This article is reprinted with permission from the
December 29, 1998
edition of
New York Law Journal.
1998 NLP IP Company.


'Disney': Severance and the Business Judgment Rule

By: Joseph E. Bachelder


IN OCTOBER the Delaware Court of Chancery (William B. Chandler III, Chancellor) dismissed a shareholders' derivative action that challenged a $140 million severance package paid by Walt Disney Co. to Michael Ovitz who, at the time of his severance, had been employed as president of Disney for only 14 months. The case has been appealed. 1

In a colorful description, the Chancellor prefaces the opinion as follows:

Just as the 85,000-ton cruise ships Disney Magic and Disney Wonder are forced by science to obey the same laws of buoyancy as Disneyland's significantly smaller Jungle Cruise ships, so is a corporate board's extraordinary decision to award a $140 million severance package governed by the same corporate law principles as its everyday decision to authorize a loan . . .. When the laws of buoyancy are followed, the Disney Magic can stay afloat as well as the Jungle Cruise vessels . . .. Nature does not sink a ship merely because of its size, and neither do courts overrule a board's decision to approve and later honor a severance package, merely because of its size. 2

The Chancellor begins the opinion with the following observation:

This is a noteworthy case because the severance payment is large -- larger than even the expert hired by the Disney Board to explain the contract imagined it to be, larger than almost anyone anywhere will receive in the lifetime of any of the parties, and perhaps larger than any ever paid. 3

The Chancellor then frames the basis for his decision as follows:

The case appears to be exceptional because of the sheer dollar amount involved. But does that mean the amount is so large that this Court should use its equitable powers to stop its payment? Does that mean it is so large that the conventional corporate governance laws of Delaware do not apply? No . . .. Unless Plaintiffs can plead with specificity facts that rebut the presumption of the business judgment rule, that the Board was corrupted and could not make a decision fairly and independently, in the best interests of the Corporation, then the Board's decision will stand. 4

Non-Fault Termination

The severance package of $140 million came due under the Ovitz employment agreement if Disney terminated him without cause or if he resigned with the consent of the company. The latter was the form the termination took (a Non-Fault Termination). The severance package included, among other things, the vesting of options to 3 million shares (that continue to be exercisable for 24 months following termination), a $10 million special bonus (based on a termination before Sept. 30, 2000) and an amount equal to $7.5 million times the number of fiscal years remaining on his contract.

The court considers the fiduciary responsibilities of the board of directors using a "two-prong" approach: (1) were the directors disinterested and independent and (2) was the challenged transaction the result of "a valid exercise of business judgment"? 5

The court describes the first issue in terms of whether a board member could "benefit financially" or, on the other hand, could "suffer materially" from a decision in the transaction in question. 6 After review of the situations of each individual director (some of whom had very close ties to the Disney chairman, Michael Eisner) the court concludes that a majority was disinterested.

Business Judgment Rule

On the second issue the court considers whether (a) in approving the severance agreement and (b) in agreeing thereafter to a Non-Fault Termination pursuant to that agreement, the board was protected by the business judgment rule. As expressed by the court, the issue was whether "the Board was well-informed, careful and rational in approving the Employment Agreement or granting Ovitz's Non-Fault Termination." 7

The court begins its discussion of this issue by noting:

Plaintiffs offer several statements made by Graef Crystal, the financial expert who advised the Board on the Employment Agreement, including his admission that "nobody quantified [the total cost of the severance package] and I wish we had." 8

The court concludes that the complainants failed to establish a case that the defendant directors did not meet the test of the business judgment rule:

Even if the Board did fail to calculate the potential cost to Disney, I nevertheless think that this allegation fails to create a reasonable doubt that the former Board exercised due care. Disney's expert did not consider an inquiry into the potential cost of Ovitz's severance benefits to be critical or relevant to the Board's consideration of the Employment Agreement. Merely because Crystal now regrets not having calculated the package is not reason enough to overturn the judgment of the Board then. It is the essence of the business judgment rule that a court will not apply 20/20 hindsight to second guess a board's decision, except "in rare cases [where] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment." Because the Board's reliance on Crystal and his decision not to fully calculate the amount of severance lack "egregiousness," this is not that rare case. (footnote omitted). 9

The court next considers whether, notwithstanding reasonableness and care in the board's process of approving the contract, the result constituted corporate waste, i.e., did they " 'authorize an exchange that is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration'"? 10

After briefly reviewing the terms of the employment agreement -- particularly those relating to stock options, some of which Ovitz was allowed to keep and some of which he forfeited -- the court concludes, "I simply do not agree with the Plaintiffs' characterization of the exchange between Ovitz and Disney as so one-sided that no business- person of ordinary, sound judgment could conclude that Disney received adequate consideration." 11

The court also considers whether the board of directors in granting Ovitz a non-fault termination after 14 months of employment breached its fiduciary duty. It notes that the board faced difficult choices, given Ovitz's unsatisfactory performance. It could have continued him as president, but that would not have been a satisfactory course, as the plaintiffs acknowledged. In order to terminate Ovitz for "cause" the board would have to find, under the contract, that he was "either grossly negligent or malfeasant during his tenure . . .." 12 It could not find either circumstance. Finally it rejected plaintiffs' assertion that Ovitz had quit:

First, [Plaintiffs] allege that on September 5, 1996, Ovitz wrote a letter to Eisner in which Ovitz stated that he was very dissatisfied with the role he had been assigned at Disney and wanted to leave the Company. Second, Plaintiffs allege that, as early as September 12, 1996, it was reported that Ovitz was actively seeking other employment. 13

The court responds to these allegations as follows:

While I would agree that Ovitz's September 5 letter to Eisner and his search for another job provide strong evidence of Ovitz's lack of commitment to the Company, they are not legally tantamount to a voluntary resignation. 14

Before concluding its opinion, the court also addresses issues relating to disclosure and a separate claim against Ovitz for breach of contract and for breach of fiduciary duty. It finds against the plaintiffs on both issues.

Sixty-five years ago the United States Supreme Court considered another case involving the reasonableness of compensation. That case arose under the corporate law of New Jersey. Rogers v. Hill, 289 U.S. 582 (1933).

In that case several executives of American Tobacco Co. had received bonuses that plaintiffs claimed were excessive. The bonuses were paid under a plan that had been approved by shareholders in the form of a by-law adopted in 1912. The by-law provided that if the net profits of American Tobacco exceeded about $8.2 million in any year, the president of the company would receive payment of 2.5 percent of such excess, and each of five vice presidents would receive 1.5 percent, an aggregate of 10 percent of the annual net profit exceeding $8.2 million.

The years in issue were 1921 through 1930. For these years the president received bonuses under the plan as a vice president [1921-25] and as president [1926-30]):


    Hill   By-Law        
    1921   $ 89,833.84   }   As Vice President
    1922   82,902.61
    1923   77,336.54
    1924   88,894.26
    1925   97,059.38    
    1926   188,643.45   }   As President
    1927   268,761.45
    1928   280,203.68
    1929   447,870.30
    1930   842,507.72


Adjusted for the changes in the Consumer Price Index, or equivalent, for the period through 1997, these bonuses represent about $23 million in current dollars, far less than the $140 million severance package provided Ovitz. This was in addition to other compensation paid the president, including salary and another form of incentive plan, a "cash credit" award. (Only partial information is given as to the amounts of salary and cash credit award paid the president during this period and those amounts are substantially less than the net profits bonus shown above).

Information also is given as to two other executives, and this information is for only two of the years, 1929 and 1930. These amounts are substantially less than the amount paid the president.

In reaching its decision the Supreme Court comments as follows:

While the amounts produced by the application of the prescribed percentages give rise to no inference of actual or constructive fraud, the payments under the by-law have by reason of increase of profits become so large as to warrant investigation in equity in the interest of the company. Much weight is to be given to the action of the stockholders, and the by-law is supported by the presumption of regularity and continuity. But the rule prescribed by it cannot, against the protest of a shareholder, be used to justify payments of sums as salaries so large as in substance and effect to amount to spoliation or waste of corporate property. The dissenting opinion of Judge Swan indicates the applicable rule: "If a bonus payment has no relation to the value of services for which it is given, it is in reality a gift in part, and the majority stockholders have no power to give away corporate property against the protest of the minority." 60 F2d 109, 113. The facts alleged by plaintiff are sufficient to require that the District Court, upon a consideration of all the relevant facts brought forward by the parties, determine whether and to what extent payments to the individual defendants under the by-laws constitute misuse and waste of the money of the corporation. 15

Preceding the comment just quoted, the Court stated a presumption regarding the passage of the by-law on which the net profits bonus was based: "The by-law was adopted in 1912 by an almost unanimous vote of the shares represented at the annual meeting and presumably the stockholders supporting the measure acted in good faith and according to their best judgment." 16

Changing Perceptions

What can explain the difference in results under Rogers v. Hill and In Re Walt Disney Co. other than the passage of 65 years and, perhaps, changing perceptions of what constitutes corporate waste in the context of executive compensation? Following are some observations on this point:

1. Ovitz's agreement was the result of an arm's length negotiation that resulted in Ovitz's agreeing to join Disney and thereby giving up his position at Creative Artists Agency, which he had founded, and from which he reputedly received cash payments each year in excess of $30 million. It is reasonable to assume that without such a severance package Disney would not have succeeded in attracting Ovitz from Creative Artists.

2. A by-law net profits bonus adopted by shareholders nearly a decade before the beginning of the years in question (and nearly two decades before the end of the period in question) is a rather insensitive compensation instrument for measuring executive pay year after year. While shareholders could repeal the by-law, it may not have been an easy task for a dissenting shareholder to obtain a new vote by shareholders on the by-law.

Assume that in 1998 the Delaware Chancery Court addressed the facts in Rogers v. Hill except that the bonus plan, instead of a by-law adopted by shareholders, was a plan adopted by the board of directors two decades earlier that had not been re-examined by the board since its original adoption. Perhaps a Delaware court might find in such circumstances that the bonus was subject to court review, not because of size alone but because of a 20-year absence of attention to whether it continued over such period to provide an appropriate formula.

Such a court might find that these circumstances did not reflect a reasonable exercise of business judgment by the board of directors. In that case, a complainant might overcome the presumption of the business judgment rule, even in a Delaware court, on the basis of an unreasonable absence of attention over a lengthy period of time, rather than on the basis of the size of the award alone.


1 In Re Walt Disney Co., C.A. No. 15452 (Del. Ch. Oct. 7, 1998), 1998 Del. Ch. LEXIS 186. Notice of Appeal was filed with the Supreme Court of Delaware on Nov. 4, 1998.

2 Id. at 2-3. (Lexis citations preceded by an asterisk are to screen/page numbers assigned in the database.)

3 Id. at 4.

4 Id. at 4-5.

5 Id. at 14 (citing Aronson v. Lewis, 473 A2d 805, 815 [Del.1984]).

6 Id. at 17.

7 Id. at 40.

8 Id. at 41.

9 Id. at 41-42 (language in quotation marks is from Aronson v. Lewis, 473 A2d at 814).

10 Id. at 43 (quoting Glazer v. Zapata Corp., 658 A2d 176, 183 [Del. Ch. 1993]).

11 Id. at 45.

12 Id. at 47.

13 Id.

14 Id. at 48-49.

15 Rogers v. Hill, 289 U.S. at 591-92 (language in quotation marks is from dissenting opinion in earlier decision in same case handed down by Court of Appeals for the Second Circuit).

16 Id. at 591.