November 07, 2005
On August 9, 2005, in The Walt Disney Company Derivative Litigation, the Delaware Chancery Court, after a 37-day trial, ruled in favor of the directors of The Walt Disney Company, finding that they did not violate their fiduciary duty of good faith. The plaintiffs in the litigation were shareholders who sued derivatively on behalf of the corporation. They sought damages from the directors in the amount by which the compensation paid to Michael Ovitz under his employment agreement (the "OEA") was "excessive." The court did not indicate the amount that it would have found to have been excessive if the plaintiffs had won, but it could easily have been in the tens of millions of dollars. If the court had found that the defendant directors did not satisfy their duty of good faith, they would have been personally liable to Disney for the excessive compensation.
Much has been written about this opinion. We felt it was important to take a deep breath and consider the impact of the opinion in light of the specific lines of reasoning employed by the Court, and not just the conclusory language quoted in press reports and initial analysis provide by commentary immediately following release of the opinion. As a result, this e-alert is somewhat longer and more detailed than many of your other e-alerts. This e-alert will focus on the court’s opinion as it applied to the four members of the compensation committee that approved the OEA, directors Russell, Watson, Poitier, and Lozano.
General Observations About the Disney Case
* The general thrust of the court’s opinion is that the conduct necessary for directors to avoid personal liability for business losses caused by a breach of good duty is low, being defined by "minimalist proceduralist standards." The low level of conduct necessary to avoid liability is captured by the court’s statement that directors will not be liable unless there is a "wide disparity" between the process the directors used in approving the transaction and a process that would have been "rational."
* "Best practices" of corporate governance, while laudable, are not incorporated into the duty of good faith and are not the standard to be used in determining liability.
* The court’s opinion appears to be a step back from the court’s earlier opinion in the case, in which it refused to dismiss the complaint (the "2003 Opinion"). The 2003 Opinion had been widely interpreted as incorporating best practices into the substance of fiduciary duty (although that opinion did not explicitly make that claim), so that a failure to comply with best practices implied an actionable failure to comply with fiduciary duty. If, as many thought, the 2003 Opinion represented a major departure from the mainstream of Delaware law, this opinion appears to have heard that criticism and to some extent looks like a retreat back toward the mainstream. The opinion may have very well overshot the mark and gone too far. If so, this opinion may be far from the last word on the duty of good faith.
* The opinion runs for 175 pages. At times, the court seems overwhelmed by the sheer volume of information produced at the trial. Certain key legal concepts appear to be perhaps too narrow or too underdeveloped and it is reasonable to assume that there may be significant future litigation on concepts key to the opinion, such as the term "all reasonably available material information," a concept defined only by metaphor, "ostrich-like" approach and "bury their heads in the sand," and the meaning of "material," when the issue is whether a transaction is material to the corporation.
* Compliance with fiduciary duty is judged on a director-by-director basis. In addition, each director has an obligation to fully inform himself. Taken together, these propositions mean that if certain directors perform an investigation for a committee or the board, they must make a full presentation of relevant facts to the other directors. If not, the other directors would not have fully informed themselves and could be deemed to have violated their fiduciary duties.
* While the opinion appears to substantially lower the standard of conduct expected of directors under the duty of good faith, it would be unwise for directors, in light of the possibility that this opinion could possibly have gone too far in lowering the standard and also in light of the issues that are likely to be subject to future litigation, to shape their conduct in reliance on this opinion. The court’s opinion is best viewed as only the latest skirmish in a battle that will continue for some time to define the contours and substance of the conduct of directors under the duty of good faith.
The 2003 Opinion
The decision in this case is deemed especially important by corporate governance experts because it represents what is apparently a significant moderation of positions taken in the 2003 Opinion in connection with a motion to dismiss. In that opinion, the court denied that motion, allowing the case to go to trial. In the 2003 Opinion, the court used the same general definition of the duty of good faith (a breach of the duty involving a "conscious disregard of duty") as it did in the 2005 decision, but indicated, contrary to the 2005 decision, that a director would not satisfy the duty of good faith unless he was active in ascertaining1 and very well informed about,2 the relevant facts.
The 2003 Opinion was widely seen as incorporating current best practices of board conduct into the duty of good faith, so that the failure to follow current best practices would be a violation of the duty of good faith. The Chief Justice of the Delaware Supreme Court suggested in a speech that the duty of good faith might be usefully employed as a doctrinal hook to incorporate the emerging consensus on best corporate governance practices into fiduciary duties. He later wrote that "it is arguable—but not settled—that the issue of good faith may be measured . . . against the backdrop of Sarbanes-Oxley and the SRO3 requirements."4 The possibility that directors could be personally liable to the corporation for damages for a breach of the duty of good faith was troubling to directors and most certainly encouraged them to adopt best practices.
Why the Plaintiffs Sued the Directors for a Breach of the Duty of Good Faith
Delaware’s corporation law, like the laws in all other states, has a provision that is generally known as a "director protection statute." In Delaware, it is Section 102(b)(7) of the Delaware General Corporation Law. That section allows a corporation to adopt a provision in its certificate of incorporation that insulates directors from personal liability for damages for breaches of the duty of due care. But it does not permit corporations to insulate directors from personal liability for (i) acts or omissions (a) not in good faith or (b) which involve intentional misconduct or (ii) a knowing violation of law. Disney, like most public corporations, had included such a provision in its certificate of incorporation.
The plaintiffs claimed that the process by which the directors approved the OEA was deficient, asserting that the directors failed to devote sufficient care and attention to the process. If the plaintiffs had fashioned their claim as one the violation of the duty of care, the director protection provision on the certificate would have prevented them from recovering damages even if they proved that the directors violated that duty. Accordingly, the plaintiffs, using the same facts that would be relevant to a duty of care claim, sued the directors on the basis that their conduct violated the duty of good faith.
The Duty of Good Faith
The court described the duty of good faith in general, and not particularly helpful, terms as follows:
The good faith required of a corporate fiduciary includes . . . all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders.
In derivative litigation against directors (and the Disney litigation was derivative), courts employ the presumption of the business judgment rule. This creates a presumption that a director acted in good faith. In order to prevail on a claim based on a violation of the duty of good faith, a shareholder/plaintiff must overcome that presumption by proving by a preponderance of the evidence that the director committed an act of bad faith.
The Disney court identified three principal categories of bad faith (which includes a failure to act in good faith). The categories are:
* where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation,
* where the fiduciary acts with the intent to violate applicable positive law,
* where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. The court’s opinion used other formulations of this type of violation, including "intentional dereliction of duty" and "deliberate indifference and inaction in the face of a duty to act."
For current purposes, only the third category of bad faith was really at issue in the Disney case, although the court also concluded that the directors also believed that they were acting in the best interests of the corporation.
Accordingly, the remainder of this e-alert will focus on the issue of the "conscious disregard of duty."
Application of the Duty of Good Faith to the Disney Facts — Threshold Issues
As a threshold matter, the court was careful to create a framework on analysis that allowed, and even required, lower expectations for director conduct than those required by the 2003 Opinion. It did so in two ways, neither of which appears particularly exceptional or objectionable in light of existing Delaware law.
First, the court distinguished between the standard of conduct required where the corporation statute requires action by the directors (as in the case of mergers where the directors must recommend the merger to shareholders) and the standard of conduct required in connection with other action by directors, including actions required (as in Disney) by a corporation’s governing documents such as bylaws or committee charters. While the court did not say so precisely, its meaning was clear -- in the latter category, a lesser standard of conduct will satisfy the duty of good faith.
Second, the court made clear, several times, that the best practices of corporate governance do not define the content of the duty of good faith. The court said at various points in the opinion:
Delaware law does not -- indeed, the common law cannot -- hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices. . . .
the best practices of corporate governance include compliance with fiduciary duties. Compliance with fiduciary duties, however, is not always enough to meet or to satisfy what is expected by the best practices of corporate governance. . . .
defendants’ conduct is not measured against the best practices of corporate governance.5
Application of the Duty of Good Faith to the Disney Facts — Particular Issues
The court’s opinion is very fact specific, and as a result it is difficult to get a clear understanding of what the court considers to be conduct necessary in order for a director to avoid a breach of the duty of good faith based on a "conscious disregard of duty," " intentional dereliction of duty," or "deliberate indifference and inaction in the face of a duty to act." But as we read the opinion, it is best read as holding that the Disney directors did not consciously disregard their duties for three reasons:
* they did not adopt an "ostrich-like" approach;
* they were informed of all material information reasonably available; and
* they considered the issue for a not-insignificant period of time.
As a general matter, we believe that using a metaphor to articulate a doctrine is always troubling, since the precise or intended meaning of metaphors can be difficult to pin down. The only situation in which the court suggests what "ostrich-like" may mean involves the report by Crystal, the compensation expert. The court noted that Crystal had faxed a memorandum to Russell and presumably this is the "report." That report failed to calculate the value of the no-fault-termination provision of the OEA, which was arguably a material fact. The court noted that the directors did not have "actual notice that would lead them to believe . . . that Crystal’s analysis was inaccurate or incomplete." The court concluded that "without that knowledge, I conclude that the compensation committee acted in good faith." In the context of a report that failed to include an important calculation, a requirement that the directors must have "actual notice that would lead them to believe . . . that Crystal’s analysis was inaccurate or incomplete" seems close to saying that the directors must have realized that the report was incomplete or inaccurate.
The high level of knowledge required in order to be able to charge a director with "ostrich-like" behavior appears consistent with the relevant standard which focuses on the director’s mental state, requiring that the director act consciously ("conscious disregard of duty"), intentionally (" intentional dereliction of duty"), or deliberatively ("deliberate indifference and inaction in the face of a duty to act"). It is worth noting that other Delaware cases, including the 1996 Caremark case, have indicated that a breach of fiduciary duty can be predicated on a lower degree of knowledge, in that case, the failure to follow up on suspicion. In that case, the court said:
The case can be more narrowly interpreted as standing for the proposition that, absent grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company’s behalf.
Informed of All Material Information Reasonably Available. The court concluded that Russell, Watson, Poitier, and Lozano had each informed themselves of "all material information reasonably available."
While the court used the term "reasonably available" eleven times, it does not define or explain the term. Dictionary definitions of "available" suggest two slightly different meanings of the word. In one sense, the word "available" is used to indicate "present and ready for use; at hand;" in the other sense, it is used to indicate "capable of being gotten; obtainable." In the context of the Disney case, "capable of being gotten; obtainable" presumably would imply getting information through investigation. It appears that the court uses the first meaning, so that "all material information reasonably available" means "all material information reasonably present and ready for use or at hand." This is a narrow reading of the obligation of directors to assure that they have the information necessary to make an informed decision.
This narrow reading of "reasonably available" is supported by the court’s evaluation of the conduct of Russell. The court rejected the claim that he violated his fiduciary duty on the basis that "he failed to inform himself of all material information reasonably available in making decisions." The court reached this conclusion even though Russell did not investigate and learn two apparently material, and rather easy to learn, facts. One fact was Ovitz’s income at his previous employer and the other was Ovitz’s problems with the Department of Labor. The court conceded that it would have been better if Russell had investigated but the failure to do so did not constitute a failure to obtain all material reasonably available6.
The narrow approach to the meaning of "reasonably available" in connection with Russell’s failure to investigate is supported by the court’s discussion of the directors’ obligation to take an active role. The court noted that Poitier and Lozano "did very little" in connection with the hiring of Ovitz. Their involvement was limited to participation at a meeting of the compensation committee where the compensation arrangements were approved. At that meeting, "the compensation committee was provided with a term sheet of the key terms of the OEA and a presentation was made by Russell (assisted by Watson), who had personal knowledge of the relevant information by virtue of his negotiations with Ovitz and discussions with Crystal." Both Poitier and Lozano "were present for and participated in the discussion that occurred." Their level of involvement in the hiring process was in contrast with Russell's and Watson's, who were quite active. Russell was involved in negotiating the compensation arrangements and both Russell and Watson were involved in extensive analysis of the economics of the arrangement. Watson, who was less involved than Russell, was involved in "helping Russell evaluate the financial ramifications of the OEA" and he "conducted extensive analyses of Ovitz’s proposed compensation package." The court noted that "there is no question that in comparison to those two, the actions of Poitier and Lozano may appear casual or uninformed," but concluded that they did not violate their fiduciary duty of good faith. The rationale is that "Delaware law does not require (nor does it prohibit) directors to take as active a role as Russell and Watson took in connection with Ovitz’s hiring."
In this connection, it should be noted that the court indicated that the proper means for evaluating the conduct of directors is on a director-by-director basis. Each director must fully inform himself of all material information reasonably available. Poitier and Lozano had very little direct knowledge about the OEA. They did have a term sheet, but received most of their information from presentations by Russell and Watson. It follows that if Russell and Watson had not made the presentations, but merely provided Poitier and Lozano with a recommendation in favor of the OEA, Poitier and Lozano may not have informed themselves of all reasonably available material information.
Whether later courts will view the term "reasonably available" in the same narrow manner as the Disney court (meaning information readily at hand) is an open question. As we read Disney, the information that was "reasonably available" to Poitier and Lozano was information already known to them, a summary of the terms of the OEA, and a report by the persons who negotiated the OEA.
Materiality. The court indicated that the standard of conduct required of directors in Disney is lower than that required by Smith v. Van Gorkom, an important case decided in 1985 that held directors personally liable for damages in connection with the approval of a merger. Among the reasons why a lower standard of conduct was acceptable in Disney were (i) the transaction in Van Gorkom, a merger, was "material" to the corporation while Ovitz’s OEA was not material to Disney and (ii) the merger in Van Gorkom had "financial ramifications" are "significantly larger" for the corporation than the OEA had for Disney.
The Disney court evaluated the materiality of the OEA to Disney in terms of the size of the company and in particular in terms of the authority granted to officers to act without approval of the board of directors.
the compensation committee’s later decision to approve the economic terms of the OEA [has] . . . to be understood in context. In fiscal 1996, the Company had almost $19 billion in revenues, and more than $3 billion in operating income. . . . Roth, below both Eisner and Ovitz in the chain of command, had authority to budget the development and marketing of feature films, apparently without prior authorization from Eisner, Ovitz or the board. Between these two motion pictures alone, Roth had the authority to spend almost $250 million, with an expected profit of ten percent. Id. If Roth had this much authority, the proposition that Eisner, the Company’s chief executive officer, entered into the OLA without prior board authorization, or that the compensation committee approved Ovitz’s contract based upon a term sheet and upon less than an hour of discussion, seems eminently reasonable given the OEA’s (relatively small) economic size.
Impact on Litigation
The Disney case creates formidable hurdles for a plaintiff seeking to pursue a claim against directors based on a breach of the duty of good faith. The court notes that in order for a complaint to survive a motion to dismiss, the complaint must "articulate ‘facts that suggest a wide disparity between the process the directors used . . . and that which would have been rational.’" It is not sufficient to plead "conclusory statements" as to the conduct of the directors. The court, quoting another case involving a takeover, noted that it was insufficient to plead "conclusory statements that the target’s board rejected an offer based upon ‘(1) the interested director’s desire to consummate [the deal proposed by the other bidder], (2) a desire to benefit [the majority shareholders] with a quick deal, (3) dislike of [the spurned bidder], or (4) a personal desire to complete the sale process.’ It is necessary to plead facts supporting those conclusions. In the 2003 Opinion, the court noted that "t he complaint must set forth ‘particularized factual statements that are essential to the claim.’ Mere speculation or opinion is not enough."
The standards set forth in this opinion will make it more difficult for a plaintiff to plead that the directors breached their fiduciary duties. The complaint will have to provide factual allegations to the effect that the directors were not informed of all material information reasonably available. The minutes are not likely to state that information was available to directors, but they did not receive it. Or the complaint will have to provide factual allegations that the directors had actual knowledge of facts that would lead a director to believe there was a problem, but that the directors failed to follow up. Well-drafted minutes would not contain such statements. Or the complaint will have to provide factual allegations that the time spent by the directors was insufficient Again, well-drafted minutes would not allow a plaintiff to make such an allegation.
1 In finding that the complaint contained allegations that stated a cause of action against the directors, the court noted that the complaint alleged that the directors failed to "inquire," to "explore alternatives," and to "evaluate implications." The court said:
[The] complaint alleges that the New Board: (1) failed to ask why it had not been informed; (2) failed to inquire about the conditions and terms of the agreement; and (3) failed even to attempt to stop or delay the termination until more information could be collected. If the board had taken the time or effort to review these or other options, perhaps with the assistance of expert legal advisors, the business judgment rule might well protect its decision. In this case, however, the . . . complaint asserts that the New Board directors refused to explore any alternatives, and refused to even attempt to evaluate the implications of the non-fault termination.
Return to article.
2 In refusing to dismiss the complaint, the court noted that the complaint alleged the following failings, which indicated a breach of the duty of good faith.
* No copy of the September 23, 1995 draft employment agreement was actually given to the committee. Instead, the committee members received, at the meeting itself, a rough summary of the agreement. The summary, however, was incomplete.
* The committee also did not receive any of the materials already produced by Disney regarding Ovitz’s possible employment. No spreadsheet or similar type of analytical document showing the potential payout to Ovitz throughout the contract, or the possible cost of his severance package upon a non-fault termination, was created or presented.
* Nor did the committee request or receive any information as to how the draft agreement compared with similar agreements throughout the entertainment industry, or information regarding other similarly situated executives in the same industry.
* The committee also lacked the benefit of an expert to guide them through the process.
Return to article.
3 SRO refers to securities exchanges, such as the New York Stock Exchange, and Nasdaq, which are referred to by the SEC as "self-regulatory organizations." Return to article.
4 He also made a somewhat more limited statement, indicating that "the utter failure to follow the minimum expectations of Sarbanes-Oxley, or the NYSE or NASDAQ Rules . . . might . . . raise a good faith issue." Return to article.
5 The court did note that a complete failure to follow any best practices might be deemed a violation of the duty of good faith. The court quoted the by now former Chief Justice of the Delaware Supreme Court to the effect that "the utter failure to follow the minimum expectations of Sarbanes-Oxley, or the NYSE or NASDAQ Rules . . . might . . . raise a good faith issue." Return to article.
6 Would the better course of action have been for Russell to have objectively verified Ovitz’s income from CAA? Undoubtedly, yes. Would it have been better if Russell had more rigorously investigated Ovitz’s background in order to uncover his past troubles with the Department of Labor? Yes. Return to article.