This article is reprinted with permission from the
August 29 , 2005
edition of
New York Law Journal.
2005 NLP IP Company.


Directors Prevail in the 'Disney' Case

By Joseph E. Bachelder

On Aug. 9, 2005, Chancellor William B. Chandler III of the Delaware Court of Chancery handed down his decision in In Re The Walt Disney Company Derivative Litigation,2005 Del. Ch. LEXIS 113. The decision is in favor of all defendant directors, including Michael D. Eisner, chairman and chief executive officer of The Walt Disney Co. (TWDC), and Michael S. Ovitz, whose severance is the subject of the case, on all counts.[1] The plaintiffs have indicated that they will appeal.

At issue was the liability of the directors for the payment of an estimated $140 million in severance payments and benefits to Mr. Ovitz. Mr. Ovitz was hired as president of TWDC pursuant to employment arrangements authorized by the board of directors in late 1995. He was fired 14 months later.

The court's opinion is replete with harsh criticisms of Mr. Eisner and other directors. In the end, however, the court concludes that the plaintiffs failed to show that the defendants violated their fiduciary duties including the obligation to conduct themselves in good faith.

Standard of Fiduciary Duty for Directors

The court emphasizes the distinction between the ideal of good corporate governance and the standard of fiduciary duty for which directors are legally held accountable.

Fiduciaries are held by the common law to a high standard in fulfilling their stewardship over the assets of others, a standard that (depending on the circumstances) may not be the same as that contemplated by ideal corporate governance. Yet therein lies perhaps the greatest strength of Delaware's corporation law. Fiduciaries who act faithfully and honestly on behalf of those whose interests they represent are indeed granted wide latitude in their efforts to maximize shareholders' investment. Times may change, but fiduciary duties do not. Indeed, other institutions may develop, pronounce and urge adherence to ideals of corporate best practices. But the development of aspirational ideals, however worthy as goals for human behavior, should not work to distort the legal requirements by which human behavior is actually measured. 2005 Del. Ch. LEXIS 113, at *5.

The court found that the directors were protected by the business judgment rule.[2] The business judgment rule creates a presumption that directors, in exercising their business judgment, have done so in good faith and have adhered to their duties of loyalty and care. The court found that the plaintiffs failed to overcome that presumption. An important feature of the case, discussed below, is the attention given by the court to the issue of "good faith" on the part of Disney directors.

Key Circumstances

Among the circumstances noted by the court in reaching its conclusions are the following:

1. TWDC's management crisis and Mr. Ovitz's outstanding reputation.When Mr. Ovitz was hired, in the fall of 1995, a combination of circumstances had brought on a leadership crisis at Disney. Frank Wells, president and number two to Michael Eisner, was killed in a helicopter crash in 1994. Also in 1994, Mr. Eisner was diagnosed as having heart disease and underwent quadruple bypass surgery. In late 1995, Disney acquired ABC/Capital Cities, resulting in an enormous expansion of Disney. In a desperate need for a president, Mr. Eisner turned to an old friend and one of the most powerful figures in Hollywood, Mr. Ovitz. At least on its face, the hiring of Mr. Ovitz as president seemed a "perfect" solution to a dire leadership need at Disney.

2. Mr. Ovitz's compensation package at Creative Artists Agency (CAA).Mr. Ovitz, a cofounder of CAA, had an annual income of approximately $20 million. Disney had to provide him with at least a comparable economic opportunity to attract Mr. Ovitz.

3. Mr. Eisner's knowledge of Mr. Ovitz.Virtually throughout their careers, Mr. Eisner and Mr. Ovitz had been friends. Mr. Eisner knew Mr. Ovitz on both a social and professional basis. Who better to judge the value of Mr. Ovitz than Mr. Eisner? There is no doubt that the court was impressed with Mr. Eisner's having a good-faith basis for his judgment that Mr. Ovitz was an outstanding choice as president.

4. Compensation analyses.Two members of the Compensation Committee, its Chairman, Mr. Irwin E. Russell, and another member, Mr. Raymond L. Watson (himself a former chairman of TWDC) received compensation analyses and reports from Graef Crystal, one of the best known executive compensation consultants in the country and himself an adviser on previous contracts at TWDC. While Mr. Crystal did not appear before the full Compensation Committee, or before the full board, he did consult directly with Messrs. Russell and Watson and furnished them written reports.

5. Mr. Russell's role.Mr. Russell, as chairman of the Compensation Committee, conducted the negotiations with Mr. Ovitz's counsel. Mr. Russell was very experienced in the business of Hollywood, including compensation matters. While the court notes that, in an ideal situation, it would have been better if someone other than Mr. Eisner's personal attorney (which Mr. Russell was) had handled the negotiations, this fact did not sway its finding that Mr. Russell was in good faith and not in breach of his fiduciary duties.

6. Sanford M. Litvack's Role.Mr. Litvack, executive vice president for law and human resources and TWDC's chief of operations, as well as a director, was experienced in executive compensation arrangements at TWDC. While not conducting the negotiations himself, he was close to the drafting of the contract.

7. Materiality of Mr. Ovitz's package in context of Disney's size.By any "normal" standards, the Ovitz severance package was huge. The court acknowledges, however, that in judging the appropriateness of a compensation/severance package a board reasonably can take into account the package's materiality in terms of its size relative to the size of the employer. The court notes that in 1995, the year of Mr. Ovitz's hiring, the revenues of TWDC were almost $19 billion and the operating income was more than $3 billion. In this context Chancellor Chandler concludes, "Notwithstanding earlier statements by this Court [citing his own decision at an earlier stage of the litigation (2004 WL 2050138, at *7 n.64)] and the Delaware Supreme Court (Brehm,746 A2d at 259), I conclude that the NFT was not economically material to the Company." Id. at *237 n.577. ("NFT" refers to the Non-Fault Termination severance package.)

The above discussion of circumstances leading the court to its decision does not mean the court was not critical of the directors. As noted above, the court directed criticism at individual directors and made clear that this case was not an example of good corporate governance. Circumstances that were criticized by the court included:

* Failing to verify Mr. Ovitz's income and investigate his background to uncover his past troubles with the Department of Labor.

* The Compensation Committee's spending only 25 to 30 minutes in review of Mr. Ovitz's employment arrangements.

* Failure by certain members of the Compensation Committee to review the compensation consultant's report.

* The board generally giving in too easily to the wishes of Mr. Eisner.

Hiring Versus Firing

Phase I (Hiring) versus Phase II (Firing) of Mr. Ovitz:

Most of the court's opinion addresses the hiring of Mr. Ovitz; however, the complaint also addresses fiduciary liability in connection with the firing of Mr. Ovitz and the last part of the opinion addresses this. This issue concerns primarily whether the board breached its fiduciary duties in not firing Mr. Ovitz for cause, in which event he would not have received severance.[3],[4]

In contrast to the complaint, the facts and circumstances brought out at trial indicate that significant attention was given to whether Mr. Ovitz was entitled under his contract to a "Non-Fault Termination"--entitling him to severance--or whether he could be terminated for cause. The trial brought out that there were numerous discussions by directors on that subject and that Mr. Litvack advised Mr. Eisner and other directors that there was no basis for a termination for cause. The court does criticize TWDC, and specifically Mr. Eisner and Mr. Litvack, for not obtaining a formal opinion from counsel on the subject. (Mr. Litvack testified he spoke to a partner at the law firm of Dewey Ballentine on the issue of "cause" under the Ovitz contract but the court was not convinced that such a conversation took place.)

Nonetheless, the court concludes that, in its own judgment, there is not a basis for a termination for cause under the contract based on the facts and circumstances before it. The court also concludes that Mr. Ovitz did not have an obligation to go before the board and "protest" his own termination. Such a discussion could have led to a reversal of the Non-Fault Termination treatment and the court found that Mr. Ovitz had no obligation to do that. Thus, in connection with Mr. Ovitz's firing, the court finds that none of the directors breached any fiduciary duty or acted in bad faith.

Good Faith, Director Liability

In finding for the defendant directors, the court found an absence of self-interest in the directors (a traditional test of fiduciary loyalty) and that the directors were not grossly negligent (noted by the court as the traditional Delaware standard of care for corporate directors; in this connection see footnote 417, Id. at *155, citing Delaware authority). In addition to these two traditional tests, the court separately considered whether the directors acted in good faith.

Chancellor Chandler discusses the role and meaning of "good faith" as part of a director's responsibilities under Delaware law. In a footnote the court makes the following statement regarding the role of good faith:

In the end, so long as the role of good faith is understood, it makes no difference whether the words "fiduciary duty of" are placed in front of "good faith," because acts not in good faith (regardless of whether they might fall under the loyalty or care aspects of good faith) are in any event non-exculpable because they are disloyal to the corporation. See 8 Del. C. § 102(b)(7).5 Id. at *177 n.463.

The court also provides a definition of "good faith":

Upon long and careful consideration, I am of the opinion 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. (emphasis in original) Id. at *175.

Chancellor Chandler, however, does not limit himself (as indicated in the quotation) to this one definition of good faith. In the next paragraph he states:

To create a definitive and categorical definition of the universe of acts that would constitute bad faith would be difficult, if not impossible. And it would misconceive how, in my judgment, the concept of good faith operates in our common law of corporations. Fundamentally, the duties traditionally analyzed as belonging to corporate fiduciaries, loyalty and care, are but constituent elements of the overarching concepts of allegiance, devotion and faithfulness that must guide the conduct of every fiduciary. The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty, in the narrow sense that I have discussed them above, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders. Id. at *176.

Conclusion

While the latest decision in the Disneylitigation represents a legal victory (at this stage) for the TWDC directors (it being subject to appeal by the plaintiffs to the Delaware Supreme Court), it is not a "road map" to director immunity from future liability. The pivotal concept of "good faith" is not, as presented by the court, a very specific or precise guideline for director behavior.[6] If a future court finds sufficiently egregious acts or nonacts to warrant (in its judgment) culpability of directors will it simply identify them as being, for example, "without honesty of purpose" or "in deliberate disregard of duties" and hence not in good faith? Good faith becomes a conclusion rather than a guideline for future behavior. It reminds the author of the statement by Justice Potter Stewart regarding hard-core pornography, "I know it when I see it...."[7]

In any event, directors generally should not reach hasty conclusions (or comfort levels) as to this decision and, again, it is subject to appeal to the Delaware Supreme Court which, in such event, undoubtedly will have its own views on the matter.


FOOTNOTES:

[1] The hiring of Mr. Ovitz took place in late 1995 and his firing took place at the end of 1996. Nearly a decade passed between the actions giving rise to this litigation and the decision by Chancellor Chandler on Aug. 9, 2005.

As noted by the court, "The trial consumed thirty-seven days (between Oct. 20, 2004 and Jan. 19, 2005) and generated 9,360 pages of transcript from twenty-four witnesses. The court also reviewed thousands of pages of deposition transcripts and 1,033 trial exhibits that filled more than twenty-two 31/2-inch binders." 2005 Del. Ch. LEXIS 113, *3.

Thus far, there have been four published decisions by the Court of Chancery and one by the Delaware Supreme Court (reversing Chancellor Chandler's original dismissal of the complaint).

To assist the reader in examination of this litigation, the five decisions are as follows (the Roman numeral references are the author's and do not correspond to references by Chancellor Chandler in the current decision):

Disney I: In Re The Walt Disney Company Derivative Litigation, 731 A.2d 342 (Del. Ch. 1998)

Disney II: Brehm, et al., v. Eisner, et al., 746 A.2d 244 (Del. 2000)

Disney III: In Re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003)

Disney IV: In Re The Walt Disney Company Derivative Litigation, 2004 Del. Ch. LEXIS 132

Disney V: In Re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113

[2] The court also noted the exculpation of directors from the consequences of lack of care provided by TWDC's certificate of incorporation pursuant to Delaware General Corporation Law (DGCL) § 102(b)(7). Section 102(b)(7) permits a Delaware corporation, by provision in its charter, to exculpate directors from monetary damages for violation of the duty of care provided they otherwise are in compliance with other obligations, including the duty of loyalty, and not engaging "in acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law." The defendants, however, did not need to rely on an affirmative defense under that exculpatory provision because of the court's finding that the plaintiffs did not overcome the presumption of the business judgment rule.

[3] The court refers to the board at the time of Mr. Ovitz's firing as the New Board because of a change in its membership between the time of Mr. Ovitz's hiring and the time of his firing. However, all but two of the directors were members of the board at both the time of hiring and the time of firing.

[4] The court examined the TWDC certificate of incorporation and bylaws and concluded that under these corporate documents, and the termination provisions of the Ovitz employment agreement, the board had no duty to act and properly left the matter of the Ovitz termination to Mr. Eisner and Mr. Litvack. The court found that, in the termination of Mr. Ovitz, Mr. Eisner and Mr. Litvack acted in good faith and without gross negligence.

[5] While the court references DGCL § 102(b)(7), the text of the opinion to which the statement is a footnote speaks to fiduciary duties of directors generally.

[6] The column includes comments on the "guideline role" of this latest Disney decision because Chancellor Chandler makes the following observation in the introduction to the opinion,

I have tried to outline carefully the relevant facts and law, in a detailed manner and with abundant citations to the voluminous record. I do this, in part, because of the possibility that the Opinion may serve as guidance for future officers and directors - not only of The Walt Disney Company, but of other Delaware corporations. Id. at *8.

The point being made in the column is that while the opinion represents a thorough and careful examination of the role and meaning of good faith in a very complex set of facts and circumstances, it is more an exposition on, than a guideline for, director behavior.

[7] Jacobellis v. Ohio, 378 US 184 (1964).