Part II of this article appears in the November 2004 issue of The Metropolitan Corporate Counsel.
Are the winds of change blowing and gusting from the Delaware Judges? The metaphors in vogue today to describe the corporate scene are intriguing. There is talk of storm clouds, revolution, transition, sea change and the like. To be sure, Enron, Worldcom and the other scandals, followed by Sarbanes-Oxley and the Stock Exchange Rules were a startling wake-up call, to say the least.
The Landscape Of The 1990s And The Early 21st Century
I say "wake-up call" not to suggest that corporate practitioners and judges had been asleep pre-Enron. To the contrary, the movement toward best corporate practices was a definite trend in the 1990s, and somewhat before. Corporate counselors were advising many boards to clean up their structure and intensify their diligence. This movement probably arose out of the environment of the 1980s when the takeover era produced financial changes and a refocusing of Delaware corporate jurisprudence. The watershed year of 1985 featuring Smith v. Van Gorkom,1 Unocal,2 Moran v. Household3 and Revlon4 was indeed a time when many of the rules of the road did change in the context of mergers and acquisitions.
Then came the 1990s with cases like Time Warner,5 Paramount v. QVC,6 Cede v. Technicolor,7 Kahn v. Tremont,8 Unitrin,9 Blasius,10 Quickturn11 and others. However one may analyze those cases and the others in the decade of the 1990s, it was an era involving further explications of Delaware jurisprudence - and an increasing complexity of that jurisprudence. It was also an era of an increasing incidence of voluntary best practices in corporate America concurrently with the emerging scandals.
So, while our jurisprudence and best corporate practices were developing in the late Twentieth Century and the early Twenty-First Century, we suddenly found a change in the landscape. That change was not the doing of the judges or that of responsible corporate boards and counselors. It was the result of scandals such as Enron, Worldcom and others. Those scandals changed the regulatory, business and adjudicative landscape.
But, in my opinion, this new landscape does not mean that the Delaware Courts have lurched in a new and menacing direction that would cause panic in the boardroom. The substantive law has not changed. The processes of the boards have been brought under closer scrutiny by a more precise focus that is influenced by improved pleading by those challenging board governance and action in litigation.
Let's take a quick look at how we got to this place. In the 1990s there was a paradox. We see it now only by the clarity of 20:20 hindsight. First, the economy and the securities markets then were on the ascendency. Second, there were reform movements gathering momentum in the areas of voluntary best practices of corporate governance and lawyer ethics.
As for the economic scenario, the decade of the 1990s represented the halcyon days of the boom. We all know that. And we now know - painfully well - that the malignant tumors that would lead to the bust that was to follow the boom were growing undetected, and perhaps camouflaged by the joy of the boom.
As for the reform movements of the 1990s in corporate governance and lawyer ethics, many major corporations were strengthening their boards through voluntary best practices. Institutional investors were demanding greater independence and accountability of directors, while the Delaware courts were exhorting enhanced standards of director conduct as the right policy and as an arguable safe harbor from state fiduciary duty liability concerns. In the words of Charles Dickens' Tale of Two Cities:12
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going directly the other way."
Boom and bust cycles are an inevitable phenomenon that we have seen throughout American economic history. The reasons for the bust often have their seeds in the reasons for the boom. And so it was in our most recent dramatic boom/bust cycle where more than $7 trillion of market value was lost from the zenith in the Spring of 2000 to the nadir in the summer of 2002.
I do not intend today to bore you with an exhausting chronicle of the Delaware corporate opinions that have been decided during my twelve-year term that is just ending. What I would like to do is try to juxtapose the words and music of a few cases with considerations of best corporate governance practices.
To be sure, the quest for optimum corporate governance practices has been influenced by a number of recent events that are external to Delaware jurisprudence. One need only mention Enron, Worldcom, Sarbanes-Oxley,13 SEC Rules, the listing requirements of the SROs,14 investor activism and the activity of some state attorneys general.
Delaware jurisprudence has been and will continue to be a significant constellation in the galaxy of corporation law and corporate governance. This is true for several reasons. First, American corporation law - as exemplified by Delaware law - is a common law regime, unlike the code form of corporate or company law of many jurisdictions outside the United States. Second, because it is a common law regime, Delaware law is dependent for its credibility on the competence, predictability and intellectual honesty of expert judges. Third, for nearly a century the Delaware courts have been working at corporate ajudication on a consistently heavy schedule. Delaware now has over half a million business entities registered in the state, of which over 65% are corporations and the rest are alternative entities such as limited liability companies, limited partnerships and the like. About 60% of the Fortune 500 corporations and about half of the companies listed on the New York Stock Exchange are incorporated in Delaware. Given this high penetration of Delaware corporations in the American business scene, the Delaware courts have an enormous responsibility not only to adjudicate disputes on a level playing field but also to set the tone for the context in which those disputes will be resolved.
Sarbanes-Oxley, The SEC Rules And The Action Of The SROs
One of the more interesting and challenging facets of this phenomenon going forward is how - if at all - Sarbanes-Oxley, the SRO requirements and the quest for optimum corporate practices will play out in Delaware courts. Sarbanes-Oxley has many dimensions, one of which is an intrusion by the federal legislative branch into the internal affairs of corporations. Internal affairs have long been thought to be the province of state law, while regulation of markets (primarily through disclosure and procedural requirements) has been thought to be largely (though not entirely) a subject that can properly be regulated by federal law.
Despite the limited intrusion into internal corporate affairs of Sarbanes-Oxley and the listing requirements of the exchanges, the only direct enforcement mechanism in the legislation is relegated to the SEC, and the principal remedy of the exchanges is delisting. There is no provision for a private right of action in the Sarbanes-Oxley statute or the SEC Rules. In a culture where many corporate disputes play out in class and derivative suits, one wonders how the creativity of plaintiffs' counsel in such cases will manifest itself. Many of us in Delaware believe these issues may play out to some extent in Delaware courts - and with no certain outcome.15
The quintessential application of common law adjudication does leave us, however, with the principle that there are evolving expectations of corporate directors in carrying out their fiduciary duties. The Disney case16 and the Caremark case17 are examples of how our courts may view the evolution of those directorial expectations. There are others, of course.
We have been seeing the expectations of directors evolve under state law for years. I will mention one area where the common law approach of the Delaware law of fiduciary duty has been progressing. This is the issue of good faith. As I see it, the development of the common law in this area is the antithesis of the "one size fits all" rigidity of certain aspects of the Sarbanes-Oxley regulatory law, the SEC Rules and the listing requirements of the SROs.
A question was raised this morning whether a financial expert should be held to standards that are higher than those applicable to other directors. I do not believe that is or should become the law. All directors are equal and may rely in good faith, on corporate books, officers' report and experts under the Delaware law.18 The issue may be whether the reliance by the financial expert is in good faith, as a factual issue, and those facts may vary from director to director in the context of good faith reliance.
Although the law of fiduciary duty recognizes the evolving expectations of the standards of conduct of directors and officers, we must keep in mind that the business judgment rule is alive and well, and it continues unabated to protect directors' informed decisions made in good faith, enabling them to set strategic goals for prudent risk-taking. What has evolved is a sharper judicial focus on the processes employed by directors, but it is not a regulatory clamp on their business judgment. That focus has been sharpened by more precise pleading that can survive a motion to dismiss. Cases that are not properly pleaded will be dismissed. Cases that are properly pleaded will survive a motion to dismiss and permit discovery, perhaps trial. The Disney case and some other cases like Malone v. Brincat19 and the ARCO20 case that have evoked discussion have been decided on motions to dismiss where the court must accept for purposes of the motion that the allegations are true.
Take the area of compensation, for example. There is a belief -I suggest it is a myth - that there is no limit to what compensation committees may award CEOs and other senior managers. Of course, there is no bright line or dollar limit. Likewise, there is no such thing as pay that is abstractly too high - it is like asking "how high is up?" But that does not mean there are no limits. Judicial review of these kinds of director decisions is not about dollar amounts in isolation. It is all about process. Yet, the process must be genuine, not a disingenuous, rote "check the box" exercise.
I will mention just one recent, relevant Delaware case, although there are others in various federal courts applying state law.21 The Disney case involved the board's alleged handling of the extraordinary severance pay to Mr. Ovitz, the number two officer, brought to the company by Mr. Eisner, the CEO. The issue as alleged was about process and how the board allegedly permitted a lucrative contract and then a payout of $140 million for a short term, failed officer.
In the year 2000 the Delaware Supreme Court upheld the dismissal by the Court of Chancery of the original derivative complaint. It was very poorly drafted, but we thought there might be a potential claim. We reversed the part of the Chancellor's decision that ordered the dismissal with prejudice. We held that the dismissal of the original complaint should be without prejudice, remanding the case to the Court of Chancery to permit plaintiffs to replead.22 The plaintiffs redrafted the complaint on remand, and it survived the motion to dismiss before the Chancellor, so the case is now in discovery and heading toward trial.23
This new complaint was developed after plaintiffs obtained books and records, as we had urged plaintiffs to do for years. The amended complaint set forth a new and a more precise pleading based on the fiduciary duty of good faith. There can be exculpation under a charter provision authorized by the Delaware statute24 for due care violations, but not for good faith violations. Generally speaking, lack of good faith may, in some circumstances, be inferred if a board abdicates its responsibility by not exercising its business judgment or its decision or conduct is so irrational that no reasonable director would credit the decision or conduct.25
One must read the Chancellor's May 2003 opinion in the Disney case in its entirety to understand the facts alleged in the totally new complaint. Here is part of what the Chancellor concluded on remand in denying a motion to dismiss the new complaint:
"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."26
It must be kept in mind that the Chancellor's decision in the Disney case is on a motion to dismiss the complaint. Thus, it is not final, and there has been no trial or review by the Supreme Court. Indeed, the defendants emphatically deny the charges. Nevertheless, good counseling suggests that the Chancellor's decision should be respected as presumptively correct. Directors should therefore take heed, as part of best practices.
1 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
2 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
3 Moran v. Household Int'l, Inc., 500 A.2d 1346 (Del. 1985).
4 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).
5 Paramount Communications, Inc. v. Time, Inc., C.A. No. 10866, 1989 WL 79880 (Del. Ch. July 14, 1989), aff'd, 571 A.2d 1140 (Del. 1990).
6 Paramount Communications Inc. v. QVC Network, Inc., 637 A.2d (Del. 1994).
7 Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993).
8 Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997).
9 Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361 (Del. 1995).
10 Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).
11 Quickturn Design Sysm., Inc. v. Shapiro, 721 A.2d 1281 (Del. 1998).
12 Charles Dickens, A Tale of Two Cities, 1 (Bantam Books, 1981) (1850).
13 15 U.S.C.A. § 7245.
14 The self-regulatory organizations (SROs) I refer to are the New York Stock Exchange and the NASDAQ. The New York Stock Exchange corporate governance rules are available at www.nyse/com/pdfs/finalcorpgovrules.pdf. The NASDAQ corporate governance rules are available at http://cchwallstreet.com/NASD/NASD.
15 William B. Chandler III & Leo E. Strine, Jr., The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State, 152 U. Pa. L. Rev.953 (2003).
16 Brehm v. Eisner, 746 A.2d 244 (Del. 2000); In re Walt Disney Co. Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003).
17 In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
18 8 Del. C. § 141(e). See, Brehm v. Eisner, 746 A.2d at 261-62.
19 Malone v. Brincat, 722 A.2d 5 (Del. 1998).
20 McMullin v. Beran, 765 A.2d 910 (Del. 2000).
21 See, e.g. In Re Abbott's Laboratories Derivative Shareholders Litigation, 325 F.3d 795 (7th Cir. 2003); McCall v. Scott, 239 F.3d 808 (6th Cir. 2001).
22 Brehm, 746 A.2d 244.
23 Walt Disney, 825 A.2d 275.
24 8 Del. C. § 102(b)(7).
25 See, e.g., Walt Disney, 825 A.2d 275; Caremark, 698 A.2d 959; and Gagliardi v. Trifoods Intern., Inc., 638 A.2d 1049 (Del. Ch. 1996).
26 Walt Disney, 825 A.2d at 289.
The Hon. E. Norman Veasey is the retired Chief Justice of Delaware and Senior Partner at Weil, Gotshal & Manges LLP. This article is based on remarks made by Chief Justice Veasey on May 4, 2004 at the 2004 Corporate Governance Conference of the J.L. Kellogg School of Management. It is being published by us in two parts.