Judgment Calls

Recent shareholder suits may be opening cracks in the protection afforded by the business-judgment rule.

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.


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