The rights and wrongs Ovitz

Corporate governance in America

Aug 11th 2005
From The Economist print edition

What the Disney verdict means for boards of directors

IF NOTHING else, the lawsuit concerning the hiring and firing of Michael Ovitz by the Walt Disney Company has ensured that corporate-governance can never again be dismissed as irredeemably boring. The trial, although concerning events at the media giant in 1995-96, commanded acres of space in the sorts of gossipy society magazines that had not hitherto been interested in the nuances of directors' fiduciary responsibilities to shareholders.

The trial, before Delaware's Court of Chancery, generated much colourful detail, most of it highly embarrassing to all concerned, especially Mr Ovitz and Disney's then chief executive, Michael Eisner, who fell out spectacularly with the longtime friend he had hired as his number two and ended up 14 months later paying a package worth $140m to go away.

However entertaining, the case did nothing for the Disney shareholders—and the usual bunch of class-action lawyers—who brought it. This week, a judge rejected their claims that members of Disney's board of directors breached their fiduciary duties to shareholders. This decision—especially given the overwhelming evidence produced in the trial that Disney's corporate governance was far below what would nowadays be considered adequate—was greeted with dismay by shareholder activists. That is unfair. In fact, the 174-page ruling, by Delaware's Chancellor, William Chandler, is full of common sense, and should be essential reading for anyone interested in good corporate governance.

Judge Chandler is clearly appalled by what passed for corporate governance at Disney in the mid-1990s. As he writes in one devastating paragraph:

By virtue of his Machiavellian (and imperial) nature as CEO, and his control over Ovtiz's hiring in particular, Eisner to a large extent is responsible for the failings in process that infected and handicapped the board's decision-making abilities. Eisner stacked his (and I intentionally write “his” as opposed to “the company's”) board of directors with friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally than truly independent directors.

As for the hiring of Mr Ovitz, on what was then possibly the highest package ever given to a non-boss, Judge Chandler concludes that “for the future, many lessons of what not to do can be learned from defendants' conduct here.” Given the importance of Delaware law to big American firms, most of which are incorporated there, expect those lessons to be widely learned. Indeed, this week's decision arguably means that directors will be legally liable in future if they do not learn them.

So why on earth were the defendants acquitted? Put simply, the judge distinguished between getting a decision wrong, and doing wrong—a crucial distinction that has sometimes seemed to be ignored during America's backlash against bosses in recent years. The decision to hire Mr Ovitz clearly turned out to be a poor one, such that firing him—even at a cost of $140m—was probably the right thing to do. But taking poor decisions is not by itself a breach of a director's, or an entire board's, fiduciary duty of care to shareholders. Under Delaware's “business judgment” rule, directors are protected if they can be shown to have followed proper procedures and done so in good faith. The worst that can be said of Disney's directors, concluded Judge Chandler, fairly convincingly, was that they did not act in bad faith, but may have been guilty of “ordinary negligence”—which, under the business judgment rule, is not enough to breach fiduciary responsibility.

There had been fears that a ruling against Disney's board would have been seen as a mortal blow to the business judgment rule, leading to a paralysing risk aversion in American boardrooms as directors minimised their legal exposure. If so, said Judge Chandler, who clearly shared those fears: “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.”

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