The power of perception
Each year brings new challenges for corporate directors. They contend with legislative changes from Sarbanes-Oxley on down, warnings from SEC enforcers and novel proxy issues. Then there are the legal opinions that can subtly or dramatically shape their world.
The Delaware courts probably demand the most attention since they are often the source for the most cutting-edge decisions in corporate law. It is also the home jurisdiction to a majority of the United States’ listed companies. In the last year alone, the Court of Chancery and the Supreme Court have ruled on options backdating, bonuses and the right of shareholders to more information on merger proposals to name a few. The outcome of these rulings may place the state’s reputation as the ‘most corporate-friendly jurisdiction in the country’ at risk.
While Delaware has long been famous for having a very high threshold for director liability, there are signs that the courts are becoming more willing to hold boards accountable on matters they might have previously passed over. The shift began two years ago, when the Court of Chancery issued its opinion in In re Walt Disney derivative litigation in what some called ‘the case of the decade’ on the issue of director fiduciary duties.
The case, which casts a long shadow today, had to do with the disastrous hiring and firing of former Disney president Michael Ovitz that left the company paying severance fees of $140 million for a little more than a year of work. Shareholders sued the board for breach of fiduciary duties and waste in connection with the matter. A five-week trial pointed up some poor decision making, including the compensation committee spending less than an hour sorting out Ovitz’s astonishing pay package.
While chancellor William Chandler said in his opinion Eisner and the board made some terrible decisions, they did so in good faith, and were thus protected by Delaware’s business judgment rule. The rule gives companies, directors and officers wide latitude for their decisions as long as they are made with ‘the duty of care and the duty of loyalty.’
A changing environment
The business judgment rule remained the bedrock for Disney that it has been for other companies incorporated in Delaware, but Chandler signaled that it could be cracked.
Chandler went out of his way to say that the courts, in the wake of the Enron and WorldCom ‘debacles’, hold directors to more stringent standards today than those under which Disney board operated in the 1990s. The implication was that with a new focus on corporate governance the conduct might be judged in a harsher light.
‘I think it was a warning,’ says Charles Elson, the Woolard chair of corporate governance in the University of Delaware’s College of Business and Economics. ‘If anyone thinks Disney was a green light for poor director behavior, they’re kidding themselves.’
Fast forward to today to a climate of heightening of tension between shareholders and management, plaintiffs have been emboldened to attack directors’ decisions or their processes for making those decisions, often striking at the business judgment rule.
Such claims formed the cornerstone of recent complaints leveled in Chancery Court against two companies for backdating and spring loading stock option grants.
In those cases, Ryan v Gifford and In re Tyson Foods, shareholders allege the directors of the underlying companies deliberately or negligently shrugged off these questionable awards practices, thus breaching their fiduciary duties of loyalty and/or care.
Preliminary rulings in the cases should worry directors. In February, Chandler, who is also deciding these matters, issued opinions allowing the cases to proceed to trial with wording seeming to rule out any possibility that options manipulation might be protected under Delaware’s business judgment rule.
He has a strongly negative take on backdating and spring loading. In the Ryan opinion, Chandler writes: ‘A director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders and yet satisfy his duty of loyalty.’
He adds that he is ‘unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith.’ Interestingly, the chancellor could have invoked the statute of limitations since the manipulation occurred years ago, but chose to toll it because of apparent concealment.
Elson says Chandler’s rulings are signs the court is ‘much more critical’ of director missteps, as it indicated it would be post-Disney. ‘While he hasn’t imposed liability, he’s telling directors to take notice.’ The next director to sit before Chandler may not get off as lightly.
Lowering the bar?
Since former chancellor William Allen’s decision in In re Caremark International in 1996 the standard for imposing liability on a director has been gross negligence. It’s a high bar, and requires sustained inattention to serious issues of the corporation over time. Even so, Delaware has held directors accountable many times. At a recent Harvard corporate governance summit, vice chancellor Leo Strine noted rulings against officials at HealthSouth, Hollinger and Houlihan Lokey. ‘We do it,’ he said. ‘The question is how often should that occur and what should the standard be?’
Boards need to be given space to do their jobs and make some mistakes. ‘The court is not going to step in and second guess the business decisions of informed board directors,’ says Paul Fioravanti, a partner in Delaware’s Prickett, Jones & Elliott. ‘The court doesn’t want to take over the boardroom and it never has.’
Some observers read recent decisions to mean the standards for director oversight and responsibility are changing, but others disagree. ‘The standards aren’t new,’ says Francis Pileggi, a partner with Fox Rothschild in Delaware. ‘The courts are just being less forgiving when applying them.’
In any case, the court seems more willing to show annoyance at questionable decisions. For example, in ATR-Kim Eng Financial Corp v Araneta, Strine called several directors ‘stooges’ and ‘mere tools’ as they stood by and watched Araneta, the majority shareholder, transfer 90 percent of the company’s asset to members of his family in violation of his fiduciary duties. He imposed liability on them for failing to carry out their duty to protect ATR Financial and ATR Capital Partners, the minority shareholders.
In an unusual move, he shifted plaintiffs’ legal fees to the defendants since the conduct was so egregious. It went against the normal application of the American Rule under which parties to litigation normally bear their own costs regardless of the case’s outcome. The decision was ‘highly critical’ and ‘a further signal of the kind that started with Disney,’ Elson says.
One case that got a lot of attention in March was Valeant Pharmaceuticals International v Jerney, in which the former president and director of a pharmaceutical company was required to disgorge a $3 million bonus that he and his eleven fellow directors had approved. The Court also ordered him to repay the legal fees incurred in his defense as well as a share of the costs of the special litigation committee investigating the matter.
This case highlights the minefield that directors must navigate when approving bonuses for themselves and others. ‘You can’t get a better example of how serious these issues are,’ Pileggi says. ‘This case is important for every director to read.’
The company got into trouble because there were no disinterested directors evaluating the decision to give each director a bonus. The compensation committee members also had conflicts of interest. Because there was so much unfairness, the directors lost the protection of the business judgment rule.
Fioravanti, involved in the case on the side of an investor and the company, agrees about its importance. ‘It’s considered a textbook example of how not to make an executive compensation decision,’ he says. ‘You didn’t have a disinterested board of directors; you didn’t have a disinterested compensation committee.’
He adds that the opinion contains a lot of ‘mileposts’ for the board and compensation committees to make sure they reach bonus decisions that are fair to the corporation and to shareholders.
Finally, a corporate secretary’s or director’s Delaware reading list should include Stone v Ritter, a Delaware Supreme Court decision handed down in November. A key part of the decision was its answering of a question left open by Disney on ‘good faith’ in director conduct, clarifying that it is not a stand-alone fiduciary duty, but is part of the duty of loyalty.
Education and revision is vital
But those in the compliance field should know it had important things to say about what constitutes best practice in compliance programs. The opinion said it’s not enough to merely adopt a reasonable program; it must demonstrate its effectiveness in regular reports. It went on to say boards may also be held to a duty of continuing education on developments in compliance.
‘So far there has been little commentary on the duty of ongoing review and revision of compliance programs,’ says Andrew Demetriou, a partner at Fulbright & Jaworski.
In any case, the decision was in keeping with typical Delaware style – not terribly punitive, but full of moral suasion. While it gives plaintiffs’ attorneys something to work with in their next lawsuits challenging behavior, it also gives directors plenty of guidance in how to avoid liability.
Courts are not in the business of making laws but it is their job to interpret them and, if recent cases are anything to go by, judges’ appetite for corporate misconduct or negligence is waning. The business judgment rule should no longer be relied upon for protection. But it is not just director liability cases where opinion is changing. Delaware and other courts are taking a harder line on M&A due diligence requirements, consumer protection, environmental failures and securities violations.