A lawsuit by Disney shareholders is shaking up much more than just Disney. Thanks to a Delaware court ruling, less-than-conscientious board members everywhere are running scared. Michael Ovitz’s $101 million severance package from Disney seven years ago has taken on a new significance for directors everywhere. A Delaware judge has ruled that Disney’s directors failed to make a good faith effort to do their job when they approved the Ovitz contract and – once again – when they gave him all that exit money. It’ll take more than a good bit of animation to get the Mouse House out of this.

In fall 1996, Michael Eisner, the chairman and CEO of Walt Disney Co. wrote a three page letter to Michael Ovitz, his new Disney president.

In a three-page, handwritten letter dated Oct. 9, 1996, Eisner proposed an amicable separation to Ovitz, a friend who had literally stood by him after his coronary-bypass surgery two years earlier.

“We must work together to assure a smooth transition and deal with the public relations brilliantly,” Eisner wrote. “I am committed to make this a win-win situation, to keep our friendship intact, to be positive, to say and write only glowing things. You still are the only one who came to my hospital bed—and I do remember.”

“This all can work out!”

It has not worked out—not even close. Ovitz walked away with a severance package that was generous even by entertainment-industry standards. For 15 months of labor, he got $38 million in cash, plus stock options valued at $101 million.

That package caused an uproar and triggered a lawsuit by Disney shareholders, who want their money back. Since then none of them—not Ovitz, not Eisner, not the company, not shareholders—has fared very well. Ovitz’s next venture failed, Eisner’s reputation soured, and Disney shares currently trade at about $22 each, the same price as when Ovitz left in ’96.

We revisit this unhappy moment in Hollywood history seven years later not merely for its gossip value but because the shareholder lawsuit that it provoked has, improbably, taken on enormous significance for the boards of public companies. In a ruling issued in May that has become must-reading in corporate boardrooms, Delaware judge William B. Chandler III said that the suit can go to trial. His reason: The facts, as alleged, indicate that Disney’s directors failed to make a good-faith effort to do their job when they approved Ovitz’s contract and once again when they allowed him such a lucrative going-away present. The $140 million package represented nearly 10% of Disney’s net income in 1996.

The Disney directors who are defendants—there are 18 in all, including Eisner, Ovitz, and such well-known figures as former Senator George Mitchell, former Capital Cities CEO Thomas S. Murphy, and actor Sidney Poitier—all have been subpoenaed to testify. So have Hollywood bigwigs Sean Connery, Martin Scorsese, former Seagram chairman Edgar Bronfman, Revolution Studios chief Joe Roth, and Ron Meyer, Ovitz’s former partner at Creative Artists Agency. Lawyers for the shareholders want the directors to return the money that Ovitz was paid, plus interest, to Disney’s coffers. They also want Disney to radically shake up its board, stripping Eisner of his chairmanship and getting rid of the directors who, the lawsuit alleges, failed to do their jobs.

This is a big deal, and not just for Disney. Judge Chandler’s opinion has put directors of public companies on notice that the courts in Delaware, where more than half of the FORTUNE 500 are incorporated, are inclined to hold them to a higher standard of performance than has been expected in the past. Boards have enjoyed virtually unlimited protection from lawsuits, particularly on the issue of executive pay—until now. Says Scott Spector, a partner in the corporate group of the Silicon Valley law firm of Fenwick & West: “This case has tremendous importance at a time when executive compensation is under intense media and shareholder scrutiny.”

Already directors are feeling multiple pressures: Institutional investors are paying more attention to governance; insurance companies are asking more questions before they write policies that protect directors and officers of public companies from liability; shareholder lawsuits are proliferating; and regulators want to give shareholders access to proxy statements so that they can vote out the directors who are no more essential than a sprig of parsley on a filet of sole.

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