United States: Board Lessons from the Disney Decision

On August 9, 2005, Chancellor William B. Chandler III, in the Delaware Court of Chancery, issued a decision in the case of In re Walt Disney Co. Derivative Litigation, a case that awaited resolution for nearly a decade. The decision favored the Disney corporate directors, who were defending against allegations of breaches of fiduciary duty in connection with the hiring of Michael Ovitz as president of Disney in 1995, and Ovitz's non-fault termination in 1996 that entitled Ovitz to a severance payment worth $140 million. While the court's decision found that each of the directors "fulfilled his or her obligation to act in good faith and with honesty of purpose," the court also observed there were "many aspects of [the directors'] conduct that fell significantly short of the best practices of ideal corporate governance." ¹

Although the directors won the lawsuit, the decision criticizes many aspects of the Disney board's process. The court's opinion is less about the rules themselves than about the expectations of the board and how those expectations have changed over the ten years since Ovitz's hiring and termination. Ultimately, the Disney board did enough to avoid civil liability, but not enough to avoid the time, energy, cost and reputational damage of the litigation.

The following are some of the key lessons contained in the decision, and suggestions for additional actions any board can take to ensure optimal corporate governance.

1. The business judgment rule remains the standard used to judge actions by disinterested and independent directors.

• The court declined to hold aspirational standards of conduct as the standard used to judge liability. While the court encouraged officers and directors to employ "best practices" as understood at the time of their action, it noted that Delaware law does not require every board decision to meet that very high standard.

• In the words of the court, "the essence of business is risk," and the court declined to assess liability based on the ultimate outcome of good faith actions by officers or directors.

2. Directors' actions are judged on an individual basis.

• The court analyzed the conduct of each director and his or her action or inaction in connection with the approval of the employment contract.
• The court's analysis in this regard follows recent cases that have judged the directors on an individual basis rather than judging the conduct of the board as a whole.
• Simply stated, not only should a director exercise the diligence to be informed and make a decision in good faith, but there should be documentation of the due diligence, the debate and the decision. Minutes or other appropriate documentation are now of added importance in litigation. It is possible that had the Disney board minutes shown adequate deliberation, the case may have been disposed of on a summary judgment motion.
• It is important to have truly independent directors, who actively question management, use available information and retain experts when appropriate.
• A director's duties may increase in magnitude if a transaction is material in size compared to the corporation's business.

3. Although the plaintiffs' attempt to impose an additional duty of good faith failed, the court offered guidance on when a good faith action could succeed.

• While the traditional duties of a director are a duty of care and a duty of loyalty, the court recognized a concept of good faith by identifying three of the "most salient" examples of bad faith:
• "where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation,"
• "where the fiduciary acts with intent to violate applicable positive law" or
• "where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties."
• All of the examples discussed in the opinion have an element of intent.

4. The provision of the Delaware General Corporation Law allowing corporations to protect directors from monetary liability for "duty of care" claims was effective.

• Section 102(b)(7) allows a corporation to adopt a charter provision to prohibit a monetary recovery from a director for a claim based on a duty of care (but not for a breach of a duty of loyalty or bad faith/intentional misconduct).
• Since the Disney plaintiffs could not prevail even by proving gross negligence, the plaintiffs were required to plead and prove that the directors' conduct was not in good faith - a far higher standard.
• The presence of this provision in the Disney corporate charter ultimately did not decide the outcome of the case, since the court found that the plaintiffs failed to prove even gross negligence; however, the opportunity to increase the burden of proof on the part of potential plaintiffs should not be overlooked.

5. The positive aspects of Disney's corporate procedures and the additional actions that can be taken:

Positive aspects of Disney's procedures:

• Directors were not unduly influenced by management and reached the hiring and termination decisions on their own.
• The compensation committee hired a qualified independent consultant.
• Action was taken following arm's-length negotiation and consideration of qualifications.

Additional actions that a board may wish to consider:

• Separate the roles of the board and the CEO in the decision-making process.
• Supplement the work of the independent compensation consultant with other professionals - legal, tax, possibly a skilled negotiator.
• Go beyond market considerations to consider business goals and internal equity.

The dispute in the Disney case can be summarized as one involving an executive compensation and severance package, and whether the Disney board members breached their fiduciary duties in connection with the 1995 hiring and 1996 termination of Michael Ovitz as president of Disney.

On the first issue in the case, the court held that there was no breach of fiduciary duty in the hiring of Michael Ovitz. In making this determination, the court did not apply a standard of "good faith," but rather a standard of "waste" - which required the plaintiffs to prove that no reasonable person would think that Ovitz's compensation was commensurate with the services Disney received. In holding for the Disney directors on this issue, the court found that the directors did not violate this standard because they had not "irrationally squandered or given away corporate assets."

On the issue of Ovitz's termination, the court concluded that Ovitz could not have been terminated for cause under his employment agreement. While the court did not explain which facts it relied on in a record that encompassed a 37-day trial, with over 1,000 trial exhibits, it did conclude that Ovitz "did not commit gross negligence or malfeasance while serving as [Disney's] President."

While the court (i) criticized numerous flaws in the process used at Disney, and in particular the actions of Michael Eisner, Disney's Chief Executive Officer, (ii) found that there were many lapses, and (iii) held that "the actions [of the Disney board] fall far short of what shareholders expect and demand from those entrusted with a fiduciary position," the court held that these shortcomings were not in violation of law.² The court declined to apply a more exacting review to business decisions as a result of changing business norms, stating that "Unlike ideals of corporate governance, a fiduciary's duties do not change over time."

In holding that two of Disney's directors had not breached their fiduciary duties, the court distinguished the process used at Disney from that used by the board of TransUnion in a famous 1985 Delaware Supreme Court case, Smith v. Van Gorkum. In Van Gorkum, the directors had failed to read the merger agreement, failed to obtain a fairness opinion from an independent source and met only briefly to approve the transaction. While the Disney board members were also alleged to be uninformed, the court distinguished the facts in Disney from TransUnion: (i) the Ovitz transaction was not material in size compared to Disney's business, while the TransUnion transaction was a sale of the company; (ii) while both boards met for a brief period of time, the Disney board had been informed in advance of the matter to be discussed; and (iii) while neither board had read the document it approved, the Disney board relied on a term sheet and summary presentation presented by a fellow director knowledgeable about the negotiations. Consequently, the court held that the board members had "all material information available, even though they were not privy to every conversation or document."

It is worth noting that the plaintiff's counsel has been quoted in news sources as being in the process of preparing to appeal the Chancery court decision.