08.26.2005
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Updates
In early August 2005, the Delaware Court of Chancery issued its opinion after a widely publicized three-month trial in In re The Walt Disney Company Derivative Litigation, absolving Disney's directors of liability in connection with the 1995-1996 hiring and firing of former Disney president Michael Ovitz. Ovitz received a severance package of approximately $140 million after his unsuccessful 14-month tenure at Disney. Chancellor Chandler's opinion, which focused on directors' duty of good faith, affirmed traditional notions of fiduciary duties under Delaware law and deferred to the business judgment of directors acting in what they believed to be the best interests of the corporation.
Chancellor Chandler sharply criticized the action (and inaction) of the directors as falling short of the ideals of corporate governance in the post-Enron and WorldCom era, but concluded that fiduciaries could not be held liable under Delaware law for failing to comply with aspirational ideals of best practice. Noting that "the essence of business is risk," the court warned that where directors act in good faith to make informed decisions on behalf of shareholders, they should not be subject to legal liability based on the wisdom of their judgments, even if, as here, they go spectacularly awry.
Opinion Focuses on Good Faith Standard. The opinion continued the focus of the Delaware courts on the good faith standard applicable to fiduciaries under Delaware corporate law. A finding of failure to act in good faith would have exposed the Disney directors to personal monetary liability through loss of the protection provided by Disney's Certificate of Incorporation and Section 102(b)(7) of Delaware General Corporation Law.
The court posited that "the concept of intentional dereliction of duty, a conscious disregard for one's responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith." It listed, as examples of bad faith, instances where a fiduciary
- intentionally acts with a purpose other than that of advancing the best interests of the corporation,"
- acts with the intent to violate applicable positive law," or
- intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties."
After an extensive analysis of the facts, the court found that the Disney directors did not act in bad faith.
This Update highlights key issues from the Court's decision and offers practical guidance.
Background — The Hiring and Termination of Ovitz
The evidence produced at trial showed that Michael Eisner, Disney's Chairman and CEO, recruited Michael Ovitz to become the company's president after the sudden death of the then-president in a helicopter crash and Eisner's own unexpected quadruple bypass surgery. Ovitz and Eisner were well acquainted both socially and professionally, having been friends for nearly 25 years. Ovitz, who was the head of what was considered Hollywood's premier talent agency, Creative Artist Agency (CAA), had an annual income of approximately $20 to $25 million a year from CAA and owned 55 percent of the company. Ovitz had also been negotiating with a Disney competitor.
At Eisner's direction, Irwin Russell, who was chairman of the compensation committee and also Eisner's personal attorney, took the lead in negotiating the compensation aspects of Ovitz's contract. Russell enlisted the aid of two people to help with the financial analysis: Raymond Watson, another member of the compensation committee and the past chairman of Disney's board who had helped design the pay structure for Eisner and the former president; and compensation consultant Graef Crystal. Crystal had previously headed Towers Perrin's compensation practice, had consulted on behalf of Disney for many years, and was well known in the industry for criticizing extravagant executive compensation.
Eisner signed a letter agreement with Ovitz and issued a press release announcing Ovitz's hiring (but not the financial terms of the contract), before any formal committee or board action had been taken. Prior to that time Russell and Watson had contacted the two other members of the compensation committee (Sidney Poitier and Ignacio Lozano) by phone to discuss the general terms of the negotiations, and Eisner had informed the other board members individually by phone of the announcement. The first compensation committee meeting to consider the Ovitz's hiring was held over a month later, when the committee met for one hour to consider the Ovitz employment agreement and several other matters. The committee members were provided with a term sheet for Ovitz's contract, but not a draft of the agreement. Russell and Watson made a presentation to the committee, outlining the process they had followed in August and describing Crystal's analysis. Following that meeting, the Ovitz arrangements were discussed at an executive session of the board (excluding two other management directors but not Eisner), then with the entire board of directors, which unanimously elected Ovitz President.
Ovitz's five-year compensation arrangement, which was valued by Crystal at approximately $24 million per year—the highest ever for a non-CEO of a public company—contained a highly favorable "non-fault" termination provision whereby he would receive cash and acceleration of stock options if he was terminated at any time during the five-year contract for any reason other than good cause, defined as gross negligence or malfeasance.
Shortly into Ovitz's tenure at Disney, it became clear to Eisner that Ovitz was not working out at Disney and that it was in the company's best interest to terminate him. Based on the advice of the general counsel, Sanford Litvack, who was also a board member, that there were no grounds on which to terminate Ovitz for cause, and that there was no requirement to seek compensation committee or board approval of the termination, Eisner and Litvack treated Ovitz's departure as a "non-fault" termination, resulting in Ovitz's $140 million severance package.
The Court's Decision
The court described Eisner as "having enthroned himself as the omnipotent and infallible monarch of his personal Magic Kingdom," and was critical of his many "lapses," which included his failing to keep any directors outside a small circle of confidants informed during the negotiation process, stretching the boundaries of his authority, and prematurely releasing a press release that placed significant pressure on the board to approve his decision. Nonetheless, the court concluded that Eisner acted in good faith in hiring Ovitz. Eisner had an objective belief that hiring Ovitz was in the best interest of the corporation, based on the need for someone to shoulder some of Eisner's work and on Ovitz's stellar reputation.
Directors' Conduct Analyzed Individually. The court proceeded to analyze the conduct of each director individually, where possible, recognizing that this director-by-director approach was a departure from some older Delaware case law which had analyzed the conduct of directors as a whole. Russell, who as chair of the compensation committee performed most of the negotiation of the financial aspects of the contract, was, similar to Eisner, found to have acted in good faith. While the court had some criticisms of his performance, it found that he "for the most part knew what he needed to know, did for the most part what he was required to do, and that he was doing the best he thought he could to advance the interests of the Company." Likewise, the remaining members of the compensation committee, although minimally involved, did not act in bad faith in their approval of Ovitz's contract.
Directors' Conduct Reasonable. The court distinguished the Van Gorkom case, where the directors breached their fiduciary duties by approving the sale of the company in the face of opposition by management, in a short two-hour meeting with no prior notice of the topic and no documentation provided prior to or at the meeting, both in terms of the process followed by the Disney directors and nature and economic importance of the Ovitz contract in the context of Disney's $19 billion in revenues and more than $3 billion in operating income. In this context "the proposition that Eisner . . . entered into the [letter agreement] without prior board authorization, or that the compensation committee approved Ovitz's contract based upon a term sheet and upon less than an hour of discussion, seems eminently reasonable given the [employment agreement's] (relatively small) economic size."
The court noted that a review and discussion of the full text of the employment agreement were not required, nor was it necessary for an expert to make a formal presentation in order for the board to rely on that expert's analysis, "although that certainly would have been the better course of action." Although criticisms could be made of Crystal's analysis, including his failure to calculate the cost of a potential non-fault termination, the court found that Crystal had been selected with reasonable care, and that the compensation committee reasonably relied on Crystal's analysis as relayed by Russell and Watson.
The court found that the remaining directors did not have a duty to independently analyze and approve Ovitz's contract. It was sufficient that the directors knew who Ovitz was, what position he would have at the company, and the key terms of the contract. Although the directors may have underperformed as fiduciaries, they did not fail to inform themselves of all reasonably available material information, and did not breach their fiduciary duties.
The court also found that Eisner as CEO had the right to terminate officers without formal committee or board action under the terms of the company's certificate of incorporation and bylaws and the compensation committee charter. Eisner rightly believed that Ovitz's termination was in the best interests of the company, and was well informed as to his inability to terminate Ovitz for cause and avoid triggering the severance pay. Because the directors had the right, but not the duty, to make decisions terminating officers of the company, the directors did not violate their duties of care or good faith.
Lessons From the Disney Decision
Although Disney's directors were absolved of liability in this case, the Chancellor noted that "[f]or the future, many lessons of what not to do can be learned from [the Disney board's] conduct here." Aside from the obvious benefits in striving for best practices in corporate governance, complying with best practice may also serve to deter plaintiffs from filing lawsuits such as in the Disney litigation. In Disney, the court initially denied the directors' motion to dismiss and held that the allegations were sufficient to go to trial as to whether the directors' conduct was so egregious as to lack good faith. Disney's directors were ultimately cleared but nearly 10 years after the events took place, and only after lengthy and costly litigation and damage to reputations. By striving for best practices in corporate governance, directors are much more likely to have a basis to dismiss any such claims and avoid a trial.
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Practical Tips The following practical lessons can be learned from the Disney decision: Involve the Independent Directors at an Early Stage. The entire compensation committee, or the group of independent directors making executive compensation decisions, should be involved in the early stages of executive employment negotiations. In Disney, half of the compensation committee was active in negotiations and the other half came in "very late in the game." While the court held that the committee members' actions did not violate fiduciary duties, it noted that the failure to fully investigate Ovitz's background and the late involvement of two members were not the best practices. Ideally, the entire compensation committee should review all material information reasonably available and spend a sufficient amount of time discussing the terms of the relevant agreement. Seek the Advice of an Executive Compensation Expert. The compensation committee should have the authority and resources to solicit advice from independent employment compensation experts. That advice should include input on the proposed compensation terms and industry-comparable information. In Disney, the compensation committee was entitled to rely on the input of the outside compensation expert, even though the expert's analysis may have been incomplete or flawed, because he had been selected with reasonable care, his analysis was within his professional competence, and the directors had no reason to question his conclusions. The court also noted that the committee was not compelled to follow the expert's advice "to the letter," as the advice is meant to "assist the board's decisionmaking—not supplant it." Although the Disney committee did not do so, good practice dictates distributing the expert's report in advance and having the expert attend the committee meeting so that members can probe the advice given and ask additional questions. Provide Directors With Sufficient Notice and Materials Prior to the Meeting. Provide notice and materials well in advance of any meeting at which an executive employment agreement is to be discussed. The materials should include, at a minimum:
If the final form of agreement differs materially from the version submitted to the compensation committee or board, summarize and communicate any changes prior to execution. Allow Sufficient Time for Discussion. Although the Disney court held that there was no evidence that the board did not sufficiently discuss the employment agreement, the length of board discussions was a factor. Directors should insist that sufficient time be allotted in meetings for a detailed discussion of employment agreement terms, reasonably commensurate to the compensation involved and the significance of the officer. Document the Process. Draft minutes of meetings at which employment agreements are discussed to accurately reflect the length and the content of the directors' deliberations, highlight key elements of the decision-making process, and reflect whether there was active inquiry and discussion. Chancellor Chandler noted that it would have been "extremely helpful" if Disney's compensation committee minutes had indicated "in any fashion" that the discussion relating to Ovitz's employment agreement was longer and more substantial than discussion of other issues during that particular meeting. Importance of Succession Planning. The events that led to the Disney litigation were precipitated by the unexpected death of Disney's president and the discovery of the CEO's heart ailment. The focus by the CEO on a single candidate for president underscored the apparent lack of any succession planning at Disney. Planning for the succession of the CEO and other key officers is one of the most critical functions of the board of directors. Instituting and implementing a robust succession planning process can help a board avoid the kind of long and contentious litigation endured by the Disney directors. |
Additional Information
This Update is intended only as a summary of the decision in In re The Walt Disney Company Derivative Litigation. You can find a copy of the full text of the Court's decision at http://courts.delaware.gov/opinions/(ymaqvrn5bplq3n45izvbwx55)/download.aspx?ID=64510. You can find discussion of other recent cases and other topics of interest on our website.
