Part I of this article appears in the October 2004 issue of The Metropolitan Corporate Counsel.
As I noted in Part I of this article, the Disney case is ongoing and unresolved. Its outcome will be instructive to directors everywhere. Whatever that outcome, I am confident that there will be no support for some of the incorrect perceptions that have been recently expressed that Delaware courts are second-guessing business judgments of directors rather than adhering to the time-honored business judgment rule, and that this trend has "evidenced an erosion in the level of protection afforded by state statutes," such as the Delaware exculpation statute, Section 102(b)(7).1
With all due respect, I have to say that this is a misreading of recent Delaware jurisprudence. The same is true of some further suggestions that "it appears clear from these recent cases that courts can easily sidestep this statutory defense by directors in most cases if the court is otherwise inclined to hold the directors personally liable."2 The Courts are not "sidestepping" the statutory protection of directors for negligence or gross negligence. Those protections are assured. At the same time, the statute does not permit the stockholders to adopt a charter provision that would exonerate directors for (i) breach of the "duty of loyalty," (ii) "acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law," (iii) wrongful payments of dividends; or (iv) "any transaction from which the director derived an improper personal benefit." The question in the Disney case and in other cases will be on which side of the line the directors' conduct may fall.
It has also been suggested3 that Vice Chancellor Strine's decision in the Oracle case4 requires a court to consider "social and personal connections" when determining independence issues, and that this consideration "may greatly reduce the number of independent directors on most boards, thereby significantly limiting the legal protections available from independent director approval." A close reading of the Oracle decision and the recent Delaware Supreme Court's Martha Stewart decision,5 however, show that Oracle was confined to a Special Litigation Committee (SLC) process where the committee had the burden affirmatively to prove its own independence. Such a committee has enormous power to cause the dismissal of a derivative suit where pre-suit demand on the board is excused. Moreover, in Oracle the Stanford University connection was not unearthed until there was discovery. The Delaware Supreme Court's decision in late March in the Martha Stewart case makes it crystal clear that social and personal connections do not themselves disqualify a director as independent. Here is some of what we held in the Martha Stewart case:
"Independence is a fact-specific determination made in the context of a particular case. The court must make that determination by answering the inquiries: independent from whom and independent for what purpose? ...
"A variety of motivations, including friendship, may influence the demand futility inquiry. But, to render a director unable to consider demand, a relationship must be of a bias-producing nature. Allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director's independence. ..."
Therefore, independence issues, like many other issues in Delaware jurisprudence, are highly contextual. One must consider not only the precise facts of the case, but also the procedural posture. Moreover, best corporate practice models by individual corporations often contain their own, tailored concepts of independence. An independent director must have courage and cannot shy away from the goal of "constructive skepticism," in Arthur Levitt's words. Although "one size fits all" concepts of independence are prevalent in some quarters, that is not true in Delaware jurisprudence. The inquiry in Delaware continues to be: Independent from whom and for what purpose? Those purposes vary from pre-suit demand, to Special Litigation Committees, to leveraged buy outs, to parent-subsidiary transactions, among others.
The Conscience Of The Board
Among the prime areas of best corporate practices is the trend toward director independence, executive sessions and empowerment of directors in exercising their primacy in corporate governance. I think the proper use of independent committees, in particular, the Nominating/Corporate Governance Committee of the board may hold the key to the future of best corporate practices. This committee, with the guidance of the General Counsel, should be the conscience of the board to see that the right processes are responsibly and conscientiously carried out and supervised. I can think of several major categories where such an independent committee can contribute to a paradigm of best practices, beyond the critical and independent central duty of establishing the criteria for, and the nominating and training of, directors. Most corporations using best practices have, and follow, comprehensive charters for these committees. A few of these categories of committee duties that should be in the charter of the Governance Committee, in the charters of other independent committees or split among the responsibilities of those committees are as follows:
The "Big Picture": Don't Panic - Just Do The Right Thing!
Directors are not required to be perfectionists in their processes in any context. Nor are they guarantors of good results. Even in a Revlon situation, where directors are expected to maximize stockholder value, all that the law requires is that they act reasonably under the circumstances. The Supreme Court decision in Paramount v. QVC6 makes it clear that a good faith, reasonable process is all that is required.
In a recent Court of Chancery decision, Vice Chancellor Lamb in the Mony Group Litigation,7 applied the common sense reasonableness test of Paramount v. QVC. In Mony, the Court said:
"The court will scrutinize 'the adequacy of the decisionmaking process employed by the directors, including the information on which the directors based their decision [and] ... the reasonableness of the directors' action in light of the circumstances then existing.' However, the court must review the decision-making process in light of the complexity of the directors' task in a sale of control. As the Delaware Supreme Court stated in Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1993):
'[t]here are many business and financial considerations implicated in investigating and selecting the best value reasonably available. The board of directors is the corporate decisionmaking body best equipped to make these judgments. Accordingly, a court applying enhanced judicial scrutiny should be deciding whether the directors made a reasonable decision, not a perfect decision. If a board selected one of several reasonable alternatives, a court should not second-guess that choice even though it might have decided otherwise or subsequent events may have cast doubt on the board's determination.'"8
Moreover, Vice Chancellor Strine said this in a speech last year - and I completely agree with him:
"I won't pretend that directors don't have reason to be concerned, ... but ... the legal reality today is identical to the legal reality a year ago: Independent directors who apply themselves to their duties in good faith have a trivial risk of legal liability. Let me repeat that: If you do your job as a director with integrity and attentiveness, your risk of damages liability is minuscule."9
So, what are the corporate governance issues that may be relevant to state court proceedings involving the potential liability of directors?
1. Independence is often important in our caselaw for various purposes. As a result of the evolution in the expectation of directors, "real" independence status and - most importantly - independent actions may come to be expected in derivative pre-suit demand issues, special committees, interested director transactions and in good faith issues generally.
2. Process is key. But I do not mean an artificial, form-over-substance, robotic process. I mean a good faith pro-active, inquisitive, real and searching process by directors.
3. Total understanding is essential. There is no such thing as a "stupid question." Directors must drill down to achieve mastery of the subject of their decisionmaking in the context of the business and strategy of the firm, which they must also understand fully.
4. Optics are important in litigation. So real independence and genuine processes will be scrutinized by Delaware courts. The optics may be helpful in litigation if a pattern of general best practices is a genuine part of the corporate culture.
I would certainly not say that directors who do not have these good practices are vulnerable to liability. But if they do have good corporate governance processes, those processes and the optics might help in the eyes of a court.10
The corporate governance regime depends on an active board and works only when people of integrity operating in the right corporate culture make it work. The system depends on trust in people - especially the directors, regulators and courts. The Chairman of the SEC, Bill Donaldson, has said, "We can write all the laws we want, but in the final analysis it's going to be the human characteristic" that helps set the tone for the markets.
At the end of the day the most effective prophylactic to protect against liability is for the directors to implement a pattern of best corporate governance practices.
1 See the ACE Report, Issue No. 52, January 2004, submitted to the May 5, 2004, Kellogg Conference.
4 In Re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003).
5 Beam v. Stewart, No. 501, 2003, 2004 Del. LEXIS 162 (Del. Mar. 31, 2004).
6 637 A.2d 34 (Del. 1994).
7 2004 WL 303894 (Del.Ch.).
8 Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d at 45 (emphasis supplied).
9 Leo E. Strine, Jr., Director Liability Warnings, Business & Securities Litigator, February 2003.
10 Aspirational standards of director conduct are not necessarily coextensive with the standards of judicial review. See Melvin A. Eisenberg, The Divergence of Standards of Conduct and Standards of Review in Corporate Law, 62 Fordham L. Rev. 437 (1993); see also Model Bus. Corp. Act §§ 8.30, 8.31 (1999).
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.