Fortunately for directors and officers, at least in Delaware there is now substantial evidence indicating that mentality was a temporary reaction, and that the pendulum is now swinging back to protecting rather than punishing directors and officers.  In other words, the Delaware judiciary seem more focused on attracting and retaining quality directors and officers than on deterring future wrongdoing.

In recent months, the Delaware Supreme Court issued a series of decisions which articulated very protective liability standards for directors and officers.  These cases, when considered in combination, signal an important and positive shift in the D&O liability climate, at least in Delaware.

Some of these recent Delaware Supreme Court decisions are summarized below.

A.                 Disney (In re The Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006)).  In the most anticipated and publicized opinion by the Delaware Supreme Court in many years, the Court in June 2006 affirmed the Chancery Court ruling after a lengthy trial that the directors of Disney acted in good faith and were protected by the Business Judgment Rule in connection with their hiring and subsequent termination of Michael Ovitz as Disney’s president.  In hindsight, Ovitz’ one-year employment by Disney, which ended with his termination and payment of $140 million in severance, was unquestionably a huge failure.  However, the Delaware Supreme Court ruled that the defendant directors were neither grossly negligent nor failed to act in good faith in connection with the hiring or termination of Ovitz.  The Court adopted a broad interpretation of the good faith element of the Business Judgment Rule, identifying the following examples as a failure to act in good faith which could create liability:

·                     The fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation

·                     The fiduciary acts with intent to violate applicable positive law;

·                     The fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.

By including an element of intent in each of these examples, the Court significantly limited director and officer liability based purely upon negligent or even reckless wrongdoing.  The Court also observed that plaintiffs’ burden of proof is particularly difficult with respect to claims for corporate waste, noting that such a claim exists “only in the rare, unconscionable case where directors irrationally squander or give away corporate assets.”

B.                 AmSouth (Stone v. Ritter, 2006 Del. LEXIS 597 (Del. 2006)).  In the most recent pronouncement of D&O liability standards, the Delaware Supreme Court on November 6, 2006 affirmed the Chancery Court’s dismissal of a shareholder derivative lawsuit against 15 directors of AmSouth Bancorporation.  Plaintiffs in the lawsuit alleged that the defendant directors failed to implement appropriate internal controls consistent with the 1996 Caremark decision by the Delaware Supreme Court, thereby allowing lower level employees of the corporation to commit certain violations of law.  Although the defendant directors had no involvement in or warnings about the employees’ violations of law, plaintiffs argued the directors should be liable for the $50 million fine levied against the corporation by regulators as a result of the employee wrongdoing.

Unlike the Disney decision, which dealt with the applicability of the Business Judgment Rule to affirmative decisions by directors, the AmSouth case dealt with the directors’ alleged failure to properly oversee corporate operations and to adopt adequate reporting systems and compliance programs.  Although this alleged failure to act is not protected by the Business Judgment Rule (which applies only to actual business decisions), the Court nonetheless adopted a protective standard of liability, holding that a director is liable for oversight failure only if the director (i) utterly fails to implement any reporting or information systems, or (ii) consciously fails to monitor or oversee the systems.  Like the Disney decision, the Court recognized an intent element to this type of claim, stating that liability exists for such oversight failures only if “the directors knew that they were not discharging their fiduciary obligations,” and the oversight failures are sustained or systemic.  According to the Court, such a claim against directors for employee failures is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”

Interestingly, the Court rejected the existence of a fiduciary duty of good faith, separate from the traditional fiduciary duties of care and loyalty.  Instead, the Court stated that acting in good faith is an element of a director’s fiduciary duty of loyalty, but does not constitute a separate fiduciary duty.

In the most explicit recognition by the Delaware Supreme Court since Enron that protecting directors against liability is beneficial to shareholders because the protection encourages qualified persons to serve as directors, the Court reiterated the following quote from the 1996 Caremark decision:

Such a test of liability—lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight—is quite high.  But, a demanding test of liability in the oversight context is probably beneficial to corporate shareholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

C.                 Benihana (Benihana of Tokyo Inc. v. Benihana Inc., 906 A.2d 114 (Del. 2006)).  In August 2006, the Delaware Supreme Court ruled that the directors’ approval of a refinancing transaction that paid for refurbishing the Benihana steakhouse chain was protected by the Business Judgment Rule, even though the transaction shifted ultimate control of the company to the officers.  Because a majority of the directors who approved the refinancing transaction were independent, did not profit unduly from the transaction and had legitimate business reasons for their actions, the directors were not personally liable and did not have to prove the transaction was fair and in the best interests of shareholders.  The Delaware Supreme Court concluded that the defendant directors were well informed about alternative deals and there was no proof to support the dark motives that plaintiffs tried to ascribe to the board’s decision.

D.                 General Motors (In re GM (Hughes) Shareholder Litigation, 897 A.2d 162 (Del. 2006)).  In March 2006, the Delaware Supreme Court ruled that directors of General Motors were not personally liable for shareholder derivative claims relating to the company’s sale of its Hughes Electronics Corporation subsidiary.  The Court held that ratification of that transaction by GM shareholders confirmed the applicability of the Business Judgment Rule.  Because plaintiffs failed to provide any good faith basis for questioning the shareholder ratification, plaintiffs’ claims against the directors were dismissed.

There is far less evidence a similar shift towards protecting directors and officers is occurring in other states.  Several factors may explain this apparent D&O liability dichotomy which seems to be developing between Delaware and at least some other important states.  First, Delaware courts more than other courts appear to be increasingly focused on encouraging qualified directors and officers to serve rather than deterring future wrongdoing by severely and publicly punishing questionable conduct.  Second, Delaware courts may be more incentivized than other states to nurture a deferential legal environment for directors and officers in order to maintain Delaware’s status as the preferred domicile for U.S. corporations.  Third, courts in other states may be simply waiting to follow the lead of the Delaware courts, as has been the practice of many states in the past.  Fourth, state court judges in many states are not as experienced and capable of scholarly corporate jurisprudence as the judges in the Delaware Chancery Court and Supreme Court, and may be more plaintiff-oriented in their views.

One of the practical consequences of this apparent difference in D&O liability standards among states is the forum selection by plaintiffs when filing shareholder derivative lawsuits against directors and officers.  Although little empirical data is available relating to derivative lawsuit filings, there appears to be a trend toward those lawsuits being filed outside Delaware.  Even though a derivative suit involving a Delaware corporation should be subject to legal precedent from Delaware courts rather than the state in which the lawsuit is filed, judges in other states may be persuaded by the more pro-plaintiff legal environment in those other states.

From a D&O defendant’s perspective, this is obviously a troubling strategy and increases the risk of personal liability for directors and officers.  In large cases with multiple and competing derivative lawsuits being filed, different lawsuits in different jurisdictions is especially dangerous since the defendants may not be able to consolidate the multiple lawsuits into one proceeding.  In that situation, defendants are forced to simultaneously defend multiple lawsuits in different states, even though all of the lawsuits allege the same wrongdoing and seek the same damages on behalf of the same company.  Not only are defense costs much higher in such multi-state litigation, the risk of contradictory or inconsistent results are very real.

An example of the dangers from this duplicative state court litigation is the recent derivative lawsuits on behalf of Oracle Corporation against its CEO, Larry Ellison.  Multiple and substantially the same shareholder derivative lawsuits were filed against Ellison in Delaware and California state courts arising out of Ellison’s sale of nearly $900 million in company stock shortly before the company announced revised negative earnings estimates.  In the derivative lawsuit filed in Delaware, the Delaware Supreme Court affirmed the Chancery Court’s ruling that Ellison committed no wrongdoing and was not liable.  However, in the parallel derivative lawsuit filed in California, the California state court judge refused to dismiss the suit and scheduled an expedited trial.  Under the circumstances, Ellison settled the California derivative lawsuit by paying $100 million plus an additional $22 million in plaintiff attorney fees, even though the Delaware Supreme Court determined he did nothing wrong.

As the Ellison case demonstrates, directors and officers continue to have significant liability exposure despite the recent string of protective rulings by Delaware courts.  This exposure confirms the continued importance of high quality insurance protection for directors and officers.  Because these claims for breach of fiduciary duties most frequently are asserted in shareholder derivative suits and because settlements and judgments in shareholder derivative suits are not indemnifiable under the law of Delaware and most other states, companies are well advised to maximize the quality of protection afforded under their D&O insurance program for non-indemnifiable loss.  Unquestionably, the best means to accomplish that result is to purchase high quality Side A Excess DIC insurance which affords extraordinarily broad coverage and has limits of liability dedicated solely to non-indemnifiable losses incurred by directors and officers.  As the popularity of Side A policies increases, a wide variety of coverage and pricing options are now available in the market for such policies.  Directors and officers should be very careful when purchasing Side A policies to make sure the policy they purchase provides the coverage they desire.  Frequently, the assistance of knowledgeable insurance brokers or other advisors who have specific expertise in Side A policies is important in that process.