Litigation

Delaware Court of Chancery Decides Disney/Ovitz Compensation Case In Favor Of All Director Defendants

“Times may change, but fiduciary duties do not.” Chancellor Chandler, In re The Co. Deriv. Litig., Consolidated C.A. No. 15452, slip op. at 3 (del. Ch. Aug. 9, 2005)

On August 9, 2005, the Delaware Court of Chancery issued its decision in the seminal Disney/Ovitz compensation case, In re Derivative Litigation, In the end, the Disney case concluding that the defendant directors and officers of The Walt Disney Company did not violate their fiduciary duties when they hired Michael Ovitz nearly ten broke little new legal ground: years ago and then fired him a little over one year later.

the considerations undertaken The closely-watched case has provided years of fodder for court-watchers and Hollywood- watchers alike, especially given the personalities involved and the enormity of the estimated by Disney’s senior officers and $140 million severance package paid to Ovitz after his stunted tenure. In the end, Chancellor

Board in the hiring and firing of Chandler concluded: breaches of duty are determined on a director-by-director basis, as opposed to viewing Ovitz withstood scrutiny as a the board as a whole

the Court should take into account the corporate governance climate in existence at the matter of due care, loyalty and time the activities occurred, as well as the materiality of the transaction when weighed good faith. against the gravity of other decisions ordinarily undertaken by the company’s Board (or, indeed, even left to ) and

while corporate governance “best practices” may provide context in which to evaluate the fulfillment of director/officer fiduciary duties, they do not provide an absolute standard for determining whether such duties have been violated.

Although the Court attempted to bolster its prior efforts to define a “duty of good faith” in the context of traditional directorial duties of due care and loyalty, in the end it broke little new legal ground: the considerations undertaken by Disney’s senior officers and Board in the hiring and firing of Ovitz would have withstood scrutiny as a matter of due care, loyalty, or of good faith, however defined, when viewed in the context of the corporate governance environment as it existed in the mid-1990s. At the same time, however, this case provides a virtual roadmap of “Director Don’ts” for both actual deliberative processes and the documentation of such processes.

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Background and Key Holdings

In his 2003 opinion denying the defendants’ motion to dismiss the second amended complaint, Chancellor Chandler sent shock waves through corporate board rooms when he implied that the Company’s directors might be subject to liability for violating a newly-emerging “duty of good faith,” i.e., based on plaintiffs’ allegations that “the defendant directors consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care about the risks’ attitude concerning a material corporate decision.” In re The Walt Disney Co. Deriv. Litig., 825 A.2d 275, 289 (Del. Ch. 2003) (emphasis in original).

These allegations were tested in 37 days of trial, which generated 9,360 pages of transcript from 24 witnesses and 1,033 trial exhibits. After carefully reviewing that record, the Court While the Court focused found, in a 174-page Opinion, that the director defendants did not breach their fiduciary duties.

substantial discussion on The Court’s key findings include: The decision to hire Ovitz and the Compensation Committee’s approval of his employment whether a “duty of good faith” agreement was not grossly negligent or in bad faith, given that: (1) the Compensation Committee Chair was fully informed of the details of the proposed agreement, retained a also existed under Delaware respected compensation consultant, Graef Crystal, to review and prepare a report on it, and discussed it in varying levels of detail with other members of the Committee (although law, its discussion did not not necessarily together as a group); and (2) , Disney’s Chairman and clarify exactly what this CEO, relied on Crystal’s analysis and discussed Ovitz’s hiring with individual directors, including, in particular, individual members of the Compensation Committee.

concept entails. The was not under a duty to discuss and approve Ovitz’s termination pursuant to the Company’s governing instruments and Eisner, in his roles and subject to the control of the Board, possessed the right to remove subordinate officers and employees of the corporation. Hence, Eisner’s termination of Ovitz without Board approval or intervention did not usurp any Board authority and the Board did not violate their fiduciary duty of care in failing to meet prior to the termination or more closely question whether Ovitz should be terminated without cause.

Eisner’s decision to terminate Ovitz was not an act of bad faith and did not breach his fiduciary duties as “he weighed the alternatives, received advice from [Disney General Counsel Sanford Litvack] and then exercised his business judgment in the manner he thought best for the corporation.” He “was not personally interested in the transaction in any way that would make him incapable of exercising business judgment.”

Litvack analyzed Ovitz’s employment agreement and Ovitz’s performance and opined in good faith that there was no cause for terminating Ovitz. He also concluded that any attempt to terminate for cause would likely lead to costly litigation and would harm Disney’s reputation.

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Ovitz did not breach his duty of loyalty by receiving the no-fault termination payment because he played no part in the decisions which resulted in his being terminated and, moreover, the termination was not for cause.

The Court strongly rejected the plaintiffs’ claim for waste — i.e., that Ovitz’s compensation package incentivized Ovitz to leave the Company and receive a no-fault termination payment — because such a finding would have to be based on certain preposterous assumptions, including: (1) that Ovitz was somehow able to determine if he would be terminated and whether such a termination would be with or without cause; and (2) that Eisner had agreed to terminate Ovitz even before Ovitz had been hired.

Disney’s Legal Implications

Implication 1 — No Substantial Change to Legal Standard Under Which Directors or Chancellor Chandler was Officers of Delaware Corporations Will Be Held Liable careful to distinguish what Support for a new “duty of good faith?”

In its finding that the directors acted in good faith and discharged their fiduciary duties of Delaware law requires of due care and loyalty, the Court relied upon well-established standards under Delaware

corporate fiduciaries — that law governing these duties. While the Court focused substantial discussion on whether a “duty of good faith” also existed under Delaware law, its discussion did not clarify exactly they not breach fiduciary what this concept entails. Describing the duty as one to avoid any conduct “disloyal to the corporation,” Chancellor Chandler ultimately wrote that the threshold for liability for failing duties — from so-called “best to act in good faith is high: such a breach requires an “intentional dereliction of duty, a practices of ideal corporate conscious disregard for one’s responsibilities . . . . [This] may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best governance.” interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act.”

At the same time, it remains unclear how the duties of due care, loyalty, and good faith will interrelate in the post-Disney era. One of the Court’s formulations of the duty of good faith – i.e., a “[d]eliberate indifference and inaction in the face of a duty to act . . . , conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct.” — appears to encompass elements of both the duties of care and loyalty. Given the almost certainty of an appeal in this matter, it appears the Delaware Supreme Court will have an opportunity to clarify the precise contours and interrelationship of these duties.

Directors’ and officers’ fiduciary duties should not be equated with “aspirational ideals” or “best practices of ideal corporate governance.”

In his analysis, Chancellor Chandler was careful to distinguish what Delaware law requires of corporate fiduciaries — that they not breach their fiduciary duties — from so-called 08.2005 | 03 “best practices of ideal corporate governance” — a standard which he asserted the Disney

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directors “fell significantly short of.” According to Chancellor Chandler, “[u]nlike ideals of corporate governance, a fiduciary’s duties do not change over time.” Thus, while “strongly” encouraging directors and officers to employ “best practices,” the Court concluded that: “Delaware law does not — indeed, the common law cannot — hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices. . . .” The Court explained this conclusion as follows:

[s]hould the Court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decisions-makers would necessarily take decisions that minimize risk, not maximize value. The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike. That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary duties, but within the boundaries of those duties are free to act as their judgment and abilities dictate, free of post hoc penalties from a reviewing The Court rejected the court using perfect hindsight. Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased. plaintiffs’ attempts to hold Implication 2 — Breaches of Duty Are To Be Determined Director-By-Director, Not By certain directors to a generally Viewing The Board As A Whole

Another legal milestone lurking in the background of the Disney decision involved whether the higher standard in light of their defendant directors and officers would be evaluated according to sliding-scale standards, specialized expertise, except based on their individual positions and experience. Recently, in In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. May 3, 2004, where it was specifically revised June 4, 2004), Supreme Court Justice Jacobs (acting in his capacity as Vice Chancellor) suggested that individual directors with greater knowledge of the company and the relevant. industry may be held to a standard of review which demands greater scrutiny of a proposed transaction. The decision set off a firestorm of commentary, and at one point prompted former Delaware Supreme Court Chief Justice E. Norman Veasey to say it “should probably be read more narrowly as a factual decision in the context of [that] particular trial record.”

The Disney court cited the Emerging Communications decision, but only in support of the proposition that, in determining whether there was a breach of fiduciary duty, a court should look not at the board of directors as a whole, but rather at each officer or director on an individual basis (or, where relevant, as a sub-group, such as when the information available and other facts and circumstances were the same for that sub-group). In addition, Chancellor Chandler rejected the plaintiffs’ attempt to hold the attorney directors, Stanley Gold, George Mitchell and Irwin Russell, to a generally higher standard in light of their legal background, and took the fact of “special expertise” into consideration only where it was specifically relevant, as in the case of Litvack’s provision of legal advice.

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Practical Lessons From Disney: Director “Do’s And Don’ts”

The Disney decision is replete with practical lessons stemming from the Court’s description of the ways in which the Ovitz compensation and termination process “fell significantly short of” corporate governance ideals. A few key “takeaways” include:

Lesson 1 — Document, Document, Document the Bases for Board Decisions

The Court’s decision provides yet another reminder of some of the lessons learned from Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985): if decision making practices by boards of directors can be shown to be adequate, courts will respect the business judgment rule and will defer to any reasonable decision which emerges from such an acceptable process. Thus, the bottom line is that directors, while they need to act in the best interests of the Simple steps of ensuring that corporation, also need to be able to show that they acted in the best interests of the

important documents are corporation. Without evidence of the reasonableness of any deliberative process, a court is less likely to determine the merits of a case pre-trial and might even not be convinced adequately distributed and that that the process was actually reasonable. Notable in the Disney case is the extent to which Chancellor Chandler looked to non-Board meeting conversations, exchanges, and decisions and their bases are informal meetings in support of his finding that no fiduciary duties had been breached. adequately memorialized will Others might not be so fortunate.

Had there been better documentation relating to decisions that were made in the Disney likely make the defense of case, as well as better distribution of information to those involved in the process, it might decisions made by directors have been that the case would have been dismissed, thus avoiding the significant expense and risk of trial. and officers easier, and may For example, there were instances where documents could have (and perhaps should help avoid the costly and have) been created, circulated, and made part of the Board Minutes. The defendants’ position in the case would have benefited from: lengthy litigation of such (1) some form of summary, created around August 1995, perhaps from Eisner to the Board, of the reasons why Ovitz was the best choice for President, to which issues in court. documents supporting this conclusion (such as the compensation consultant’s report) could have easily been attached and

(2) a document from Litvack (and/or other attorneys) to the Board and Eisner summarizing the legal advice that Ovitz was entitled to a no-fault termination payment under his employment contract

Indeed, the documentation of the deliberative process was so sparse that at one point there was some dispute as to whether or not the Board held an Executive Session at which Ovitz’s impending termination was discussed: while the Court concluded that such a session was held, some Board members did not recall such a session and Eisner himself 08.2005 | 05 testified that it “was not an official executive session, but instead [a gathering of] the non- management directors in a room to discuss Ovitz.”

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There were also certain key documents that did exist but were not circulated to all Directors nor made a part of the Board minutes. Examples include: (1) an August 1995 memorandum authored by Russell, which states, inter alia, that “all the members of the Compensation Committee heartily endorse this pay package. Watson had a long discussion with Ignacio Lozano and I had two long conversations with Sidney Poitier in which all the details were reviewed and discussed before the deal was signed”; (2) Crystal’s report regarding Ovitz’s proposed compensation; (3) Ovitz’s biography; (4) the Ovitz Letter Agreement, which outlined the essential terms of his employment; and (5) the Ovitz compensation term sheet.

Bottom Line:

Important information which forms the basis for and explains actions taken by directors (together with any reports from experts or others retained to assist the The Court’s decision suggests deliberative process) should be adequately memorialized and distributed to all that corporations should pay Committee or Board members and made part of the Board or Committee minutes. Board or Committee minutes should contain more than sparse summaries of who close attention to when and attended the meetings and who made presentations.

If less formal discussions have been held at prior Board meetings or Executive under what circumstances Sessions thereof, they should be referenced (with a short description of the discussion) in the minutes of the Board meeting in which the related action is taken Board action need to be taken. (or reported on). Thus, important informal deliberations should be incorporated into formal documentation.

While minutes of Executive Sessions might be less detailed than those of actual Board meetings, the fact of an Executive Session, along with an identification of the directors present, should be clearly set out in formal Board minutes.

In sum, simple steps of ensuring that important documents are adequately distributed and that decisions and their bases are adequately memorialized will likely make the defense of decisions made by directors and officers easier, and may help avoid the costly and lengthy litigation of such issues in court.

Lesson 2 — Be Very Clear As To When Board Action Is Required

Chancellor Chandler found, after a careful review of Disney’s Charter, By-laws and prior practice, that Board action was not required to terminate Ovitz’s employment and pay him his no-fault termination payments under his employment contract. Chancellor Chandler also found that the $140 million severance payment was not “material” to the Company’s operation, in light of the Company’s overall revenues and in light of other decisions of similar magnitude which were typically handled by management rather than by the Board. The centrality of these findings to the Court’s decision suggests that corporations should pay close attention to when and under what circumstances Board action need be taken. 08.2005 | 06

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Bottom Line:

Directors, officers, and General Counsel must be sure that they know what matters can only be taken by Board action and what additional matters — although not required to be acted upon by the Board — should nonetheless be considered by the Board or one of its Committees.

Where there is doubt as to whether a Board need act because of the materiality (either quantitatively or qualitatively) of an issue or when there is a conflict (or perception of a conflict) of interest, such as the termination of a friend, a more prudent course of action would be to bring the decision to the Executive Committee, or at least have such a matter reviewed by the Executive Committee. Indeed, the purpose of Executive Committees and shortened or waiver of notice provisions is to provide for such review and action in between regular Board meetings.

Officers and directors should Conclusion

take heed from this Chancellor Chandler’s 174-page decision provides a fascinating behind-the-scenes analysis of Disney’s controversial hiring and less-than-ceremonious ouster of Ovitz a little over a year cautionary tale of how the later. Despite lengthy discussion of the newly-emerging “duty of good faith,” the Chancery Court in the end fell back on fairly traditional notions of corporate fiduciary duties in concluding decision-making process that neither the members of the Disney Board nor its senior officers had violated their duties occurred at Disney, and how, when hiring and terminating Ovitz. At the same time, the case must be read in the context in which Ovitz’s tenure took place — almost ten years ago, and long before anyone had heard of in particular, that process Sarbanes-Oxley or associated “Enron” or “WorldCom” with “unprecedented fraud.” Would the

was documented. decision have come out differently if Ovitz had been hired and fired using the same processes now? It is difficult to speculate, but the call may have been much closer. Regardless, today’s officers and directors should take heed from this cautionary tale of how the decision-making process occurred at Disney, and how, in particular, that process was documented. Indeed, had the process been more orderly and the documentation more thorough, the litigation might never have ensued or, at a minimum, would likely have not followed the course it did.

THIS ALERT WAS WRITTEN BY STEPHEN D. ALEXANDER* AND BETH I.Z. BOLAND, SECURITIES

LITIGATION/CORPORATE GOVERNANCE PARTNERS IN BINGHAM MCCUTCHEN’S AND

BOSTON OFFICES, RESPECTIVELY. ASSOCIATES T. PETER POUND (BOSTON), JENNIFER CORINIS

(BOSTON) AND JENNIFER PHELPS (LOS ANGELES) PROVIDED DRAFTING AND RESEARCH ASSISTANCE.

08.2005 | 07 * Mr. Alexander represented director defendants Roy E. Disney and Stanley P. Gold as trial counsel in this

litigation.

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Boston For more information about the Alert, please contact any of the attorneys listed below: Hartford

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