Client Publication June 5, 2003

In re The Walt Disney Company Derivative Litigation:

Implications for Directors and Executives

The latest decision of the Delaware Court of provided to the committee. The Court made
Chancery issued last week in In re The Walt Disney particular note of the facts that the committee was not
Company Derivative Litigation1 provides a advised by a compensation consultant and that they
cautionary tale for members of compensation did not receive any information on how the
committees, for board members generally and for arrangement compared with similar agreements in the
executives in negotiating their compensation entertainment industry.
packages.
The committee was informed that
The facts in Disney relate to the well- negotiations would continue and that the option grant
publicized hiring – and ultimate termination – of would be delayed until the contract was finalized.
Michael Ovitz as the president of The Walt Disney The committee unconditionally approved the
Company. The amended complaint contended that agreement, without requesting to review the final
the defendant directors knowingly or intentionally document, and granted Eisner the authority to
breached their fiduciary duty of due care in both approve the final conditions. After the compensation
approving Ovitz’s employment arrangement and committee meeting, the full board met. Following
failing to consider the terms of Ovitz’s termination as minimal discussion, the board as then constituted
negotiated exclusively by Disney’s chief executive appointed Ovitz without apparently asking questions
officer (and close personal friend of Ovitz), Michael about the potential costs of the arrangement to the
Eisner. company or observing other procedural safeguards,
leaving the final negotiations to Eisner.
The Facts Alleged in Disney
Ovitz began his service on October 1, 1995,
As summarized by the Court, the plaintiffs without having entered into a definitive agreement.
contended that Eisner unilaterally decided to hire The committee received a status report that
Ovitz over the initial objection of certain Disney negotiations were ongoing as of October 16, but they
directors based on Ovitz’s perceived lack of were provided with neither a draft of the agreement
experience. Once the Disney compensation nor any additional facts. Several drafts of the
committee was convened to discuss the hiring, they agreement were circulated among Ovitz, Eisner and
met for under an hour and for the bulk of that time their attorneys before the agreement was ultimately
discussed topics other than Ovitz’s package – executed on December 12, 1995, to be retroactively
including a finders’ fee to be paid to one of the effective to October 1. Neither the board nor the
directors for helping to recruit Ovitz. The committee compensation committee approved the final form of
was not provided with a draft of Ovitz’s agreement agreement.
during their deliberations, nor did they receive an
estimate of the aggregate potential costs of his The final agreement differed from the
arrangement or information regarding the exercise summaries of the drafts previously provided to the
price of the five million Disney stock options being committee in that Ovitz’s options were in the money
granted to him. Internal documents raising concerns at the time the agreement was signed, because the
about the size of the option grant, as well as a letter to strike price was set at the October 16 compensation
one director from a compensation expert warning committee meeting. The Court indicated that this
against paying large signing bonuses, were not allowed Ovitz to receive in the money options if the
stock price rose before the agreement was executed,
but would give him the ability to argue for the strike
price to be set at the time of signing if it were lower.
1
Memorandum Opinion, Case No. 15452, May 28, Additionally, the final agreement provided Ovitz with
2003 (referred to herein as “Disney”), on remand the benefits of a non-fault termination as long as he
from the Delaware Supreme Court’s decision in did not act with gross negligence or malfeasance,
Brehm v. Eisner, 746 A.2d 244, 249 (2000).
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whereas the prior drafts that had been summarized to new complaint … the facts belie any assertion that
the committee would only provide him with those the [Disney Board] exercised any business judgment
benefits if he were wrongfully terminated by Disney. or made any good faith attempt to fulfill the fiduciary
The plaintiffs alleged that the amount that was duties owed to Disney and its shareholders.”4
ultimately paid to Ovitz under this provision
exceeded $140 million. Chancellor Chandler wrote that “[t]hese
facts, if true, do more than portray directors who, in a
Ovitz’s tenure at Disney proved less than negligent or grossly negligent manner, merely failed
successful and negotiations regarding his non-fault to inform themselves or to deliberate adequately
termination among Ovitz, Eisner and one board about an issue of material importance to their
member began on December 11, 1996. That board corporation. Instead, the facts alleged in the new
member wrote two letters to Ovitz, indicating that complaint suggest that the defendant directors
Ovitz would undergo a non-fault termination as of consciously and intentionally disregarded their
December 27th and that he would receive nearly $40 responsibilities, adopting a ‘we don’t care about the
million in cash, plus vesting of three million stock risks’ attitude concerning a material corporate
options. The letter was signed by Eisner and the decision.”5 In rejecting the motion to dismiss the
board member; there was no record that the board as claim based on a Section 102(b)(7) waiver provision,
then constituted either reviewed or approved the Chancellor Chandler stated that, “where a director
letter, nor did they raise any questions about the consciously ignores his or her duties to the
termination. The plaintiffs contended that Disney’s corporation, thereby causing economic injury to its
by-laws required the board’s approval of Ovitz’s non- stockholders, the director’s actions are either ‘not in
fault termination. good faith’ or ‘involve intentional misconduct’.
Thus, plaintiffs’ allegations support claims that fall
The Decision outside the liability waiver provided under Disney’s
certificate of incorporation.”6
Due to the procedural context of the
decision, the Court was compelled to assume the In addition to the alleged breach of the duty
truth of the facts in the complaint. On those facts, the of care by the board, the plaintiffs also contended
Court concluded that Delaware corporate law’s that, because Ovitz was serving as an officer prior to
“theoretical justification for disregarding honest finalizing his employment agreement, he owed the
errors simply does not apply to intentional company a duty to negotiate honestly and in good
misconduct or to egregious process failures that faith so as not to advantage himself at the
implicate the foundational directoral obligation to act shareholders’ expense. The Court again made note of
honestly and in good faith to advance corporate Eisner and Ovitz’s twenty-five year relationship and
interests.”2 As a consequence, the Court permitted stated that Ovitz should have negotiated with an
the plaintiffs to proceed to discovery and refused to impartial entity – such as the compensation
accept the defendants’ contention that the complaint committee – rather than with his good friend. The
alleged only a breach of the directors’ duty of due Court also specifically noted that, because the final
care. This latter finding is significant in that version of the employment agreement differed
Disney’s charter provision, which is based on Section significantly from the summaries of the drafts that
102(b)(7) of the Delaware General Corporation Law, were provided to the directors prior to his hiring, the
would serve to exculpate the directors from personal Court was unable to dismiss the claims against Ovitz
liability for a breach of their duty of due care, unless on his motion since the facts as alleged sugges ted that
the claim involved either a breach of the directors’ the subsequent changes were not the result of arms’
duty of loyalty to the corporation or its stockholders length bargaining and were the product of Ovitz
or acts or omissions not in good faith or that engaging in a self-interested transaction by
constitute intentional misconduct or a knowing negotiating with his close personal friend.
violation of the law.
The Court went on to state further that, in
Despite his statement that the “Court is connection with the termination of his employment,
appropriately hesitant to second-guess the business Ovitz did not advise the Disney board of his
judgment of a disinterested and independent board of departure, but worked with Eisner to negotiate a
directors,”3 Chancellor William B. Chandler III, contract that was ultimately entered into without
writing for the Court, opined that “[a]s alleged in the

4
Id. (emphasis in original).
2 5
Disney at 32-33. Id. at 28 (emphasis in original).
3 6
Id. at 22. Id. at 29 (emphasis in original).
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board approval. The Court made specific note of the enlisting the aid of outside counsel in
fact that Ovitz was also a member of the board at the negotiation for the company to the extent the
time of his termination, citing its recent holding in directors deem appropriate.
Texlon v. Meyerson7 that directors’ decisions on their
own compensation raise duty of loyalty issues that • In circumstances where they deem it
necessary or advisable, independent
place them outside of the protection of the business
judgment rule and that, when challenged, the receipt directors should have the authority to retain
of self-approved benefits is subject to a showing of their own compensation consultants and to
engage separate and independent legal
fairness to the corporation. In sum, the Court stated
that “the Ovitz/Eisner exit strategy allegedly was counsel to advise in the review and
designed principally to protect their personal structuring of executive compensation
arrangements.
reputations, while assuring Ovitz a huge personal
payoff after barely a year of mediocre to poor job • Directors should ensure that proper
performance. These allegations, if ultimately found procedural mechanisms are in place so that
to be true, would suggest a faithless fiduciary who they are timely provided with all relevant
obtained extraordinary personal financial benefits at documentation concerning an executive
the expense of the constituency for whom he was officer’s employment or severance
obliged to act honestly and in good faith.” 8 arrangements. Directors should be provided
with substantially final versions of
Observations for Executive Arrangements documents that they are requested to
In light of the Disney case, independent approve, and with interim drafts to the
directors should consider certain of the following extent that they are involved in the
practices when negotiating and approving executive negotiation process. In addition, copies of
compensation arrangements, many of which are supporting documentation, such as equity
already part of most companies governance practices. compensation agreements and plans that are
referenced in the primary agreement, should
be made available to the directors. Directors
• A company’s independent directors – most
should also be provided with an estimate of
typically those comprising a designated
the potential aggregate costs of the
compensation committee – should take an
arrangements that they are approving,
active role in the negotiation and review of
including an estimate of the value of any
the terms of executive officers’ employment
equity-based compensation.
and severance packages. Members of the
board who are also part of company • Without exclusively relying on
management should recuse themselves from benchmarking to set compensation levels,
board discussions of their own pay independent directors should be provided
packages. with and consider compensation practices at
peer companies in similar industries when
• To the extent that the negotiations relate to
setting executive pay and severance.
the arrangements applicable to a chief
executive officer or other situations (like the • Independent directors should be provided
facts alleged in Disney) in which the chief with adequate time to review the
executive officer may be argued to have a arrangements that they are approving, to
personal interest or bias, the chairman of the discuss their terms and the opportunity to
compensation committee or designated raise any issues or questions they may have.
independent directors should conduct the Directors may need to meet more than once
negotiations on the company’s behalf. on a particular arrangement where the
circumstances warrant. Board and
• In negotiations with senior executives, the
committee minutes should reflect the
independent directors should be sensitive to
deliberative process of the directors.
the fact that it may not be advisable to make
the company’s general counsel the principal • The directors should ensure that the
legal negotiator with a person to whom he or company complies with all disclosure
she will ultimately report. In such obligations attendant to the engagement and
circumstances, the directors should consider termination of its executives.
Companies should also take steps to ensure
7
that negotiations of executive compensation
802 A.2d 257, 265 (2002). arrangements are conducted in an arms’ length
8
Disney at 32.
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manner. This is particularly important when shareholders in good faith. These cases have not
executives are re-negotiating their existing arisen solely in the context of employment and
employment arrangements, or when they are compensation decisions, and those that have – such
negotiating severance arrangements, as they will as Disney – have ramifications that reach beyond
necessarily be fiduciaries of the company at the time their facts. The Disney case represents a noteworthy
of these negotiations. step by the Delaware courts in what appears to be its
resolve to address the conditions and practices that
* * * * *
may have led to the recent scandals in corporate
The Disney decision is the latest in a series America.
of recent cases involving allegations that directors
failed to exercise their duties to a corporation and its

This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal
advice. We would be pleased to provide additional details or advice about specific situations if desired. For
more information on the topics covered in this memorandum, please call your contact at Shearman & Sterling
or any of the following attorneys:

Stuart J. Baskin John J. Cannon, III Creighton O’M. Condon

New York New York New York
(+1 212) 848-4974 (+1 212) 848-8159 (+1 212) 848-7628
[email protected] [email protected] [email protected]

Alan S. Goudiss Doreen E. Lilienfeld Clare O’Brien

New York New York New York
(+1 212) 848-4906 (+1 212) 848-7171 (+1 212) 848-8966
[email protected] [email protected] [email protected]

Linda E. Rappaport Peter J. Rooney

New York New York
(+1 212) 848-7004 (+1 212) 848-7871
[email protected] [email protected]

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