06.21.2006

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Updates

In the Delaware Supreme Court's recent opinion in the Disney case, Justice Jacobs provided better "best practices" advice for compensation committee decision making (and by analogy, board and other board committee decision making) than we may have seen in decades. The court also rejected the argument that making a decision in the absence of adequate information and deliberation amounts to bad faith.

This Update shares the court's views on compensation committee best practices and the duty of good faith, and asks (and suggests answers to) some questions the decision raises.

Background on the Disney Case

Under his employment agreement with The Walt Disney Company, Michael Ovitz received a severance payout of approximately $130 million after only about 14 months of employment. The Delaware Court of Chancery, after an extensive review of the facts, determined in 2005 that Disney's directors did not breach their fiduciary duties or commit waste in connection with the severance payout. 

The Delaware Supreme Court's Opinion in Disney

The Delaware Supreme Court agreed with the lower court's determination that Disney's compensation committee members had complied with their fiduciary duties of "due care" and "good faith" in approving Michael Ovitz's employment agreement. In assessing whether the committee members had breached their fiduciary duties, the Delaware Supreme Court described what would have happened had the committee followed a "best practices" (or "best case") scenario, from a process standpoint.

Compensation Committee "Best Practices".  For material compensation decisions, the best practices for the compensation committee process include:

    • Requiring a Tally Sheet. Compensation committee members should require that their materials regarding proposed compensation arrangements include a spreadsheet making different, alternative assumptions and showing the range of potential payments in the most reasonably foreseeable alternative scenarios that could arise. The court noted that a tally sheet for the Ovitz employment agreement should show the cost to Disney if Ovitz's employment terminated during each of the five years of the agreement's initial term.
    • Hiring a Compensation Expert to Develop and Explain the Tally Sheet. Either an outside expert or a member of the compensation committee with comparable experience should lead the committee through the plan or arrangement (in Disney's case, the Ovitz employment agreement) so that the committee members understand the important aspects. Using the Tally Sheet. The committee should base its deliberations and decision on the information reflected in the tally sheet. Keeping Committee Meeting Minutes. The minutes of the committee's meeting should capture the decisions of the committee, and should reflect the length and general points of the discussion and highlight key elements of the decision-making process. In its Disney opinion, the Delaware Court of Chancery noted that it would have been "extremely helpful" to the court if the minutes had indicated "in any fashion" that the discussion relating to the employment agreement was longer and more substantial than the discussion relating to the other issues.
    • Attaching the Tally Sheet to Minutes. The tally sheet reviewed by the committee should be filed with the records of the meeting (and by analogy, so should any other significant materials provided to the committee in connection with its deliberation — for example, a copy of the agreement, or summary of the agreement, that the committee reviewed, or both). While the court did not address any alternatives to attaching the tally sheet to the minutes, if the tally sheet includes personal or other sensitive information about the included individuals of a type that a company would not normally disclose publicly or make available to shareholders, then a possible alternative to attaching the tally sheet to the minutes could be to have the minutes refer to the tally sheet and note that a copy of the tally sheet is filed in the company's human resources records, or in another appropriate place.
    • Defining What Actions Constitute a Violation of the Duty of "Good Faith" Under Delaware Law. The Supreme Court upheld the Court of Chancery's nonexclusive definition of "bad faith" under Delaware law as a director's "intentional dereliction of duty" or "conscious disregard for one's responsibilities." In addition, the court likewise confirmed that a lack of due care, consisting of grossly negligent conduct without any malevolent intent, does not — and cannot — equal bad faith. These holdings put to rest the uncertainty in fiduciary duty law raised by the Court of Chancery's earlier ruling that allowed the Disney case to proceed.

Practical Implications of the Disney Decision — "Quantify. Discuss. Document."

The Delaware Supreme Court noted that had the "best practices" scenario been followed, there would have been no dispute (and no basis for litigation) over what information was furnished to the committee members or when it was furnished.

The Delaware Supreme Court's endorsement of tally sheets supports the increasing emphasis on compensation committees understanding, and companies disclosing, the total value of compensation for executives. Widespread and increasing interest in executive pay and the perceived inadequacy of current disclosure prompted the SEC earlier this year to release proposed rules that would significantly change the form and content of this disclosure, and which propose requiring companies to disclose whether and how they use tally sheets in connection with compensation decisions.  Even though these proposed rules are not yet final, an increasing number of companies (e.g., Citigroup, Ford, General Electric, Staples and Sherwin-Williams) disclosed in their recent proxy statements that their compensation committees use tally sheets as part of their review and setting of executive compensation.

Questions that occur to us — and our suggested responses — include:

Q: How do these "best practices" apply to a smaller company?

A: The essence of the endorsed procedures is "Quantify. Discuss. Document." Even a small team can (and will!) do these things well when arriving at an important decision. Smaller company directors can, and should expect to, follow this type of process for every important decision.

Q: How effective is it to use a committee member as the "compensation expert"?

A: It can be highly effective to use an experienced committee member as the compensation expert, but it places a tremendous burden on that director. As the Delaware Court of Chancery made clear in its In re Emerging Communications, Inc. decision, a committee member with special knowledge and background has a special obligation — even if (as in that case) the committee retains an outside expert.

Q: Who keeps the minutes and what level of detail should appear in the minutes?

A: Either an attorney or a careful person who has consistently drafted minutes should keep the minutes of board and committee meetings. Minutes should include references to or copies of all significant materials provided to the directors in preparation for the meeting, including, for example for a compensation committee meeting approving a new executive officer employment agreement, the tally sheet, employment agreement, summary provided by compensation expert or counsel, or report of compensation expert. The minutes should note the significant issues discussed by the committee, but generally should not detail who said what. The minutes should also indicate starting and ending times for the meeting and either describe the time spent on each decision or tailor the length of the description of each decision to reflect the relative time spent.

Q: Who decides the reasonable range of compensation alternatives for the tally sheet, especially if an external compensation expert is not involved?

A: This is where a company's outside expert and inside advisors earn their keep. These professionals should provide the first set of ranges for the tally sheet. Directors should question and test these ranges, and insist on seeing a revised tally sheet showing any changes that they would find useful before making a decision. There is nothing more frustrating for a company's internal staff and outside experts than a board that passively accepts the materials provided and does not question, push back, challenge or test the recommendations.

Q: How far can we apply this "best practices" guidance? A: Although the Delaware Supreme Court's decision specifically addressed compensation committee deliberations regarding executive compensation, the general themes behind the procedures it outlined would be appropriate for decisions by other board committees and by the full board, as well as for the full board in its role providing oversight of committee decisions: "Quantify. Discuss. Document."

Additional Information

You can find the full text of the Delaware Supreme Court's decision in In re The Walt Disney Company Derivative Litigation at http://courts.delaware.gov/opinions/(y501l1453qrhjvvfdzlhnv55)/download.aspx?ID=77400. You can find the full text of the Delaware Court of Chancery's opinion in In re The Walt Disney Company Derivative Litigation at http://courts.delaware.gov/opinions/(ymaqvrn5bplq3n45izvbwx55)/download.aspx?ID=64510. You can find discussion of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.