Mr. Toad's Wall Street Ride

For the past 12 years, excessive executive compensation has been at the forefront of corporate governance issues, particularly when corporate reform is discussed.

The Walt Disney Derivative Litigation, a 10-year legal saga from 1996 to 2006, brought this issue sharply into focus.

When the dust finally settled in that case, the Delaware Supreme Court upheld a court decision that Disney's board had acted in good faith when it obligated itself to pay a $140 million severance package to Walt Disney Co. executive Michael Ovitz, despite Ovitz having worked at Disney for little more than a year.

Other high-profile cases have since added fuel to the debate regarding the merits of large executive payouts, including the Eliot Spitzer-led lawsuit over Richard Grasso's $140 million deferred compensation pay package with the New York Stock Exchange.

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Executive compensation is again at the forefront of public debate with the market collapse. For a person trying to navigate through the latest news to emerge from Wall Street, the last few weeks have been a bit like being a passenger on Disneyland's Mr. Toad's Wild Ride. Everywhere you looked, a different financial institution came crashing into focus; the target of a buyout, bankruptcy, government takeover or rumors of the same. Not surprisingly, the huge executive compensation packages afforded these failed companies' CEOs became critical show-stoppers for the bailout package.

The time therefore seems ripe to re-examine the wild ride that has been executive compensation in the post-Disney litigation era.

As the nation's largest financial institutions were acquired, merged or declared bankruptcy, the executive compensation reportedly awarded these companies' failed CEOs remained enormously high. For example:

• The government seized mortgage giants Fannie Mae and Freddie Mac on Sept. 7. Nevertheless, ousted mortgage executives Daniel Mudd and Richard Syron will receive $5.64 million and $3.97 million in retirement benefits, respectively; princely sums for the man on the street.

• Venerable investment bank Lehman Brothers announced its bankruptcy filing on Sept. 14, the largest bankruptcy in U.S. history. Lehman's CEO, Richard Fuld, received a compensation package worth $71.9 million in 2007.

• Insurance conglomerate American International Group Inc. was forced to accept the federal government's ownership of 80% of the company in exchange for the Federal Reserve's loan of up to $85 billion. Earlier this year, its then-CEO, Martin Sullivan, received a severance package worth $47 million. But perhaps sensing the prevailing winds, Sullivan's successor, Robert Willumstad -- himself ousted as part of the federal government's loans to AIG after only a few months on the job -- rejected a severance payout valued at $22 million.

• Federal regulators seized Washington Mutual, the nation's largest savings and loan, on Sept. 25, preventing what would have been the largest bank failure in U.S. history. The next day, regulators announced its sale to J.P. Morgan Chase & Co. It was reported that Alan Fishman, WaMu chief executive for less than three weeks, is eligible to receive a $11.6 million cash severance, and intends to keep his $7.5 million signing bonus.

How did we get from the Walt Disney derivative litigation to here?

The legal standard governing executive compensation has been in place for more than seven decades. In Rogers v. Hill (1933), the U.S. Supreme Court established that overall compensation must be reasonable in proportion to the value of the services rendered. Over the years, Delaware state courts (the leading jurisdiction for corporate governance standards) have hewed closely to the Rogers v. Hill formulation. In examining whether an executive's compensation is proportionate to the services rendered, Delaware courts typically consider a variety of factors, including the executive's ability and experience, the level of compensation paid to others in similar circumstances, whether the compensation was "shocking," and whether the compensation meets Internal Revenue Service guidelines.

While the legal standard governing executive compensation has remained the same over the years, the compensation packages themselves grew exponentially. In this modern era in which corporations pay huge executive compensation packages--especially for sub-par performing companies--no other recent case provided as good an opportunity to re-examine excessive compensation as did the Walt Disney Derivative Litigation.

In 1994, Disney CEO Michael Eisner commenced negotiations with long-time friend and business acquaintance Ovitz for the position of Disney's president. Ovitz was a Hollywood power broker and co-founder of the privately held Creative Artists Agency. His annual compensation was more than $23 million a year as a Hollywood agent. To entice Ovitz to leave CAA and come to Disney, a public company, Ovitz was awarded a compensation package of $24 million per year: At the time, the richest pay package ever awarded a corporate officer. Under a "no-fault" provision of Ovtiz's employment agreement, Ovtiz was to receive a total package of compensation and options worth $140 million in the event he was terminated.

In fall 1996, just over a year after he joined Disney, Ovtiz clearly was a poor fit with the other Disney executives. Disney terminated Ovitz, but because Ovtiz was not accused of any wrongdoing, his enormous no-fault severance compensation kicked in. Disney shareholders immediately sued.

After 10 years of litigation, the Delaware courts let Ovitz keep his compensation, and the Disney board -- although he court took it to task for poor corporate governance practices -- was exonerated of all claims against its members. In their decisions, the Delaware courts afforded the Disney board the protection of the long-established "business judgment rule," a rule which protects corporate boards' decisions regarding executive compensation. The business judgment rule presumes that corporate boards act "on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company." This presumption can be rebutted if a plaintiff can show that a board breached its fiduciary duty of care or duty of loyalty to the company, or acted in bad faith.

By the time the Disney case was finally decided in 2006, new scandals like Enron and WorldCom had emerged. Although the Disney courts said they would not hold boards liable for failure to follow best practices, the courts did acknowledge that best practices evolve over time. This evolution means that at any given time, there is a minimum standard of practice below which a board should not fall. Thus the Disney courts acknowledged they had reviewed Ovtiz' compensation with reference to 1996 best practices, not the practices that had rapidly evolved after Enron and WorldCom.

Despite the recent outburst against executive compensation, the law remains that in the absence of a demonstration of bad faith, or a breach of the duty of care, or a showing of corporate "waste," directors setting executive compensation are entitled to the business judgment rule. It is therefore extraordinarily hard to address excessive compensation with existing legal standards. In response, the drafters of the bailout have been urged to include federal legislation to address the issue of executive compensation, particularly regarding executives of failed corporations. But resulting federal legislation will likely be narrowly focused. And federal legislation establishing general limits on CEO pay will no doubt engender strong opposition that will view such limits as anathema to the free-market underpinnings of the American economy.

Over the long-term, even though the Disney case upheld Ovitz's massive compensation package, individual state corporate law may nevertheless provide the best vehicle to address excess executive compensation on a prospective basis. This is because corporate governance will likely continue to evolve in the fashion Disney predicted: A board's fiduciary duties will remain the same, but best practices required to meet those duties are expected to change over time.

Given the unprecedented corporate failures, boards' business judgments will be increasingly challenged, and boards that have not recently considered the issue would be wise to re-examine their best practices concerning executive compensation. Certain executives will continue to command--and deserve--extremely high compensation packages. But a board's decision to award such a salary should be transparent and well-documented. Both the compensation committee and the full board's treatment of the issue should be memorialized. Some companies, like Apple Inc., have opened the matter to shareholder debate. Many others have considered performance-based compensation standards for executives, or a claw-back policy that requires executives to return their compensation if the company is required to restate earnings.

Twelve years later, perhaps the true legacy of the Disney case is that as times change, governance standards evolve. The Disney trial court said a "fiduciary's duties do not change over time" but "how we understand those duties may evolve ... ." A board's duties when setting executive compensation will remain protected by the business judgment rule, but over time, boards may be required to satisfy a higher standard of process before they approve large compensation packages. The evolution of that process is plainly occurring now.

L. Anthony Pellegrino is a litigator at the international law firm of Milbank, Tweed, Hadley & McCloy LLP. He practices in the firm's New York office.

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