06.26.2003
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Updates
On May 28, 2003, the Delaware Court of Chancery issued a ruling that could expose directors of The Walt Disney Company (Disney) to personal liability for asserted breaches of their fiduciary duties in the hiring and subsequent termination of Michael Ovitz as Disney president—decisions that resulted in an alleged $140 million payout for a year's work.
The Chancery Court decided that the facts alleged by the plaintiffs—including that the Disney directors failed to review final versions of Ovitz's employment agreement and improperly delegated authority to negotiate the terms of the agreement to Michael Eisner, the chief executive officer of Disney and a longtime friend of Ovitz—were sufficient to state a claim that the directors had "consciously and intentionally disregarded their responsibilities" in approving Ovitz's compensation arrangements and thereby breached their duty of good faith. Under Delaware law, directors can be protected from personal liability for breaches of their duty of care, but not if they lacked "good faith."
The decision in In re The Walt Disney Company Derivative Litigation was not a bolt from the blue. Last year, Chief Justice Norman Veasey of the Delaware Supreme Court, speaking on executive compensation, warned: "if directors claim to be independent by saying, for example, that they based decisions on some performance measure and don't do so, . . . the courts in some circumstances could treat their behavior as a breach of the fiduciary duty of good faith."
The Employment and Termination of Ovitz
The Chancery Court ruled on a motion to dismiss filed by the Disney directors and Michael Ovitz; therefore, it was compelled to treat the facts alleged by the plaintiffs as true.
The plaintiffs alleged that Michael Eisner decided in 1995 to hire his longtime friend Michael Ovitz as president of Disney. Eisner sent a letter to Ovitz outlining proposed employment terms despite the objections of three Disney board members. When Disney's compensation committee, and subsequently the full board, met to discuss Ovitz's proposed employment arrangements, the directors had only a rough term sheet, provided at the time they met. They did not have available to them, and did not request, a full draft of the employment agreement, the advice of an executive employment expert, or documents analyzing the potential payout to Ovitz over the life of the contract, the possible cost of his severance package, or how the proposed agreement compared with similar agreements in the entertainment industry. After deliberations, in each case lasting less than an hour, during which few questions were asked regarding the content of the agreement, the committee and the board approved the hiring of Ovitz and authorized Eisner to negotiate the unresolved terms of Ovitz's employment agreement.
Ovitz began serving as president of Disney on October 1, 1995, while still negotiating his employment agreement. On October 16 the compensation committee was advised of the ongoing negotiations and given another rough summary of the latest draft agreement. The final agreement was executed on December 12, but backdated to October 1.
The final agreement differed significantly from the earlier summaries. The stock options were priced on the October 16 compensation committee meeting date, making them well in the money by the time the final agreement was executed. The agreement also contained a highly favorable "non-fault" termination provision whereby Ovitz would receive cash and stock options, allegedly worth a total of $140 million, so long as he was not terminated for gross negligence or malfeasance. In the earlier summaries, Ovitz would have received these benefits only if he were wrongfully terminated or died or became disabled.
Less than 11 months after Ovitz assumed the Disney presidency, he began discussing his departure with Eisner and another Disney board member. Although Disney's bylaws appeared to require full board approval of such a decision, Eisner and the board member signed a letter to Ovitz stating that his departure would be treated as a "non-fault" termination so that he would receive the generous non-fault termination benefits, even though, under the terms of his agreement, he had not met the necessary criteria. The Disney directors did not review or approve the arrangement, or raise any objections during the 15-day time period between the letter's publication and its effective date.
The Court's Decision
The Chancery Court allowed the shareholders' suit to proceed because the alleged facts "portray directors consciously indifferent to a material issue facing the corporation." Despite a virtual "information vacuum," the directors granted Eisner the authority to finalize the terms of the employment agreement. The court said that instead of fulfilling their duty of care, the Disney directors' alleged conduct evidenced a "we don't care" attitude about a material corporate decision.
In the Court's view, the directors were not entitled to the protection of the business judgment rule—which gives deference to informed, disinterested director decisions—because they had not exercised "any business judgment or made any good faith attempt to fulfill the fiduciary duties they owed to Disney and its shareholders." If, in fact, the defendants knew that they were making decisions without adequate information and without adequate deliberation, then, the Court concluded, they could not have been acting honestly or in good faith.
The conclusion that the Disney directors may have failed to act in good faith could potentially result in personal liability for the Disney board. Disney's Certificate of Incorporation, in reliance on Section 102(b)(7) of Delaware General Corporation Law, eliminates the directors' personal liability to the company for breach of their duty of care (a so-called "raincoat" provision). Neither Disney's raincoat provision nor Section 102(b)(7), however, permits protection for a director's breach of the duty of good faith or for intentional misconduct. By way of comparison, Section 23B.08.320 of the Washington Business Corporation Act, which authorizes similar raincoat provisions, also denies protection for acts of intentional misconduct but allows protection for breaches of the duty of good faith.
Practical Lessons From the Disney Decision
To protect against a Disney-like result when negotiating compensation arrangements with executive officers, boards should consider taking the following steps. (Many of these suggestions will be facilitated by the adoption of proposed amendments to the New York Stock Exchange listing standards requiring wholly independent compensation committees that are empowered to retain their own independent compensation advisors.)
- Involve the Independent Directors at an Early Stage.
- The compensation committee, or a subset of independent directors, should be actively involved in the early stages of executive employment negotiations. In
Disney
- , the plaintiffs describe a largely inactive compensation committee that failed to ask questions, failed to review drafts of the relevant agreement and failed to spend sufficient time discussing the terms of the Ovitz 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. Failure to hire a compensation expert influenced the Chancery Court's conclusion that the Disney directors may not have satisfied their fiduciary duties.
- Compare Terms With Industry Standards. Directors should seek input on the proposed compensation terms compared with those typical in the relevant industry. An executive compensation expert can assist in such an analysis.
- Allow Sufficient Time for Discussion at Board Meetings. The brevity of the board discussions was also a factor in Disney. Directors should insist that sufficient time be allotted in meetings to allow for a detailed discussion of employment agreement terms. The length of the directors' deliberations should be reasonably commensurate with the aggregate amount of compensation involved.
- Provide Directors With Sufficient Materials Prior to the Meeting. Send directors a package of materials well in advance of any meeting at which an executive employment agreement is to be discussed. The package should include, at a minimum:
- a full draft of the proposed agreement,
- a summary of the key provisions,
- an analysis of the aggregate cost of the agreement to the company and, where relevant,
- any internal company documents that could shed light on the reasonableness of the terms.
If the final form of agreement differs materially from the version submitted to the compensation committee or board, distribute the final version prior to execution.
- Negotiate Compensation of Existing Officers Through an Independent Committee. The Disney Court stressed the importance of arm's-length negotiations when a company negotiates with one of its senior executives. Such negotiations should be carried out by a committee of independent directors or at the very least by an impartial officer or board member who must seek final approval of the agreement terms from the independent committee. The committee should consider retaining independent legal advisors to assist it in the process, if necessary.
- 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, reconstruct the key elements of the decision-making process, and, if true, reflect that directors asked questions and actively discussed the terms of the transaction. The minutes of the Disney board and compensation committee meetings, obtained by the plaintiffs through a shareholder request to inspect the books and records of Disney, played a key role in allowing the plaintiffs to defeat the directors' motion to dismiss the complaint.
Perhaps the most practical advice to directors comes from Chief Justice Veasey: "Directors who are supposed to be independent should have the guts to be a pain in the neck and act independently." In Disney and other cases, the Delaware courts are serving notice that directors who fail to discharge their duty to "be a pain in the neck" may experience serious pain in their pocketbooks.
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 discussion of other recent cases and other topics of interest on our website.
