August 11, 2005
No Skeleton with a Scythe
Posted by Elizabeth Nowicki

I find this discussion fascinating, as I am currently working on two “duty of care” papers. Below is my response to the suggestion that the duty of care and Van Gorkom are dead or dying. I agree with Steve Bainbridge's earlier post, but I get to the same result (I think) with a different formula.

Here is the generic duty of care analysis as I have gleaned from the Delaware courts. I break the analysis down into numbered steps to make it easier to work with, because I think that shorthand analysis is one of the ways that Delaware’s judiciary muddles some of their case law in this area:

  1. Directors are afforded significant deference from the judiciary. If a director is sued for an alleged breach of his duty of care, he will automatically be afforded the protection of the Business Judgment Rule Presumption.

  1. If, however, the plaintiff can show that one of the factual prerequisites to the business judgment rule does not exist, the director will be stripped of the protection of the presumption, and his actions will be more closely scrutinized.

  1. The four factual prerequisites to the BJR are: a decision made, in good faith, absent conflicts, after the director has become reasonably informed (and the director must not be GROSSLY NEGLIGENT with respect to this “informed” point).

  1. If one of these four factual prerequisites is missing, the action at issue will be reviewed using a reasonableness and fairness standard.

  1. However, a director can also be protected statutorily with a charter provision similar to that authorized by DGCL 102(b)(7).

  1. If a director defendant shows that such a charter provision exists, he is again presumptively protected unless a plaintiff can show that the alleged duty of care breach is based on or revolves around or is predicated on an act taken “not in good faith.” (Let us please ignore the duty of loyalty for now -- Lyman Johnson does incredible work with that in his recent article.)


Van Gorkom lives on as indicated in point 3 above. The duty of care lives on, assuming a DGCL 102(b)(7) provision, in point 6 above.

As the above analysis applies to Disney:

In the Disney case, I seems that we all agree that there is a sticky point with respect to my point 6 above. The plaintiffs’ need to show that the defendant directors acted “not in good faith.” If we agree that the definition proffered on p.123 of the Disney opinion is a useful way to assess “not in good faith,” then, interestingly, we move a bit away from fraud and closer to gross negligence with “not in good faith.”

The Chancellor said on p.123:

“Upon long and careful consideration, I am of the opinion that the concept of intentional dereliction of duty, a conscious disregard for one’s responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith. Deliberate indifference and inaction in the face of a duty to act is, in my mind, conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct....”

This language – “in the face of a duty to act,” for example, and “intentional dereliction of duty” – leads us back to a basic duty of care analysis. Did the directors breach their duty of care in a way that falls within the Chancellor's definition of "good faith"? Well, if we remove the directors from the BJR protection b/c we view their “informed” efforts as grossly negligent, then we are working with a reasonable and fair standard for purposes of assessing whether they breached their duty of care. And they would be hard-pressed to satisfy that standard. So it seems that we could find that the duty of care had been breached. And then we would circle back and query whether, having so found, the breach was based on inaction or deliberate indifference or intentional dereliction, such that the conduct was now within the reach of the Chancellor’s “good faith” definition.

The above should give a sense of why I am troubled by the opinion. Moreover, hopefully it is easy to see why the compensation committee’s actions give me pause. (A poster named Roger Hipp broke down the facts nicely in a response to my earlier “Respectful Reservations” post.) Either the actions at issue were taken “not in good faith,” such that both the BJR protection AND the statutory protection are stripped from the get-go, or the actions are “grossly negligent” with respect to the “informed” obligation, which triggers the 102(b)(7) “good faith” analysis as noted above.

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Is Van Gorkom dead?
Posted by Account Deleted

Steve Bainbridge, responding to my earlier post, says no.

Maybe, to paraphrase a great American, that depends on what the meaning of "dead" is.  The rule -- that a duty of care is always a prerequisite to the business judgment rule -- is plainly gone, at least in 102(b)(7) cases. 

What about limiting the rule to the sort of major transaction involved in Van Gorkom, as Steve suggests?  Still dead. Chancellor Chandler implies that, at least in a 102(b)(7) case, Disney-type abdication would have been enough for liability in this situation.

So, perhaps, good faith -- conscious disregard without conflict of interest  -- is still alive for that narrow category of cases. 

But Van Gorkom did not involve conscious disregard.  It did not involve a "supine" board's failure to pay attention to one of the highest-profile employment contracts in the history of business.  It involved nailing an experienced, sophisticated board for selling the company for 40% more than the current market price.  Would that happen again, at least in a 102(b)(7) situation?  No way.  No earthly way, unless, as I do not believe will happen, the Supreme Court reverses in Disney.

So does Van Gorkom have any kind of a pulse?  Maybe, in the following limited sense:  No case ever dies in Delaware.  Often cases are preserved as alternative tools the court can draw from as the facts and times require.  At worst, cases go into suspended animation, to be dug up for freakish facts when none of the cases in current "inventory" are useful. 

That's where I think Van Gorkom is going.  Not six feet under, but into a sort of cryogenic state. We might see it walking around in a kind a Frankenstein, Living Dead-ish gait at some point.  An imitation of life. But still dead.

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Is Van Gorkom Dead
Posted by Steve Bainbridge

I'm afraid I don't agree with Larry Ribstein's claim that "Van Gorkom is finally dead, a stake through its heart." In my view, Van Gorkom rested on the absence of a sufficient record of any deliberative process. Put differently, I understand the case as teaching that, if the decision making process is adequate, the court will continue to defer to the decision that emerges from that process.

The basic thrust of the Van Gorkom opinion then is that the board must provide some credible, contemporary evidence that it knew what it was doing. If such evidence exists, the court will not impose liability—even if the decision proves to have been the wrong one.

The trouble on the facts of Van Gorkom seems to have been two-fold. First, the magnitude of the decision. A merger is the biggest decision the company can ever make: to sell itself to an outsider. A decision of lesser magnitude is likely to get less close scrutiny. It is also a final period transaction. Second, the process was so severely flawed as to suggest that the board had been captured by Van Gorkom.

For the business judgment rule to perform its economic function, of course, it must preclude judicial review of the merits of the board’s decision. This is what Van Gorkom did: it was the process by which the decision was made, not its substance, that is at issue. (Unfortunately, the Delaware Supreme Court subsequently clouded the issue. In the Cede & Co. v. Technicolor case, the court implied that plaintiff could rebut the business judgment rule by showing that the decision itself was grossly negligent. This puts the cart before the horse: it allows the court to review the substance of the director’s decision, instead of simply reviewing the process by which the decision is made.)

In sum, I have always thought Van Gorkom requires two conditions to be met before the court will set aside the business judgment rule. First, we must be dealing with a major transaction having final period consequences. Second, there must be pervasive evidence that the board of directors has abrogated its decisionmaking authority.

Nothing about the Ovitz case changes my mind or suggests to me that Van Gorkom is a dead letter. The $140 million paid to Ovitz was smaller in relation to the total value of Disney than the $200 million was in relation to the value of Trans Union. Moreover, approval of even a large and unusual employment contract is more routine then approval of the sale of the company and the Disney board at least did hire an outside expert.

When a Delaware court allows directors to escape liability in connection with a final period transaction in which the process gives what Larry calls "some pretty strong facts for abdication of the board's supervisory role" then I'll agree that Van Gorkom is dead. But not before.

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Tower Air
Posted by Account Deleted

A commenter to one of my posts refers to the Tower Air case in the Third Circuit as being “much more relevant” to the future of fiduciary duties.  I don’t think so. That case was (1) decided before Disney; (2)  a decision before trial; (3) did not opine on the effect of 102(b)(7); and (4) applies a federal pleading rule.   If points 1-3 aren’t enough, on point 4, even if the court reaches the right result both as to the applicable law and as to the application of that law, I do not think the future of internal governance law is in the federal courts.

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The Disney case excerpted
Posted by Account Deleted

As discussed here, I have excerpted the Disney case in the on-line supplement to Ribstein & Letsou, Business Associations.

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The appeal and beyond: the end of the Enron era
Posted by Account Deleted

Disney has been appealed.  If there's no settlement, I expect affirmance. As others (e.g, Larry H) have observed, the fact that Chandler held a trial, the embarassment of the trial itself, and Chandler's strong normative language are likely to have an effect on corporate practices.  Unless there's some change in the environment, I doubt the Supreme Court will think a reversal necessary to send a message.

One thing that might provoke the Supreme Court to stronger action is, as Mark Roe would say, some federal rumblings.  But the fallout from Sarbox has not been good, and I doubt Cox is going to be pushing major SEC initiatives into internal corporate governance.

If it does act, the Supreme Court may try to clarify good faith.  But what can it do?  The key to the case is the holding, not the rule.  If the defendants are not liable, they have been exonerated in the face of some pretty strong facts for abdication of the board's supervisory role, whatever the court says the rule is. 

That's why this case is so important (as I've said, the case of the decade).  It presented both high profile and the exact right facts to test whether there was anything left of a non-loyalty fiduciary duty.  Van Gorkom is finally dead, a stake through its heart. 

The case is also important because of its timing. Together with the Cox ascendancy and the chastening effect of the Sarbox fallout, this opinion marks the official end of the Enron era.

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Respectful Reservations Regarding Ruling?
Posted by Elizabeth Nowicki

Am I to understand that most, if not all, of you believe that yesterday’s Disney opinion represents … well… a 100% correct interpretation and application of the law that will be adopted and sustained across the board?  I say this with the utmost respect for Chancellor Chandler, as I am of the view that he is obviously a brilliant jurist.  But I have some concerns about the opinion, and I am not sure that it represents the final word on the duty of care and good faith.

Specifically, although the opinion was obviously thoughtfully and painstakingly written, there are points in the opinion where I respectfully disagree with the recitation of the law.  Further, taking the findings of fact in the opinion as a given, there are instances where the application of the law to the facts troubles me.  I am actually a bit surprised to have this reaction, because I fully expected that, either way this case was decided, there would be little room to question the opinion and ultimate holding.  (Basically I agree with what I think Profs. Bainbridge and Smith said – this case could have gone either way.)

In addition, plaintiffs’ counsel has indicated that the decision will be appealed, so this opinion might not be the final word in this case. Five years from now, yesterday’s opinion might be but a fuzzy memory, with the responsive Supreme Court opinion instead taking its place in our Corporations textbooks. (I am not suggesting that this will (or should) happen. I am only noting that it might be a bit early for Wachtell, Lipton (for whom I also worked) and other firms to take too much away from yesterday’s Disney directors’ Delaware triumph. To wit, many of us might have a difficult time recalling exactly what valuable information we gleaned initially from the lower courts in the Unocal, Van Gorkom, and Emerald Partners cases.)

In any event, am I alone in my reluctance to wholeheartedly embrace yesterday’s opinion at this juncture?  And am I alone in suggesting that Delaware jurisprudence in this area is a bit… inconsistent, such that I would not bet the farm on any one iteration of the current state of the common law in this area?

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Risk-taking & Fiduciary Duty
Posted by Gordon Smith

One important justification for judicial deference towards directors relates to the desire to promote risk-taking. I am interested in exploring a simple question: would imposing liability on Disney's directors dampen the enthusiasm of other directors for risk?

Corporate lawyers are fond of distinguishing between the substance of a decision and the process by which a decision is made. In the Disney case, for example, the plaintiffs challenged both the substance of the board's decisions to hire and fire Michael Ovitz under the terms of his employment agreement (arguing that he was paid too much for his services) and the process by which those decisions were made (arguing that the directors did not adequately consider their decisions). The substantive claims fall under the heading of "waste" and the procedural claims fall under the headings of "due care" and "good faith" (and, with respect to Ovitz, "loyalty").

The risk-taking rationale for the business judgment rule appears to focus on the substance of board decisions. Courts refrain from second-guessing board decisions, even when they turn out badly, because courts want to encourage directors to consider risky strategies without worrying about personal liability if the strategies fail. At the same time, courts do not want to encourage sloppy procedures! As a result, application of the business judgment rule is premised on fulfilling minimum procedural requirments. Consider Chancellor Allen's canonical description of the risk-taking rationale for the business judgment rule, which Chancellor Chandler quoted in fn 407 of the Disney opinion:

Corporate directors of public companies typically have a very small proportionate ownership interest in their corporations and little or no incentive compensation. Thus, they enjoy (as residual owners) only a very small proportion of any “upside” gains earned by the corporation on risky investment projects. If, however, corporate directors were to be found liable for a corporate loss from a risky project on the ground that the investment was too risky (foolishly risky! stupidly risky! egregiously risky!—you supply the adverb), their liability would be joint and several for the whole loss (with I suppose a right of contribution). Given the scale of operation of modern public corporations, this stupefying disjunction between risk and reward for corporate directors threatens undesirable effects. Given this disjunction, only a very small probability of director liability based on “negligence”, “inattention”, “waste”, etc. could induce a board to avoid authorizing risky investment projects to any extent! Obviously, it is in the shareholders’ economic interest to offer sufficient protection to directors from liability for negligence, etc., to allow directors to conclude that, as a practical matter, there is no risk that, if they act in good faith and meet minimalist proceduralist standards of attention, they can face liability as a result of a business loss.

Gagliardi v. TriFoods Int’l Inc., 683 A.2d 1049, 1052 (Del. Ch. 1996).

Notice that Chancellor Allen presumes that the directors "act in good faith and meet minimalist proceduralist standards of attention." In other words, if the process is adequate, the court will not second-guess the substance. Of course, the main point of the Disney case was to determine whether the process used by Disney's directors was adequate to justify the protections of the business judgment rule. Now we are getting to the crux of the matter: does the desire not to second-guess substance require judicial restraint in second-guessing process?

In a word, yes.

Remember that courts are asked to review a board's decision-making process only when a decision has turned out badly. Under such circumstances, plaintiffs inevitably find procedural infirmities, and the temptation to engage in hindsight reasoning is enormous. Surely the directors should have anticipated the events that ultimately led to this disaster!

If courts are serious about encouraging risk taking by directors, such reasoning must be confined to a limited range of cases, and Delaware has done just that. After Smith v. Van Gorkom, the Delaware legislature essentially took the duty of care off the table, and the Disney decision limits the duty of good faith to an exceedingly small set of cases. Generally speaking, therefore, the Delaware courts will intervene with board decisions only when directors are subject to a conflict of interest. This was the point recently made by Larry Ribstein. If the Delaware courts attempted to be more aggressive, Chancellor Chandler warned of dire consequences: "The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike."

This brings us back to the question that started this post: would imposing liability on Disney's directors dampen the enthusiasm of other directors for risk? In my view, this would happen only if the actions of Disney's directors were viewed as falling within the range of ordinary director behavior. If the Disney directors were portrayed as having abdicated their directorial responsibilities -- and the facts on this are quite close -- then imposing liability would not have the ripple effects described by Chancellor Chandler.

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August 10, 2005
Van Gorkom and 102(b)(7)
Posted by Steve Bainbridge

Elizabeth Nowicki suggests:

If the Van Gorkom case arose in today's 102(b)(7) world, the directors should still be liable under a correct interpretation and application of 102(b)(7). Do I think the majority of Delaware courts would ever reach that same conclusion? No.

I agree with the first part but not the second. As for the latter, if Randy Holland got to write the opinion, I bet he would. Indeed, about 5 years ago or so, I heard Holland give a speech from which I inferred that he thinks 102(b)(7) would not have saved the Trans Union board.

As to the first part, I observed in my Corporation Law and Economics treatise that:

.... notice that the statute apparently distinguishes self-dealing (“improper personal benefit”) from the duty of care. Given Technicolor’s conflation of loyalty and care causes of action, plaintiffs can end-run § 102(b)(7) provisions by characterizing their claim as a loyalty violation. Interestingly, Chancellor Allen has suggested that Van Gorkom itself can be interpreted as a loyalty case.[1] Similarly, the Delaware supreme court has opined that Van Gorkom included a disclosure violation and implied that such violations have a loyalty component.[2] Ironically, a § 102(b)(7) provision thus might not have insulated the directors from liability in the very transaction that motivated the statute’s adoption.

[1] Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1052 n.4 (Del. Ch. 1996) (“I see it as reflecting a concern with the Trans Union board’s independence and loyalty to the company’s shareholders”).

[2] Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1166 n.18 (Del. 1995) (“In Van Gorkom, it was unnecessary for this Court to state whether the disclosure violation constituted a breach of the duty of care or loyalty or was a combined breach of both since 8 Del.C. § 102(b)(7) had not yet been enacted.”). In addition, according to the Sixth Circuit, a § 102(b)(7) liability limitation provision may not insulate directors from duty of care claims based on intentional or reckless misconduct. McCall v. Scott, 250 F.3d 997, 1000-01 (6th Cir. 2001).

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The Business Judgment Triumphant
Posted by Steve Bainbridge

I'm still absorbing the opinion (gotta love footnote 1)  and don't want to shoot from the hip, but I appreciate Gordon's invitation to chime in anyway. First, I was struck by Sean Griffith's comment that the decision "slides the scale back in the direction of board authority and away from judicial accountability." Good. As I observed in my article The Business Judgment Rule as Abstention Doctrine:

Two conceptions of the business judgment rule compete in the case law. One views the business judgment rule as a standard of liability under which courts undertake some objective review of the merits of board decisions. This view is increasingly widely accepted, especially by some members of the Delaware supreme court. The other conception treats the rule not as a standard of review but as a doctrine of abstention, pursuant to which courts simply decline to review board decisions. The distinction between these conceptions matters a great deal. Under the former, for example, it is far more likely that claims against the board of directors will survive through the summary judgment phase of litigation, which at the very least raises the settlement value of shareholder litigation and even can have outcome-determinative effects.

Like many recent corporate law developments, the standard of review conception of the business judgment rule is based on a shareholder primacy-based theory of the corporation. This article extends the author's recent work on a competing theory of the firm, known as director primacy, pursuant to which the board of directors is viewed as the nexus of the set of contracts that makes up the firm. In this model, the defining tension of corporate law is that between authority and accountability. Because one cannot make directors more accountable without infringing on their exercise of authority, courts must be reluctant to review the director decisions absent evidence of the sort of self-dealing that raises very serious accountability concerns. In this article, the author argues that only the abstention version of the business judgment rule properly operationalizes this approach.

Based on what I've seen from the opinion thus far (and most of what I've read here), it looks like Chandler basically agrees that courts typically ought to abstain except where there is a loyalty issue or, perhaps, a gross failure of process in connection with a final period problem.

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What's left of fiduciary duties?
Posted by Account Deleted

I want to step back a little and see where this case leaves us in terms of directors’ fiduciary duties. 

There seems to be general agreement that, although the Chancellor acknowledged and attempted to define the good faith duty, his holding, based on the facts of this case, didn’t leave much room for it to operate. 

We already know that there’s no real duty of care left.  This, by the way, takes care of the Caremark duty. Though I realize the Chancellor nodded to it a couple of times in the opinion (three, to be exact), it’s hard to see where it fits with the kind of conscious indifference the Chancellor was requiring.   Even where the board actually sees a chief executive messing up, the court’s holding on the Ovitz termination suggests that the board need not intervene if the ceo has the power to make the decision.

So this leaves the duty of loyalty.  This is consistent with the analysis of fiduciary duties in my article, Are Partners Fiduciaries? 2005 U.Ill. L. Rev. 209, which shows how the fiduciary duty is, simply, a duty of unselfishness.

The opinion suggests that courts may end up using good faith to expand the kinds of conflicts that might give rise to a duty of loyalty.  So the focus from now on will be solely on conflicts.  The substance and procedure of board decisions will be relevant only in limiting the circumstances in which managers will be liable for conflict of interest.

One implication of this, as I have discussed in my article, Accountability and Responsibility in Corporate Governance, is that corporate social responsibility is basically irrelevant to corporate governance law.  Since managers are not liable unless they’re conflicted, they have the power to decide whether to help society or not.  It’s possible, but unlikely, that a court would hold that a “social” objective supplies a relevant conflict.

A corollary is that the whole idea of duties to creditors in the near-insolvency situation is also irrelevant.  (This is an issue I plan to address for the Maryland conference on this issue in November). Again, the board can do what it wants, including helping creditors, or not, unless it’s conflicted.  So the board can take an action that may not serve shareholder interests, whether or not it serves creditor interests.  Obviously the board  can serve shareholder interests, though there may be a question whether a broad interpretation of the credit agreement justifies a duty in the “penumbra” of the agreement.

So now we can get down to what really matters.  The most important words in the opinion, in my view, are these, near the beginning of the opinion (slip, p. 4):

The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, and not from this Court.

What could be clearer?  If managers are "faithful," they're not liable.  Period. End of story. You can fire them, reduce their pay, whatever, but don't run to the court for help.


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Friendship, the bottom line
Posted by S_Griffith

In a memorandum discussing the Disney opinion, my former law firm, Wachtell, Lipton, proclaims that “the Business Judgment Rule is Alive and Well” (and, presumably, living in Delaware). I’m guessing other top firms will soon make similar announcements to their clients, creating a chorus of defense firm triumphalism. And they’ll be right.

The bottom line issue concerning good faith is this: will it give plaintiffs’ lawyers a new means of surviving the motion to dismiss? The answer, as Wachtell and other firms have figured out, is: not really.

Chancellor Chandler makes clear that good faith is presumed as a part of the business judgment rule—“Delaware law presumes that directors act in good faith when making business judgments” (120). So, in order to sustain a good faith claim, plaintiffs will have to overcome the business judgment rule (124). As all of us know, that is not easily done, and the Chancellor did nothing to lighten the plaintiffs’ load when proceeding under a claim of bad faith as opposed to, say, negligence.

Still, to be fair, the Chancellor’s opinion does create another argument that plaintiffs can make in seeking to rebut the business judgment rule. Plaintiffs’ lawyers can now claim that the board’s decision-making process stems from a motive other than the best interests of the corporation. How can they do this, short of the evidence of smoldering lust I suggested in my first post? They might try to show a total absence of deliberation, but I imagine most corporations will be able to construct an adequate paper trail (primarily in board minutes) to rebut this suggestion. So when will good faith really provide any kind of life raft to a plaintiffs’ firm looking to survive the motion to dismiss?

Only, Chandler suggests, where there is “an imperial CEO or controlling shareholder with a supine or passive board” (footnote 487). The best chance for a bad faith claim, in other words, involves (1) a board stacked with the CEO’s cronies, and (2) an act that the CEO wants the board to accept for personal rather than professional reasons.

Disney fulfilled condition (1) but not condition (2).

The single most important thing the defense did at trial was to show that Eisner and Ovitz didn’t really have a friendship, but rather a business relationship. Remember Ovitz on the stand (the richest man I have ever pitied) saying that Eisner was his best friend? Remember Eisner shrewdly responding a few days later that Ovitz was “a guy who had a hundred best friends”? That was not only a Hollywood moment in little Delaware. It was also, I believe, a turning point in the trial. Once it was plainly established that friendship was not a motive for the mistakes the board made, the good faith claim went away. As I note in my article, the 2003 opinion repeats some variant of the word “friend” fifteen times. The first thing I did when I got this opinion last night was search for “friend.” It appears only eight times. Once I saw that I knew the board had won. As long as the motive is business, not friendship, there’s little else the plaintiffs can say.

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Responses to the “other Larry”
Posted by Elizabeth Nowicki

Larry, obviously you were asking difficult questions with no easy answers in the post below, but I wanted to respond to some of your questions because (a) they are thought-provoking and (b) I suspect I might be outside the bell curve with some of my responses. My numbers below mirror your numbers.

1. Yes, I am still reading. I found the opinion to be a fascinating work; kudos to Gordon for putting this responsive forum together.

2. Ditto.

2b. Yes and no. If the Van Gorkom case arose in today's 102(b)(7) world, the directors should still be liable under a correct interpretation and application of 102(b)(7). Do I think the majority of Delaware courts would ever reach that same conclusion? No.

3. Most (many?) of the officers implicated in the situations I assume you are envisioning would have been directors, right? (e.g. CEO, COO, who also sat on the Board) If those folks acted unilaterally when they held both titles, would you still be asking your question? (Your question being “First, how should the conduct of officers be judged when they act unilaterally?”)

4. Did anyone else take pause with the portion of the opinion to which Larry refers when he says “The Chancellor’s conclusion [re New Board] seems to rest heavily on authority concepts: even though the Board had concurrent power to act on the matter, he says, Eisner had the power as well, so the Board had no duty to act. (p. 168)”?

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Issues with Christine and Sean
Posted by Hamermesh

Christine: What I think your post misses is what I referred to in my earlier post, namely the enormous costs to the directors in defending the case, even though they won (so far). OK, I know Disney probably paid for their lawyers, and they’re not out of pocket in dollar terms, but they spent a lot of time in depositions and in Georgetown, Delaware, of all places, and haven’t exactly enjoyed warm publicity. So I disagree with your advice to directors not to do anything differently. This might have been an avoidable mess, had the OEA been developed with better process and greater comp committee study and involvement and documentation.

Sean: I’m sympathetic to your singling out executive comp for special treatment. But how far do boards have to be involved? Was the NFT determination a matter of “executive compensation” that the Disney board should have been involved in? How many officers’ pay packages do boards have to function on? All of them? Just the CEO? Where’s the line? Can’t a board draw the line itself? If not, who draws it for them?

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The Tax and Financial Engineering Angle
Posted by Victor Fleischer

I will leave the Delaware fiduciary duty stuff to the experts, but I thought I would talk a bit about the role that the tax law and financial engineering played in the story.  The comp committee wanted to give Ovitz "downside protection," by which they apparently meant a guaranteed salary.  To preserve the appearance of pay-for-performance, they offered some of this guaranteed salary in the form of options, but if the options failed to appreciate to at least $50 million, Disney would make up the difference. 

This guarantee ran into a 162(m) problem: 

To that end, Santaniello concluded that the $50 million guarantee presented negative tax implications for the Company, as it might not have been deductible.  Concluding  that the provision must be eliminated, Russell initiated discussions on how to  compensate Ovitz for this change—from this, an amalgamation of amendments to certain terms of the OEA arose in order to replace the back-end guarantee. 

(Opinion pp. 26-27.)

Section 162(m) of the Code provides that corporations may not deduct compensation in excess of $1 million unless it is qualified performance-based compensation.  A guarantee means that the compensation is no longer performance-based.  I find it telling (but not at all unusual) that Disney's response was not to renegotiate for stronger performance-based incentives, but instead to seek a financial engineering solution that allows as little economic downside risk as possible without running afoul of 162(m).  Disney accomplished this by, among other things, lowering the strike price of some of Ovitz's options to at-the-money and increasing the severance package.  Long-dated at-the-money options are almost as good as receiving cash or stock, but produce better tax consequences for the executive.  I have written extensively about how the tax code distorts financial incentives in the private equity context.   The public company context is, sadly, even more distorted.  When it comes to corporate governance, tax only hurts.  It never helps.

Among other problems, the Code encourages the sort of financial engineering that makes meaningful review by a board of directors more difficult.  If Ovitz were simply offered $150 million in straight cash, guaranteed, the board might have asked more questions.  Instead, to ensure that the compensation was deductible, Ovitz received a package that was economically similar to cash, but more complicated and confusing.  The desire to camouflage the compensation is not primarily tax-related, but the tax Code's bias against cash salaries doesn't help.

The end result was a nonsensical compensation design that, as Professor Murphy testified, provided perverse incentives for Ovitz to perform badly and get fired.  The Board gets a free pass on this silly compensation design, apparently, because of the "type of person" Ovitz is.  The Chancellor, seemingly dismissing the relevance of incentives, explains: 

First, based upon my personal observations of Ovitz, he possesses such an ego, and enjoyed such a towering reputation before his employment at the Company, that he is not the type of person that would intentionally perform poorly. Ovitz did not build Hollywood’s premier talent agency by performing poorly. Second, nothing in the trial record indicates to me that Ovitz intended to bring anything less than his best efforts to the Company.

(Opinion p. 132.)  It should not be enough to point to an executive's reputation as a stand-up guy.  Incentives matter, and contracts should be designed with financial incentives in mind.  (Otherwise we should just drop the pay-for-performance charade and give cash.)  I don't think it's unreasonable to expect compensation committee members to understand a bit about incentives and conduct some meaningful review of the contracts. 

Whether meaningful review of the compensation design is a matter for Delaware law or "best practices" I do not have the expertise to say.  But I will suggest that if Delaware doesn't get its act together with respect to executive comp, we may soon see federal intervention, for better or for worse, perhaps through the tax Code.  And that's not likely to help anyone.

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