Client Alert

In a decision rendered earlier this month in In Re The Walt Disney Co. Derivative Litig., No. 411, 2005 (June 8, 2006), the Delaware Supreme Court unanimously affirmed the Delaware Court of Chancery’s August 2005 ruling that The Walt Disney Company board of directors did not breach their fiduciary duties in connection with the hiring and later termination of former President Michael Ovitz. As discussed below, the ruling comes as welcome news to the corporate community since it reaffirms the protections afforded by the business judgment rule for disinterested directors who act in good faith and adequately inform themselves prior to making business decisions - - even if their conduct does not necessarily amount to "best practices" in today’s corporate governance climate. The ruling also sheds (somewhat) more light on director conduct that may amount to bad faith, an important distinction since, under Delaware statutory law, director conduct that is not in good faith cannot be protected from monetary liability under corporate exculpation or indemnification provisions.

Background

Disney hired Michael Ovitz as its President effective October 1995. Ovitz was terminated without cause 14 months later in December 1996. Under the terms of Ovitz’s employment agreement with Disney, the without cause termination resulted in a non-fault termination payment to Ovitz valued at approximately $130 million. In 1997, several Disney shareholders filed a derivative lawsuit against the current and former directors of Disney alleging that the directors had breached their fiduciary duties in hiring Ovitz and approving the terms of the Ovitz employment agreement (including the large non-fault termination payment) and in electing to terminate Ovitz without cause, thus triggering the non-fault termination payment, and alleging that the directors’ conduct amounted to corporate waste. ¹ In August 2005, the Delaware Court of Chancery held that the Disney directors did not breach their fiduciary duties or commit waste in connection with the hiring and termination of Ovitz and the payment of the non-fault termination payment. (See our earlier Client Memo summarizing the August 2005 Court of Chancery decision.) Plaintiff shareholders appealed the August 2005 Court of Chancery decision to the Delaware Supreme Court.

Analysis

On appeal to the Delaware Supreme Court, the plaintiff shareholders’ core claim asserted that the Disney directors had breached their fiduciary duties to act with due care and in good faith in connection with the approval of the Ovitz employment agreement, the Ovitz termination and the payment of the non-fault termination payment. The plaintiffs thus claimed that the directors should not have been entitled to the protection of the business judgment rule but instead should have borne the burden of demonstrating that their actions were entirely fair to Disney. ² 

In addressing the plaintiff shareholders’ core claim, the Court separately analyzed the due care and good faith determinations.

Duty of Care. The Court addressed the due care determination first, ultimately agreeing with the Court of Chancery, based on the factual record before it, that the directors on the compensation committee and the board generally were adequately informed of all material information reasonably available to them prior to making their respective decisions with respect to Ovitz’s employment agreement and his hiring as President.

In a detailed discussion of the facts on which the Court based its conclusions, the Court agreed with the Court of Chancery’s determination that the compensation committee had failed to satisfy "best practices" of corporate governance in considering and approving Ovitz’s employment agreement. Despite such failure, however, the Court concluded that the facts were sufficient to support a finding that the compensation committee had adequately informed itself (and thus exercised due care). As noted in the Practice Pointers section below, the Court’s detailed discussion on "best practices" offers some helpful guidance to compensation committees in considering executive compensation matters.

Good Faith. The Court addressed the good faith determination next. On appeal, the plaintiff shareholders asserted that a finding of bad faith did not require a subjective bad motive or intent but rather that bad faith was synonymous with the duty of care. The Court quickly dispensed with this claim on two grounds. First, the Court affirmed the Court of Chancery’s articulated standard for bad faith fiduciary conduct, which standard was an "intentional dereliction of duty, a conscious disregard for one’s responsibilities." Second, the Court noted that even if bad faith was synonymous with a failure to exercise due care (which connection the Court expressly disputes later in its opinion), it had already concluded that the directors did not breach their duty of care.

Acknowledging that the duty to act in good faith remains an "unchartered" area of Delaware corporate fiduciary law, the Court offered some "conceptual guidance to the corporate community" to help directors and their advisors assess whether certain conduct may amount to bad faith. The Court identified two types of fiduciary conduct that constitute a breach of the duty to act in good faith (or, said another way, that constitute bad faith), and one type of conduct - - gross negligence - - that clearly does not. The first category of conduct is "subjective bad faith", where the fiduciary has intent to do harm, which the court said amounts to "classic, quintessential bad faith." The second category, "at the opposite end of the spectrum," involves a lack of due care, i.e., action taken due to gross negligence but without bad intent. The Court said that this type of conduct does not constitute bad faith; that is, gross negligence (including the failure to be adequately informed of all material facts) does not, without more, equate to bad faith. The third category, a middle ground which conceptually lies between subjective bad faith and gross negligence, is that type of fiduciary conduct contemplated by the Court of Chancery’s articulated standard, a "intentional dereliction of duty, a conscious disregard for one’s responsibilities". The Court noted that this second category of fiduciary conduct "does not involve dishonesty (as traditionally defined) but is qualitatively more culpable than gross negligence." In order to protect the interests of corporations and their shareholders, the Court said, this middle ground of conduct must be treated as "a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith."

Although the Court acknowledged that there may be other categories of fiduciary conduct which constitute bad faith, the Court declined to offer a "definitive and categorical definition of the universe of acts that would constitute bad faith". The Court also declined to address the issue of whether a failure to act in good faith may serve as an independent basis for imposing liability on a director or officer, as is the case with the duty of care and duty of loyalty.

Practice Pointers

Several practice pointers can be taken from this most recent installment of the Disney litigation: 

• Duty of Care and Best Practices: The decision confirms that directors do not breach the duty of care by failing to abide by best practices of corporate governance. Nevertheless, the Court suggests that litigation and potential liability can be avoided if best practices are observed. 
• Compensation Committee Best Practices: The decision offers useful guidance to compensation committees for "best practices" in approving executive compensation. For instance, in a "best practice" scenario, the Court said, all compensation committee members should receive in advance a spreadsheet or other similar document prepared by a compensation expert which discloses the different amounts of consideration to be paid to the executive under various forseeable circumstances, the spreadsheet would be explained to the committee members either by the compensation expert (although the expert is not legally required to present the information) or a committee member with knowledge about the subject, the spreadsheet would be attached to the minutes of the meeting and the minutes would reflect that the spreadsheet and the related discussions form the basis of the committee’s decision. 
• Importance of Keeping Good Minutes: The decision, and particularly the Court’s discussion of "best practices," serves as a reminder to boards and committees that the deliberative process for important actions and the information provided in connection with such process should be well documented in the corporate minutes.
• Duty to Act in Good Faith: The decision explicitly recognizes a duty to act in good faith that is separate from but which may overlap with the duties of care and loyalty. The existence of a separate duty of good faith has been a subject of debate among commentators and practitioners in recent years and the decision offers some of the first specific guidance on this issue. The concept of a separate duty to act in good faith is especially important given that, as the Court noted, exculpation and indemnification provisions under Delaware law remain available to directors for breach of the duty of care but not if the director has acted in bad faith. 
• Understand the Duties and Authority of the Board and its Committees: In resolving issues relating to the termination of Ovitz, the Court had to determine whether the board or Michael Eisner (Disney Chairman/CEO) had the authority under Delaware law and Disney corporate governance documents to terminate Ovitz. The Court ultimately determined that the board and Eisner had concurrent authority; however, it noted that the Disney corporate governance documents were ambiguous on this issue and the Court was forced to rely on legal rules of construction to reach its determination. The decision thus serves as a reminder to boards and committees that each must understand and act within the proper scope of their authority under not only statutory law, but also under internal corporate governance documents such as the corporate charter, bylaws, committee charters and other corporate guidelines.

Conclusion

The decision is a resounding endorsement of the Court of Chancery’s decision. Many commentators had anticipated that the Supreme Court would use the Disney decision as an opportunity to modify Delaware fiduciary duty law in a material way. The fact that the Supreme Court declined to do so provides comfort that, where disinterested directors adequately inform themselves prior to making business decisions, the principles of the business judgment rule generally remain intact.

1 The plaintiffs did not assert any breach of loyalty claims against the Disney directors.

2 The plaintiff shareholders also asserted on appeal that (i) even if the directors were entitled to the protection of the business judgment rule, the non-fault termination payment constituted corporate waste, and (ii) Ovitz breached his fiduciary duties of care and loyalty to Disney in negotiating for and accepting the non-fault termination payment. The Supreme Court rejected such claims and affirmed the Court of Chancery’s holding that the non-fault termination payment did not constitute waste and that Ovitz did not violate his fiduciary duties in connection with negotiating for, and receiving, the non-fault termination payments. Since the Court’s holdings with respect to these claims do not offer significant additional guidance, they are not specifically addressed in this memorandum.