Tightening the Reins on Corporate Governance:
The Increasing Judicial Scrutiny of Director Care and Independence

August 2003

In the wake of Enron and other scandals involving corporate governance, U.S. courts appear to have little patience for rubber-stamping directors. Particularly when directors are challenged by shareholders in derivative lawsuits, recent decisions have held that the business judgment rule does not protect directors who breach their duty to act in good faith, in the best interest of the company. Directors may find it more difficult to dismiss derivative claims challenging their decisions, adding to the cost to defend and settle such claims.

by John E. Black Jr.
Boundas, Skarzynski, Walsh & Black, LLC

The renewed concern about the integrity of corporate management may be prompting courts to scrutinize more closely decisions by directors challenged by shareholders in derivative lawsuits. Since January 2003, several courts have issued opinions critical of director independence and care. These opinions seem to signal that courts in the post-Enron era have little patience for directors who do not take seriously their duty to act in good faith in managing the corporation’s affairs, and will limit traditional protections for directors, such as the business judgment rule, liability opt-out provisions, and special litigation committees, to encourage appropriate management. With this heightened scrutiny, directors may find it more difficult to dismiss derivative claims challenging their decisions, adding to the cost directors and their insurers may incur to defend and settle such claims.

Limiting the Business Judgment Rule Protection for Inattentive Directors

Two recent cases hold that the “business judgment rule,” one of the most significant protections for directors against shareholder challenges to their management, does not apply where the directors allegedly breached their duty to act in good faith by failing to devote sufficient attention to corporate business. The business judgment rule presumes that, in making business decisions, “the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.” See Aronson v Lewis, 473 A2d 805, 812 (Del 1984).

If a shareholder perceives a director has breached a corporate duty, and the corporation has not protected its rights, the shareholder may seek to enforce that duty through a derivative action on behalf of the corporation against the director. To overcome the rule’s presumption, the plaintiffs must raise a reasonable doubt that the directors exercised proper business judgment. In evaluating this, the court will look at the substance of the transaction, as well as whether the directors made an informed decision. See Grobow v Perot, 539 A2d 180, 189 (Del 1988).

In a May 2003 ruling, the Delaware Chancery Court determined that directors were not shielded by the business judgment rule when they failed to exercise good faith in approving an excessive executive compensation arrangement. See In re Walt Disney Co. Derivative Litigation, 2003 WL 21267266, 2003 WL 21267266 (Del Ch 2003).

In Disney, shareholders brought a derivative action alleging that the board of directors “consciously and intentionally disregarded their responsibilities” to the corporation by failing to oversee the hiring of Michael Ovitz as president of Disney in October 1995. According to the Complaint, Michael Eisner, the CEO of Disney, unilaterally hired Michael Ovitz, the founder and head of CAA, a talent agency, and a close friend. Eisner did not consult with the board of directors nor the compensation committee prior to making the initial offer to Ovitz.

Although the board of directors and the compensation committee approved the hiring, they approved it in less than an hour on the same day it was first presented. Both committees saw only a rough, incomplete summary of the employment agreement, received no expert advice on the agreement, and approved it without seeing a final version. The board of directors, which met immediately after the compensation committee, asked no questions about salary or termination terms. Instead, the board delegated authority to Ovitz and Eisner to work out the terms of the agreement, which were generous.

Ovitz was not successful as president of Disney. He was not a good second-in-command, which he and Eisner soon recognized. Ovitz wanted to leave Disney, but was concerned about breaching the terms of the agreement or losing non-fault termination benefits in the contract. The court noted that Eisner and Ovitz worked together to arrange for Ovitz to receive the non-fault termination benefits. Although the board was aware that negotiations were underway to terminate Ovitz’s employment, it took no action. The final termination agreement, dated December 27, 1996, was more favorable than Ovitz’s employment contract, accelerating his non-fault termination, with a payout of more than $38 million in cash, together with $3 million dollars in “A” stock options. Neither the board nor the compensation committee reviewed or approved the termination letter, although Disney’s bylaws required board approval.

The Chancery Court concluded that these facts, if true, did “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.” The facts alleged suggested “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.” Observing that this conduct was not in good faith in the best interests of the company, the court held the complaint alleged a breach outside of the business judgment rule’s protection.

Similarly in a March 2003 opinion, the Seventh Circuit Court of Appeals held that the business judgment rule would not apply where directors failed over a 6-year period to correct known problems, causing loss to the corporation. See In re Abbott Laboratories Derivative Litigation, 325 F3d 795 (7th Cir. Mar 28, 2003). In Abbott, the shareholders of the company brought a derivative suit alleging that the sustained inattention of the directors breached their fiduciary duty of good faith, causing Abbott to incur a $100 million fine and requiring it to withdraw from the market its in vitro diagnostic kits.

The Complaint alleged that from 1993 until 1999, the U.S. Food & Drug Administration (FDA) conducted 13 inspections of Abbott’s Abbott Park and North Chicago facilities to ensure that data concerning Abbott’s in vitro products were valid and accurate, and that the human subjects were protected from undue hazard. The FDA initially notified Abbott on October 20, 1993, that an inspection had found adulterated in vitro products and, over the next 2 years, sent further warning letters to Abbott, its chairman of the board of directors, and chief executive officer.

The issue became public on January 11, 1995, when The Wall Street Journal published an article stating that the FDA had “uncovered a wide range of flaws in Abbott Laboratories’ quality-assurance procedures used in assembling medical-diagnostic products.” The FDA and Abbott entered into a comprehensive Voluntary Compliance Plan in July 1995 to address the problems, but the FDA became frustrated with continuing delays in correcting the problems and terminated the Compliance Plan on February 26, 1998. The FDA sent the fourth and final certified Warning Letter on March 17, 1999, to Abbott’s CEO, which the Bloomberg News subsequently reported.

The FDA filed a complaint against Abbott on November 2, 1999, and that day the parties signed a consent decree prohibiting Abbott from manufacturing the in vitro devices, imposing a $100 million fine, and ordering Abbott to destroy the in vitro kits and withdraw them from the U.S. market. The suspension resulted in a $250 million loss, and Abbott announced it would take a $168 million charge against its earnings in the third quarter of 1999. At the time of the derivative complaint, all but 4 of Abbott’s 13 directors served on the board during that 6-year period.

The court determined that the extensive paper trail concerning the violations indicated there was a “sustained and systematic failure of the board to exercise oversight,” that was intentional as the directors knew of the violations and took no steps to prevent or remedy the situation. The court, therefore, found that 6 years of noncompliance, inspections, warning letters, and notice in the press, which resulted in the largest civil fine ever imposed by the FDA and the destruction and suspension of products that accounted for approximately $250 million in corporate assets, indicated the directors’ decision to not act was not made in good faith and was contrary to the best interests of the company. Accordingly, the court held that the plaintiffs sufficiently pleaded a breach of the duty of good faith so the directors’ actions fell outside the protection of the business judgment rule.

Limiting the Statutory Liability Exemption for Inattentive Directors

The Court in Abbott also limited another protection typically enjoyed by directors—the liability exemption provision that corporations are authorized by statute to adopt. Typically, state corporate statutes allow the corporation to adopt a provision exempting its directors from personal liability to the corporation or its shareholders for monetary damages arising from a breach of the duty of care, subject to certain limitations.

For example, the Delaware statute provides that the liability exemption does not apply to a director’s liability:

1. for breach of the director’s duty of loyalty to the corporation or its stockholders;
2. for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;
3. under § 174 (i.e., liability of directors for unlawful payment of dividend or unlawful stock purchase or redemption); or
4. for any transaction from which the director derived an improper personal benefit. Del. Code Ann. tit. 8, § 102(b)(7).

In Abbott, the court determined that the directors also were not protected under Abbott’s liability limitation provision. As permitted by the Illinois statute that mirrored the Delaware statute, Abbott had amended its Articles of Incorporation to protect its directors from personal liability for breach of the duty of care. The court observed that the plaintiffs accused the directors of gross negligence and intentional conduct in failing to address the FDA problems. As such, the complaint alleged facts that implied a breach of loyalty or of good faith, not the duty of care. Because the directors allegedly acted with “a conscious disregard of known risks, which conduct, if proven, cannot have been undertaken in good faith,” the Court held the liability limitation provision did not apply.

Limiting the Presumption of Director Independence

Two recent cases involving special litigation committees indicate that courts are more closely examining the nature of ties between directors that may undermine their independence. A special litigation committee ("SLC") is an independent committee of the board of directors appointed to consider whether the corporation should pursue or terminate shareholder derivative litigation against the directors. The SLC is a last chance for a corporation to control a derivative claim when a majority of its directors cannot impartially consider the demand. The board vests its power to determine what to do with the suit to a committee of independent directors. Generally, if the SLC recommends terminating the derivative suit, the court will defer to the recommendation if the committee shows its members were independent, acted in good faith, and had a reasonable basis for their conclusions.

In an unusual ruling, in January 2003 the Delaware Chancery Court held that an SLC was not independent before the SLC even had an opportunity to complete its investigation. See Biondi v Scrushy, 820 A2d 1148 (Del Ch 2003). The case concerned a derivative action brought against directors of HealthSouth and its CEO, Richard Scrushy, with respect to insider trades of large blocks of HealthSouth’s stock while they were in possession of material, non-public information. HealthSouth was the purchaser in one of the sales, a $25 million sale by Scrushy.

The plaintiffs brought the derivative suit to remedy alleged injuries that HealthSouth suffered because of the trades made by Scrushy and the other directors before the company publicly announced the information. After the filing of the derivative suit, the HealthSouth board appointed an SLC to consider the derivative litigation. The SLC initially was composed of an existing director, Larry D. Striplin Jr., and a new director, Jon Hanson. Subsequently, HealthSouth appointed another new, independent director, Robert P. May, to serve as chairman of the SLC.

The SLC requested the court to stay the derivative action during its investigation. Although litigation typically is stayed during an SLC’s investigation, the court noted that an odd confluence of unusual and highly troubling facts, taken together, demonstrated the SLC could not meet its burden to prove independence, even if it eventually decided to seek termination of the derivative litigation. The court concluded that it could not defer to any decision by the SLC because the committee was not sufficiently independent of the HealthSouth CEO, Richard Scrushy.

The court noted that both of the initial SLC members had close ties to Scrushy. Both served with him on the board of the National Football Foundation and College Hall of Fame, Inc., of which Hanson had been the chairman. Striplin and Scrushy were also large contributors to college sports programs in Alabama, and a stadium at a college in Alabama is named Scrushy-Striplin Field. In addition, after the appointment of May, Striplin resigned from the SLC due to press reports questioning his ability to serve impartially, particularly in light of a large contract his glass company had received from HealthSouth. When he resigned, he issued a strong statement supporting Scrushy.

The court also found that the board had inadequately delegated authority to the committee. The same day the SLC was created, HealthSouth undercut the SLC’s credibility by hiring the law firm of Fulbright & Jaworski L.L.P. to investigate the securities trading issues at the heart of the pending lawsuits the SLC was formed to investigate. Later, HealthSouth published a press release proclaiming that Fulbright & Jaworski had issued a report clearing Scrushy. SLC Chairman May was quoted in the press release affirming that this “thorough outside review … puts to rest any question …” concerning Scrushy’s prior knowledge of material facts relevant to the insider trades in question in the litigation.

In a ruling that highlights the increasing focus that courts are paying to the possibility that ties between directors not arising from familial connections or formal business arrangements may compromise the directors' independence, the Delaware Chancery Court held in a June 2003 unpublished opinion that an SLC was not independent where the defendant directors had extensive charitable ties to SLC members. In Oracle, an SLC was formed to review various derivative actions against four directors that alleged the directors engaged in insider trading while in possession of material, non-public information showing that Oracle would not meet the earnings guidance it gave to the market for the third quarter of its fiscal year 2001. The derivative complaint centered on alleged insider trading by Lawrence Ellison, Oracle’s chairman, chief executive officer, and largest stockholder; Jeffrey Henley, its chief financial officer, executive vice president, and a director; Donald Lucas, a director who chaired the Executive Committee and the Finance and Audit Committee; and Michael Boskin, a member of the Finance and Audit Committee.

The SLC was comprised of two outside directors, Hector Garcia-Molina and Joseph Grundfest, well-respected professors at Stanford University. Professor Garcia-Molina was the chairman of the Computer Science Department at Stanford, and Professor Joseph Grundfest was the W.A. Franke Professor of Law and Business at Stanford. Professor Grundfest, a former commissioner of the SEC, directed the Stanford Law School’s well-known Directors’ College and the Roberts Program in Law, Business, and Corporate Governance.

The SLC, assisted by outside legal counsel, conducted an extensive investigation that resulted in a 1,110-page report (excluding appendices and exhibits) concluding that Oracle should not pursue the claims. The report reviewed and accepted its members’ independence, noting that:

1. neither received compensation from Oracle other than as directors and neither were on the board at the time of the alleged wrongdoing;
2. both were willing to return their compensation as SLC members if necessary to preserve their status as independent; and
3. neither had material ties to Oracle or any defendant. Consistent with the report, the SLC moved to terminate the derivative litigation.

The court granted discovery focusing on the independence of the SLC, the good faith of its investigation, and the reasonableness of its conclusion. In discovery, the plaintiffs discovered the SLC members had more extensive ties than had been disclosed, including that:

• Defendant Boskin taught Grundfest when Grundfest was a Ph.D. candidate in the 1970s.
• Boskin and Grundfest are senior fellows and steering committee members at the Stanford Institute for Economic Policy Research (SIEPR). Although the SLC noted this was largely honorary, SIEPR’s Web site stated that senior fellows actively participated in research and its governance.
• Lucas made significant contributions to Stanford and was a Stanford alumnus, both for undergraduate and graduate degrees. He donated individually approximately $4.1 million and, as chairman of a Foundation, $11.7 million. These amounts included $424,000 donated to the SIEPR, for which he chaired the Advisory Board.
• Ellison also made significant contributions to Stanford, directly and indirectly through Oracle. Ellison was the sole director of the Ellison Medical Foundation, which donated $10 million to Stanford. Oracle also donated $300,000 and established an educational foundation—the Oracle Help Us Help Foundation—of which Stanford was the appointing authority. In 2000 and 2001, the years Ellison made the challenged trades, Ellison and Stanford discussed creating an Ellison Scholars Program modeled on the Rhodes Scholarship for which the proposed $170 million budget was put together by John Shoven, the SIEPR director.

The court concluded that the SLC did not meet its burden of persuading the court that there was no material issue calling into doubt its independence, and therefore denied the SLC’s recommendation to discontinue the derivative action. The court reasoned that independence depends on “whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind.” The court noted this is consistent with prior case law defining independence as meaning that “a director’s decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.” See Aronson at 816.

Noting that the law should not ignore the social nature of human relations, the court stated that a director will be considered compromised if the director is beholden to an interested person—not only in a financial sense, but also flowing out of “personal or other relationships” to that person.

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