The New and Emerging Fiduciary Duties of Corporate Directors

How times have changed since 2006. Then, in the heyday of record growth and earnings, corporate consultant Greg Taxin commented in the New York Times that “only actors, professional baseball team managers, and corporate directors have the luxury of being rehired, at exorbitant salaries, after completely bombing out.”

Today, the public is outraged at Wall Street excesses and angered by revelations of executives who received hefty salaries and severance payments even as their companies dissolved. Corporate directors’ decisions are being closely scrutinized-both by the media and by the courts. What once were pedestrian legal suits against a corporation are now accompanied with claims against corporate directors intended to expose them to significant and personal liability.

In these increasingly turbulent financial times, lawsuits will assert claims against companies and directors on novel and untested theories. Even in the best of times, it is no easy task for directors to clearly understand the nature and scope of their fiduciary duties. Today, with growing public demand for regulatory oversight of corporations’ adherence to corporate governance practices, it will be critical for directors to have a comprehensive and current understanding of the law as it unfolds.

The evolution of directors’ fiduciary duties

Traditionally, directors’ fiduciary duties have been understood as follows:

u2022 duty of care: requires deliberative decision-making processes based on full and credible information;

u2022 duty of loyalty: prohibits self dealing, misappropriation of corporate assets, conflicts of interest, lack of independence or disloyal conduct; and

u2022 duty of good faith: forbids conduct motivated by an actual intent to impede, interfere with or harm the corporation, or violate the law.

The Caremark decision

In 1996, the landmark decision by the Delaware Chancery Court in Caremark International Inc. Derivative Litigation enlarged directors’ duty of due care to include the duty to properly oversee company operations. Prior to Caremark, liability for a breach of that fiduciary duty typically required affirmative wrongful conduct by a director. Post Caremark, “oversight liability” claims are based not on a director’s affirmative wrongful act but rather on a director’s failure to act, which in Caremark, was the directors’ failure to detect and prohibit company employees’ systematic violations of federal anti-kickback laws. Since Caremark, plaintiffs have creatively and aggressively alleged Caremark “oversight liability” claims against corporate directors.

Disney and Stone: Recasting good faith and loyalty

Two 2006 decisions by the Delaware Supreme Court-Walt Disney Company Derivative Litigation and Stone v. Ritter-significantly extended Caremark by holding that directors’ failure to properly oversee company operations could constitute not only a breach of their duty of care (as previously held by Caremark) but also a breach of their fiduciary duties of good faith and loyalty.

The Walt Disney plaintiffs alleged that Disney directors failed to oversee the company’s decision to enter into an employment contract with Michael Ovitz that included a $130 million severance payment provision. Unlike Caremark, in which the directors’ failure to oversee company operations was pled as the basis for a breach of their duty of care, the Walt Disney plaintiffs claimed that the Disney directors’ failure to oversee the Ovitz contract also breached their duty of good faith.

Although ultimately ruling in Disney’s favor, the court nonetheless adopted this new theory, holding that a director who “intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties” can breach not only his duty of care, but also his duty of good faith. Soon thereafter, the Delaware Supreme Court decision Stone v. Ritter held that directors’ failure to “act in the face of a known duty to act” also could breach their duty of loyalty.

Walt Disney and its progeny create real-life, practical, and serious consequences for directors. When sued, directors routinely rely on their rights, created by corporate charter, for indemnification by the company and immunity from money damages. Directors found to have breached only their duty of care retain both of those rights. However, directors who breach their duties of good faith/loyalty can lose both rights. Extension of the oversight liability standard as a basis for the breach of the duty of good faith/loyalty thus places directors in a new and riskier situation in which their indemnity and immunity rights are at stake. Caremark, Walt Disney, and Stone have produced a rash of litigation that attempts to recast “oversight liability” fiduciary duty of care claims as claims for breach of the duties of good faith and loyalty, in an effort to expose company directors to personal liability.

Recent cases regarding oversight liability are unsettled and evolving

In 2008, the Delaware courts issued three opinions (Ryan v. Lyondell, McPadden v. Sidhu, Lear Corporation Shareholder Litigation) that continued to drill down on when and how directors can be found to have breached their duty of oversight. Ryan broadly defined that duty when, in connection with a company merger, the court castigated what it described as the directors’ “apparent ‘do nothing, hope for an impressive-enough premium, and buy a fairness opinion’ approach to discharging a director’s fiduciary obligations when selling the corporate enterprise” and denied the directors the protection of their company’s immunity provision, pending trial. McPadden adopted a more conservative approach, holding that directors’ conduct in connection with oversight of the sale of a company subsidiary, although “grossly negligent,” was not bad faith.

Lear, the most recent decision of the Delaware Chancery Court, may be a clear message of that court’s intention to confine director liability to a systematic failure of director oversight, and halt the judicial trend extending it to discrete corporate transactions. Lear addressed “the hardest question in corporation law: what is the standard of liability to apply to independent directors with no motive to injure the corporation when they are accused of indolence in monitoring the corporation’s compliance with its legal responsibilities?” The court concluded that oversight liability requires “a sustained or systematic failure . . . to exercise oversight” and cautioned that it should not be applied to a single transaction. The court explained that, “in the transactional context, a very extreme set of facts would seem to be necessary to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties” and pointedly noted that “Courts should . . . be extremely careful about labeling what they perceive as deficiencies in the deliberations of an independent board majority over a discrete transaction” as bad faith.

Schoon: A threat to directors’ advancement rights

Advancement rights are created by corporate charter and provide directors with advance payment for legal fees and expenses incurred in connection with lawsuits relating to actions taken by them on the corporation’s behalf. Directors rely on their advancement rights to prevent them from being personally responsible for the payment of significant fees in advance of an ultimate indemnity determination.

Advancement claims often arise after a director ceases service to the corporation. Although directors might assume that advancement rights established by a corporate charter vest when they join the board, a 2008 Delaware Chancery Court case-Schoon v. Troy Corporation-concluded otherwise when it upheld the right of the corporation to amend its charter to deny advancement rights to a former director, holding that charter-provided advancement rights do not vest when a director joins the board of directors, but instead when a claim for advancement is asserted or threatened.

How can directors best protect themselves?

Under Delaware law, it is clear that directors have the fiduciary duty to “act in the face of a known duty to act.” In today’s world, nearly every company, public and private, has reporting and compliance obligations that can be construed as duties to “act in the face of a known duty to act.” For example, most companies have reporting obligations unique to the sector in which they operate; others have more general obligations established by federal law-such as Sarbanes-Oxley-or state law. In order to satisfy their oversight responsibilities, directors should understand the reporting and compliance obligations of the companies on whose boards they sit, be fully informed regarding the systems in place intended to ensure that the companies satisfy those obligations, and require regular and complete reports from management with respect to the existence, operation, and supervision of those systems.

Recently, public indignation over skyrocketing executive compensation has been fueled by the financial crisis. Calls for reform have been met with pointed editorials focused on directors’ obligations to oversee and monitor executive compensation. The obligations of banks and financial institutions, and their directors, to fairly set executive compensation was underscored in the Emergency Economic Stabilization Act of 2008 (H.R. 1424). It is likely that future lawsuits will focus on compensation decisions made at the board level. Directors can protect themselves by ensuring that they closely oversee company compensation decisions, satisfy their duty of care by making informed, deliberative decisions based on full and credible information, and conduct themselves in good faith by grounding their conduct in the best interests of the company, and not the individual interests of affected executives.

Moreover, post-Schoon, directors who rely solely upon charter-provided advancement rights may be at risk. Directors should protect themselves by:

u2022 understanding that charter-provided advancement rights may not vest when directors join the company’s board and that events triggering the vesting of those rights may not occur until well after a director resigns;

u2022 negotiating for charter language that provides for mandatory advancement and vests the right to advancement at the director’s commencement, or continuation, of his service on the board of directors; and

u2022 negotiating a contract that confirms the contractual nature of the director’s advancement rights, reciting that he receives it in consideration for his agreement to serve on the company’s board of directors.

Looking ahead: oversight liability with distressed companies

Two recent cases from the United States Bankruptcy Court in Delaware may portend of future cases in which directors’ oversight liability is at issue in connection with troubled or distressed companies. In re the Brown Schools recognized directors’ oversight liability for damages based on the company’s “deepening insolvency” caused by the directors’ wrongful perpetration of a company’s existence and operation. In re Bridgeport Holdings upheld an oversight claim based on directors’ (1) abdication of decision-making authority to a restructuring adviser they hired to steer their troubled company through a sales process; (2) failure to properly monitor the sales process; and (3) sale of the company in an “abbreviated and uninformed sale process.”

In these and other types of situations, directors can protect themselves by requiring regular and comprehensive reports from outside professionals hired by management and, once again, ensuring that they have taken steps necessary to satisfy the separate obligations imposed on them by the fiduciary duties of care, good faith, and loyalty.

Elizabeth B. Burnett is a litigator with Mintz Levin Cohn Ferris Glovsky and Popeo, PC. Having served as Chair of the Litigation Department for ten years, Ms. Burnett possesses a special expertise in business fraud, corporate governance, and fiduciary duty matters. She may be reached at [email protected]. Elizabeth Gomperz is a senior associate at the Firm and can be reached at [email protected]. A former financial analyst, her practice also focuses on fiduciary duty disputes.