This article is reprinted with permission from the
August 29, 2003
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 Delaware court, not to be acting in "good faith" in reaching a decision on executive pay.

The script for this elephant-in-the-living-room scenario actually is a product of three cases in the Delaware courts involving The Walt Disney Co. [Disney]. The latest decision -- we will call it Walt Disney III -- was rendered in May by the Delaware Court of Chancery, on remand from the Delaware Supreme Court, in In re The Walt Disney Co. Derivative Litigation, 825 A2d 275 [Del. Ch. 2003].

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 Sept. 26, 1995 the compensation committee met and discussed the employment of Mr. Ovitz. According to the court:

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 Delaware corporate law [and co-author of Walt Disney II] is Chief Justice Norman Veasey of the Delaware Supreme Court. The serious implications of Walt Disney III may be seen in remarks by Chief Justice Veasey in 2002 at a conference on executive compensation sponsored by the University of Delaware:

[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 New York court:

"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. Ct. 1954].

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] Id. at 278.

[5] Id. at 281.

[6] Id.

[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, Sept. 29, 2002, [3 at 2.