Practical Steps For Directors
To Consider After Disney
Brian Pastuszenski
Don’t forget to use common sense.
Brian Pastuszenski
is a partner in Goodwin Procter’s Corporate
and Litigation Groups and co-chair of the
Securities Litigation & SEC Enforcement
Practice. His practice is concentrated in the
areas of securities class action and shareholder
litigation defense, defense of SEC proceedings,
internal corporate investigations, corporate
governance and compliance matters,
merger and acquisition-related litigation,
and other high-stakes business litigation. Mr.
Pastuszenski is currently representing special
board committees, public companies, and
individual directors and officers in connection
with internal corporate investigations, SEC
proceedings, and shareholder litigation
relating to stock option practices.
On August 9, 2005, after a 37-day trial, the Delaware Chancery Court issued an important decision in the
eight-year-old shareholder derivative lawsuit against the
board of directors of The Walt Disney Company. In re
Walt Disney Co. Derivative Litigation, 907 A.2d 693 (Del. Ch.
2005) aff ’d, 906 A.2d 27 (Del. 2006). That lawsuit had
challenged Disney’s hiring and later no-fault termination
of one-time Hollywood power broker Michael Ovitz. The
principal take-aways from this decision include:
• The court’s 174-page written opinion does not
toughen the standards under Delaware law by which
corporate directors are judged, as some feared it
might;
• To the contrary, the court’s opinion reaffirms the
bedrock principle of Delaware law that corporate directors who make business decisions on the basis of
reasonably adequate information will be protected
from liability if they believe in good faith that those
decisions are in the company’s and shareholders’
best interests;
• Moreover, the Disney decision reaffirms the “wide
latitude” that Delaware law gives directors who act
in good faith even when—as the court found true of
the Disney directors—the degree of diligence and
care reflected in their actions falls “significantly short
of the best practices of ideal corporate governance”;
The Practical Lawyer | 43
44 | The Practical Lawyer • Nonetheless, the opinion does not give corporate directors a free pass. Particularly when the
corporate decision being challenged is material to the company’s revenues and earnings,
the opinion is a reminder to corporate directors that they must make good faith efforts to
inform themselves of “all material information reasonably available to them” to retain
the protections of the business judgment rule,
which protects the decisions of corporate
directors from second-guessing by the courts.
The Disney Case: Background and
Rulings • In 1995, Disney hired Ovitz as its
president, agreeing to an employment arrangement
that guaranteed Ovitz a sizeable payout if he were
ever terminated without cause. At the time he was
hired, Ovitz was the well-known head of a Hollywood talent agency and a long-time close friend
of Disney CEO Michael Eisner, who championed
bringing Ovitz on board. Although the Ovitz employment agreement was conditioned on approval
of the Disney board of directors, Eisner issued a
press release announcing Ovitz’s hiring before the
board as a whole had considered Ovitz’s appointment. About 14 months later, Eisner fired Ovitz,
in large part because of Ovitz’s failure to integrate
with the Disney corporate culture. Under the nofault termination provisions of his employment
agreement, Ovitz became entitled to an additional
$38 million in cash and the immediate vesting of
options to acquire three million shares of Disney
stock.
The litigation that followed Ovitz’s termination attacked the alleged failure of the Disney
board of directors to fulfill its fiduciary duties under Delaware law in connection with Ovitz’s hiring, the terms of his employment agreement and
the ultimate decision to terminate him without
cause. Among other things, the lawsuit claimed
that the directors intentionally had abdicated their
responsibilities, kowtowed to Eisner’s strong desire
April 2007
to hire his friend Ovitz, and supposedly exercised
no independent judgment or review in approving
Ovitz’s hiring and the terms of his employment.
The Chancery Court found that the plaintiffs’
complaint adequately called into question whether
the directors had consciously ignored their duties,
and let the case go to trial.
No Breach Of Fiduciary Duty
Based on the evidence at trial, Chancellor William B. Chandler, III concluded that none of the
Disney directors had breached their fiduciary duties. The court’s opinion, though, is hardly a pat
on the back for the Disney board. Rather, Chancellor Chandler was highly critical of the Disney
directors, and concluded that many aspects of the
board’s conduct “fell significantly short of the best
practices of ideal corporate governance.” He also
criticized Eisner for having “stacked his...board
of directors with friends and other acquaintances
who, though not necessarily beholden to him in a
legal sense, were certainly more willing to accede
to his wishes and support him unconditionally than
truly independent directors.”
Despite their shortcomings, however, Chancellor Chandler 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.
As such, the court found that the directors had not
lost the protection of the business judgment rule.”
Under the business judgment rule, corporate directors who make a business decision are presumed “to
have acted on an informed basis” and “in the honest
belief that the action taken was in the best interests
of the company [and its shareholders].” Chancellor
Chandler explained, however, that this presumption disappears when a director’s conduct is “grossly
negligent” (in the sense that the director has made
an “unintelligent or unadvised judgment” by failing
to take minimally sufficient steps to inform himself
before making a decision), when a director has acted
Directors After Disney | 45
in “bad faith” by intentionally or consciously abdicating his duties, when there is evidence of fraud or
“self-dealing in the usual sense of personal profit or
betterment,” or when a director’s decision “cannot
be attributed to any rational business purpose.” In
that event, a director would be required affirmatively to show that the decision made was “entirely fair”
to the company and its shareholders.
“Minimally Sufficient Steps”
Chancellor Chandler found that the Disney
directors had taken minimally sufficient steps to
inform themselves about Ovitz and his proposed
employment arrangement before approving it, and
had acted in the good faith belief that entering into
that arrangement with Ovitz ultimately would be
in Disney’s best interests. In that regard, the court
evaluated each director’s conduct, one by one. The
court found, among other things, that the members of the compensation committee had discussed
Ovitz’s employment agreement “for a not insignificant length of time” before approving it (apparently at least for 25-30 minutes). The court also noted
that even though the compensation committee had
neither reviewed nor discussed the full text of the
draft employment agreement, the committee had
received and discussed a term sheet setting out the
key terms of the agreement and had the benefit of
a presentation by two directors who had worked
closely with Eisner in negotiating and evaluating
the terms of the agreement. In addition, the court
found that the committee had appropriately relied
in good faith on an analysis of the proposed compensation structure prepared by a third-party consultant, even though the analysis may have been
deficient in certain respects. The court also noted
that the compensation committee had made its decision knowing that Ovitz “was a highly-regarded
industry figure” who was “widely believed to possess skills and experience that would be very valuable to the Company”—in other words, Ovitz was
not an unknown commodity on which the commit-
tee had decided to lavish riches. The court further
explained that the overall dollar amount of the
compensation potentially payable under the Ovitz
agreement was immaterial in terms of both Disney’s revenues and operating income. With respect
to the full board’s decision to elect Ovitz as Disney’s
new president, the court found it adequate that the
board members, “before voting, were informed of
who Ovitz was, the reporting structure that Ovitz
had agreed to and the key terms” of the employment agreement. Because the board members “did
not intentionally shirk or ignore their duty, but acted in good faith, believing they were acting in the
best interests of the Company,” the court found no
breach of fiduciary duty.
The court explained in its decision that while
the “best practices of corporate governance include
compliance with fiduciary duties,” “Delaware law
does not...hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices.”
The court observed that a director who acts “faithfully and honestly” on behalf of shareholders will
be given “wide latitude.” Applauding the “advantage of the risk-taking, innovative, wealth-creating
engine that is the Delaware corporation,” Chancellor Chandler also stressed that courts should not use
“perfect hindsight” to second guess the decisions of
disinterested directors who act on an informed basis and in good faith, even when those decisions—
like Ovitz’s hiring and termination—ultimately go
“awry, spectacularly or otherwise.”
PRACTICAL STEPS FOR DIRECTORS TO
CONSIDER AFTER DISNEY • The Disney decision’s implications for corporate governance no
doubt will be debated for years to come, particularly given that the plaintiffs in the case have appealed
the decision to the Delaware Supreme Court. What
follows are a few practical steps directors should
consider in the wake of the Disney saga:
• Review your company’s D&O insurance program
and directors’ indemnification and advancement rights.
46 | The Practical Lawyer Litigation challenging compliance with a
director’s fiduciary duties can be very expensive, and often can last many years. Directors
should understand how much directors’ and
officers’ liability insurance is available in the
event of a lawsuit, and what that insurance
will (and will not) cover. Perceived deficiencies
in coverage should be addressed promptly.
Having an attorney expert in such matters
review this coverage can be extremely valuable. In addition, ask whether your company’s
by-laws or charter provide for mandatory
advancement of legal expenses and indemnification in the event of litigation. All insurance policies have deductibles, and a director
or officer must look to his or her company for
payment of legal expenses before coverage is
triggered (or if coverage is exhausted). Mandatory advancement means that a director or officer will not have to wait until the conclusion
of litigation to have his or her legal fees paid.
Having a separate indemnification agreement
that supplements or supersedes whatever rights
are otherwise provided by the bylaws/charter
can also be useful in plugging holes and providing superior protection for directors;
• Ensure that your company’s charter includes an “exculpation” provision. Although evidence of “gross
negligence” will make the business judgment
rule inapplicable, a shareholder plaintiff who
proves that a director has been “grossly negligent” still cannot recover money damages
against that director if the corporation’s charter includes a “director exculpation” provision as permitted by section 102(b)(7) of the
Delaware Corporation Law. Such provisions
immunize directors from money damages for
breaches of fiduciary duty unless the plaintiff
proves that the director is guilty of self-dealing or was otherwise disloyal, intentionally
violated the law or otherwise acted in “bad
faith,” committed fraud or the like. Chancellor
April 2007
Chandler concluded that “bad faith” connotes
an “intentional dereliction of duty, a conscious
disregard for one’s responsibilities,” as opposed
to simply careless conduct;
• Minutes should reflect active board involvement and
questioning. Throughout his decision, Chancellor Chandler looked to the minutes of Disney
board and compensation committee meetings
for evidence of how much time directors spent
discussing Ovitz and the terms of his employment agreement. The Disney decision underscores the need for thoughtfully prepared
minutes (including minutes of executive sessions) that make clear the board or committee
members actively considered important issues,
asked questions about those issues in an effort
to inform themselves “of all material information reasonably available to them,” and duly
deliberated about those issues before reaching
a decision. In addition, minutes ideally should
reflect that board and committee members
received and had an opportunity to consider
important agreements or other documents on
which board/committee action was required;
• Retain outside experts. Particularly when significant amounts of executive compensation are
being considered, compensation committees
should consider retaining their own outside
experts who can help committee members
understand the comparability of the proposed
compensation and assess how much the company might be required to pay the executive
under various scenarios (including no-fault
termination);
• “Best practices” are still worth striving for. Although
Chancellor Chandler made clear that complying with Delaware law does not necessarily
mean complying with the “aspirational ideal
of best practices,” he nonetheless encouraged
“directors and officers to employ best practices, as those practices are understood at the
time a corporate decision is taken.” According
Directors After Disney | 47
to Chandler, adopting best practices of corporate governance will insure that a director
will be “unremittingly faithful to his or her
charge.” Directors also should keep in mind
that the yardstick by which their actions may
be judged may change over time. Chancellor Chandler noted in his decision that “the
actions (and the failures to act) of the Disney
board that gave rise to this lawsuit took place
ten years ago,” before “the Enron and WorldCom debacles, and the resulting legislative
focus on corporate governance.” It remains to
be seen, however, what standards will be used
to judge the conduct of directors occurring
now and in the years to come;
• The conduct of each director matters. Directors
should not assume that they will avoid liability just because the board as a whole did an
adequate job. Each director should take care
to ensure that his or her conduct reflects that
level of care and diligence required of directors, and otherwise complies with his or her
fiduciary duties. In the past, some courts have
considered the conduct of the board of directors collectively in deciding whether to assess
liability, without focusing on what individual
directors did. In Disney, Chancellor Chandler
rejected this approach. He noted that more
recent cases have assessed potential director
liability on a director-by-director basis, stating that the “liability of the directors must be
determined on an individual basis because the
nature of their breach (if any), and whether
they are exculpated from liability for that
breach, can vary for each director”;
• The nature and materiality of the transaction make
a difference—don’t forget to use common sense. Despite the significant compensation that Disney
agreed to pay Ovitz, Chancellor Chandler
noted that the amount involved was immaterial to Disney from either a revenue or operating income perspective. Chandler took this
fact into account in deciding whether the care
and diligence employed by the Disney directors had been adequate. Conversely, directors
should keep in mind that their actions may be
scrutinized more strictly when the decisions
being challenged are material from a financial
point of view. Let your common sense guide
you—the more significant the decision the
directors are being asked to make, the more
likely that decision will be a magnet for litigation. In addition, directors should not forget
the special rules that apply to certain acquisition transactions—for example, a decision to
sell the company or a controlling interest in
the company. In those situations, the board is
required not simply to have made a good faith,
informed business judgment, but to have obtained the best price available for shareholders
under the circumstances.
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