The Brief: Law School Institute for Law and Economics

For Corporate Directors, Loyalty is the Best Policy, Says Justice Holland

Delaware Supreme Court Justice Randy Holland, L’72, counsels corporate directors how to avoid lawsuits: stay loyal to the company.Delaware Supreme Court Justice Randy Holland, L’72, says Delaware corporate directors who want to protect themselves from shareholder lawsuits and court-imposed penalties should adopt the Marine Corps motto, Semper Fi.

Justice Holland explained why during last November’s Distinguished Jurist Lecture, which is sponsored by the Institute for Law and Economics. The lecture was published in the April issue of the University of Pennsylvania Journal of Business Law.

He said shareholders usually challenge board decisions, and sue directors for financial losses, during corporation litigation. Shareholders can only recover losses, he said, if they can prove that directors were disloyal to the corporation.

On the other hand, Justice Holland said, directors are protected by the business judgment rule, meaning courts will not second-guess a board’s decision as long as directors are loyal.

Loyalty involves acting in good faith, on an informed basis, and in the corporation’s best interests, said Justice Holland. Directors who stand to personally gain from a financial transaction or are connected to an individual who does are considered disloyal, he said.

Justice Holland cited Smith v. Van Gorkom as an example. In that case, the Delaware Supreme Court held that the TransUnion board of trustees breached the duty of care by not investigating a proposed merger sufficiently before approving it. The court denied the board the protection of the rule and held the directors personally liable for $23.5 million.

The decision sent “panic throughout the boardrooms of Delaware directors,” said Justice Holland, and “generated a liability insurance crisis” because no one wanted to serve on boards anymore out of fear of being sued. In response, most Delaware corporations adopted a resolution that allows shareholders to excuse directors from paying monetary damages if they are found guilty of gross negligence, but not if they breach the duties of good faith and loyalty. As a result, duty of care is now seen as “almost aspirational” and shareholders seeking to sue now focus on loyalty and good faith, said Justice Holland.

The Walt Disney decision also “raised considerable consternation in boardrooms,” said Holland. The Disney board fired CEO Michael Ovitz without cause less than one year after he was hired, did not vote on his termination, and paid out $140 million in severance pay. Shareholders alleged that the board acted in bad faith and sued to recover the severance pay.

The Disney case was significant because it set the precedent for shareholders to sue if they allege that directors acted in bad faith. The court ultimately decided in the board’s favor, but clarified the relationship between good faith and loyalty a few months later in Stone v. Ritter. The court explained that acting in good faith is a part of the duty of loyalty and failure to do so may result in liability, said Holland.