This article is reprinted with permission
from the
edition of
New York Law Journal.
© 2003 NLP IP Company.
'Disney': Spotlight on 'Good Faith' and
Directors' Liabilities
By Joseph
E. Bachelder
For directors dealing with executive pay, a
recent Delaware Court of Chancery decision reflects the proverbial
"elephant in the living room." That "elephant" represents
the risk that directors may be found, in the opinion of a
The script for this
elephant-in-the-living-room scenario actually is a product of three cases in
the
Mr. Ovitz's $140 Million in 14 Months
The litigation involves a shareholders'
challenge to Michael Ovitz's receiving an estimated
$140 million in severance pay and other entitlements after 14 months of serving
as president and a director of Disney. In the first decision [Walt Disney I], the Court of Chancery dismissed the original complaint. n1 In the second decision [Walt Disney II], the Delaware
Supreme Court remanded the case to the Court of Chancery to permit plaintiffs
to file an amended complaint as to certain of their claims. n2
There are several issues. The issue this
column addresses involves the determination of the circumstances in which a
court may find lack of "good faith" in directors' actions [or
inactions], thus negating the exculpatory relief available to directors under §
[102[b][7] of the Delaware General Corporation Law.
That section permits a corporation to provide its directors exemption from
liability for certain breaches of fiduciary duties by including in its
certificate of incorporation:
[a] provision eliminating or limiting the
personal liability of a director to the corporation or its stockholders for
monetary damages for breach of fiduciary duty as a director, provided that such
provision shall not eliminate or limit the liability of a director: [i] For any breach of the director's duty of loyalty to the
corporation or its stockholders; [ii] for acts or omissions not in good faith
or which involve intentional misconduct or a knowing violation of law; [iii]
under § [174 of this title; or [iv] for any transaction from which the director
derived an improper personal benefit. ... Del. Code Ann. tit. 8, § [102[b][7] [2001].
Disney has such a provision in its
certificate of incorporation.
As a result of the judicial inquiry in the
Walt Disney cases, an erosion may take place not only in the scope of
protection under § [102[b][7] but also in the
traditionally assumed protection under the business judgment rule. While good
faith is generally a prerequisite to invoking the business judgment rule, for
directors who have had nothing personally at stake in a matter under
consideration, who have been informed on it and who have discussed it, there
has been reason to believe that they do not risk personal liability for the
decision they reach on the matter. This comfort level may lower in light of the
Walt Disney cases.
In addition to the erosion to statutory and
common-law protections noted above, the implication of the Court of Chancery
opinion in Walt Disney III is that the indemnification protection afforded
under § [145 of the Delaware General Corporation Law, in circumstances like
those described in the preceding paragraph, may not be as certain as thought.
The protection of § [145 includes, among its prerequisites, that "the
person acted in good faith and in a manner the person reasonably believed to be
in or not opposed to the best interests of the corporation. ..." Del. Code
Ann. tit. 8, § [145[a] [2001]. Statutory protection
for reliance on corporate records and on certain other information also is
predicated on "good faith" reliance. Del. Code Ann. tit. 8, § [141[e] [2001]. A related point involves the protection
afforded under policies of directors' and officers' liability insurance. To the
extent that such policies do not already contain a "good faith"
condition for coverage, it is likely that such condition will be included in
future policies.
Criteria
for Lack of Good Faith
The criteria being asserted in Walt Disney
III to show lack of good faith [and therefore the inapplicability of § [102[b][7]] are the same criteria used to show lack of care. If
the same criteria can be used to establish lack of care or lack of good faith,
at what point does lack of care "cross the line" and become lack of
good faith?
Following are samples of the court's
statements regarding the presumed facts based on the amended complaint:
According to the new complaint, neither the
Old Board [meaning the Board as constituted when Mr. Ovitz
was hired] nor the compensation committee reviewed the actual draft employment
agreement. Nor did they evaluate the details of [Mr.] Ovitz's
salary or his severance provisions. No expert presented the board with details
of the agreement, outlined the pros and cons of either the salary or non-fault
termination provisions, or analyzed comparable industry standards for such
agreements. n3
The facts as pleaded in Walt Disney III
suggest severe dereliction by the directors involved.
The concern here is with the absence of any
real guidelines regarding the meaning of "good faith." As already
noted, there is a potentially dangerous overlap between a circumstance
involving lack of care in which directors enjoy protection under § [102[b][7]
and a circumstance involving lack of good faith based on lack of care in which
directors lose that protection. Where does one end and
the other begin?
The Court of Chancery in Walt Disney III
states its conclusion on the presumed facts before it, in part, as follows:
[P]laintiffs' new
complaint suggests that the Disney directors failed to exercise any business
judgment and failed to make any good faith attempt to fulfill their fiduciary
duties to Disney and its stockholders. Allegations that Disney's directors
abdicated all responsibility to consider appropriately an action of material
importance to the corporation puts directly in question whether the board's
decision-making processes were employed in a good faith effort to advance
corporate interests. In short, the new complaint alleges facts implying that
the Disney directors failed to "act in good faith and meet minimal proceduralist standards of attention." n4
Compensation
Committee
Despite these statements by the court, there
appears to have been some attention by directors to the decision-making process
based on the amended complaint in Walt Disney III. On
The compensation committee was informed that
further negotiations would occur and that the stock option grant would be
delayed until the final contract was worked out. The committee approved the
general terms and conditions of the employment agreement, but did not condition
their approval on being able to review the final agreement. Instead, the
committee granted Eisner the authority to approve the
final terms and conditions of the contract as long as they were within the
framework of the draft agreement. n5
The court notes that the minutes of the board
meeting, which followed the compensation committee meeting, at which Mr. Ovitz was appointed do not reflect engagement by the board
on compensation and severance issues. It also notes:
The minutes of the meeting were fifteen pages
long, but only a page and a half covered [Mr.] Ovitz's
possible employment. A portion of that page and a half was spent discussing the
$250,000 fee to Russell for obtaining [Mr.] Ovitz. n6
By the court's own words, there was at least
some attention by the compensation committee and, to a lesser extent it would
appear, by the full board to the process of entering into the agreement with
Mr. Ovitz. Again, when does lack of care turn into
lack of good faith? Is the court second-guessing what appears to be a
carelessly reached bad business decision?
A principal commentator on "good
faith" under
[I]f directors claim to be independent by
saying, for example, that they base decisions on some performance measure and
don't do so, or if they are disingenuous or dishonest about it, it seems to me
that the courts in some circumstances could treat their behavior as a breach of
the fiduciary duty of good faith. ... n7
A Single Misstep?
The implications of Chief Justice Veasey's statement are important and worrisome. A single
procedural misstep, if deemed serious enough, could "in some
circumstances" be found to represent a breach of the duty of good faith.
What kind of circumstances? The problem with this approach is its lack of
guidelines. Nothing better evidences this than the term "good faith"
itself. Following is a comment on the meaning of "good faith" by a
"Good faith" is an intangible and
abstract quality with no technical meaning or statutory definition. It
encompasses, among other things, an honest belief, the absence of malice and
the absence of a design to defraud or to seek an unconscionable advantage. An
individual's personal good faith is a concept of his own mind and inner spirit
and, therefore, may not conclusively be determined by his protestations alone. Doyle v. Gordon, 158 NYS2d 248, 259-60 [N.Y. Sup.
In another case, In re Caremark
International, Inc. Derivative Litigation, 698 A2d 959, 971 [Del. Ch. 1996],
Chancellor William T. Allen commented:
[I]n my opinion only a sustained or
systematic failure of the board to exercise oversight -- such as an utter
failure to attempt to assure a reasonable information and reporting system
exits [sic] -- will establish a lack of good faith that is a necessary condition
to liability. Such a test of liability -- lack of good faith as evidenced by
sustained or systematic failure of a director to exercise reasonable oversight
-- is quite high. But, a demanding test of liability in the oversight context
is probably beneficial to corporate shareholders as a class, as it is in the
board decision context, since it makes board service by qualified persons more
likely, while continuing to act as a stimulus to good faith performance of duty
by such directors.
Conclusion
Magnified by the post-Enron
corporate-governance environment, there is no question that Walt Disney III
will convey a warning to directors to carry out their duties with care and in
good faith. But will Walt Disney III swing the judicial pendulum too far
against justifiable protections for directors? As the economist Milton Friedman
said in 2002: "[t]he system doesn't work unless business is willing to
take risks." n8
FOOTNOTES:
[1] In re The Walt Disney Co. Derivative Litig.,
731 A2d 342 [Del. Ch. 1998].
[2] Brehm v. Eisner, 746 A2d 244 [Del. 2000].
[3] In re The Walt
Disney Co. Derivative Litig., 825 A2d 275, 288 [Del.
Ch. 2003] [Bracketed statement added].
[4]
[5]
[6]
[7] As reprinted in "What's Wrong with
Executive Compensation?" a roundtable moderated by Charles Elson, Harvard Bus. Rev. 68, 76 [January 2003].
[8] Sylvia Nasar, "Private Sector; An Economic Reality Check From
Someone Who's Seen It All," The New York Times,