The Disney Decision by ps94506



The Disney Decision

August 23, 2005

The much awaited Disney decision1 released on August 9, 2005 is good news
for corporate directors in many respects. Chancellor Chandler of the Delaware
Court rejected the shareholder complaint that the directors and certain officers
of Disney had breached their fiduciary duty in the way in which they had
handled the hiring and ultimate termination of Michael Ovitz as President of
The Walt Disney Company ("Disney"). Mr. Ovitz had joined Disney as
President in 1995, signing an employment contract worth over $23 million a
year. Little more than a year later, he was terminated, receiving a termination
package with a reported value of over $140 million. Although Chancellor
Chandler found much to criticize in the way in which the Disney board
conducted itself, its actions (or inaction) were not sufficient for a finding of
liability. He did however state that a board which demonstrated deliberate
indifference and inaction in the face of a duty to act could be found to have
breached their fiduciary duty. This is new ground for directors' liability in the
United States – as it would be in Canada.

      In re The Walt Disney Company, 2005 Del. Ch. Lexis 113.                                                              >perspective
                                                                       August 23, 2005
Why the Decision is Significant
For corporate directors, among the most troubling aspects of the allegations in Disney was
that they were framed as a breach of the duty of loyalty and good faith. Had the plaintiffs
been successful in arguing that the failure of the board to be more engaged in Disney's
employment relationship with Mr. Ovitz was a breach of this aspect of their fiduciary duty,
the directors and officers would have had no recourse to their insurance, indemnities or the
exculpation provisions (discussed below) in the corporation's governing documents. In
2003, the Disney directors sought to have the suit against them dismissed, arguing in part
that Disney's very dominant CEO, Michael Eisner, had been responsible for the process of
both hiring and firing Mr. Ovitz, and that he had not brought these matters to the board for
approval before announcing them publicly. Chancellor Chandler refused their request to
have their names struck from the action, saying that the matter should proceed to trial.
This left open for several years the possibility that an action of this nature, framed as a
breach of the duty of loyalty and good faith, could succeed against the members of the
board of directors. The failure of the plaintiffs to prove their case has resolved this issue
for the time being (on facts similar to Disney), in favour of corporate directors. However,
Chancellor Chandler went to some length to set out the circumstances in which a director
could be found to have breached his or her fiduciary duty – circumstances that include one
"where the fiduciary intentionally fails to act in the face of a known duty to act,
demonstrating a conscious disregard for his duties".

The Disney decision comes 20 years after the decision in Smith v. Van Gorkom, the
decision that sent a chill through boardrooms across the United States. In that case, the
directors were sued successfully for having breached their duty of care to shareholders in
approving a merger between Trans Union and a company in the Marmon Group of
companies. The deal paid shareholders $55 a share at a time when the shares were trading
at $38 and the transaction was approved by the shareholders. In spite of this, the Court
found that the directors had breached their duty of care (which is similar to the duty of care
in Canada) because of the failure in the process the directors had followed in approving the
transaction. Although Mr. Van Gorkom, the Chairman of the Board, had put the deal in
front of the board with no advance warning, and the directors were given no information to
review in advance of the meeting, the board approved the transaction in two hours. The
fact that the shareholders received a significant premium for their shares was irrelevant,
because the directors did not know what Trans Union's value was and were therefore not in
a position to assess the adequacy of the premium. The Court found that the directors were
grossly negligent in approving the sale of Trans Union upon two hours' consideration,
without prior notice and without the exigency of a crisis or emergency. It was not enough
that there was no fraud or bad faith on the part of the Trans Union board. The Court stated
that directors have a duty to inform themselves prior to making a business decision of all
material information reasonably available to them, and to assess such information with a
critical eye.                                                                           >perspective
                                                                                    August 23, 2005
Page 3

Chancellor Chandler referred extensively to the decision in Smith v. Van Gorkom but
found that the nature of the decision being made by the Disney board and the information
it had before it made the circumstances much different. The employment contract and
termination arrangements for a President did not rise to the same level as the sale of the
company. While the arrangements with Mr. Ovitz were largely controlled by Disney CEO
Michael Eisner, the board was aware of the discussions and some of the directors
participated actively in the negotiation process.

Criticism by the Court
Although Chancellor Chandler found that the actions of the directors and officers of
Disney did not rise to the level of a breach of fiduciary duty, he could not condone the
process they had followed. Much of his criticism was levelled at Mr. Eisner, to whom he
referred as having "enthroned himself as the omnipotent and infallible monarch of his
personal Magic Kingdom". The decision cautions that Mr. Eisner's actions should not
serve as a model for fellow executives and fiduciaries to follow and included among his
many "lapses", the following:

   •     he failed to keep the board informed as he should have
   •     he stretched the outer boundaries of his authority as CEO by acting without specific
         board direction or involvement
   •     he prematurely issued a press release that placed significant pressure on the board
         to accept Mr. Ovitz and approve his compensation package in accordance with the
         press release
   •     "To my mind, these actions fall short of what shareholders expect and demand from
         those entrusted with a fiduciary position. Eisner's failure to better involve the
         board in the process of Ovitz's hiring, usurping that role for himself, though not in
         violation of law, does not comport with how fiduciaries of Delaware corporations
         are expected to act."
Chancellor Chandler was also critical of the board, noting the contrast between ideal
corporate governance practices and "the unwholesome boardroom culture at Disney". He
described how "ornamental, passive directors contribute to sycophantic tendencies among
directors and how imperial CEOs can exploit this condition for their own benefit,
especially in the executive compensation and severance area."

Words of Comfort for Directors and Officers
Throughout the decision, Chancellor Chandler made a number of observations that should
provide comfort to corporate directors and officers who are wondering how much the
world has changed for them in the post-Enron era. Among these:                                                                           >perspective
                                                                                    August 23, 2005
Page 4

   •     The actions being complained of took place more than ten years ago - applying 21st
         century notions of best practices in analyzing whether those decisions were
         actionable would be misplaced.
   •     The standard to which directors and officers are held as fiduciaries of a corporation
         may not be the same as that contemplated by ideal corporate governance – in fact,
         Chancellor Chandler stated that a failure to adhere to ideals of good governance
         that are not otherwise required by law may not lead to liability:
                Aspirational ideals of good corporate governance practices for boards of directors
                that go beyond the minimal legal requirements of the corporation law are highly
                desirable, often tend to benefit stockholders, sometimes reduce litigation and can
                usually help directors avoid liability. But they are not required by the corporation
                law and do not define standards of liability

   •     The only logical way for a corporation of Disney's size and scope to operate is for
         everyday governance to be "under the direction of" the board of directors, not "by"
         the board. "As a general rule, a CEO has no obligation to continuously inform the
         board of his actions as CEO, or to receive prior authorization for those actions."

What Guidance Does the Disney Decision Offer for Canadian Directors
Because Canadian corporate law, jurisprudence and accepted standards of governance are
so similar to those in the United States, the Disney decision will be of interest to directors
of Canadian corporations. However, there are substantive differences between Canadian
and U.S. law that must be kept in mind in applying the Disney decision in a Canadian

   •     Under U.S. corporate law, the duty of care is part of the fiduciary duty. Canadian
         corporate law imposes two duties on directors and officers – the fiduciary duty (the
         duty to act honestly and in good faith, with a view to the best interests of the
         corporation) and the duty of care (the duty to exercise the care, diligence and skill
         that a reasonably prudent person would exercise in comparable circumstances). It
         is in part this difference in approach that has led the U.S. courts to the view that
         directors may have a fiduciary duty to creditors when the corporation is "in the
         vicinity of insolvency", while Canadian law (as recently articulated by the Supreme
         Court of Canada in the Peoples decision) takes the position that no such duty is
         owed by Canadian directors to the corporation's creditors.
   •     Disney, like many other Delaware corporations, had in its articles an "exculpation
         clause" for its directors and officers. The Delaware corporate statute was amended
         in response to the Smith v. Van Gorkom decision to allow corporations to limit the
         liability of their directors and officers in situations which in Canada would
         essentially amount to a breach of the duty of care. It may not extend to breaches of
         loyalty or good faith or to transactions from which the director derived a personal                                                                                        >perspective
                                                                                                 August 23, 2005
Page 5

         benefit. Most Canadian corporate statutes specifically prohibit such exculpation
         clauses in a corporation's articles.
   •     The Canadian business judgment rule is different from the American business
         judgment rule discussed in the decision. In the United States, there is a
         presumption that directors' decisions have been made on an informed basis, in good
         faith and with the honest belief that the action taken was in the best interests of the
         company. To overcome this presumption, a plaintiff must show not only that the
         director failed to exercise his or her fiduciary duty (including the duty of care), but
         that the director was "grossly negligent" in failing to do so. In other words, the
         onus is on the plaintiff to rebut the presumption that the directors acted properly.
         This is different from the approach taken by Canadian courts, which do not assume
         that the directors behaved appropriately, but instead review the processes followed
         by the directors in reaching their decision to determine whether those processes
         were in fact appropriate. An interesting contrast can be drawn between the Disney
         decision and the 2002 decision in UPM-Kymmene Corp. v. UPM-Kymmene
         Miramichi Inc. often referred to as the "Repap" decision. In that decision an
         Ontario court found that the compensation committee of Repap Enterprises Ltd.
         had completely abandoned its oversight responsibilities in connection with an
         employment contract with Repap. The Court held that the directors had breached
         their duty of care, but not their fiduciary duty. Whether a Canadian court would be
         prepared to consider an action in a situation similar to Disney or Repap as a breach
         of fiduciary duty remains an open question.

Notwithstanding the differences in Canadian law, the decision in Disney is a milestone in
the development of U.S. law dealing with directors' duties that will be considered and
referred to both in Canadian courtrooms and in Canadian boardrooms.


For further information, contact Michael Disney (416.863.5540), Bill Gula (416.863.5511)
or Carol Hansell (416.863.5592) in our Toronto office, Alan Golden (514.841.6414) in our
Montréal office or Guy Lander (212.588.5511) in our New York office.

Davies Ward Phillips & Vineberg LLP, with over 225 lawyers, practises nationally and
internationally from offices in Toronto, Montréal, New York and Paris, and is consistently
at the heart of the largest and most complex commercial and financial matters on behalf of
its North American and overseas clients.

The information and comments contained herein are for the general information of the
reader and are not intended as advice or opinions to be relied upon in relation to any
particular circumstances. For particular applications of the law to specific situations, the
reader should seek professional advice.                                                                            >perspective
                                                                                     August 23, 2005

To top