October 2005
By Mark R. High The recent decision of the Delaware Chancery Court captioned In re the Walt Disney Company Derivative Litigation, Consol. C.A. 15452 (Del. Ch. August 9, 2005), has attracted a lot of attention. Strictly, it focuses on executive compensation, hiring decisions, and termination payments. Viewed more broadly, however, it is just the latest in a string of important Delaware corporate decisions on the duties of a Board of Directors. Unlike many of these decisions, perhaps best exemplified by Smith v. Van Gorkum, 488 A. 2d 858 (Del. 1985), and more recently by Saito v. McCall, C.A. No. 17132-NC (Del. Ch. Dec. 20, 2004), the directors were completely exonerated in Disney. It is thus being hailed as a clear cut victory for the old-fashioned business judgment rule analysis. There are, however, a few cautionary notes to observe before we break out the champagne. What's the Story? The facts in Disney are pretty well known in the corporate world, having been detailed in a book by James B. Stewart called DisneyWar. The short version is that Michael Eisner, Disney's Chairman, hired Michael Ovitz, a long-time acquaintance of his, to serve as the Disney president. Ovitz got a five-year contract, including generous stock options and other benefits. Only a year later, Ovitz was fired, and ultimately received a reported $140 million for approximately 12 months' worth of (apparently unsatisfactory) work. On the surface, this seems a horrible story, and the Disney shareholders should have had an easy case demonstrating that the Disney board abused its discretion and made an improper decision. When viewed a little more carefully, however, the facts tell a more nuanced story. In 1995, Disney's then-current president has recently been killed in a plane crash, thus disrupting Disney's succession plan. Eisner is under great pressure to find a new successor. He settles on Ovitz, one of the most powerful and independent men in Hollywood at the time. Ovitz headed Creative Artist Agency, a high profile talent agency, where he claimed he was making at least $20 million per year. Eisner, nonetheless, is determined to bring Ovitz on. Eisner takes a personal interest in Ovitz' negotiations with minimal input from the Disney Board of Directors. He does enlist some help from the Board's compensation committee, which consults with a compensation expert. In the end, Ovitz agrees to come on board in return for a five-year contract which calls for seven-figure, maybe eight-figure annual compensation, numerous stock options, and certain protections in case he is terminated without cause. The Disney Board does approve the deal, but with only limited discussion and somewhat after the fact (Ovitz is already remodeling his new Disney office at the time). The Disney-Ovitz relationship proves to be a disaster almost from the start. Within six months, Eisner concludes that Ovitz must go. Eisner and his lieutenants struggle to find a reason to terminate Ovitz for cause, but ultimately conclude that the facts do not support this course of action. Eisner nonetheless moves forward and terminates Ovitz without cause, triggering some serious golden parachute style payments. Again, the Disney Board ratifies the action, but in a rather belated and summary fashion. Several Disney shareholders promptly sue the members of Disney's board of directors individually, alleging a breach of their duties of loyalty and care to the company. The suit attacks both the decision to hire and the decision to fire Michael Ovitz. In 2003, the case survives the defendants' motions to dismiss, thus catching the corporate world's attention. Reviewing Director Duties and Liabilities In Disney, the judge goes through an extended discussion of a director's duty of loyalty and duty of care. He examines the concept of good faith, briefly considering whether it is a separate duty owed by directors or is an integral part of the duties of loyalty and care. The judge eventually focuses on bad faith as being easier to define than good faith. He concludes that, if a director can be shown to have acted in bad faith, he or she may be liable to a company and its shareholders. He describes bad faith as having intentionally taken or failed to take a certain action, driven by a motive which runs counter to a company's best interest. He seems to say that this motive must be shown explicitly, rather than merely inferred through reviewing a director's actions and examining the results. Grave consequences could have flowed from a finding that the Disney directors breached their duties of loyalty and good faith. - The directors could have been held personally liable for any damages the Court might have awarded. Delaware General Corporation Law ("DGCL") Sec. 102(b)(7) allows Delaware corporations to adopt provisions in their charters which release directors from personal liability for breaches of the duty of care. This release from personal liability is not available for breaches of a director's duty of loyalty, however, nor for acts or omissions not performed in good faith. - The directors could have been prevented from being indemnified by the company against their damages or even expenses incurred in the suit. DGCL Sec. 145 allows indemnity only "if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation . . . ". - Many traditional D&O insurance policies intended to protect officers and directors do not cover damages resulting from intentionally dishonest or criminal acts, willful violations of law, or profit gained by a person who is not legally entitled to receive it (essentially insurance-speak for acts taken in bad faith or breaches of the duty of loyalty). Thus, the Disney complaint was brought in a way which could have inflicted maximum personal damage on the directors individually, if the case had gone against them. Further, insurance can be rescinded if the insurer determines that the company or any individual applicant made misrepresentations in its application (such as supplying inaccurate financial statements, even if believed to be accurate when submitted). Where insurance coverage survives these challenges, proceeds generally are payable to the company, not the individuals covered, which means they may not make their way to the directors (upon the company's bankruptcy, for example). This potential combination of personal liability, no indemnification, and lack of D&O insurance coverage is every director's worst nightmare. In Disney, the judge determines that the directors did not breach their duties of loyalty and that bad faith was not present. The directors, including Eisner, did not have any individual agendas which conflicted with that of the company, either in hiring Michael Ovitz or in terminating him. There was no intentional dereliction of their duty and no intentional violation of law in performing their responsibilities. Further, they were "at most", ordinarily negligent, a status "insufficient to constitute a violation" of their fiduciary duties. Chancellor Chandler's analysis seems to be that Disney had a problem, and its officers and directors addressed that problem in good faith with their decision to hire Ovitz. This created another problem, which they addressed in good faith by deciding to terminate him. They paid the bargained-for consideration resulting from that decision. Although these decisions, in retrospect, may have been bad ones, the judge concludes that they were not illegal nor made in an illegal manner. The judge spends some time describing the context within which he has made this decision. He waxes eloquent about Delaware corporations and their virtues, calling them innovative, wealth-creating engines. He notes that the foundation of this system is to encourage risk taking; to second-guess business decisions with hindsight would only stifle that process. He describes the market as being the best check on corporate decision-making, encouraging it to make its own collective evaluation of corporate decisions, and calling for the corporations to live with the consequences. The judge does note that the Disney directors may not have followed the existing best practices model of corporate governance. He makes clear, however, that it is not these theoretical best practices standards which govern directors' actions, but only a certain minimal legal requirement that he considers more relevant in the real world, and which was met in this case. Hold on a Minute. This is all great language which should prove comforting to directors throughout the land in making corporate decisions. Before directors go forth relying on merely a pure heart to protect them when performing their functions, however, I suggest a few cautions. First, this decision, as extensive and sincere and authoritative as it is, is only that of a trial court. The plaintiffs are pursuing an appeal to the Delaware Supreme Court, which has not been reluctant to impose rigorous standards of care on Delaware directors. Although some might argue, as Chancellor Chandler noted, that it would not be fair to apply present-day standards to past activities, the tenor of recent Delaware cases such as In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. May 3, 2004), means that we cannot rule out a reversal of this decision. Second, the court stresses that the Ovitz employment decisions were not material events in the life of the Disney company. There was no change of control involved, for example, as in Van Gorkum. Neither were the sums involved of a material amount, in light of Disney's revenues of almost $19 billion during 1996, a year in which Disney made 30 movies at an average cost of $52 million each. Thus, the board was justified in not spending a lot of time on this situation when it had bigger fish to fry. The finding that the transaction was not material was critical to the defense, and perhaps is the key to the decision. If so, then the attention which this case has drawn may end up being seen as much ado about nothing. Third, this situation unfolded almost ten years ago, in a climate much different than the one facing directors in this post-Enron world. The judge says that fiduciary duties do not change over time. While this may be true in a strict legal sense, it may not be terribly accurate. The duties may not change, but the actions required to meet those duties are certainly different today than they were ten years ago. While Sidney Poitier, the film star and a member of Disney's compensation committee at the time, may have met his duty of care by participating in a couple 20 minute conference calls from his yacht in the Mediterranean in 1995, one must question whether this would be accepted as sufficient today. Where Do We Go from Here? Despite this, there are certain lessons we can take from this case. The judge reviewed the actions not of the directors as a whole, but individually. This may bring us closer to the day where no director will attend a board meeting without his or her personal counsel. Further, it indicates that directors can no longer sit back and let others, especially management, carry the work load. A person asked to join a board of directors must make sure they are qualified to take on the resulting responsibilities. Once on board, they need to do the work required to understand and supervise the company's business, competitive environment, financial condition, and strategic direction. It has also become important to memorialize not only the board's decision on issues before it, but also the process that went into making that decision. This will call for more detailed recordkeeping, more special committees, and more descriptive minutes of committee and board meetings. Minutes should report not just final decisions, but should also at least outline the process by which an important decision was reached and the key considerations reviewed. While this increased detail may only serve to encourage second-guessing among the plaintiff's bar, it cannot be avoided. Companies and their board members will want to review their existing D&O insurance policies. The insurance industry has developed new products over the last few years in which insurers can agree to not seek to rescind the coverage of all directors if only some of them have engaged in bad acts or made misrepresentations on their applications. This "severability" undertaking could allow innocent or independent directors to maintain their insurance and perhaps have direct access to its proceeds, sometimes even if the company ends up in bankruptcy. Finally, the deference which the Disney board showed to its chairman, Eisner, should not be emulated. While it is inevitable that the main information source for the board is the company's management, directors need to maintain an independent and assertive posture in performing their duties. It is important to monitor the big picture of the company's situation, always asking whether the board is involved in the important issues facing the company, and making sure it has access to the information and resources required to review those issues. In sum, we have not heard the last of this case, and directors of public companies should not slacken in their efforts to diligently perform their duties.