Delaware Supreme Court Addresses Board Fiduciary Duties
By: RHONA E. SHWAID
November 2006
On June 8, 2006, the Delaware Supreme Court issued an opinion affirming that directors of The Walt Disney Company did not breach their fiduciary duties in connection with the employment and termination of Michael Ovitz as president. In re the Walt Disney Co. Deriv. Litig., No. 411,2005 (June 8, 2006). Although Ovitz’s brief employment of 14 months resulted in the payment of more than $130 million as a “no-fault” termination fee, the Court maintained the basic notion that directors of a Delaware corporation will be given significant deference in managing corporate affairs and making business judgments, even when such actions fall “significantly short of the best practices ideal of corporate governance.” While the decision did not deviate from basic established principles of the “business judgment rule,” the Court’s decision is instructive in several significant respects:
The Duty of Good Faith
Traditionally, directors are thought to have two main duties: the duty of care (i.e., the obligation to exercise the same care that an ordinary, prudent person would exercise under similar circumstances), and the duty of loyalty (i.e., the obligation not to make self-interested decisions that conflict with the interests of the corporation and its stockholders). The Court made clear that there is also a duty of good faith, that is separate from, although intertwined with, the duties of care and loyalty. The Court identified subjective bad faith as extreme conduct where a director (considered a “fiduciary”) acts with actual intent to do harm. Gross negligence represents fiduciary action that recklessly disregards potential consequences, but that is not motivated by a “malevolent intent.” The Court clearly stated that gross negligence (including a failure to inform oneself of all of the available facts), while a violation of the duty of care, in itself does not constitute bad faith.
The Court also noted that fiduciary action that falls between these two categories—that is, conduct not motivated by an actual intent to do harm, but more culpable than gross negligence—involves an “intentional dereliction of duty [and] a conscious disregard for one’s responsibilities.” Such reckless conduct, in the Court’s opinion, violates the duty to act in good faith.
The Court declined to provide a list of acts that would violate the duty of good faith, but expressed that behavior motivated by an intent to cause harm, reckless judgment, and disregard for one’s duties as a director, will not be protected.
Best Practices For Determining Executive Compensation
The Disney compensation committee could have improved its decision-making process with regard to Ovitz in several ways:
- The committee should have received a spreadsheet prepared by or with the advice of an expert, indicating the amount the executive would receive under each circumstance provided for in the employment agreement (e.g., if the executive is terminated for particular causes, for no cause, voluntarily terminates employment, etc.).
- The terms of employment and termination should have been explained by an expert or a knowledgeable committee member, and the spreadsheet should have been filed with the minutes of the meeting for future reference.
- The compensation committee did not necessarily have to review the employment contract, as long as members were aware of key contractual terms and their implications; had received information from a compensation expert; and had consulted with at least one person involved in negotiating the contract.
Overall Lessons from the Disney Decision
The business judgment rule still protects decisions of fiduciaries of Delaware corporations. It does not require that fiduciaries act perfectly, but does require that directors and officers observe appropriate process, be well-informed, be well-advised, and keep the best interests of the corporation and its stockholders in mind at all times. Process is key. Processes should be implemented to ensure and document that directors and officers are informed of material facts, have procured necessary advice, and have had an opportunity to discuss and analyze the facts and advice in reaching decisions.