of the Company, Eisner was found to have acted in good faith and without gross negligence.

Board Members Should Stay Active

The court made clear that “sycophantic” deference to a CEO is not appropriate. The court commented that the Disney board of directors was “stacked” with friends and acquaintances of Eisner who were “certainly more willing to accede to his wishes and support him unconditionally than truly independent directors.” The court noted that in the context of an environment of a powerful CEO or controlling shareholder combined with a passive board “the concept of good faith may prove highly meaningful” to “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”.

Reliance on Experts and Counsel

The court found it helpful to the director defendants that they relied upon the advice of an executive compensation consultant in negotiating Ovitz's compensation package. Section 141(e) of the Delaware General Corporation Law protects reliance by directors upon such experts. The case that the board was making an informed business decision would have been bolstered by a formal presentation by such expert at a compensation committee or board meeting and having the expert available at the meeting to respond to questions. The court also looked favorably on Eisner's reliance on Disney's general counsel on whether Ovitz could be fired for cause and whether he needed to seek board consent to take such action. With respect to Litvack, the court found, that his determination not to obtain a formal opinion from outside counsel was made in good faith, as he believed that such an opinion would not be helpful and involving more people in the termination process would increase the potential for news of the impending termination to leak out. Although the court ultimately agreed as a substantive matter with Litvack's conclusions and held that he was adequately informed and arrived at such conclusions in good faith, a more prudent course would have been to have reached his conclusions in consultation with outside counsel and to have obtained some written advice stating outside counsel's agreement.

Documentation of Process

Proper recordation of meetings (including the simple fact that such meetings have taken place) will go a long way in demonstrating that directors are complying with their duty of due care. Corporations should also consider including a description of the basis for board action in the minutes and referencing any prior meetings in which the board action was discussed.

Clarify Authority in Certificate of Incorporation and Bylaws

The Disney court's conclusion that Eisner had the requisite authority to terminate Ovitz without board consent and that the board did not breach its duty of due care because it did not have a duty to act, depended heavily on the court's reading of the Disney certificate of incorporation and bylaws. Corporations would be well served to review their certificate of incorporation and bylaws to clarify the scope of authority of executive officers.

Consider the Materiality of the Decision

Whether board inaction constitutes “gross negligence” depends in part on whether the transaction or matter is “material” to the corporation. Therefore, the court's conclusion that the $140 million severance payment to Ovitz was not material to Disney helped to insulate the directors from liability. The court went to significant lengths to distinguish this case from a prior Delaware case, Smith v. Van Gorkom , 488 A.2d 858 (Del. 1985), which involved a board acting on a proposed merger agreement in a flawed process consisting of a single 2-hour board meeting, called on short notice and without presentation of any documentation, to discuss and deliberate on and approve the sale of the company — an unquestionably material transaction. As the materiality of the decision increases, the court is likely to judge more harshly whether directors were sufficiently informed of all material information and adequately considered the proposed action.