(FORTUNE Magazine) – In Fall 1996, Michael Eisner, the chairman and CEO of Walt Disney Co., decided he had made a big mistake. Just a year earlier he had hired Hollywood power broker Michael Ovitz as Disney's president. Ovitz had flopped, badly. The men needed to find a way to disengage without unduly embarrassing either of them.

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, you may recall, 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."

To be sure, the Disney case will not by itself change the way boards do business. But it's one more reason directors need to take their jobs more seriously in the aftermath of Enron, WorldCom, and Sarbanes-Oxley. 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.

To understand why the Disney case matters, you need to know a little about Delaware. The economy of this tiny state--it's just 30 miles across and 100 miles long--consists largely of DuPont, banking, beaches, and the business of corporate law. Companies choose to incorporate there because since 1899 the state government has made it easy for them to do so. Back then other states required a special act of the legislature to form a corporation. Delaware asked only for a few forms and a small filing fee.

Those fees began to add up. Today tax revenues from the 400,000 firms incorporated in Delaware bring in about $500 million, or about 20% of the state budget. Wilmington law firms keep busy with corporate cases too. It's no wonder Delaware's legislators and judges have been as hospitable to corporations as its coastal resorts are to the Washington families who flock there every summer.

Rarely have the Delaware courts rendered judgments that displeased corporate executives or compliant boards. In a 1985 case known as Smith v. Van Gorkom, directors were found to have neglected their fiduciary duty when they approved a CEO's decision to sell a company on what the judge called an "uninformed" basis. So startling was this verdict that the New York City takeover attorney Martin Lipton suggested, in a memo to clients, that "perhaps it is time to migrate out of Delaware." The memo became public, as surely it was supposed to. The Delaware courts got the message and resumed their management- friendly ways.

Typically executives and directors are protected by an oversized legal umbrella known as the business judgment rule. It says, in essence, that courts should not second-guess business decisions if they are made in good faith and with the best interests of the company in mind. In practice this has meant that a corporate director who was merely stupid, lazy, or inattentive had little to fear in the courtrooms of Delaware. "Unless the directors did something tremendously horrible, they weren't going to lose the protection of the business judgment rule," said Ira Bogner, a partner at Proskauer Rose in New York who specializes in executive compensation.

That's why few people took notice when the firm of Milberg Weiss filed its derivative lawsuit against Disney in January 1997, days after Ovitz had left. (A derivative lawsuit is one filed by shareholders, acting on behalf of a company, that seeks redress against directors and officers.) Lawsuits are filed all the time, and no one expected this one to go anywhere, even if it came from the firm led by William Lerach, the most feared tort lawyer in America. This was 1997, after all. Enron was a hot stock, corporate governance was a snooze, and no one outside Maryland or Ohio knew Sarbanes or Oxley. The Disney case was, in fact, initially dismissed by the Court of Chancery, the state's lower court. But Delaware's Supreme Court kept it alive, saying that the complaint, while "inartfully drafted," raised "very troubling" issues. The court noted that the payment to Ovitz was "exceedingly lucrative" and that the board's process appeared to be "casual, if not sloppy and perfunctory."

In January 2002--after the world had changed--the plaintiffs refiled the suit. By then Sarbanes-Oxley and new governance rules proposed by the stock exchanges had put Delaware on the defensive. If the state was perceived to be doing a less-than-rigorous job of protecting shareholders, the federal government might take more responsibility for corporate law, thereby eroding Delaware's power.

Such shifts in the political climate have a way of seeping into the judicial process, says William Allen, a former Delaware Chancery Court judge who is now a professor of law and business at New York University. "It would not be unreasonable to assume that the Delaware courts are responding to the Enron and WorldCom headlines and the intrusion, so to speak, of the federal government into the internal governance of corporations," he says. During a roundtable discussion published this year by Harvard Business Review, E. Norman Veasey, chief justice of the Delaware Supreme Court, said, "Directors who are supposed to be independent should have the guts to be a pain in the neck and act independently." Clearly, the climate in Delaware has changed.

For a court system seeking to reassert its relevance, the facts alleged by the Disney complaint, were irresistible. According to the complaint, Eisner was advised by three directors--Stephen Bollenbach, Sanford Litvack, and Irwin Russell--not to hire his old friend Ovitz. He opted to do so anyway. And he hired Russell, his personal lawyer, to represent Disney in its negotiations with Ovitz. Russell was paid $250,000 for his work. Russell then sat on the compensation committee that approved Ovitz's hiring based on a summary of the deal. No written contract went before the board. Ovitz's contract was then altered in his favor without board approval. The board did not retain a compensation expert to analyze Ovitz's deal, the complaint alleges.

When it became clear that Ovitz was not working out, Eisner "was willing to elevate his friendship with Ovitz over Disney's interests" and "capitulated to his friend's desire to leave" on favorable terms, the complaint alleges. The board, it appears, did not try to negotiate with Ovitz to obtain better terms for the company and its shareholders. Instead, the complaint says, the directors "adopted a supine attitude in acquiescing to the lopsided severance that the conflicted Eisner had negotiated with his friend." The suit says Ovitz's payout was worth more than what he would have earned if he had kept coming to work for the rest of his five-year contract. "How you get into trouble," says Steven Schulman, the lawyer for the shareholders, "is if the executive runs the company and then the directors just meet once in a while and casually check things out, at the invitation of the CEO."

These are all, it must be said, unproven charges. A Disney spokesperson told FORTUNE that Eisner and the directors would not talk about the case. Ovitz's lawyer, too, declined requests for comment. Still, judge Chandler's decision to grant a trial must have made for sobering reading in the Mouse House. While noting that the facts of the case remain disputed, Chandler wrote: "It is rare when a court imposes liability on directors of a corporation for breach of the duty of care, and this court is hesitant to second-guess the business judgment of a disinterested and independent board of directors. But the facts alleged in the new complaint do not implicate merely negligent or grossly negligent decision-making by corporate directors. Quite the contrary; plaintiffs' new complaint suggests that the Disney directors failed to exercise any business judgment and failed to make any good-faith attempt to fulfill their fiduciary duties to Disney and its stockholders."

Corporate lawyers have interpreted Chandler's decision as a strong signal that boards must take their duties more seriously. Charles Elson, the director of the Center for Corporate Governance at the University of Delaware, sees "a real shift to a much more balanced, nuanced approach to governance. They are clearly giving more weight to the shareholder side." Says Bill Allen, the Delaware judge turned law professor: "This is clearly a signal to directors of public companies that they need to be engaged."

How is the Disney suit likely to turn out? It's hard to say. Ovitz and Eisner will be deposed this month, and a trial is scheduled for early 2004. But most shareholder lawsuits don't go to trial. They are costly for plaintiffs and embarrassing for defendants. While settlement talks have begun in the case, "everyone is very, very dug in," an insider tells FORTUNE. It is theoretically possible that directors could be held personally liable for the costs of a settlement or judgment. It's most likely though that the costs would be paid by a group of insurance companies led by National Union, a unit of American International Group, which wrote Disney's policies to protect officers and directors from liability.

A big obstacle to a settlement is that the plaintiffs are asking for a lot more than money. They feel so confident about the case that they are trying to make Disney a poster child for board reform. To that end Schulman has hired shareholder activist Robert A.G. Monks and his law firm to advise them. Monks would like to see all the directors who approved the Ovitz deal leave the board, and he wants Disney to appoint a strong, independent board chairman to replace Eisner. "Wrongs have been committed in this case, and there ought to be accountability," says Rick Bennett, a colleague of Monks's who is advising the plaintiffs.

While Disney has enacted governance reforms in the post-Ovitz era, Eisner so far has been unwilling to give up power. He beat back a boardroom rebellion last year led by directors Roy Disney and Stanley Gold. Partly because Disney's stock is up by about 34% in 2003, Eisner has regained the solid support of a majority of the board, and insiders say he is closely managing Disney's handling of the lawsuit. "The culture at Disney remains very executive-centric, Eisner-centric," says plaintiffs lawyer Schulman.

In that sense nothing has changed at Disney. But the world around the company is changing, unmistakably, for the better. No matter what the outcome of this lawsuit, boards of directors today are going to have to do a better job of representing shareholders. What a radical idea. How odd that this Hollywood story that won't go away may be giving us a happy ending.