United States: Trouble at the House of Mouse - Pending Delaware Decision Could Have Lasting Implications

Originally published Spring 2005

Over the last several years, corporate governance has become a hot topic among politicos, in the courts, and perhaps most important, in the court of public opinion. Scandalous stories involving Enron, Tyco, Adelphia, Martha Stewart, and the New York Stock Exchange/Dick Grasso have all made front-page news on multiple occasions. With the enactment of the Sarbanes-Oxley Act of 2002, Congress implemented sweeping reforms, dramatically affecting public companies (and in some instances, private companies). At the same time, Delaware courts have been wrestling with executive compensation issues, beginning with a derivative action filed against The Walt Disney Company.¹ At stake in the Disney trial is Delaware's long-held practice of granting great deference to corporate decision makers.

The Disney litigation involves claims that Disney's directors breached their fiduciary duties to Disney's shareholders in connection with their approval of the hiring and severance agreements with former Disney president Michael Ovitz. In 1996, longtime Disney CEO Michael Eisner hired his close personal friend, Ovitz, as president of Disney, with very little input from the Disney board. At the time of the hiring, speculation was rampant that Ovitz was the anointed heir apparent to Eisner as Disney's CEO. As the founder and driving force behind the Creative Artists Agency, an influential talent agency, Ovitz was deemed by many to be the "most powerful man in Hollywood." Despite the close relationship between Eisner and Ovitz, Ovitz's tenure as Disney president soured virtually before the ink dried on Ovitz's employment agreement. Within 15 months, Ovitz left Disney with a severance package estimated at $140 million.

In 1997, shareholder plaintiffs filed a derivative lawsuit in Delaware Superior Court against Disney's directors, alleging that the Disney board had breached its fiduciary duties to Disney's shareholders in approving Ovitz's employment and severance agreements. Predictably, the Delaware Court of Chancery dismissed the suit, because among other things the directors were shielded by the business judgment rule (i.e., the court deemed that the directors were well informed, careful, and rational in approving the employment and severance agreements).

The plaintiffs appealed and in early 2000, the Supreme Court of Delaware remanded the Disney case to the Court of Chancery to provide the "plaintiffs a reasonable opportunity to file a further amended complaint." The plaintiffs accepted the court's invitation to amend their complaint and in 2003, the Delaware Chancery Court, to the surprise of many in the corporate world, denied the director's motion to dismiss the suit. The media attention to the Disney proceedings has been intense, with live testimony garnering considerable television and press coverage. The formerly close personal relationship between high-profile players Eisner and Ovitz, coupled with the extraordinarily generous severance package given to Ovitz, has made the Disney litigation compelling drama.

Courtroom theatrics aside, the Disney trial presents a serious challenge to the status quo of corporate governance. Delaware has been a bastion of corporate activity primarily because its courts and lawmakers have consistently shielded directors from liability under the business judgment rule. Historically, absent a showing to the contrary, Delaware courts presume that directors act in good faith, are reasonably well informed, and act in the best interest of the corporation's shareholders. The courts have been reluctant to substitute their business judgment for a director's business judgment. Application of the business judgment rule in essence ensures that boards of Delaware companies are free to make informed decisions, regardless of whether the decisions, when viewed in hindsight, produce poor results for the corporation and its shareholders.

Perhaps the Delaware Supreme Court's invitation to the Disney plaintiffs to file an amended complaint and the trial court's denial of the director's motion to dismiss are responses to the extraordinary facts related to the Ovitz severance package. However, it is equally likely that the Disney trial is a product of a series of highly publicized corporate scandals. Regardless, the specter looming over the corporate world in connection with the Disney litigation is that the business judgment rule will be applied less frequently when assessing director liability in derivative suits. Although the Disney litigation stands for the proposition that directors may face personal liability in connection with awarding severance packages, the real fear is that the shield of the business judgment rule will be applied in a restricted, less deferential manner in connection with all corporate activity.

By virtue of Sarbanes-Oxley and the Disney drama unfolding in Delaware, the relationship between management and shareholders has fundamentally changed with a mandate that directors become actively engaged in obtaining information about the corporate actions they ratify and that the rationale supporting director decisions be well grounded in reason. It also appears that contrary to past practice, the business judgment rule may not shield directors for making exceptionally bad decisions, even if directors acquire sufficient knowledge and act in their reasonable view, in the best interest of shareholders.

After Disney, boards and compensation committees must carefully consider executive compensation, including the award of options and severance packages. It has become especially important for compensation committees to seek independent outside counsel in connection with assessing the reasonableness of compensation and severance arrangements. Ultimately, well advised, experienced, independent directors actively engaged in the decision-making processes of their companies are likely to receive the benefit of the business judgment rule regardless of the Disney outcome.

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