The Ghost of Michael Ovitz Still Haunts the Disney Board
from
November/December 2003
by Julie Connelly
Just imagine that you’re a director of a well-known, almost iconic company and a judge responding to a shareholder complaint says this about you: “As alleged, the facts belie any assertion that you exercised any business judgment or made any good-faith attempt to fulfill the fiduciary duties you owed to the company and its shareholders.” You’d probably have visions of ending your days in some Dickensian debtors’ prison, your reputation as tattered as the rags on your body.
For board members of the Walt Disney Co., to whom those words were addressed by Judge William B. Chandler III of the Delaware Chancery Court, personal financial ruin is a possibility, however remote. The judge denied the directors’ motion to dismiss a shareholder derivative action and allowed it to proceed to discovery. The plaintiffs, a group of 17 aggrieved Disney shareholders represented by the firm of Milberg Weiss Bershad Hynes & Lerach—yes, that Milberg Weiss—allege that the Disney directors breached their fiduciary duties when they approved the employment agreement Disney chairman and CEO Michael Eisner negotiated in 1995 while hiring talent agent Michael Ovitz, then his close pal, as president. The individual investors and various trustees who brought the suit also claim that the directors breached their duties again in December 1996, when they allowed Ovitz to walk away from the job after just 14 months with a severance package that the suit values at more than $140 million. The plaintiffs want all those serving on Disney’s board at the time Ovitz joined the company—and three more who were there when he left, including Ovitz himself—to put that money back in the Disney coffers. (See the box on page 55 for who those directors are.) In addition, the plaintiffs are seeking accumulated interest, calculated at five percentage points over the federal discount rate, that could add another $70 million or so to the total.
Judge Chandler’s opinion is a wake-up call to all directors, especially at a time when executive compensation is a hot issue. Though settlement is a likely outcome of the Disney case, the message is that the Delaware courts are going to scrutinize fat compensation deals—and that directors who are overly deferential to the CEO in matters of pay may end up personally stuck with some of the tab. As E. Norman Veasey, chief justice of the Supreme Court of Delaware, suggested at a Harvard Business Review roundtable earlier this year, “Directors who are supposed to be independent should have the guts to be a pain in the neck and act independently.”
The Chancery Court opinion may also reflect a new direction that the Delaware courts are taking with regard to the notion of good faith. Compensation expert Joseph E. Bachelder III of the Bachelder Law Firm in New York City notes: “The opinion in the Disney litigation suggests that token attention by board members to their engagement in an executive-compensation matter, when they knew, or should have known, that their attention was inadequate, may result in a court finding an absence of good faith, setting aside the presumption of the business-judgment rule, and finding personal liability on the part of the directors. In this context, the issue of good faith is sitting there like an elephant in the living room.” Bachelder believes the Chancery Court is warning directors that merely following a review process in a cursory, pro forma way will not shield them if they knowingly fail to give sufficient attention to the executive-compensation matter under their review.
And when that happens, it could be check-writing time for board members, because they’ll become personally liable for any damages resulting from their actions. “It is a very, very rare case where directors are forced to pay out of their own pockets,” says Lawrence A. Hamermesh, who heads the Widener Institute of Delaware Corporate Law in Wilmington, Delaware. “But this Disney case is a reminder that it is not impossible.”
The so-called A-side of D&O liability insurance policies covers those insured in derivative suits, says Steve Shappell, director of the legal department of Aon’s Financial Services Group. That’s because “there is no exclusion in the policy for bad faith, only for fraud and dishonest conduct.” But if the A-side of Disney’s policy isn’t sufficient to cover the entire settlement—and few outside the company and the insurer know whether it is—then the directors might have to pony up individually.
Of course, at this point the Disney board members are as innocent as Snow White. Says company spokesman John Spelich: “The procedural decision simply says that the plaintiffs get a chance to prove what they have asserted, not that what they have asserted is true. The court’s ruling does not address the merits of these claims, and all the defendants continue to contest the allegations vigorously.” Nonetheless, it is unusual for plaintiffs to defeat a motion to dismiss in Delaware courts.
Perhaps the board’s laid-back style is responsible. Evelyn Cruz Sroufe, a partner at the Perkins Coie law firm in Seattle and a former director of Willamette Industries, says, “This case does reflect a level of casualness not seen in boardrooms anymore.”
So what happened out there at Disney headquarters in beautiful downtown Burbank back in August 1995? Why did Eisner decide to hire Ovitz, then considered the most powerful man in Hollywood? According to a December 1996 Vanity Fair article, Eisner tried to explain it all to a small group of directors by saying that Ovitz would shoulder some of the creative responsibility at Disney.
True, Eisner had undergone quadruple-bypass surgery the year before and had no anointed successor, but the three directors to whom he broke the news—Disney CFO Stephen Bollenbach, Sanford Litvack, the chief of corporate operations, and Irwin Russell, Eisner’s personal lawyer—were reportedly outraged. “Why are you doing this?” Bollenbach is said to have kept asking Eisner. After all, Ovitz’s Creative Artists Agency was immensely successful, but he had no experience in running a publicly held company. Bollenbach, according to Vanity Fair, announced, “Well, I won’t report to him.” Litvack chimed in: “I won’t do it, either.”
Russell also objected to the new boss. Nevertheless, as chairman of the compensation committee, he wound up negotiating the terms of Ovitz’s employment. An important issue in the shareholder case is whether Russell was or was not advised by compensation expert Graef Crystal, who had in the past helped Eisner put together his own pay packages. If the comp committee members retained a consultant to help them craft Ovitz’s deal, it will be harder for the plaintiffs to prove that the board acted in bad faith. “There’s nothing that says that directors can’t rely on an expert just because that expert’s advice is bad,” says Lawrence Hamermesh.
Crystal would not talk to Corporate Board Member about his role, but he did say that he stands by two articles he wrote in December 1996, just after Ovitz decamped from Disney. In one of them, a piece for the San Francisco Business Times, he said, “I was an adviser to the compensation committee of Disney’s board when the Ovitz deal was struck.”
The plaintiffs, however, contend that compensation committee and board minutes, along with other internal Disney documents, suggest otherwise. They allege that Crystal was retained to advise on a new contract for Eisner, not Ovitz. Milberg Weiss’s Steven G. Schulman, the plaintiffs’ attorney, told Corporate Board Member, “Crystal had some peripheral involvement with the Ovitz compensation, but not enough to satisfy the Delaware law that he was an expert hired by the board or the compensation committee to advise on this matter. He was hired by Eisner to redo Eisner’s compensation.”
Negotiations with Ovitz, who was represented by his own advisers, went on for six weeks or so and were apparently difficult. Ovitz had twice before blown himself out of the water with exorbitant salary demands, first in 1989 and 1990, when he was negotiating with the Japanese to head Sony’s movie and record divisions, and again in June 1995, when Edgar Bronfman Jr. courted him to run Seagram’s MCA properties. His employment agreement was still not complete when the Disney compensation committee met on September 26, 1995, to vote on it. The meeting lasted an hour, and the full board met after that.
Although a complete draft of Ovitz’s five-year employment agreement was flying back and forth between his lawyers and Disney, the compensation committee was presented with only a two-and-a-half-page, single-spaced summary that said Ovitz would get, among other benefits, an annual base salary of $1 million, a discretionary bonus of up to $10 million a year, and two options grants totaling five million shares. Were Ovitz to die, be wrongfully terminated by Disney, or become permanently disabled at any time during the five years, he would receive a “non-fault” termination package consisting of the current value of his remaining salary, annual bonuses of $7.5 million, a lump-sum payment of $10 million, and the immediate vesting of the first options grant of three million shares.
The committee did not see—or, apparently, ask to see, says the complaint—an analysis of the contract, the exercise price on the options, a spreadsheet indicating what it might cost Disney to make good on the non-fault termination, or anything to indicate what comparable executives in comparable jobs were being paid. Instead, the committee members approved Ovitz’s contract “subject to such reasonable further negotiations within the framework of the terms and conditions described” as Eisner might approve.
They also spent some time discussing and finally agreeing to pay committee chairman Irwin Russell a $250,000 fee for negotiating the contract. The subsequent board meeting confirmed the payment and elected Ovitz president of Disney, but his employment agreement wasn’t discussed, according to the suit. The complaint further claims that neither Bollenbach nor Litvack shared any earlier misgivings with the compensation committee or the full board. “Well,” says Evelyn Sroufe of Perkins Coie, “this is the objection that institutional investors have to inside directors—that they are not independent.”
Unfortunately, among the trifling details left unresolved in Ovitz’s contract and to be negotiated subject to Eisner’s approval was the circumstance that might give rise to a non-fault termination. What Eisner and Ovitz negotiated between them turned out to be a substantial departure from what had been summarized for the compensation committee. “Instead of protecting Ovitz from ‘wrongful’ behavior by Disney, the provisions concerning no-fault termination now contemplated that Ovitz would have access to these massive benefits as long as he did not engage in detrimental behavior defined as ‘gross negligence’ or ‘malfeasance,’” according to the plaintiffs’ complaint. Speaking generally about such agreements, James Fox of Fox Lawson & Associates, a compensation consulting firm in St. Paul, Minnesota, says, “The fact is that nobody ever gets fired for gross negligence and malfeasance. It would require a high hurdle to prove. If the terms are met for malfeasance, the police would be involved.” There is no record that the compensation committee did anything about this change, the complaint alleges.
Ovitz’s tenure at Disney was not happy, and at times his behavior bordered on the bizarre. He broke down walls to give himself a larger office than Eisner’s, employed six assistants to Eisner’s three, kept drivers waiting when he knew he wasn’t going to need them, and reportedly demanded his own cook in the executive kitchen. Bollenbach, now head of Hilton Hotels, told Vanity Fair that Ovitz made a point of frequently whispering in Eisner’s ear at meetings, “to show he literally had the boss’s ear.” There were more serious issues. One was Ovitz’s support for the distribution of Kundun, a Martin Scorsese film about the Dalai Lama. The Chinese government objected to the film’s portrayal of China’s relations with Tibet and hinted that there could be trouble for the proposed Disney theme park in Shanghai.
Meanwhile, the Eisner-Ovitz friendship was becoming strained. “I’ve known him for 25 years, but after he came to the company, I don’t know him at all,” Eisner reportedly said to Bollenbach shortly after Ovitz’s arrival. For his part, Ovitz told Vanity Fair in August 2002 (this was the famous article in which he blamed his troubles on Hollywood’s “gay mafia”), “Michael cut my legs off at every opportunity. Every division that reported to me, he told them to ignore me and report to him.”
By September 1996 Ovitz had again tried and failed to get a job at Sony, and both he and Eisner determined that he should move on. Eisner, the plaintiffs allege, capitulated to his friend’s desire to leave but “without sacrificing any of the financial benefits of [his employment agreement]”—the ideal solution from Ovitz’s standpoint.
On December 11 Ovitz, Eisner, and Litvack met to finalize Ovitz’s departure, and the following day Litvack sent Ovitz a letter stating that by “mutual agreement” his employment would end on January 31, 1997, that “this letter will for all purposes of the Employment Agreement be given the same effect as though there had been a ‘Non-Fault Termination,’” and that the company would pay him everything owed him under such an agreement. Two weeks later Litvack sent Ovitz another letter specifying that his departure would be treated not as if it were a non-fault termination but as a non-fault termination and moving his last day up to December 27, 1996. The letter detailed the bushel of sugarplums that would fall into Ovitz’s lap: $38,888,230.77 in cash (after tax), to cover the contract-termination payment of $10 million and the net current value of salary and bonus due Ovitz through the end of his contract, plus the three million options, which would vest immediately. Using the Black-Scholes options-pricing model, the plaintiffs valued those at $101.5 million. The grand total was $140.3 million—about 10% of Disney’s net income that year.
According to the plaintiffs, there is no record of Eisner’s mentioning to the Disney board or any of its committees that Ovitz was leaving the company and was being given a non-fault termination. Moreover, it does not appear that any of the directors, having heard the news once it became public on December 12, raised any questions or objections. Presumably some of them knew that Ovitz’s job performance was unsatisfactory—Eisner had told director Raymond Watson that he “made an error in judgment in who I brought into the company”—but, says the complaint, no one seems to have made any effort to find out whether Ovitz could be terminated for cause.
The Disney directors were complaisant in a payout that was actually worth more to Ovitz than if he had continued to work at the company. If he had, his three million options would have vested in thirds beginning in October 1998, rather than all at once when he left. His annual bonus was discretionary and could range from zip up to $10 million; his termination agreement paid him an annual, prorated bonus of $7.5 million for each of the three years and nine months left in his contract. He also received that $10 million lump-sum termination payment.
Maybe the board was asleep while all this went down. Not so the 17 shareholders. On January 7, 1997, just 11 days after Ovitz walked, they sued.
