Lawyer Article

Published in the August 23, 2005 issue of Southeast Tech Wire

• Full text of the Disney decision
• Full text of the Disney decision - Part II

In a much-anticipated decision in The Walt Disney Company derivative litigation, the Delaware Court of Chancery has held that the Disney board of directors was not liable for breach of fiduciary duty or corporate waste in connection with the hiring or termination of former President Michael Ovitz. The decision is highly critical of the board’s actions and notes that they fell “significantly short” of corporate governance best practices. Nonetheless, the Court found that because the directors acted in good faith, their actions were afforded the protection of the business judgment rule.

Background

The case was filed as a derivative lawsuit against current and former directors of The Walt Disney Company, alleging that they breached their fiduciary duties when determining the compensation and terms of termination for Ovitz. In 1995, Ovitz, a long-time friend of Disney CEO Michael Eisner, was hired as president of Disney and given a generous compensation package, including a significant payout in the event of a termination without cause. Within a year, Eisner determined that hiring Ovitz was a mistake and sought his termination. Because Ovitz refused to resign and Eisner determined that termination for cause was not merited, Eisner terminated Ovitz without cause, triggering the payment of a severance package worth $140 million. The plaintiffs alleged that the board’s limited involvement in the hiring and termination decisions was a breach of their fiduciary duties to Disney’s shareholders.

The Chancery Court originally dismissed the case in 1998, ruling that the directors had not violated their duties. The plaintiffs re-filed the case in 2003, and the Chancery Court then denied a motion to dismiss. At that time, the Court found that the plaintiffs’ complaint sufficiently alleged a breach of the directors’ obligation to act honestly and in good faith for a court to conclude, if the facts were true, that the defendant directors’ conduct fell outside the protection of the business judgment rule. After a lengthy trial, the Chancery Court on August 9, 2005 issued its opinion finding no liability for the directors.

Analysis

The Court’s 174-page decision begins with an analysis of the duties of a board of directors and the relationship between those duties and best practices of corporate governance. The Court strongly encourages directors and officers to employ best practices, as those practices are understood at the time a corporate decision is made. However, Delaware law does not hold directors liable for failure to comply with such best practices. Rather, directors owe the corporation the duties of due care and loyalty (and underlying those duties, a duty of good faith), but within the boundaries of those duties, directors are free to act as their judgment and abilities dictate.

Under Delaware law, it is presumed that in making a business decision the directors of a corporation acted on an informed basis and in the honest belief that the action taken was in the best interests of the company. The presumption can be rebutted by a showing that the board violated one of its fiduciary duties, acted in bad faith or made an unintelligent or unadvised judgment by failing to inform itself of all material information reasonably available before making the decisions at issue. If the plaintiffs can rebut the business judgment presumption, the burden shifts to the defendant directors to show that the transaction was entirely fair to the corporation and its shareholders. When, on the other hand, a plaintiff fails to rebut that business judgment presumption, he or she is not entitled to any remedy, unless the transaction constitutes waste. Proving corporate waste is an onerous burden, since the plaintiff must demonstrate that that the transaction is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration in exchange for the amounts paid.

Applying the law to the facts of the case, the Court analyzed whether the board had breached its duties in (1) hiring Ovitz and agreeing to the terms of his employment agreement (including the severance package) and (2) terminating Ovitz without cause, thereby triggering the large severance payout. As to the first issue, the Court 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. The Court stated: “In accordance with the business judgment rule (because, as it turns out, business judgment was exercised), ordinary negligence is insufficient to constitute a violation of the fiduciary duty of due care.”

The plaintiffs focused particularly on the lack of involvement of Sidney Poitier and Ignacio Lozano, two members of the Disney compensation committee, in the Ovitz hiring deliberations and likened their conduct to that of the Trans Union directors in the 1985 case Smith v. Van Gorkom. There, the Delaware Supreme Court found that the board was not protected by the business judgment rule when it approved a material transaction after a two-hour board meeting without reviewing any documentation regarding the transaction. The Disney Court drew several distinctions between that case and the Disney facts, including the materiality of the transaction at issue (noting that the $140 million severance package was not material to Disney) and the fact that Poitier and Lozano received advance notice of the meeting, reviewed a term sheet outlining the Ovitz employment agreement and discussed the hiring decision for a “not insignificant length of time.”

Regarding the termination of Ovitz, the Court found that the board was not under a duty to act because it was permissible under Disney’s governing documents for Eisner, as CEO, to fire Ovitz unilaterally. Because the board was not required to act, its inaction was not a breach of fiduciary duty. The Court noted that Eisner had explored the various options for removing Ovitz, obtained advice from counsel and exercised his business judgment in deciding to terminate Ovitz without cause. As a result, the Court held that the plaintiffs failed to prove that Eisner breached his fiduciary duties or acted in bad faith in connection with Ovitz’ termination.

With respect to the claims against Ovitz, the Court held that he did not breach his fiduciary duty of loyalty in the course of his termination because he played no part in the decisions (1) to be terminated and (2) that his termination would not be for cause. Furthermore, Ovitz’ role in his hiring negotiations occurred before he was a fiduciary, and his receipt of benefits from the severance package occurred after his fiduciary relationship ended.

Finally, the Court determined that the termination of Ovitz and payment of the severance package did not constitute waste because Ovitz could not be terminated for cause and many of the defendants testified that Disney would be better off without Ovitz. Thus, the Court could not conclude that the exchange was so one-sided as to meet the requirements of a waste claim.

Practice Pointers

Although the Disney directors were able to escape liability for their actions (or lack thereof) in connection with the hiring and termination of Ovitz, the Court repeatedly noted that the case is not a model of good corporate governance. In addition, despite the favorable holding in the Disney case reinforcing the protections of the business judgment rule, the case is but the latest of an ever-growing number of private and SEC actions challenging the executive compensation practices of corporate boards. Several practice pointers can be gleaned from the Disney case:

• Avoid situations where the CEO acts in a unilateral manner in significant corporate decisions without specific board direction or involvement. Specifically, involve the board and/or compensation committee at the earliest stages of any executive compensation and hiring decisions.
• Consult an executive compensation expert when establishing compensation and severance packages for executives. Share the expert’s recommendations with the board and/or compensation committee.
• When considering hiring and compensation decisions, the board or compensation committee should review all material information and devote sufficient time to consideration of the issues. Keep detailed minutes of any meetings at which compensation and hiring decisions are discussed.
• Assess the composition of the board of directors to ensure that outside directors are truly independent thinkers. The Disney decision characterized the Disney directors as “ornamental” and “passive” and criticized Eisner for stacking the board of directors with friends and other acquaintances who were willing to accede to his wishes and support him unconditionally.
• Review applicable state law and the company’s charter and bylaws with officers and directors to determine that officers and directors are aware of their responsibilities and the bounds of their authority.
• Review committee charters and other governance documents with directors to determine that board and committee practices are consistent with their duties and responsibilities.

Conclusion

The Disney decision appears to reinforce the business judgment rule as a strong bar to holding directors liable for business decisions. However, the case should serve as a reminder to boards of directors that executive compensation decisions carry with them the possibility of judicial review and liability. Board actions and decisions in the future could be held to a higher standard based on the lessons that should have been learned from the Disney case. If we can be of further assistance, please contact the Womble Carlyle attorney with whom you work or any one of the lawyers listed below.