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Duty of Care: Delaware Directors Be Careful

Carl Kaplan and Beth Mazzagetti (Fulbright Jaworski)


Recent Delaware court decisions appear to whittle away the provisions of law which limit the monetary liability of directors in situations involving a breach of the duty of care. Section 102(b)(7) of the Delaware General Corporation Law limits the remedies available to shareholders for a breach of duty of care by allowing provisions in a company's articles of incorporation which restrict a director's personal monetary liability. [1] Following the corporate scandals of 2002 and the federal government's attempt to monitor corporate governance through legislation, [2] Delaware courts also appear to be implementing a heightened state law governance standard, creating a new threshold that directors must meet to invoke the protection of § 102(b)(7). Prior to the recent decisions, it appeared settled that a charter provision implementing § 102(b)(7) would limit personal liability if a director breached the duty of care.

Delaware courts have articulated several duties of directors to their corporation and its stockholders as part of the overall fiduciary duty that directors owe to Delaware corporations: the duties of care, loyalty and good faith.

The duty of loyalty requires that the best interests of the corporation and its stockholders take precedence over any interest possessed by a director, officer or controlling stockholder and not shared by stockholders generally. Directors may not act inconsistently with the corporation's best interests to further some interest of their own, such as a relationship with a large stockholder or another company or a personal interest in remaining a director or officer.

The duty of loyalty requires directors to be both "disinterested" and "independent" and to refrain from conduct such as fraud, bad faith, self-dealing and actions that serve to entrench them in office. "Disinterestedness" requires that a director neither appear on both sides of a transaction nor derive any personal benefit from the transaction, other than a benefit shared by all other stockholders. "Independence" requires that a director's decision on an action must be based solely on the corporate merits of the subject rather than extraneous considerations or influences.

The duty of care requires that directors be reasonably informed of relevant facts available when making a decision. The duty of good faith is closely tied to both duty of loyalty and duty of care and requires that a director must act "in good faith, in the honest belief that the action taken was in the best interests of the company" and its stockholders. To satisfy the duty of care, a director must, then, act in good faith and be reasonably informed about his or her decisions. Mismanagement, neglect, or failure to comply with a corporation's internal laws may constitute a breach of duty of care. [3]

Until recently, duty of care cases rarely reached trial because the "business judgment" rule provided deference to a director's business decisions and facilitated the success of motions to dismiss. Under the business judgment rule; the courts would not question the merits of a director's decision; there was a presumption in the director's favor, unless it was shown by a challenger that two requirements of the rule -- acting in good faith and being reasonably informed -- had not been met. [4] The rule allowed directors to take risks without being overly cautious and was designed to protect directors against mistakes of judgment. On the other hand, neither the business judgment rule nor the protection of § 102(b)(7) applied to duty of loyalty situations. There was judicial involvement in these cases, and the burden of proof shifted to the directors to prove that they acted in the best interests of the shareholders. [5]

In a recent case, In re Walt Disney, [6] a Delaware chancery court denied a motion to dismiss an amended complaint in a derivative suit against the directors arising out of severance payments made to the President of Disney. Disney's CEO had hired his friend of 25 years to serve as President of the company. Neither the Compensation Committee nor the Board reviewed either the hiring or termination of the President. After only 12 months of work, the Board awarded the President $140 million for his service and granted him no-fault termination status which enabled his stock options and bonuses to vest.

The chancery court held that if the directors breached their obligation to act honestly and in good faith, their conduct fell outside the parameters of the business judgment rule.

Because the facts alleged here, if true, portray directors consciously indifferent to material issues facing the corporation, the law must be strong enough to intervene against abuse of trust. Accordingly, all three of plaintiffs' claims for relief concerning fiduciary breaches and waste survive defendants' motions to dismiss. [7]

The court decided that if the alleged facts were true, directors had not only engaged in grossly negligent conduct but had "consciously and intentionally disregarded their responsibilities" [8] by leaving the arrangements up to the CEO and not investigating even basic information about the employment contract. The directors consciously ignored their duties to the corporation's shareholders, and therefore could not avail themselves of protection under § 102(b)(7).

Previously, in Brehm v. Eisner, [9] a case involving a complaint arising out of the same transactions with Disney, the Delaware Supreme Court had decided the Disney directors were shielded by the business judgment rule. The Court based its decision on § 141(e) [10] of the General Corporation Law and Aronson v. Lewis [11] which applied "a presumption that in making a business decision the directors . . . acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation." [12] The Court determined that in judging the degree to which a transaction is one-sided, "Courts do not measure, weigh or quantify directors' judgments . . . irrationality is the outer limit of the business judgment rule." [13]

The disparate outcome in these two cases suggest that Delaware has implemented a new threshold which directors must meet before they are able to invoke the protection of the business judgment rule and the limitations on liability allowed by §102(b)(7). However, by the time a director exercises the caution necessary to reach this threshold, it's unlikely he or she would need § 102(b)(7) protection. That a director must exercise good faith and be well informed to meet the preliminary threshold is another way of stating the duty of care. i.e. if a director satisfies the threshold, the duty of care standard is met. In effect, the courts are disabling the statute by allowing it to reach only those directors no longer in need of its protection.

By establishing the threshold, the courts will now decide whether a director is "liable" or "not liable" -- yes or no -- on a preliminary basis or possibly a "mini" hearing basis. For example, the Disney court decided that the directors' behavior fell outside of the shield of § 102(b)(7) due to their inaction. The complaint withstood the motion to dismiss by alleging only that the board had done nothing, without addressing the directors' lack of good faith or informed mind.

Directors in private corporations should also remain mindful of the risks they face under Delaware law. In the New York Southern District case Pereira v. Cogan, [14] the court determined that a director of a private company was involved in self-dealing and unlawful dividend distribution while the company was operating within the "zone of insolvency." [15] The directors had illegally approved payments of dividends when the corporation's capital was impaired and had basically turned a blind eye to the self-interested actions of the controlling shareholder.

Applying Delaware law, the court found that the directors, by their failure to exercise diligence, had breached both their duties of care and loyalty despite the fact that there was no official board action. They breached the duty of loyalty by the nature of their close relationship with the majority stockholder and therefore the § 102(b)(7) exculpatory clause in the articles of incorporation did not apply. The recent whittling away at the duty of care and their disabling of the business judgment rule blur the demarcation between the doctrines of duty of care and duty of loyalty. Events which previously might have been considered acts of gross negligence, may now fall under the rubric of duty of loyalty despite the absence of explicit self interested dealing. [16]

The Delaware Supreme Court is still to weigh in on this issue. Delaware Supreme Court Justice E. Norman Veasey spoke to the issue at a National Association of Corporate Directors conference held in Washington D.C. in October. [17] Although he tried to assure directors that the business judgment rule was not being infringed, he then explained that in order to invoke the protection of the business judgment rule directors must take a "proactive oversight role" and be concerned with the process by which it makes decisions.

He said that directors should:

define and monitor independence; recommend whether to separate the chief executive officer function from the chair of the board, or to have a lead director; ensure a system of regular succession of independent directors; maintain internal controls; develop business ethics; review, update, and enforce committee charters; review and evaluate board schedules, the quality of board meetings, and the workload of individuals; ensure that directors carry out disclosure responsibilities; identity conflicts of interest and corporate opportunity; report malfeasance, misfeasance, and nonfeasance, anticipate and deal with insider trading issues; and maintain effective stockholder relations and communications. [18]

Veasey emphasized that Delaware judges should and will consider whether directors have complied with these threshold expectations when deciding liability: "It is all about processes." [19] The business judgment rule will no longer protect individual business decisions unless directors meet these preliminary requirements.

In 2002, 48% of board members admitted that they had declined an invitation to join a board because the risk was too great. [20] With this recent shift in Delaware's definition of duty of care, the risks are only increasing. To those directors who choose to accept the risk-Be Careful!

©2004 Carl E. Kaplan and Beth Mazzagetti


About The Authors

Carl E. Kaplan is a partner at the New York office of Fulbright & Jaworski L.L.P. He has a corporate and securities-based practice, with emphasis in the affairs of public and private high technology companies, emerging growth companies and venture capital funds.

Beth Mazzagetti is an associate in the New York office of Fulbright & Jaworski, L.L.P. Her practice focuses on corporate matters and commercial litigation.


Footnotes

[1] See DEL. CODE ANN. tit. 8, § 102(b)(7) (2003). ( The Certificate of Incorporation may also contain any or all of the following matters . . .

(7) A provision eliminating or limiting the personal liability of a director to a corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director

i) for any breach of the director's duty of loyalty to the corporation or its stockholders;

ii) for acts of omission not in good faith or which involve intentional misconduct or a knowing violation of the law. )

[2] See Sarbanes-Oxley Act of 2002, H.R. 3763, 107th Cong. (2002).

[3] See Arthur R. Pinto, Corporate Governance: Monitoring the Board of Directors in American Corporations, 46 AM. J. COMP. L. 317, 331-333 (1998); Denise Ping Lee, The Business Judgment Rule: Should it Protect Nonprofit Directors?, 103 COLUM. L. REV. 925, 941-942 (2003); Gregory Scott Crespi, Redefining the Fiduciary Duties of Corporate Directors in Accordance with the Team Production Model of Corporate Governance, 36 CREIGHTON L. REV. 623, 640 (June 2003).

[4] See Arthur R. Pinto, Corporate Governance: Monitoring the Board of Directors in American Corporations, 46 AM. J. COMP. L. 317, 331-333 (1998)

[5] See id.

[6] In Re Walt Disney Co., 825 A.2d 275, 275 (Del. Ch. May 2003).

[7] Walt Disney, 825 A.2d at 291.

[8] Id. at 289.

[9] See Brehm v. Eisner, 746 A.2d 244, 244 (Del. 2000).

[10]   A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of each member s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.  DEL. CODE ANN. tit. 8, § 141(e) (2002).

[11] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)

[12] Brehm, 746 A.2d at 264 (citing Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).

[13] Id.

[14] Pereira v. Cogan, No. 00 Civ. 619, 2003 294 LEXIS 449, at *1 (S.D.N.Y. May 12, 2003).

[15] See Sanford Krieger, Robert Schwenkel, Barry Sher, Abbott Cooper, Israel David, Directors of Private Company Held Liable in Pereira v. Cogan, LXXIV No. 15 CORPORATION 1, 1 (2003).

[16] JOSEPH W. BARTLETT, VENTURE CAPITAL: LAW, BUSINESS STRATEGIES, AND INVESTMENT PLANNING 24 (John Wiley & Sons 1994 Cumulative Supplement) ( In the Original Text, mention was made of a point of view pressed on the author by Carl Kaplan at Fulbright Jaworski Reavis & McGrath among others, anticipating that the Delaware courts, in interpreting the scope of 102(b)(7), might equate the duty of care and the duty of loyalty, meaning that strike suit plaintiffs need make only small changes in their complaints to get around the thrust of the statute. ).

[17] See Business Judgment Rule Still  Alive and Well,  Delaware Chief Justice Tells Directors  Group, 18 CORP. COUNS. WKLY. 1, 1 (October 29 2003).

[18] Id. at 1-2 (referencing § 141).

[19] Id. at 2.

[20] Lisa M. Butera, Industry in 2003: Insuring the Risks of Being a Director (Aug. 19, 2003) (citing Korn, Ferry Corporate Board Member Study 11/02).