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Recent shareholder suits may be opening cracks in the protection afforded by the business-judgment rule.
Kris Frieswick, CFO Magazine
February 1, 2004
Pity 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."
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.
Not surprisingly, judges deny they have become any more or less biased toward shareholder interests. E. Norman Veasey, chief justice of the Delaware Supreme Court, argues that the Disney case involved a simple application of existing case law, and that no new precedents were set. The business-judgment rule is "alive and well," he says. That said, Veasey concedes that board actions are now subject to review based on "evolving expectations."
"What is evolving is...the attention paid to the process used by directors, and the issue of good faith," says Veasey. He points out that the concept of good faith has changed dramatically in the past 40 years. "Boards need to know they're not living in 1963 anymore."
Today, Veasey adds, judicial expectations of board processes, independence, and good faith could also be judged "against a backdrop of relevant Sarbanes-Oxley [statutes], SEC rules, and SRO [self-regulatory organization] requirements, even though there may be no express right of private action in the federal legislation." In other words, a given board could be evaluated by a judge based on the expectations set by these new laws and requirements, even though shareholders may not be able to sue companies for breaking those laws and requirements.
Radin of Weil, Gotshal agrees with Veasey's characterization of the perceived shift. "These judges are applying the same judicial rules regarding the business-judgment rule, but they're applying these rules in light of today's norms," he says. "When you ask, 'What's good faith?' you don't just look at it in a vacuum."
Black and Browne
There are signs that shareholders are taking notice that the business-judgment rule is more permeable than before. In December, Cardinal Value Equity Partners, a hedge fund and a major shareholder of Hollinger International, filed a lawsuit accusing the company's board of lax supervision, lack of due process, and a lack of independence in approving deals and payments requested by former CEO Conrad Black for himself and other company executives.
Black resigned as CEO in November 2003 after an investigation by a special committee of the board turned up more than $300 million in management fees and noncompete payments to him, other companies controlled by him, and other Hollinger executives. About $275 million of the payments had been approved by the board. The investigation was instigated by Christopher Browne, managing director of investment-management firm Tweedy, Browne Co. in New York, which holds 18 percent of Hollinger shares. Tweedy, Browne has not yet filed a lawsuit; however, the Cardinal Value Equity Partners suit relies heavily on information uncovered in the investigation instigated by Browne.
"The Disney case had a direct effect on our decision to actively pursue this case," says Browne. "The courts are saying [boards] can't just rubber-stamp things and say, 'We can do this—we have the protection of the business-judgment rule.'"
Kris Frieswick is a senior writer at CFO.