Disney Affirmed: The Delaware Supreme Court Clarifies The Duty of Directors To Act In Good Faith

On June 8, 2006, the Delaware Supreme Court issued its much anticipated decision in In Re The Walt Disney Company Derivative Litigation.  The Supreme Court affirmed the Delaware Court of Chancery’s determination that Disney’s directors had not breached their fiduciary duties in connection with the hiring or termination of Michael Ovitz as President of The Walt Disney Company.  In so ruling, the Supreme Court clarified the parameters of the obligation of corporate fiduciaries to act in good faith and offered helpful guidance about the types of conduct that constitute “bad faith.”

The facts surrounding the Disney saga are by now well-known.[1]  Briefly stated, the litigation involved a derivative suit against Disney’s directors and officers for damages allegedly arising out of the 1995 hiring and the 1996 firing of Michael Ovitz.  The termination resulted in a non-fault termination payment to Ovitz under the terms of his employment agreement valued at roughly $140 million.  The shareholder plaintiffs alleged that the Disney’s directors had breached their fiduciary duties both in approving Ovitz’s employment agreement and in later allowing the payment of the non-fault termination benefits.

The Delaware Supreme Court affirmed the Court of Chancery’s conclusion that the shareholder plaintiffs had failed to prove that the defendants had breached any fiduciary duty.  With respect to the hiring of Ovitz and the approval of his employment agreement, the Supreme Court held that the Court of Chancery had a sufficient evidentiary basis from which to conclude, and had properly concluded, that the defendants had not breached their fiduciary duty of care and had not acted in bad faith.  As to the ensuing no-fault termination of Ovitz and the resulting termination payment pursuant to his employment agreement, the Supreme Court affirmed the trial court’s holdings that the full board did not (and was not required to) approve Ovitz’s termination, that Michael Eisner, Disney’s CEO, had authorized the termination, and that neither Eisner, nor Sanford Litvack, Disney’s General Counsel, had breached his duty of care or acted in bad faith in connection with the termination.

In its opinion, the Supreme Court acknowledged that the contours of the duty of good faith remained “relatively uncharted” and were not well developed.  Mindful of the considerable debate that the Court of Chancery’s prior opinions in the Disney litigation had generated and the increased recognition of the importance of the duty of good faith in the current corporate law environment, the Supreme Court determined that “some conceptual guidance to the corporate community [about the nature of good faith] may be helpful.”

The Supreme Court flatly rejected the notion, advanced by plaintiffs, that lack of good faith could be equated with gross negligence, which is the standard for finding a violation of the fiduciary duty of care.  The Court explained that both common law and Delaware statutory law have distinguished sharply between the duties of due care and good faith.  Specifically, the Court explained that Section 102(b)(7) of the Delaware General Corporation Law (the “DGCL”) permits a Delaware corporation through a provision in its certificate of incorporation to exculpate directors from monetary damages for breach of the duty of care, but expressly prohibits exculpation for acts or omissions not in good faith.  Similarly, the Court cited Section 145 of the DGCL, Delaware’s indemnification statute, observing that a Delaware corporation generally has the power to indemnify a director or officer for liability incurred by reason of a violation of the duty of due care but not for a violation of the duty to act in good faith.  The Court explained that any definition of bad faith that would cause a violation of due care (i.e., gross negligence) to become a de facto act or omission not in good faith would eviscerate the protections afforded by Sections 102(b)(7) and 145 of the DGCL.

The Supreme Court identified two categories of fiduciary behavior that do constitute bad faith.  The first category of such conduct is so-called “subjective bad faith,” which is evidenced by “fiduciary conduct motivated by an actual intent to do harm” to the corporation or its stockholders.  The Court referred to such conduct as “quintessential bad faith,” long recognized by Delaware corporate jurisprudence.

The other category of fiduciary conduct that constitutes bad faith, the Supreme Court observed, had been a focal point of the Court of Chancery’s prior decisions in the Disney case – “intentional dereliction of duty, a conscious disregard for one’s responsibilities.”  In concurring with the Chancellor and determining that such conduct was neither exculpable nor indemnifiable, the Supreme Court explained as follows:

[T]he universe of fiduciary misconduct is not limited to either disloyalty in the classic sense … or gross negligence.  Cases have arisen where corporate directors have no conflicting self-interest in a decision, yet engage in misconduct that is more culpable than simple inattention or failure to be informed of all facts material to the decision.  To protect the interests of the corporation and its shareholders, fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed.  A vehicle is needed to address such violations doctrinally, and that doctrinal vehicle is the duty to act in good faith.

In addition to the helpful discussion about the contours of the duty of good faith, the Supreme Court’s opinion offers guidance on several other issues.  For example, the Court affirmed the Chancellor’s rulings relating to the power of Michael Eisner, as Disney’s CEO, to terminate Mr. Ovitz as President.  The Supreme Court also adopted the same practical view as the Court of Chancery regarding the important statutory protections offered by Section 141(e) of the DGCL, which permits corporate directors to rely in good faith on information provided by fellow directors, board committees, officers, and outside consultants.  The Supreme Court’s decision also provides specific guidance on the types of processes that would have satisfied a “best practices” standard in connection with the approval of Ovitz’s employment agreement.  The Court’s observations in that regard should prove useful to practitioners seeking to better ensure that future board decisions on potentially controversial topics do not become the subject of lengthy inquiry by a reviewing court.

The Supreme Court’s decision in In Re The Walt Disney Company Derivative Litigation should provide further assurance that Delaware law regarding the liability of directors has not fundamentally changed in recent years.  The Supreme Court’s opinion supports the view that Delaware will remain vigilant in protecting against self-dealing or intentional dereliction of duty by directors, but directors do not have reason to fear that “bad” business decisions made by properly motivated directors exercising due care will give rise to potential liability.

Notes:

[1] For a more detailed discussion of the underlying facts and the Court of Chancery’s earlier opinions in the matter, see Donald J. Wolfe, Jr., Michael B. Tumas and Mark A. Morton, Notable Delaware Corporate Decisions 2005: Delaware-centric Musings on Disney, Toys "R" Us, TCI, Unisuper and Examen (2006); Michael A. Pittenger and Michael K. Reilly, Disney for Deal Lawyers, Deal Points (Spring 2006).  Both articles are available on our Web site.

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