The importance of company directors mastering effective corporate governance, as well as understanding the board’s legal obligations, has been understated by last year’s decision of the US Delaware Court of Chancery in the Walt Disney Company case. The court held that there had been no breach of fiduciary duty even though the Disney board went “spectacularly” awry in awarding a severance package estimated at US$140 million.

Directors should be wary of translating this outcome to Australian board pay decisions that result in excessive payment.

In essence, Chancellor Chandler held that the business judgment rule is alive and well. His decision drew a distinction between a director acting consistently with the basic fiduciary duties and a director following the prevailing notions of best corporate governance practices.

In effect, Disney directors won their case by acknowledging not a failure in their duty of care, but a failure in competence. That is, it is okay to be an incompetent director rather than a director who does not adequately carry through with his/her fiduciary responsibilities.

By refusing to impose legal liability on directors who acted with care and without conflict of interest but whose actions were short of the prevailing standards of good corporate governance, the court concluded that aspirational ideals are not legal obligations. The court held that there had been no breach of fiduciary duty even though the Disney board went “spectacularly” awry in awarding a severance package estimated at US$140 million. It further indicated that once a board meets its minimum legal duties, redress for its failure to follow best practices must come from shareholders and the free flow of capital in the market, not from a judge reviewing the board’s actions with perfect hindsight.

While this decision may appear to make it more difficult for a plaintiff to prove that a corporate board has breached its fiduciary duties, Chancellor Chandler only reinforced the minimum standards that each director must follow. Notably, Chancellor Chandler chided the Disney directors, indicating that their actions “fall far short of what shareholders demand and expect.”

Whether this decision signals that in the future the Delaware (and other non US) courts may raise the legal standards is at best uncertain. While the court provided the directors relief from potential liability, following better governance practice could have spared Disney and its directors years of litigation.

Interestingly, changes being considered for UK company law could mean that a duty of care will not be enough, and competence must also be demonstrated. The changes are being considered with other changes to make directors more responsive to stakeholders other than shareholders. (Space constraints limit us from exploring this further in this issue.)

Australian directors may question why Disney’s directors did not settle out of court, given that their defence of incompetence was, from a career and reputation perspective, about as damaging as failure to carry through with their fiduciary duty. The probable reason is that the directors’ D&O insurer probably called the shots, and figured that this defence would win the case, and save the insurer from a damages payout of millions, so hence refused a settlement.

In effect then, the Disney directors still lost. To avoid similar loss of reputation, it follows that a company’s directors must fully inform themselves of all reasonably available information and adopt good governance practices that have been carefully tailored to the board’s particular circumstances.

The message from the Disney decision is this: To do their job well, boards and the remuneration experts who advise them must focus not just on meeting the minimum standard of the business judgment rule but also on incorporating in their companies the best corporate governance practices.

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