Risk Management

Courts and Torts: Vetting Compensation

''It would have been a great defense'' for Disney's embattled board members to show that the chief financial officer was present at meetings of the...
Marie LeoneNovember 30, 2004

Even the The Incredibles would have a hard time rescuing the Walt Disney Co.’s compensation committee from their current predicament. In a trial eight years in the making, Disney shareholders are seeking $200 million in damages from board members and one-time president Michael Ovitz, alleging that the board failed to vet Ovitz’s controversial compensation package.

“It would have been a great defense” for Disney’s embattled board members to show that the chief financial officer was present at meetings of the compensation committee, says Stephen Skonieczny, an attorney with law firm Dechert LLP. That would be especially true if the finance chief had “laid out the economic impact of Ovitz’s compensation package” before the board approved the deal, but even a quick financial analysis would have helped to assure shareholders that the compensation committee was taking the matter seriously.

As it turned out, shareholders are alleging in Delaware Chancery Court that directors “blindly” approved Ovitz’s employment agreement in 1995 without following a process or showing a “good faith effort” to fulfill their fiduciary responsibilities. The agreement included a hefty severance arrangement worth $140 million that was paid out when Ovitz was fired in 1996 — only 14 months after accepting the job.

The lawsuit claims that not only did board members fail to review or deliberate the employment agreement, but also that the board left the final contract details to Disney chief executive officer Michael Eisner, a longtime friend of Ovitz.

“There’s not a CEO in America that would botch a hire the way Eisner did,” avers Brian Sullivan, chairman and chief executive of search firm Christian and Timbers. The hiring of Ovitz was “damn near an acquisition for Disney — easy to do, not easy to integrate,” quips Sullivan, who believes that Ovitz was the wrong fit from the start.

Sullivan stresses that the Disney lawsuit is an extreme case and that in a post-Enron environment of heightened governance, it’s not likely to happen again. Nevertheless, contends Skonieczny, shoring up executive-hiring processes “isn’t a bad idea.”

One big reason: The Disney case called into question the business-judgment rule, which has given boards wide latitude to make decisions without fear that courts will second-guess their judgment, as long as they observe their duties of loyalty and due care. (See CFO magazine’s February article “Judgment Calls.”)

Originally, the chancery court agreed with Disney that the business-judgment rule was reason enough to dismiss the case, but after a review by the Delaware Supreme Court, the lower court reversed its stance. According to an opinion memo from the chancery court, the reversal reflected the shareholder’s claims that the compensation committee members failed to exercise “any business judgment” or make “any good faith attempts” to fulfill fiduciary duties. Skonieczny and other observers contend that if Disney directors had employed using a sensible review process when hiring Ovitz, the shareholders would have had a hard time making that case.

Should the chancery court find for the plaintiffs, the defendant directors could be held personally liable for damages, and they might also might face exclusion from directors and officers’ insurance coverage.

Considering all that’s at stake, calling for more finance expertise in the boardroom seems like a relatively simple solution to the problem. Some internal process-tweaking would probably be required, however; chief financial officers generally don’t make a personal appearance when the board evaluates the proposed compensation for a top hire. That task usually falls to the general counsel, outside counsel hired by the board, and a compensation consultant, while the CFO commonly reviews the numbers with the general counsel ahead of time. Skonieczny recommends that the CFO “show up in person” to provide immediate responses to board members’ financial questions.

Even if the CFO’s appearance is merely “a 15-minute presentation,” adds Skonieczny, that personal touch could prove invaluable in documenting the process. Court papers filed by Disney shareholders point out that the board minutes do not reflect that the compensation committee made any recommendations, or that it reported to the full board, about its resolution to hire Ovitz under the generous terms of the contract.

Skonieczny acknowledges that only fairly powerful CFOs would be able “inject” themselves into the board’s compensation proceedings; until now, “the CFO has been considered the least necessary executive” to invite to those deliberations. But considering Disney’s travails over the past eight years, perhaps another such omission would be less than “incredible” and more like “flubber.”

Marie Leone’s “Courts and Torts” column appears monthly. Contact her at [email protected].

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