VideoPity corporate boards. Used to rubber-stamping the wishes of imperial CEOs, they have been ever more rudely assailed by politicians, regulators, and shareholder activists since the fall of Enron. Now, they are being challenged in courtrooms not just over failures to detect accounting shenanigans, but over actions that traditionally have fallen under the protection of the business-judgment rule.
That rule has given boards wide latitude to make decisions without fear that courts will second-guess their judgment, as long as they observe their duties of loyalty and due care. "Unless you could show a board lacked independence, didn't inform [itself], or didn't act in good faith, the court would uphold the decision," says Stephen Radin, a partner at Weil, Gotshal & Manges, "no matter how stupid the decision appeared."
Recently, however, the Delaware Chancery Court permitted two shareholder lawsuits to proceed—one involving The Walt Disney Co., the other involving Oracle Corp.—that might have been dismissed prior to Enron, say legal experts. And regardless of the outcome of those actions, the court's willingness to hear them may encourage disgruntled shareholders of other companies to test the protections of the business-judgment rule.
One didn't have to be a shareholder to be taken aback by the Disney board's approval of a $140 million severance package for Michael Ovitz, per the request of CEO Michael Eisner, in 1996. Ovitz had hardly worked a year as Disney's president when Eisner decided he wasn't the right man for the job. Still, board decisions in cases involving compensation have traditionally been shielded by the business-judgment rule, says Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. While courts "have always been very concerned about nonproportional wealth transfers to executives that were not in the normal course of business," that concern has traditionally not extended to compensation issues, he says.
In May 2003, however, the Delaware Chancery Court ruled that a shareholder lawsuit challenging the severance pay could proceed against the Disney board. The suit, an amended version of a suit filed in 2000, alleges that the board did not exercise good faith or due care in approving the severance package. (Disney has taken steps to reform its board since the Ovitz decision, appointing new directors and adopting new guidelines concerning director independence.)
A second ruling by the Chancery Court, in June 2003, reexamined another of the required conditions for the protection of the business-judgment rule: an independent board. The court refused to dismiss a shareholder derivative action charging Oracle CEO Larry Ellison and several Oracle directors with insider trading. A special litigation committee (SLC), consisting of two Oracle board members, concluded that the defendants did not have nonpublic material information before they traded their shares, and it moved to terminate the lawsuit. But shareholders fought back, claiming the SLC members weren't independent.
The court agreed: it ruled that because the two SLC members were professors at Stanford University and three of the four defendants were either major donors to or professors at Stanford, the SLC was not independent. This ruling was inconsistent with previous Delaware decisions, which had held that absent a material economic relationship, personal connections were not enough to show lack of independence.
The Oracle decision represents a "seismic shift," says Beth Boland, a partner at the Boston office of law firm Bingham McCutchen LLP. Why? Because it indicates the Delaware court's willingness "to look beyond quantifiable measures to go into soft issues—business connections, social relationships—in determining independence," she says. "They have veered away from saying, 'We're going to define independence as a bright-line, dollar calculation.'"
Since neither case has come to trial yet, it's premature to predict any precedent-setting changes to the limits of the business-judgment rule. But one thing is clear, notes Elson: "Board process and independence are going to face a tougher review than they would have a few years ago."
"Evolving Expectations"
If the courts are indeed more willing to hold boards accountable on matters they previously would have passed over, likely explanations aren't hard to find. Elson and others point to the recent spate of corporate scandals and the consequent public expectations for higher ethical standards. "The judges are creatures of the society in which they live," comments Boland. "To believe that the interpretations of legal standards don't reflect cultural norms is to put one's head in the sand."
Others believe that state courts are concerned that the Sarbanes-Oxley Act of 2002 is just the first federal incursion into corporate law, territory usually overseen by the states. State courts, the thinking goes, must be perceived as being tough on corporate misdeeds or risk further incursions. Some observers say these pressures are causing the courts to become increasingly pro-shareholder, pointing to a string of rulings in the Delaware Supreme and Chancery courts in the past year that reversed pro-board lower-court rulings.
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