Derivative Suits: Recent Developments

Numerous studies and articles document the alarming increase during the last few years in the size of settlements in securities class action lawsuits. As a result, directors, officers, insurers, brokers, and others focus almost exclusively on securities class actions when evaluating risks and structuring D&O insurance programs. Although largely ignored in that analysis, shareholder derivative lawsuits are also very important liability exposures particularly for directors since directors are named as defendants in derivative suits far more frequently than in securities class actions and since settlements and judgments in derivative suits are usually not indemnifiable by the company.

Derivative lawsuits are brought by shareholders on behalf of the company and seek to recover damages incurred by the company as a result of mismanagement, breach of one or more fiduciary duties, or other wrongdoing by directors and officers. Any settlement or judgment is paid to the company, not to the shareholders. Historically, settlements in derivative suits have been far less than settlements in securities class actions for two reasons. First, recoverable damages to the company are usually far less than potentially recoverable damages to members of the class (which are calculated based on the number of shares sold by the company or traded in the open market).

Second, defendant D&Os usually have more and better defenses to a derivative lawsuit than to a securities class action. As a result, according to a recent study by Advisen, about half of derivative suits are dismissed, as compared with only 10-15% of securities class actions being dismissed. Examples of some of the defenses available in a derivative suit that are not applicable to securities class actions include the following:

• Business Judgment Rule. If directors and officers make informed and disinterested decisions and believe in good faith they are acting in the best interest of the company, this defense applies. In essence, directors and officers are liable only for faulty procedures in making a business decision, not for making a poor-quality decision.
• Exculpation Statutes. In most states, statutes exist which relieve directors (usually not officers) from liability to the company or its shareholders for breach of their fiduciary duty of care if they acted in good faith.
• Reliance. When making decisions, directors are entitled to rely in good faith on advice from informed committees and experts.
• Pre-Suit Demand. A shareholder who wishes to file a derivative suit is required first to make a demand on the company's directors to bring the suit directly by the company, unless the shareholder alleges with particularity facts specific to each director which create a reasonable doubt that the directors could have properly exercised their independent and disinterested business judgment in responding to the demand. If in response to that pre-suit demand the disinterested members of the Board
  conclude after a thorough and independent investigation that it is not in the company's best interest to prosecute the proposed claim, the shareholders are usually prohibited from prosecuting the derivative suit on behalf of the company.

Despite these potential defenses, derivative lawsuits are frequently brought in tandem with securities class actions or when the company arguably suffers large direct losses due to perceived wrongdoing by directors or officers. Unlike the securities class action lawsuit, though, settlements and judgments in derivative suits are usually not indemnifiable and are therefore covered only under 'Side-A' of the D&O insurance policy. With the increased sensitivity of directors and officers to the threat of personal settlement contributions and the increased popularity of D&O insurance policies affording coverage for only non-indemnifiable losses (ie, 'Side-A' policies), it is now more important than ever to monitor developments in derivative suits. The following discussion summarizes some of the noteworthy recent court rulings and settlements in this area.

Disney Decision

The protracted and highly publicized derivative lawsuit against the directors and certain officers of The Walt Disney Company relating to the hiring and firing of Michael Ovitz was finally resolved (subject to appeal) on Aug. 9, 2005 when the Delaware Chancery Court issued a 174-page opinion following a lengthy trial. In re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113 (Aug. 9, 2005).

In that case, shareholders alleged the Disney directors breached their fiduciary duties to the company in connection with the hiring of Ovitz as president of the company and the termination of Ovitz 1 year later pursuant to a no-fault provision in the employment agreement. Ovitz received more than $140 million in severance pursuant to the employment agreement despite being harshly criticized for his performance during his brief tenure with the company.

The plaintiffs alleged the following facts to demonstrate the Board's culpability:

• Eisner, who was a close personal friend of Ovitz, unilaterally selected Ovitz as president;
• No draft employment agreement was presented to the compensation committee of the Board or to the Board for review before approving Ovitz's hiring;
• At the compensation committee meeting at which the employment package was approved, the committee met for less than an hour, spent most of its time on two other topics, received only a summary of the employment agreement terms, asked no questions about the employment agreement, did not take any additional time to review the agreement for approval, and directed Eisner to carry out the negotiations with regard to various unresolved and significant employment details;
• At the Board meeting at which Ovitz's employment as president was approved, no presentations were made regarding the terms of the employment agreement and no questions were raised; and
• No expert consultant advised the compensation committee or the Board regarding the employment agreement or its terms.

Pre-trial rulings by the Chancery Court suggested the directors might not have been entitled to various important defenses in light of the rather egregious facts of this case. However, after trial, the court ruled that plaintiffs did not satisfy their burden of proof in establishing that the defendant directors acted with gross negligence (for purposes of the Business Judgment Rule defense) or not in good faith (for purposes of the Exculpation Statute defense). Although recognizing that Ovitz's tenure with Disney ended in 'spectacular failure,' with 'breathtaking amounts of severance pay,' the court held that the Disney directors did not breach their fiduciary duties relating to either Ovitz's employment or his termination.

This decision is the Chancery Court's strongest pronouncement in many years in support of a court's obligation to defer to the good faith, informed decision making of directors, even though the decisions in hindsight were far from perfect. The decision also demonstrates that it is much easier for plaintiffs to allege wrongdoing than it is to prove wrongdoing by directors and officers.

The court's opinion should be quite helpful to D&O defendants in other derivative cases regarding several issues. First, the court recognized that absent a conflict of interest or other breach of the duty of loyalty, directors should rarely be found liable for mismanagement:

Because duty of care violations are actionable only if the directors acted with gross negligence, and because in most instances money damages are unavailable to a plaintiff who could theoretically prove a duty of care violation, duty of care violations are
rarely found.

Second, the court strongly endorsed the notion that courts should not second-guess good faith business decisions by directors and officers.

It is easy, of course, to fault a decision that ends in a failure, once hindsight makes the result of that decision plain to see. But the essence of business is risk ' the application of informed belief to contingencies whose outcomes can sometimes be predicted, but never known. The decision-makers entrusted by shareholders must act out of loyalty to those shareholders. They must in good faith act to make informed decisions on behalf of the shareholders, untainted by self-interest. Where they fail to do so, this Court stands ready to remedy breaches of fiduciary duty.

Even where decision-makers act as faithful servants, however, their ability and the wisdom of their judgments will vary. The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, 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 minimized risk, not maximized value. The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike. That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary duties, but within the boundaries of those duties are free to act as their judgment and abilities dictate, free of post hoc penalties from a reviewing court using perfect hindsight. Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased.

Third, recognizing that lack of good faith can create liability for directors and officers, the court indicated that conduct tantamount to intentional wrongdoing is required to constitute a lack of good faith. The court ruled that 'good faith' means to act 'at all times with an honesty of purpose and in the best interests and welfare of the corporation.' The court identified the following three 'most salient' examples of bad faith or a failure to act in good faith, all of which include the element of intent:

• 'Where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation';
• 'Where the fiduciary acts with intent to violate applicable positive law'; or
• 'Where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.'

Fourth, the court followed recent case law and held that liability must be determined on a director-by-director basis as opposed to earlier precedent that analyzed the conduct of the Board as a whole. The court explained that 'liability of the directors 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.'

Because the court concluded based on evidence presented at trial that the Disney directors 'did not intentionally shirk or ignore their duty' and acted in good faith, believing they were acting in the best interests of the company, the court entered a judgment in favor of the defendant directors even though many aspects of Ovitz's hiring 'reflect the absence of ideal corporate governance.' According to the court, directors and officers should not be held liable for 'a failure to comply with the aspirational ideal of best practices.'

Plaintiffs appealed the decision to the Delaware Supreme Court. If upheld on appeal and followed by other courts, the Disney decision affirms the broad discretion that courts should grant to directors and officers and reverses a perceived movement in the post-Enron era to hold directors and officers more accountable when their company suffers loss due to their conduct or inaction.

Oracle Derivative Settlement

Recent derivative litigation on behalf of Oracle is instructive in several respects. In 2001, shareholder class action and derivative lawsuits were filed against directors and officers of Oracle. The class action litigation alleged that the defendants misrepresented information regarding the company's operations and financial prospects, primarily with respect to a new product called 'Suite 11i.' Approximately 1 month before the company's surprising announcement that it would not meet its revenue and earnings projections, Larry Ellison (CEO) sold nearly $900 million worth of company stock.

Shareholder derivative litigation was filed in both Delaware and California state courts. Unlike related cases in different federal courts, it is often difficult to consolidate related cases in different state courts. Thus, both the Delaware and California derivative suits proceeded in separate courts even though both cases alleged the same wrongdoing and sought to recover the same damages on behalf of the company.

The derivative lawsuits (which eventually remained pending only against Ellison) alleged that the company was harmed by Ellison's conduct (most notably his sale of $900 million of company stock while allegedly in possession of material nonpublic information) because the company had been sued in the securities class action lawsuit as a result of that insider trading and because the company's reputation had been damaged. The Chancery Court in the Delaware derivative lawsuit granted defendant's motion for summary judgment, finding that Ellison did not possess material nonpublic information at the time he sold company stock. The Delaware Supreme Court affirmed that judgment.

However, the judge in the California derivative lawsuit refused to follow the findings of the Delaware courts, denied defendant's motion for judgment on the pleadings, and scheduled the case for trial in September 2005.

In the face of a possible judgment against him for several hundred million dollars plus treble damages, Ellison agreed to settle the California derivative lawsuit (although the securities class action remained pending). Pursuant to the very unusual settlement terms, Ellison agreed to pay $100 million in the name of Oracle to charities selected by Ellison and approved by Oracle. Oracle agreed to pay the plaintiff's counsel fees.

The settlement was submitted to the California court for approval. A shareholder filed an objection to the settlement, arguing that although the derivative lawsuit is purportedly on behalf of and for the benefit of Oracle, Oracle is actually losing money as a result of the litigation since the company will not receive any portion of the settlement payment but will be paying millions of dollars in plaintiff fees. The California court refused to approve the settlement because of concerns regarding the amount of the requested plaintiff's counsel fees and Oracle's agreement to pay those fees even though Oracle received no monetary consideration in the settlement.

The parties then revised the terms of the settlement, pursuant to which Ellison agreed to pay $22 million in attorneys' fees in addition to the $100 million to charities. The court approved this revised settlement, but an objector filed an appeal to that approval. Because the settlement was paid by Ellison, who allegedly realized $900 million in improper insider trading, the settlement is probably not insurable as disgorgement of ill-gotten gain.

The Oracle derivative litigation and settlement is remarkable and noteworthy in several respects.

First, the litigation demonstrates the unique problems that can arise when similar derivative suits are filed in separate states. Plaintiffs effectively may get 'two bites of the apple' and can still recover large amounts even though defendants prevail in one of the cases.

Second, the size of the settlement is unprecedented and far exceeds the historical largest derivative settlement. The question is whether this new settlement is evidence of a dramatic increase in the magnitude of derivative settlements generally or whether this new settlement is an aberration. Given the judgment in favor of Ellison by the Delaware courts, it appears reasonable to conclude this is an aberrational settlement attributable to a hostile judge and potentially catastrophic personal liability exposure to the defendant. In any event, since institutional investors are controlling the prosecution of derivative suits far more frequently now than in the past, it is reasonable to conclude the severity of derivative suits will be increasing at least somewhat.

Third, the structure of the derivative settlement pursuant to which all of the settlement is paid to charities is extremely unusual. The current Oracle directors approved this settlement structure, presumably on the basis that any ill-gotten gain by Ellison as a result of the insider trading did not harm Oracle and therefore Oracle need not be compensated in the settlement. However, that justification for paying the settlement proceeds to charities appears to be wrong for at least two reasons.

• If the company in fact incurred no harm, then the derivative claim on behalf of the company should have little or no value; and
• Under the settlement terms, the company would incur millions of dollars in uninsured loss by reason of its payment of the plaintiff fee award and could incur additional uninsured loss in the related securities class action litigation.

Independent Directors

Because derivative claims against directors are far more defensible if the directors are truly independent, the issue of who qualifies as an independent director is quite important. As exemplified by a pretrial decision in Disney and in a ruling in the Delaware Oracle derivative lawsuit, courts in recent years appeared to impose very difficult standards in defining an independent director. However, there is evidence that perceived trend is now reversing.

For example, contrary to the Disney and Oracle rulings, a U.S. District Court ruled in August 2005 that outside directors qualify as 'independent' directors for liability purposes despite 1) those directors' having personal friendships and outside business relationships with senior officers, 2) those directors' receiving significant fees from the company, and 3) the company's principal founder and CEO allegedly controlling the Board. Caviness v. Aspen Technology, Inc., 2005 U.S. Dist. LEXIS 17350 (Aug. 18, 2005).

Nonmonetary Settlements

With increasing frequency, plaintiffs in derivative suits are demanding that the company implement various types of corporate governance reforms as part of the derivative suit settlement. From the perspective of the institutional investor plaintiff, these 'corporate therapeutics' are consistent with the institutional investor's desire to enhance governance practices and improve company performance in the future. From the perspective of the plaintiff attorneys, these governance reforms not only help to justify an attorney fee award, but also can create a roadmap for the plaintiff attorneys with respect to a future lawsuit against the company and its directors and officers in the event subsequent problems arise.

The following list is an example of the types of corporate therapeutics now being demanded by plaintiffs in connection with the settlement of derivative suits. A company may already have adopted or otherwise intend to adopt many of the requested practices, but by including the practices within the settlement terms, the plaintiffs can take credit for those perceived reforms without creating any costs or significant distraction to the defendants. However, by including these practices within a court-approved settlement, the company may lose the ability to revise or abandon the practices in the future. Therefore, companies should carefully evaluate each of the proposed corporate therapeutics not just in the context of current circumstances, but with a view toward long-term governance practices.

Sample corporate reforms demanded by plaintiffs include the following:

1. Board of Directors

a. Require a minimum percentage of directors to be 'independent,' using a more rigorous definition than applicable to audit committees under the New York Stock Exchange rules;

b. Limit the number of other for-profit Boards on which directors and executive offices may serve;

c. Require the Chair or Lead Director to be an independent director;

d. Require all independent directors to purchase and hold a minimum number of shares of company stock;

e. Require a minimum percentage of director compensation be paid in company stock;

f. Specifically define the duties and functions of the Lead Director and each Board Committee;

g. Adopt relatively easy procedures for shareholders to nominate and remove directors.

2. Miscellaneous

a. Require stock option plans to be approved by shareholders and prohibit the setting or repricing of the strike price at too favorable of terms;

b. Specifically define the insider trading policy terms;

c. Prohibit various types of related-party transactions;

d. Impose limitations on severance payments.

These types of corporate therapeutics can be either in lieu of or in addition to a monetary settlement payment on behalf of the defendant directors and officers. In either event, though, the plaintiff attorney will seek a fee award from the court. A plaintiff fee payment in a derivative settlement may not be considered a loss incurred by the defendant director and officer since defendants typically are not obligated to pay the legal fees of the plaintiff. Instead, the plaintiff fee award could more appropriately be considered an obligation of the company as the beneficiary of the derivative litigation and settlement. Viewed in that light, the fee payment is not a legal obligation of the defendant directors and officers and therefore the indemnification prohibition applicable to derivative settlements would not apply.

DIC Exposure

Settlements and judgments in derivative suits represent one of the primary exposures covered under a Side-A D&O policy since those settlements and judgments are not indemnifiable in most states. Broad excess Side-A D&O policies contain a difference-in-condition ('DIC') provision, which in essence states that the excess policy will drop down to cover any loss covered by the Side-A policy but not covered by an underlying policy. A recent derivative suit settlement demonstrates the value to insureds of that DIC coverage.

In that case, the derivative suit settled for $11 million. The D&O insurers underlying the Side-A policy denied coverage based on a prior notice exclusion. Since the derivative suit settlement was not indemnifiable, denial of coverage by the D&O insurers normally would create a major crisis for the D&O defendants since they would be required to pay the settlement out of their personal assets. However, the broader excess Side-A policy did not exclude coverage for the settlement and, pursuant to the DIC provision, dropped down to cover the defendant D&Os as primary insurance, subject to the Side-A insurer's subrogation rights against the underlying insurance for any wrongful denial of coverage. Thus, solely because of the DIC provision in the excess Side-A policy, the personal assets of the defendant D&Os were protected. No other type of D&O insurance policy would afford that extraordinary protection.

Dan A. Bailey is a nationally recognized expert regarding directors' and officers' responsibilities, liabilities, indemnification, insurance, and loss prevention. As chairman of Bailey Cavalieri LLC's D&O practice group, he represents or consults with directors and officers, corporations, insurance companies, and law firms across the country. In addition to publishing dozens of articles on the subject, he is co-author with William E. Knepper of Liability of Corporate Officers and Directors (7th Edition).

Numerous studies and articles document the alarming increase during the last few years in the size of settlements in securities class action lawsuits. As a result, directors, officers, insurers, brokers, and others focus almost exclusively on securities class actions when evaluating risks and structuring D&O insurance programs. Although largely ignored in that analysis, shareholder derivative lawsuits are also very important liability exposures particularly for directors since directors are named as defendants in derivative suits far more frequently than in securities class actions and since settlements and judgments in derivative suits are usually not indemnifiable by the company.

Derivative lawsuits are brought by shareholders on behalf of the company and seek to recover damages incurred by the company as a result of mismanagement, breach of one or more fiduciary duties, or other wrongdoing by directors and officers. Any settlement or judgment is paid to the company, not to the shareholders. Historically, settlements in derivative suits have been far less than settlements in securities class actions for two reasons. First, recoverable damages to the company are usually far less than potentially recoverable damages to members of the class (which are calculated based on the number of shares sold by the company or traded in the open market).

Second, defendant D&Os usually have more and better defenses to a derivative lawsuit than to a securities class action. As a result, according to a recent study by Advisen, about half of derivative suits are dismissed, as compared with only 10-15% of securities class actions being dismissed. Examples of some of the defenses available in a derivative suit that are not applicable to securities class actions include the following:

• Business Judgment Rule. If directors and officers make informed and disinterested decisions and believe in good faith they are acting in the best interest of the company, this defense applies. In essence, directors and officers are liable only for faulty procedures in making a business decision, not for making a poor-quality decision.
• Exculpation Statutes. In most states, statutes exist which relieve directors (usually not officers) from liability to the company or its shareholders for breach of their fiduciary duty of care if they acted in good faith.
• Reliance. When making decisions, directors are entitled to rely in good faith on advice from informed committees and experts.
• Pre-Suit Demand. A shareholder who wishes to file a derivative suit is required first to make a demand on the company's directors to bring the suit directly by the company, unless the shareholder alleges with particularity facts specific to each director which create a reasonable doubt that the directors could have properly exercised their independent and disinterested business judgment in responding to the demand. If in response to that pre-suit demand the disinterested members of the Board
  conclude after a thorough and independent investigation that it is not in the company's best interest to prosecute the proposed claim, the shareholders are usually prohibited from prosecuting the derivative suit on behalf of the company.

Despite these potential defenses, derivative lawsuits are frequently brought in tandem with securities class actions or when the company arguably suffers large direct losses due to perceived wrongdoing by directors or officers. Unlike the securities class action lawsuit, though, settlements and judgments in derivative suits are usually not indemnifiable and are therefore covered only under 'Side-A' of the D&O insurance policy. With the increased sensitivity of directors and officers to the threat of personal settlement contributions and the increased popularity of D&O insurance policies affording coverage for only non-indemnifiable losses (ie, 'Side-A' policies), it is now more important than ever to monitor developments in derivative suits. The following discussion summarizes some of the noteworthy recent court rulings and settlements in this area.

Disney Decision

The protracted and highly publicized derivative lawsuit against the directors and certain officers of The Walt Disney Company relating to the hiring and firing of Michael Ovitz was finally resolved (subject to appeal) on Aug. 9, 2005 when the Delaware Chancery Court issued a 174-page opinion following a lengthy trial. In re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113 (Aug. 9, 2005).

In that case, shareholders alleged the Disney directors breached their fiduciary duties to the company in connection with the hiring of Ovitz as president of the company and the termination of Ovitz 1 year later pursuant to a no-fault provision in the employment agreement. Ovitz received more than $140 million in severance pursuant to the employment agreement despite being harshly criticized for his performance during his brief tenure with the company.

The plaintiffs alleged the following facts to demonstrate the Board's culpability:

• Eisner, who was a close personal friend of Ovitz, unilaterally selected Ovitz as president;
• No draft employment agreement was presented to the compensation committee of the Board or to the Board for review before approving Ovitz's hiring;
• At the compensation committee meeting at which the employment package was approved, the committee met for less than an hour, spent most of its time on two other topics, received only a summary of the employment agreement terms, asked no questions about the employment agreement, did not take any additional time to review the agreement for approval, and directed Eisner to carry out the negotiations with regard to various unresolved and significant employment details;
• At the Board meeting at which Ovitz's employment as president was approved, no presentations were made regarding the terms of the employment agreement and no questions were raised; and
• No expert consultant advised the compensation committee or the Board regarding the employment agreement or its terms.

Pre-trial rulings by the Chancery Court suggested the directors might not have been entitled to various important defenses in light of the rather egregious facts of this case. However, after trial, the court ruled that plaintiffs did not satisfy their burden of proof in establishing that the defendant directors acted with gross negligence (for purposes of the Business Judgment Rule defense) or not in good faith (for purposes of the Exculpation Statute defense). Although recognizing that Ovitz's tenure with Disney ended in 'spectacular failure,' with 'breathtaking amounts of severance pay,' the court held that the Disney directors did not breach their fiduciary duties relating to either Ovitz's employment or his termination.

This decision is the Chancery Court's strongest pronouncement in many years in support of a court's obligation to defer to the good faith, informed decision making of directors, even though the decisions in hindsight were far from perfect. The decision also demonstrates that it is much easier for plaintiffs to allege wrongdoing than it is to prove wrongdoing by directors and officers.

The court's opinion should be quite helpful to D&O defendants in other derivative cases regarding several issues. First, the court recognized that absent a conflict of interest or other breach of the duty of loyalty, directors should rarely be found liable for mismanagement:

Because duty of care violations are actionable only if the directors acted with gross negligence, and because in most instances money damages are unavailable to a plaintiff who could theoretically prove a duty of care violation, duty of care violations are
rarely found.

Second, the court strongly endorsed the notion that courts should not second-guess good faith business decisions by directors and officers.

It is easy, of course, to fault a decision that ends in a failure, once hindsight makes the result of that decision plain to see. But the essence of business is risk ' the application of informed belief to contingencies whose outcomes can sometimes be predicted, but never known. The decision-makers entrusted by shareholders must act out of loyalty to those shareholders. They must in good faith act to make informed decisions on behalf of the shareholders, untainted by self-interest. Where they fail to do so, this Court stands ready to remedy breaches of fiduciary duty.

Even where decision-makers act as faithful servants, however, their ability and the wisdom of their judgments will vary. The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, 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 minimized risk, not maximized value. The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike. That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary duties, but within the boundaries of those duties are free to act as their judgment and abilities dictate, free of post hoc penalties from a reviewing court using perfect hindsight. Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased.

Third, recognizing that lack of good faith can create liability for directors and officers, the court indicated that conduct tantamount to intentional wrongdoing is required to constitute a lack of good faith. The court ruled that 'good faith' means to act 'at all times with an honesty of purpose and in the best interests and welfare of the corporation.' The court identified the following three 'most salient' examples of bad faith or a failure to act in good faith, all of which include the element of intent:

• 'Where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation';
• 'Where the fiduciary acts with intent to violate applicable positive law'; or
• 'Where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.'

Fourth, the court followed recent case law and held that liability must be determined on a director-by-director basis as opposed to earlier precedent that analyzed the conduct of the Board as a whole. The court explained that 'liability of the directors 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.'

Because the court concluded based on evidence presented at trial that the Disney directors 'did not intentionally shirk or ignore their duty' and acted in good faith, believing they were acting in the best interests of the company, the court entered a judgment in favor of the defendant directors even though many aspects of Ovitz's hiring 'reflect the absence of ideal corporate governance.' According to the court, directors and officers should not be held liable for 'a failure to comply with the aspirational ideal of best practices.'

Plaintiffs appealed the decision to the Delaware Supreme Court. If upheld on appeal and followed by other courts, the Disney decision affirms the broad discretion that courts should grant to directors and officers and reverses a perceived movement in the post-Enron era to hold directors and officers more accountable when their company suffers loss due to their conduct or inaction.

Oracle Derivative Settlement

Recent derivative litigation on behalf of Oracle is instructive in several respects. In 2001, shareholder class action and derivative lawsuits were filed against directors and officers of Oracle. The class action litigation alleged that the defendants misrepresented information regarding the company's operations and financial prospects, primarily with respect to a new product called 'Suite 11i.' Approximately 1 month before the company's surprising announcement that it would not meet its revenue and earnings projections, Larry Ellison (CEO) sold nearly $900 million worth of company stock.

Shareholder derivative litigation was filed in both Delaware and California state courts. Unlike related cases in different federal courts, it is often difficult to consolidate related cases in different state courts. Thus, both the Delaware and California derivative suits proceeded in separate courts even though both cases alleged the same wrongdoing and sought to recover the same damages on behalf of the company.

The derivative lawsuits (which eventually remained pending only against Ellison) alleged that the company was harmed by Ellison's conduct (most notably his sale of $900 million of company stock while allegedly in possession of material nonpublic information) because the company had been sued in the securities class action lawsuit as a result of that insider trading and because the company's reputation had been damaged. The Chancery Court in the Delaware derivative lawsuit granted defendant's motion for summary judgment, finding that Ellison did not possess material nonpublic information at the time he sold company stock. The Delaware Supreme Court affirmed that judgment.

However, the judge in the California derivative lawsuit refused to follow the findings of the Delaware courts, denied defendant's motion for judgment on the pleadings, and scheduled the case for trial in September 2005.

In the face of a possible judgment against him for several hundred million dollars plus treble damages, Ellison agreed to settle the California derivative lawsuit (although the securities class action remained pending). Pursuant to the very unusual settlement terms, Ellison agreed to pay $100 million in the name of Oracle to charities selected by Ellison and approved by Oracle. Oracle agreed to pay the plaintiff's counsel fees.

The settlement was submitted to the California court for approval. A shareholder filed an objection to the settlement, arguing that although the derivative lawsuit is purportedly on behalf of and for the benefit of Oracle, Oracle is actually losing money as a result of the litigation since the company will not receive any portion of the settlement payment but will be paying millions of dollars in plaintiff fees. The California court refused to approve the settlement because of concerns regarding the amount of the requested plaintiff's counsel fees and Oracle's agreement to pay those fees even though Oracle received no monetary consideration in the settlement.

The parties then revised the terms of the settlement, pursuant to which Ellison agreed to pay $22 million in attorneys' fees in addition to the $100 million to charities. The court approved this revised settlement, but an objector filed an appeal to that approval. Because the settlement was paid by Ellison, who allegedly realized $900 million in improper insider trading, the settlement is probably not insurable as disgorgement of ill-gotten gain.

The Oracle derivative litigation and settlement is remarkable and noteworthy in several respects.

First, the litigation demonstrates the unique problems that can arise when similar derivative suits are filed in separate states. Plaintiffs effectively may get 'two bites of the apple' and can still recover large amounts even though defendants prevail in one of the cases.

Second, the size of the settlement is unprecedented and far exceeds the historical largest derivative settlement. The question is whether this new settlement is evidence of a dramatic increase in the magnitude of derivative settlements generally or whether this new settlement is an aberration. Given the judgment in favor of Ellison by the Delaware courts, it appears reasonable to conclude this is an aberrational settlement attributable to a hostile judge and potentially catastrophic personal liability exposure to the defendant. In any event, since institutional investors are controlling the prosecution of derivative suits far more frequently now than in the past, it is reasonable to conclude the severity of derivative suits will be increasing at least somewhat.

Third, the structure of the derivative settlement pursuant to which all of the settlement is paid to charities is extremely unusual. The current Oracle directors approved this settlement structure, presumably on the basis that any ill-gotten gain by Ellison as a result of the insider trading did not harm Oracle and therefore Oracle need not be compensated in the settlement. However, that justification for paying the settlement proceeds to charities appears to be wrong for at least two reasons.

• If the company in fact incurred no harm, then the derivative claim on behalf of the company should have little or no value; and
• Under the settlement terms, the company would incur millions of dollars in uninsured loss by reason of its payment of the plaintiff fee award and could incur additional uninsured loss in the related securities class action litigation.

Independent Directors

Because derivative claims against directors are far more defensible if the directors are truly independent, the issue of who qualifies as an independent director is quite important. As exemplified by a pretrial decision in Disney and in a ruling in the Delaware Oracle derivative lawsuit, courts in recent years appeared to impose very difficult standards in defining an independent director. However, there is evidence that perceived trend is now reversing.

For example, contrary to the Disney and Oracle rulings, a U.S. District Court ruled in August 2005 that outside directors qualify as 'independent' directors for liability purposes despite 1) those directors' having personal friendships and outside business relationships with senior officers, 2) those directors' receiving significant fees from the company, and 3) the company's principal founder and CEO allegedly controlling the Board. Caviness v. Aspen Technology, Inc., 2005 U.S. Dist. LEXIS 17350 (Aug. 18, 2005).

Nonmonetary Settlements

With increasing frequency, plaintiffs in derivative suits are demanding that the company implement various types of corporate governance reforms as part of the derivative suit settlement. From the perspective of the institutional investor plaintiff, these 'corporate therapeutics' are consistent with the institutional investor's desire to enhance governance practices and improve company performance in the future. From the perspective of the plaintiff attorneys, these governance reforms not only help to justify an attorney fee award, but also can create a roadmap for the plaintiff attorneys with respect to a future lawsuit against the company and its directors and officers in the event subsequent problems arise.

The following list is an example of the types of corporate therapeutics now being demanded by plaintiffs in connection with the settlement of derivative suits. A company may already have adopted or otherwise intend to adopt many of the requested practices, but by including the practices within the settlement terms, the plaintiffs can take credit for those perceived reforms without creating any costs or significant distraction to the defendants. However, by including these practices within a court-approved settlement, the company may lose the ability to revise or abandon the practices in the future. Therefore, companies should carefully evaluate each of the proposed corporate therapeutics not just in the context of current circumstances, but with a view toward long-term governance practices.

Sample corporate reforms demanded by plaintiffs include the following:

1. Board of Directors

a. Require a minimum percentage of directors to be 'independent,' using a more rigorous definition than applicable to audit committees under the New York Stock Exchange rules;

b. Limit the number of other for-profit Boards on which directors and executive offices may serve;

c. Require the Chair or Lead Director to be an independent director;

d. Require all independent directors to purchase and hold a minimum number of shares of company stock;

e. Require a minimum percentage of director compensation be paid in company stock;

f. Specifically define the duties and functions of the Lead Director and each Board Committee;

g. Adopt relatively easy procedures for shareholders to nominate and remove directors.

2. Miscellaneous

a. Require stock option plans to be approved by shareholders and prohibit the setting or repricing of the strike price at too favorable of terms;

b. Specifically define the insider trading policy terms;

c. Prohibit various types of related-party transactions;

d. Impose limitations on severance payments.

These types of corporate therapeutics can be either in lieu of or in addition to a monetary settlement payment on behalf of the defendant directors and officers. In either event, though, the plaintiff attorney will seek a fee award from the court. A plaintiff fee payment in a derivative settlement may not be considered a loss incurred by the defendant director and officer since defendants typically are not obligated to pay the legal fees of the plaintiff. Instead, the plaintiff fee award could more appropriately be considered an obligation of the company as the beneficiary of the derivative litigation and settlement. Viewed in that light, the fee payment is not a legal obligation of the defendant directors and officers and therefore the indemnification prohibition applicable to derivative settlements would not apply.

DIC Exposure

Settlements and judgments in derivative suits represent one of the primary exposures covered under a Side-A D&O policy since those settlements and judgments are not indemnifiable in most states. Broad excess Side-A D&O policies contain a difference-in-condition ('DIC') provision, which in essence states that the excess policy will drop down to cover any loss covered by the Side-A policy but not covered by an underlying policy. A recent derivative suit settlement demonstrates the value to insureds of that DIC coverage.

In that case, the derivative suit settled for $11 million. The D&O insurers underlying the Side-A policy denied coverage based on a prior notice exclusion. Since the derivative suit settlement was not indemnifiable, denial of coverage by the D&O insurers normally would create a major crisis for the D&O defendants since they would be required to pay the settlement out of their personal assets. However, the broader excess Side-A policy did not exclude coverage for the settlement and, pursuant to the DIC provision, dropped down to cover the defendant D&Os as primary insurance, subject to the Side-A insurer's subrogation rights against the underlying insurance for any wrongful denial of coverage. Thus, solely because of the DIC provision in the excess Side-A policy, the personal assets of the defendant D&Os were protected. No other type of D&O insurance policy would afford that extraordinary protection.

Dan A. Bailey is a nationally recognized expert regarding directors' and officers' responsibilities, liabilities, indemnification, insurance, and loss prevention. As chairman of Bailey Cavalieri LLC's D&O practice group, he represents or consults with directors and officers, corporations, insurance companies, and law firms across the country. In addition to publishing dozens of articles on the subject, he is co-author with William E. Knepper of Liability of Corporate Officers and Directors (7th Edition).