Major corporate transactions such as asset sales, mergers, and acquisitions are complex undertakings that require a high degree of skill and attention from the corporation’s managers. As a result, directors properly may structure officers’ compensation to reward their extraordinary efforts in connection with such transactions. At the same time, managers who realize they soon may be out of a job have a tendency to begin lining up their next act, in ways that may be contrary to the best interests of the shareholders they currently serve.
When do compensation plans run afoul of managers’ fiduciary duties to stockholders? While the analysis in a given case can be complex, two considerations are paramount: (1) whether the plans leave stockholders in at least as good a position after a transaction as they were in before the transaction; and (2) whether independent decisionmakers acted in good faith on the basis of material information.
“Entire Fairness” Review of Interested Transactions and the Safe Harbor of DGCL Section 144
Section 141 of the Delaware General Corporation Law (“DGCL”) sets forth the foundation of corporate governance: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors … .” 8 Del. C. § 141(a). Because boards ultimately are responsible for corporate governance, courts typically begin their analysis of board decisions by recounting the “business judgment rule”: “It is a presumption that in making a business decision the directors of a corporation acted on an informed basis in good faith and in the honest belief that the action taken was in the best interests of the company … Absent an abuse of discretion, that judgment will be respected by the courts.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000).
When directors or managers are interested in a transaction – that is, when their self-interest diverges from their fiduciary duties to stockholders – courts will apply the “entire fairness” standard of review, which shifts to directors and managers the burden of proving that the challenged transaction was the product of fair dealing, and resulted in a fair price. Weinberger v. UOP, Inc., 457 A.2d 701, 710-11 (Del. 1983). While DGCL Section 144 provides several avenues for directors, officers, and controlling stockholders to “cleanse” conflicted transactions, such avenues are not always available (or taken). Resulting cases employing the “entire fairness” standard are instructive regarding what the Delaware courts look for in analyzing compensation plans amidst shareholder allegations of fiduciary duty breach.
Executive Compensation That Withstood Scrutiny
In In re Trados Inc. Shareholder Litigation, the Delaware Chancery Court held that even though the sale of the corporation and a generous Management Incentive Plan (“MIP”) resulted in common stockholders receiving nothing for their shares, the directors’ approval of the merger was nonetheless fair. 73 A.3d 17 (Del. 2013). Trados was a software company that developed proprietary desktop software for translating documents. The cap table included preferred stockholders – including VC investors – who were entitled to a liquidation preference in the form of accumulating dividends, and who appointed two directors to the board. The company was barely profitable and the VC investors were ready for an exit. The board fired the CEO, hired a new CEO with experience readying a company for sale, and incentivized the new management team with an MIP that rewarded management with a significant portion of the proceeds from an eventual merger. 73 A.3d at 26-29. The Board eventually approved a merger for $60 million in cash and stock, with those earnings allocated among the MIP participants and dividends to preferred stockholders. 73 A.3d at 33. Common stockholders received nothing in the transaction, and a common stockholder sued the board. Id. at 34.
Because the board did not use a special committee to cleanse the merger approval, the Court applied the entire fairness standard of review. The Court found that the merger process was not fair to common stockholders, with the MIP pitting management’s self-interest against the interests of the common stockholders. 73 A.3d at 58-62. Nonetheless, the Court ultimately held that the merger transaction was fair because the common stockholders’ shares were effectively worthless both before and after the transaction: “The common stock had no economic value before the Merger, and the common stockholders received in the Merger the substantial equivalent in value of what they had before.” 73 A.3d at 78.
Lesson: In analyzing a compensation plan, courts will look beyond the ultimate value of the corporation’s shares (even if that value is zero), to determine whether the challenged plan adversely impacted that value.
Executive Compensation That Failed Scrutiny
Unsurprisingly, the very managers tasked with negotiating a corporate transaction are themselves often by the prospect leveraging the transaction for their own personal gain. In City of Fort Myers General Employees’ Pension Fund v. Haley, the CEO of Towers Watson & Co. was offered a five-fold increase in his compensation by a potential acquirer if the deal went through and he took control of the post-merger company. 235 A.3d 702, 704-05 (Del. 2020). Haley did not disclose this offer to the Towers Board. Id. Plaintiff stockholders alleged this warped Haley’s incentives and caused him to seek the bare minimum for the Towers that was sufficient to gain shareholder approval. Id.
The Delaware Supreme Court held that plaintiffs adequately alleged that Haley had breached his fiduciary duty by failing to disclose his compensation arrangement to the Board. “Plaintiffs have adequately alleged that the Board would have found it material that its lead negotiator had been presented with a compensation proposal having a potential upside of nearly five times his compensation at Towers, and that he was presented with this Proposal during an atmosphere of deal uncertainty and before they authorized him to renegotiate the merger consideration.” 235 A.3d at 719.
Related cases demonstrate the importance that committees established to cleanse conflicted bonuses themselves be conflict-free. In Valeant Pharmaceuticals International v. Jerney, a corporation’s board and its president paid themselves large cash bonuses in connection with a corporate restructuring. 921 A.2d 732 (Del. Ch. 2007). The plan to award bonuses to the directors was referred to a compensation committee, comprised of three directors who themselves stood to receive bonuses under the proposal. All defendants settled with the special litigation committee that took over the former stockholder derivative action, except former president Jerney. 921 A.2d at 735-36.
Defendant Jerney conceded in the case that the entire fairness review standard applied because there was no independent committee to approve the conflicted bonuses. 921 A.2d at 745-46. The Court of Chancery ultimately held that Jerney failed to prove that the process for awarding the bonuses was fair and failed to prove that the price terms were fair. The Court ordered Jerney to disgorge the full amount of his $3 million bonus, plus interest. Id. at 752. The Court also ordered Jerney to pay his share of the special litigation committee expenses incurred by the company and the advanced attorneys’ fees the company expended on his failed defense. Id. at 754-55.
Lesson: In analyzing a compensation plan, courts will look beyond the terms and impact of the plan to the people or bodies that authorized the plan, and whether they acted in good faith and on the basis of all material information.
Conclusion
Directors and officers of Delaware corporations are tasked with fiduciary duties of care, loyalty, and good faith to their shareholders. These duties sometimes get ignored or violated when personal compensation to directors or officers creates conflicts of interest. Although Delaware law creates mechanisms to cleanse conflicted transactions, those tools only work when independent directors – or, when required, stockholders – act in good faith and approve a conflicted transaction with the benefit of all material information.
For more information regarding Alto Litigation’s litigation practice, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, Joshua Korr, or Kevin O’Brien.
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