Brehm v. Eisner

Brief Fact Summary.

Disney shareholders (Plaintiff) contended that the corporation’s compensation committee (Defendant) breached its duty of care in approving an employment agreement to Ovitz that had the potential of granting him a severance package worth approximately $130 million in its first year; that the committee (Defendant) and remaining directors (Defendant) breached their duty of care in hiring Ovitz as Disney’s president because they acted in bad faith; and that, in any event, the payment of the severance package to Ovitz constituted waste.

Synopsis of Rule of Law.

(1) Corporate directors who are members of a compensation committee do not breach their fiduciary duty of care when approving a compensation package while their approval is based on knowledge of the financial purpose and potential consequences of the package.  (2) The appropriate standard for bad faith is an intentional dereliction of duty and a conscious disregard for one’s responsibilities.  (3) A severance package does not constitute waste where it may be attributed to a rational business purpose.

Facts.

Disney’s compensation committee (Defendant) approved an employment agreement for Ovitz to serve as Disney’s president.  This Ovitz Employment Agreement (OEA) contained No Fault Termination (NFT) terms that provided, inter alia, that in the event of a non-fault termination, Ovitz would receive: (1) the present value of his salary ($1 million per year) for the balance of the contract term, (2) the present value of his annual bonus payments (computed at $7.5 million) for the balance of the contract term, (3) a $10 million fee for termination, and (4) the acceleration of his options for 3 million shares, which would immediately become exercisable at market price.  In approving OEA with the NTF terms, the committee (Defendant) met two times.  At he first meeting, the directors (Defendant) on the committee considered a “term sheet†that summarized all the OEA’s material terms.  The committee members (Defendant) were informed that the value of the option component of the severance package could reach the $92 million order of magnitude if they terminated Ovitz without cause after one year.  Their sources of information were the value of benchmark options granted to Disney employees previously, valuations of the proposed Ovitz options that were explained to them, and the amount of downside protection Ovitz was demanding to leave a job that would have paid him between $150 million and $200 million in commissions over five years.  This meant that if Ovitz was terminated without cause, the earlier in the contract term the termination occurred the larger the severance amount would be to replace the lost commissions.  Ovitz was terminated without cause after about a year, and he was paid the severance package provided by the OEA.  Disney shareholders (Plaintiff) brought suit claiming that the compensation committee members (Defendant) had breached their duty of care by failing to properly inform themselves of material facts and hence were grossly negligent in approving the NFT provisions; that the compensation committee (Defendant) and the remaining Disney directors (Defendant) had beached their duty of care when they approved the hiring of O; and that even if the approval of the OEA was protected by the business judgment rule, the payment of the severance constituted corporate waste.  The Chancery Court rendered judgment for the directors (Defendant) on all claims, finding that even though the committee’s (Defendant) decision-making process did not nearly measure up to corporate governance “best practices,†the committee members (Defendant) breached no duty of care when they considered and approved the NFT terms of the OEA; that the business judgment rule presumptions protected the decisions of the compensation committee (Defendant) and the remaining directors (Defendant), not only because they had acted with due care but also because they had not acted in bad faith; and that the record did not support the claim that the NFT provisions of the OEA were wasteful because they incentivized Ovitz to perform poorly in order to receive payment of the NFT provisions.  The state’s highest court granted review.

Issue.

(1) Do corporate directors who are members of a compensation committee breach their fiduciary duty of care when approving a compensation package while their approval is based on knowledge of the financial purpose and potential consequences of the package?  (2) Is the appropriate standard for bad faith is an intentional dereliction of duty and a conscious disregard for one’s responsibilities?  (3) Does a severance package constitute waste where it may be attributed to a rational business purpose?

Held.

(Jacobs, J.)  (1) No.  Corporate directors who are members of a compensation committee do not breach their fiduciary duty of care when approving a compensation package while their approval is based on knowledge of the financial purpose and potential consequences of the package.  Although the committee’s (Defendant) decision-making process in this case was not ideal, it did not rise to the level of a breach of their fiduciary duty of care.  The record reveals that the committee members had knowledge of the possible value and cost to Disney of the NFT terms, and that the OEA was specifically structured to compensate Ovitz for walking away from anticipated commissions of $150 million to $200 million.  Even though some of the directors (Defendant) may not have reviewed valuation spreadsheets they received, as claimed by the shareholders (Plaintiff), such failure was harmless as others adequately informed them of the spreadsheets’ contents.  Affirmed as to this issue.  (2) Yes.  The appropriate standard for bad faith is an intentional dereliction of duty and a conscious disregard for one’s responsibilities.  The Chancery Court defined bad faith as intentional dereliction of duty and a conscious disregard for one’s responsibilities, saying that deliberate indifference and inaction in the face of a duty to act is the epitome of faithless conduct.  That court also noted that this is an appropriate standard, though not the only one, for determining whether a fiduciary has acted in good faith.  The shareholders (Plaintiff) assert that this is not the correct legal standard for bad faith.  There are three categories where there might be bad faith.  First, bad faith might occur where the fiduciary has intended to do harm purposely—which is not the case being asserted here.  Second, it is asserted that bad faith can occur where gross negligence has occurred.  However, gross negligence on its own cannot constitute bad faith.  A conclusion such as this is supported by the distinction made by legislative history and common law between the duties to exercise due care and to act in good faith, and the very significant consequences that flow from that distinction.  The legislature has allowed corporations to exculpate their directors from liability for breaches of the duty of care, but not for conduct that is in bad faith.  A definition of bad faith that would cause a violation of the duty of care to automatically become a bad faith act or omission would eviscerate such exculpatory protections.  Likewise, directors or officers can be indemnified for liability for breaching their duty of care, but not for violating the duty to act in good faith.  The third category of possible bad faith is a category of conduct between subjective bad faith and gross negligence.  This is the category addressed by the Chancery Court—where there has been an intentional dereliction of duty, a conscious disregard for one’s responsibilities.  The question is whether this category of misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith.  The answer is yes.  This type of conduct does not involve self-interest and disloyalty to the corporation, but is more culpable than simple inattention or failure to be informed.  To protect the shareholders and the corporation, conduct such as this must be proscribed.  The state’s corporation statute expressly denies exculpation from liability for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.â€Â  Thus, the statute distinguishes between subjective bad faith on the one hand, and acts that are not in good faith on the other, but nonetheless denies exculpation for both.  Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for “acts . . . not in good faith†must encompass the intermediate category of misconduct addressed by the Chancery Court’s definition of bad faith.  Therefore, this definition is upheld.  Affirmed as to this issue.  (3) No.  A severance package does not constitute waste where it may be attributed to a rational business purpose.  To recover on a claim of corporate waste, the shareholders (Plaintiff) must shoulder the burden of proving that the exchange was “so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.â€Â  In this case the issue is therefore not whether the actual payment to Ovitz constituted waste, but whether the amounts required to be paid in the event of an NFT were a wasteful obligation.  As the Chancery Court found, and contrary to the shareholders’ (Plaintiff) assertions, the NFT provisions did not provide an irrational incentive to Ovitz to perform just poorly enough to be terminated for no cause.  Instead, the OEA had a rational purpose—to induce Ovitz to leave a very lucrative position to join Disney as President.  The record showed that Ovitz had no control over whether or not he would be fired, either with or without cause; there was no proof to even suggest that at the time he entered into the OEA Ovitz would devise an early departure at the cost of his extraordinary reputation in the entertainment industry and his historical friendship with Disney’s chairman, an entirely speculative claim.  As such, the shareholders (Plaintiff) have failed to show that the approval of the NFT terms of the OEA was not a rational business decision.  Affirmed as to this issue.

Discussion.

To carry out the best practices regarding compensation packages, the court lays out a road map for compensation committees to follow.  The court said: “In a ‘best case’ scenario, all committee members would have received, before or at the committee’s first meeting . . . a spreadsheet or similar document prepared by (or with the assistance of) a compensation expert. . . . Making different, alternative assumptions, the spreadsheet would reveal the amounts that Ovitz could receive under the OEA in each circumstance that might perchance arise.  One variable among those possibilities would be the cost to Disney of a non-fault termination for each of the five years of the initial term of the OEA.  The contents of the spreadsheet would be explained to the committee members, either by the expert who prepared it or by a fellow committee member with similar knowledge of the subject.  That spreadsheet, which ultimately would become an exhibit to the minutes of the compensation committee meeting, would form the basis of the committee’s deliberations and decision. . . . If that scenario had been followed, there would be no dispute (and no basis for litigation) over what information was furnished to the committee members or when it was furnished.â€Â  This “map†should be followed by any compensation committee wanting to avoid being accused of breaching its duty of care with regards to compensation packages.