Disney, good faith, and structural bias.

• Author: Hill, Claire A.

This Article assesses the recent Disney decision and argues that on the facts presented, the decision was probably correct. However, the court squandered an opportunity to develop and articulate an appropriate doctrinal approach for the issues the case presented. The case was an excellent opportunity for courts to provide some means to constrain executive compensation, and more generally, to address problems caused by "structural bias," the cozy relationship directors may have with officers (and, less often, controlling shareholders). In such cases, there is no breach of the duty of loyalty as that duty has traditionally been articulated. However, the duty of care rubric doesn't seem properly applicable either. The directors have not simply been careless; rather, they seem to have gone through some motions of decision making when their decision was a foregone conclusion given their ties to the officers. The court created space for a doctrine of good faith, but it provided little guidance as to how that doctrine might work, even in cases like Disney itself. We suggest an extension of the duty of good faith that could provide a bit more bite. Plaintiffs should be allowed to demonstrate bad faith with a two-part showing: (1) the challenged decision occurred within an environment of structural bias, and (2) influenced by that structural bias, the directors were grossly negligent in making the challenged decision. Even if a court were to follow our suggestion, most cases would turn out as they historically have, with defendant victories. But we think that if courts articulate a doctrine requiring more scrutiny of decisions made in an environment of structural bias, a Caremark-like shift in norms and practices, directed by a combination of legal and extra-legal forces, might be encouraged.

1. INTRODUCTION II. TRADITIONAL FIDUCIARY DUTY ANALYSIS A. Duties of Loyalty and Care B. Intermediate Scrutiny and Structural Bias C. Good Faith III. THE DISNEY DECISIONS IV. DISNEY AS EXEMPLAR V. ON STRUCTURAL BIAS VI. WHAT SHOULD THE COURTS HAVE DONE? VII. LIMITS OF OUR PROPOSAL VIII. CONCLUSION I. INTRODUCTION

   The most recent decision in the Disney litigation, Disney V, (1) disappointed some corporate governance scholars and activists. The case seemed like an excellent opportunity for courts to provide some means to constrain executive compensation and, more generally to address problems caused by "structural bias," the cozy relationship directors may have with officers (and, less often, controlling shareholders). But the decision instead vindicated the directors' conduct, painting a picture of informed directors making considerable efforts to do right by their company.

   This Article assesses Disney V, and comes to several conclusions. On the facts presented, the decision was probably correct. However, the court did partially squander an opportunity--to develop and articulate an appropriate doctrinal approach for the issues the case presented. The court created space for a doctrine of good faith, but it provided little guidance as to how that doctrine might work, even in cases like Disney V itself. We suggest an extension of the duty of good faith that could provide a bit more bite. Plaintiffs should be allowed to demonstrate bad faith with a two-part showing: (1) the decision occurred within an environment of structural bias, and (2) influenced by that structural bias, the directors were grossly negligent in making the decision.

   Even if a court were to follow our suggestion, most cases would turn out as they historically have, with defendant victories. Indeed, we recognize that the issues the Disney cases present can't be fully addressed by a legal prohibition enforceable in the courts. Rather, norms-shifts and other like forces are necessary. We think that judicial articulation of a doctrine contemplating more scrutiny for decisions made in an environment of structural bias may help mobilize such forces. Consider, in this regard, the extent to which the Disney trial and attendant publicity increased focus on the issue. What we hope for, and believe may be possible, is a Caremark-like shift, (2) propelled by a combination of legal and extra-legal forces.

   This Article proceeds as follows. Part II outlines the traditional analysis courts have used to determine whether directors have breached their fiduciary duties. Part III discusses the Disney decisions themselves, using the changing political climate as a backdrop. Part IV considers the Disney decisions as exemplifying a particular type of problematic case. Part V considers the general character of those problematic cases--structural bias. In such cases, there is no breach of the duty of loyalty as that duty has traditionally been articulated. However, the duty of care rubric does not seem properly applicable either. What the directors have done is not simply to be careless; rather, they seem to have gone through some motions of decision making when, given their ties to the officers, their decision was a foregone conclusion. Part VI sets forth our doctrinal proposal, arguing that Disney-type cases ought to be dealt with as breaches of the duty of good faith. It also discusses the relationship between the two parts of the proposed test and typical circumstances in which we envision the test being applied. Part VII considers how the doctrine would be applied by courts, and the legal and extra-legal influences it might have on director conduct. Part VIII concludes.

2. TRADITIONAL FIDUCIARY DUTY ANALYSIS

   1. Duties of Loyalty and Care

      Classically, courts and commentators have split corporate fiduciary duty cases into duty of loyalty and duty of care categories. Where the courts see self-dealing as being implicated, they invoke the duty of loyalty and scrutinize the transaction carefully. Courts recognize self-dealing in situations where a director, officer, or controlling shareholder has clearly identifiable, specific monetary interests at stake in a decision that puts her own self-interest at odds with the interests of the corporation.

      A director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders. Directorial interest also exists where a corporate decision will have a materially detrimental impact on a director, but not on the corporation and the shareholders. (3) The paradigmatic cases include the hiring of a family member and transactions between the director and the corporation.

      Once the court has identified a transaction as involving a problematic conflict of interest, the transaction is presumptively invalid. However, the transaction may still be "cleansed" if the defendant can validate it using one of three methods. In Delaware, these three methods come from section 144 of the Delaware General Corporation Law; (4) most states have a variant of this statute. (5) One method of validating a conflicted transaction is to get approval of the transaction by the disinterested and independent members of the board. If the conflict is with an interested director or officer, then the disinterested and independent board's approval will itself get deferential care-type review with the benefit of the business judgment rule, as described below. (6) If the conflict is with a controlling shareholder, then approval by the disinterested directors gets less deference--the court will ask whether the transaction was fair to the corporation, but the board approval will shift the burden of proof of fairness from the defendant to the plaintiffs. (7)

      The second method of validating conflicted transactions is to get approval of disinterested shareholders. Here too, the court handles shareholder approval differently depending upon whether the transaction is with interested directors or officers, or with a controlling shareholder. In the former situation, the transaction, once approved by disinterested shareholders, is subject only to the highly deferential waste standard of review. (8) In contrast, if the transaction is with an interested controlling shareholder, then, as with board approval, the transaction is still subject to fairness review with the burden of proof shifted to plaintiffs. (9)

      The third method for validating conflicted transactions is for the defendant to show that the transaction was entirely fair to the corporation. This involves demonstrating both that the corporation followed a fair procedure and that the transaction was on substantively fair terms. (10)

      If the duty of loyalty is not at issue, then the court will scrutinize the transaction much less carefully, using a duty of care analysis. Under this analysis, defendants receive the benefit of the "business judgment rule." This is "a presumption that in making a business decision 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." (11)

      Plaintiffs have the burden of rebutting this presumption. The focus in doing so has been in showing that the directors did not act on an informed basis. The Delaware courts require plaintiffs to show that the defendant directors were grossly negligent in informing themselves prior to making the disputed decision. (12) For the most part, the courts are unwilling to hold that defendants have been grossly negligent. The one time that they did, in Smith v. Van Gorkom, the decision shocked the corporate law community, and drew a very quick reaction from the Delaware legislature. (13) Scholars still harshly criticize the decision; indeed, a bashing of Van Gorkom is a ritual of entry into the ranks of the respectable corporate law scholarly community. (14)

      The extent to which plaintiffs may, under business judgment review, argue that a decision was so substantively bad that the defendants should lose the protection of the presumption is unclear. Occasionally, the courts suggest that their...