United States: Practical Steps for Directors to Consider After Disney

Originally published October 3, 2005

By Brian E. Pastuszenski, Ettore A. Santucci and Christine S. Chung

Overview

On August 9, 2005, after a 37-day trial, the Delaware Chancery Court issued an important decision in the eight-year-old shareholder derivative lawsuit against the board of directors of The Walt Disney Company. That lawsuit had challenged Disney’s hiring and later no-fault termination of one-time Hollywood power broker Michael Ovitz. The principal take-aways from this decision include the following:

• The court’s 174-page written opinion does not toughen the standards under Delaware law by which corporate directors are judged, as some feared it might.

• To the contrary, the court’s opinion reaffirms the bedrock principle of Delaware law that corporate directors who make business decisions on the basis of reasonably adequate information will be protected from liability if they believe in good faith that those decisions are in the company’s and shareholders’ best interests.

• Moreover, the Disney decision reaffirms the "wide latitude" that Delaware law gives directors who act in good faith even where – as the court found true of the Disney directors – the degree of diligence and care reflected in their actions falls "significantly short of the best practices of ideal corporate governance."

• Nonetheless, the opinion does not give corporate directors a free pass. Particularly where the corporate decision being challenged is material to the company’s revenues and earnings, the opinion is a reminder to corporate directors that they must make good faith efforts to inform themselves of "all material information reasonably available to them" in order to retain the protections of the Business Judgment Rule, which protects the decisions of corporate directors from second-guessing by the courts.

In 1995 Disney hired Ovitz as its president, agreeing to an employment arrangement that guaranteed Ovitz a sizeable payout if he were ever terminated without cause. At the time he was hired, Ovitz was the well-known head of a Hollywood talent agency and a long-time close friend of Disney CEO Michael Eisner, who championed bringing Ovitz on board. Although the Ovitz employment agreement was conditioned on approval of the Disney board of directors, Eisner issued a press release announcing Ovitz’s hiring before the board as a whole had considered Ovitz’s appointment. About 14 months later, Eisner fired Ovitz, in large part because of Ovitz’s failure to integrate with the Disney corporate culture. Under the no-fault termination provisions of his employment agreement, Ovitz became entitled to an additional $38 million in cash and the immediate vesting of options to acquire 3 million shares of Disney stock.

The litigation that followed Ovitz’s termination attacked the alleged failure of the Disney board of directors to fulfill its fiduciary duties under Delaware law in connection with Ovitz’s hiring, the terms of his employment agreement and the ultimate decision to terminate him without cause. Among other things, the lawsuit claimed that the directors intentionally had abdicated their responsibilities, kowtowed to Eisner’s strong desire to hire his friend Ovitz and supposedly exercised no independent judgment or review in approving Ovitz’s hiring and the terms of his employment. The Chancery Court found that the plaintiffs’ complaint adequately called into question whether the directors had consciously ignored their duties, and let the case go to trial.

Based on the evidence at trial, Chancellor William B. Chandler III concluded that none of the Disney directors had breached their fiduciary duties. The court’s opinion, though, is hardly a pat on the back for the Disney board. Rather, Chancellor Chandler was highly critical of the Disney directors, and concluded that many aspects of the board’s conduct "fell significantly short of the best practices of ideal corporate governance." He also criticized Eisner for having "stacked his . . . board with friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally than truly independent directors."

Despite their shortcomings, however, Chancellor Chandler concluded that the Disney directors "did not act in bad faith, and were at most ordinarily negligent, in connection with the hiring of Ovitz and the approval" of his employment agreement. As such, the court found that the directors had not lost the protection of the "Business Judgment Rule." Under the Business Judgment Rule, corporate directors who make a business decision are presumed "to have acted on an informed basis" and "in the honest belief that the action taken was in the best interests of the company [and its shareholders]." Chancellor Chandler explained, however, that this presumption disappears where a director’s conduct is "grossly negligent" (in the sense that the director has made an "unintelligent or unadvised judgment" by failing to take minimally sufficient steps to inform himself before making a decision), where a director has acted in "bad faith" by intentionally or consciously abdicating his duties, where there is evidence of fraud or "self-dealing in the usual sense of personal profit or betterment" or where a director’s decision "cannot be attributed to any rational business purpose." In that event, a director would be required affirmatively to show that the decision made was "entirely fair" to the company and its shareholders.

Chancellor Chandler found that the Disney directors had taken minimally sufficient steps to inform themselves about Ovitz and his proposed employment arrangement before approving it, and had acted in the good faith belief that entering into that arrangement with Ovitz ultimately would be in Disney’s best interests. In that regard, the court evaluated each director’s conduct, one by one. The court found, among other things, that the members of the compensation committee had discussed Ovitz’s employment agreement "for a not insignificant length of time" before approving it (apparently at least for 25-30 minutes). The court also noted that even though the compensation committee had neither reviewed nor discussed the full text of the draft employment agreement, the committee had received and discussed a term sheet setting out the key terms of the agreement and had the benefit of a presentation by two directors who had worked closely with Eisner in negotiating and evaluating the terms of the agreement. In addition, the court found that the committee had appropriately relied in good faith on an analysis of the proposed compensation structure prepared by a third-party consultant, even though the analysis may have been deficient in certain respects. The court also noted that the compensation committee had made its decision knowing that Ovitz "was a highly-regarded industry figure" who was "widely believed to possess skills and experience that would be very valuable to the Company" – in other words, Ovitz was not an unknown commodity on which the committee had decided to lavish riches. The court further explained that the overall dollar amount of the compensation potentially payable under the Ovitz agreement was immaterial in terms of both Disney’s revenues and operating income. With respect to the full board’s decision to elect Ovitz as Disney’s new president, the court found it adequate that the board members, "before voting, were informed of who Ovitz was, the reporting structure that Ovitz had agreed to and the key terms" of the employment agreement. Because the board members "did not intentionally shirk or ignore their duty, but acted in good faith, believing they were acting in the best interests of the Company," the court found no breach of fiduciary duty.

The court explained in its decision that while the "best practices of corporate governance include compliance with fiduciary duties," "Delaware law does not . . . hold fiduciaries liable for failure to comply with the aspirational ideal of best practices." The court observed that a director who acts "faithfully and honestly" on behalf of shareholders will be given "wide latitude." Applauding the "advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation," Chancellor Chandler also stressed that courts should not use "perfect hindsight" to second guess the decisions of disinterested directors who act on an informed basis and in good faith, even where those decisions – like Ovitz’s hiring and termination – ultimately go "awry, spectacularly or otherwise."

The Disney decision’s implications for corporate governance no doubt will be debated for years to come, particularly given that the plaintiffs in the case have appealed the decision to the Delaware Supreme Court. What follows are a few practical steps directors should consider in the wake of the Disney saga:

• Review Your Company’s D&O Insurance Program and Directors’ Indemnification and Advancement Rights: Litigation challenging compliance with a director’s fiduciary duties can be very expensive, and often can last many years. Directors should understand how much directors and officers liability insurance is available in the event of a lawsuit, and what that insurance will (and will not) cover. Perceived deficiencies in coverage should be addressed promptly. Having an attorney expert in such matters review this coverage can be extremely valuable. In addition, ask whether your company’s by-laws or charter provide for mandatory advancement of legal expenses and indemnification in the event of litigation. All insurance policies have deductibles, and a director or officer must look to his or her company for payment of legal expenses before coverage is triggered (or if coverage is exhausted). Mandatory advancement means that a director or officer will not have to wait until the conclusion of litigation to have his or her legal fees paid. Having a separate indemnification agreement that supplements or supersedes whatever rights are otherwise provided by the bylaws/ charter can also be useful in plugging holes and providing superior protection for directors.

• Ensure That Your Company’s Charter Includes an "Exculpation" Provision: Although evidence of "gross negligence" will make the Business Judgment Rule inapplicable, a shareholder plaintiff who proves that a director has been "grossly negligent" still cannot recover money damages against that director if the corporation’s charter includes a "director exculpation" provision as permitted by Section 102(b)(7) of the Delaware Corporation Law. Such provisions immunize directors from money damages for breaches of fiduciary duty unless the plaintiff proves that the director is guilty of self-dealing or was otherwise disloyal, intentionally violated the law or otherwise acted in "bad faith," committed fraud or the like. Chancellor Chandler concluded that "bad faith" connotes an "intentional dereliction of duty, a conscious disregard for one’s responsibilities," as opposed to simply careless conduct.

• Minutes Should Reflect Active Board Involvement and Questioning: Throughout his decision, Chancellor Chandler looked to the minutes of Disney board and compensation committee meetings for evidence of how much time directors spent discussing Ovitz and the terms of his employment agreement. The Disney decision underscores the need for thoughtfully prepared minutes (including minutes of executive sessions) that make clear the board or committee members actively considered important issues, asked questions about those issues in an effort to inform themselves "of all material information reasonably available to them" and duly deliberated about those issues before reaching a decision. In addition, minutes ideally should reflect that board and committee members received and had an opportunity to consider important agreements or other documents on which board/committee action was required.

• Retain Outside Experts: Particularly where significant amounts of executive compensation are being considered, compensation committees should consider retaining their own outside experts who can help committee members understand the comparability of the proposed compensation and assess how much the company might be required to pay the executive under various scenarios (including no-fault termination).

• "Best Practices" Are Still Worth Striving for: Although Chancellor Chandler made clear that complying with Delaware law does not necessarily mean complying with the "aspirational ideal of best practices," he nonetheless encouraged "directors and officers to employ best practices, as those practices are understood at the time a corporate decision is taken." According to Chandler, adopting best practices of corporate governance will insure that a director will be "unremittingly faithful to his or her charge." Directors also should keep in mind that the yardstick by which their actions may be judged may change over time. Chancellor Chandler noted in his decision that "the actions (and the failures to act) of the Disney board that gave rise to this lawsuit took place ten years ago," before "the Enron and WorldCom debacles, and the resulting legislative focus on corporate governance." It remains to be seen, however, what standards will be used to judge the conduct of directors occurring now and in the years to come.

• The Conduct of Each Director Matters: Directors should not assume that they will avoid liability just because the board as a whole did an adequate job. Each director should take care to insure that his or her conduct reflects that level of care and diligence required of directors, and otherwise complies with his or her fiduciary duties. In the past, some courts have considered the conduct of the board of directors collectively in deciding whether to assess liability, without focusing on what individual directors did. In Disney, Chancellor Chandler rejected this approach. He noted that more recent cases have assessed potential director liability on a director-by-director basis, stating that the "liability of the directors must be determined on an individual basis because the nature of their breach (if any), and whether they are exculpated from liability for that breach, can vary for each director."

• The Nature and Materiality of the Transaction Make a Difference – Don’t Forget to Use Common Sense: Despite the significant compensation that Disney agreed to pay Ovitz, Chancellor Chandler noted that the amount involved was immaterial to Disney from either a revenue or operating income perspective. Chandler took this fact into account in deciding whether the care and diligence employed by the Disney directors had been adequate. Conversely, directors should keep in mind that their actions may be scrutinized more strictly where the decisions being challenged are material from a financial point of view. Let your common sense guide you – the more significant the decision the directors are being asked to make, the more likely that decision will be a magnet for litigation. In addition, directors should not forget the special rules that apply to certain acquisition transactions – for example, a decision to sell the company or a controlling interest in the company. In those situations, the board is required not simply to have made a good faith, informed business judgment, but to have obtained the best price available for shareholders under the circumstances.

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