The Appellants lead in both their brief and in the oral argument with an assertion about the Disney board of directors and the business judgment rule (BJR):

[P]laintiffs established that the presumption [of the business judgment rule] was rebutted because the Disney Board breached its fiduciary duty of care by failing to inform itself of all material information reasonably available with respect to Ovitz's employment agreement.

The Appellants are attempting to avail themselves of the enigmatic procedural system established by Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001). Is there an easy way to explain Emerald Partners? Perhaps not, but here's a go ...

To understand Emerald Partners, you need to understand how the Delaware courts approach fiduciary duty claims. They begin with the business judgment rule, which they describe as a presumption that "in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company [and its shareholders].'' If the plaintiffs cannot rebut that presumption, their case is dead in the water. Defendants win.

So the big question is: how do plaintiffs rebut the presumption?

Before Trial

Before a trial, plaintiffs rebut the presumption  of the BJR by alleging facts sufficient to support a finding that the board of directors violated the duty of care, the duty of loyalty, or the duty of good faith.

Now the tricky part.

Even if the plaintiffs successfully allege facts sufficient to support a finding that the board of directors violated its duty of care, the complaint may be dismissed if the corporation's charter contains an exculpatory provision. Under Section 102(b)(7) of the Delaware General Corporation Law, corporations can adopt a charter provision that eliminates or limits the personal liability of directors for monetary damages for breach of the duty of care (an "exculpatory provision"). In Malpiede v. Townson, 780 A.2d 1075 (Del. 2001), the Delaware Supreme Court held that where a corporation has such an exculpatory provision and the plaintiffs file a complaint that contains only a duty of care claim, the court will dismiss the compaint because the plaintiffs cannot recover monetary damages from the defendants. Or, stated another way, to survive a motion to dismiss, a complaint must allege a breach of the duty of loyalty or the duty of good faith.

How did this play out in Disney? Like most corporations today, Disney has an exculpatory provision in its charter, but in his May 2003 decision (825 A.2d 275), Chancellor Chandler concluded that the complaint alleged facts sufficient to rebut the BJR under the duty of good faith and that such claims would not be exculpated under a 102(b)(7) provision. According to Chancellor Chandler:

These facts, if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation. Instead, the facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a "we don't care about the risks" attitude concerning a material corporate decision. Knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company. Put differently, all of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule....

I also conclude that plaintiffs' pleading is sufficient to withstand a motion to dismiss under Rule 12(b)(6). Specifically, plaintiffs' claims are based on an alleged knowing and deliberate indifference to a potential risk of harm to the corporation. Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either "not in good faith" or "involve intentional misconduct." [Citing  8 Del. C. § 102(b)(7)(ii).] Thus, plaintiffs' allegations support claims that fall outside the liability waiver provided under Disney's certificate of incorporation.

Believe it or not, that's the easy part.

At Trial

Once past the motion to dismiss, the plaintiffs are not necessarily out of the woods. After a trial, the Court of Chancery may conclude that the plaintiffs have not proven facts that rebut the presumption of the business judgment rule. In such a case, the Court should rule in favor of the defendants. (Emerald Partners: "If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule operates to provide substantive protection for the directors and for the decisions that they have made.") Alternatively, the Court of Chancery might conclude that the plaintiffs have rebutted the presumption of the business judgment rule. In such a case, the burden shifts to the defendants to show that the challenged transaction was entirely fair.

Now, you might think that the defendants would be spared the trouble of proving entire fairness if the plaintiff's case rested solely on a breach of the duty of care. Why not allow the defendants to invoke the exculpatory provision and be done with it? Because Emerald Partners says so:

A determination that a transaction must be subjected to an entire fairness analysis is not an implication of liability. Therefore, when entire fairness is the applicable standard of judicial review, this Court has held that injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair. A fortiori, the exculpatory effect of a Section 102(b)(7) provision only becomes a proper focus of judicial scrutiny after the directors' potential personal liability for the payment of monetary damages has been established. Accordingly, although a Section 102(b)(7) charter provision may provide exculpation for directors against the payment of monetary damages that is attributed exclusively to violating the duty of care, even in a transaction that requires the entire fairness review standard ab initio, it cannot eliminate an entire fairness analysis by the Court of Chancery.

If the Court completes the entire fairness inquiry and concludes that the transaction was unfair, it must take the additional step of identifying which duty (care, loyalty, or good faith) is the basis for liability.

If the board's actions do not withstand the judicial scrutiny of an entire fairness analysis, the breach or breaches of fiduciary duty upon which substantive liability for monetary damages is based become outcome determinative when the directors seek exculpation through a charter provision enacted in accordance with Section 102(b)(7). Such a provision bars any claim for monetary damages against director defendants based solely on the board's alleged breach of its duty of care but does not provide protection against violations of the fiduciary duties of either loyalty or good faith. Consequently, we have held that "[t]he Court of Chancery must identify the breach or breaches of fiduciary duty upon which liability [for damages] will be predicated in the ratio decidendi of its determination that entire fairness has not been established." Accordingly, we hold that when entire fairness is the applicable standard of judicial review, a determination that the director defendants are exculpated from paying monetary damages can be made only after the basis for their liability has been decided.

Again, how did this play out in Disney? The analysis did not proceed through all of the stages outlined by Emerald Partners because Chancellor Chandler concluded that the plaintiffs did not rebut the presumption of the BJR. With respect to the hiring of Ovitz, Chancellor Chandler wrote:

I conclude that the only reasonable application of the law to the facts as I have found them, is that the defendants did not act in bad faith, and were at most ordinarily negligent, in connection with the hiring of Ovitz and the approval of the [Ovitz Employment Agreement.]

With respect to Ovitz's termination, Chancellor Chandler held that Eisner and Litvak (not Kate!) did not breach their duties and the remainder of the Disney board of directors had no duty to act. In short, the plaintiffs never overcame the presumption of the BJR.

The Disney Appeal

As noted above, the plaintiffs contend that Chancellor Chandler erred by "failing to make a threshold determination that the [Disney] board's gross negligence rebutted the presumption of the business judgment rule." The basis for their claim is the following language from the Chancellor's opinion:

The presumption of the business judgment rule creates a presumption that a director acted in good faith. In order to overcome that presumption, a plaintiff must prove an act of bad faith by a preponderance of the evidence. (emphasis added in plaintiff's brief)

This is a grossly misleading argument, which seems to be based on a fundamental misreading of
Emerald Partners. (That's easy enough to understand, as Emerald Partners is the most convoluted case in all of Delaware law.) According to the appellants, the notion of "good faith" is irrelevant at the initial stage of the inquiry, when the Court is attempting to determine whether the presumption of the BJR has been rebutted. In their view:

"Good faith" is only relevant to the court's analysis when the plaintiffs have met their burden on the due care claim, and defendants have failed to demonstrate the entire fairness of the transaction.

This is simply wrong. As explained above, the court in Emerald Partners identified three important and separate inquiries: (A) whether the plaintiffs rebutted the presumption of the BJR; and (B) if the plaintiffs were successul in rebutting the presumption of the BJR, whether the transaction was entirely fair; and (C) if the transaction were unfair, whether the basis for liability was a breach of the duty of care, loyalty, or good faith.

The appellants are referring to the inquiry at Stage C, but the Emerald Partners Court also noted that good faith is relevant at Stage A:

To rebut the presumptive applicability of the business judgment rule, a shareholder plaintiff has the burden of proving that the board of directors, in reaching its challenged decision, violated any one of its triad of fiduciary duties: due care, loyalty, or good faith. If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule operates to provide substantive protection for the directors and for the decisions that they have made. If the presumption of the business judgment rule is rebutted, however, the burden shifts to the director defendants to prove to the trier of fact that the challenged transaction was "entirely fair" to the shareholder plaintiff.

In summary, appellants argue that Chancellor Chandler botched the BJR analysis because his discussion of good faith was "premature" (i.e., should have been saved for Stage C), and he wrongly placed the burden of persuasion on the plaintiffs. Both of these claims should be rejected by the Supreme Court because good faith is an appropriate part of the analysis at Stage A and the burden of persuasion at that stage rests on the plaintiffs.

P.S. I think the whole notion of the BJR as a "presumption" is silly and Emerald Partners is a nightmare. This post is not intended as a defense of these doctrines, but merely an explication.

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