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).
But where officers or directors have a financial interest in a transaction, Delaware courts may impose 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). At the same time, Section 144 of the DGCL provides means by which liability may be avoided in a conflicted transaction. For example, liability may be precluded if the transaction is approved by a majority of disinterested directors or by a committee of at least two directors (each of whom is disinterested), or if the transaction is approved by an informed, uncoerced majority vote of disinterested stockholders.
There are cases, however, in which a company argued that the business judgment rule applied but the courts rejected this assertion and concluded that the entire fairness standard controlled. These cases are instructive regarding what the Delaware courts look for in analyzing compensation plans amidst shareholder allegations of fiduciary duty breach.
Trados
In re Trados Inc. Shareholder Litigation, 73 A.3d 17 (Del. 2013), concerned a company that developed proprietary desktop software for translating documents. The company’s 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 decided to exit the investment. The board fired the CEO, hired a new CEO with experience readying a company for sale, and incentivized the new management team with a management incentive plan (“MIP”) that would reward management with a significant portion of the proceeds from a future merger. Id. 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. Id at 33. Common stockholders, meanwhile, received nothing, and brought suit. Id. at 34.
The court held that directors owed fiduciary duties to common stockholders, and not to preferred stockholders who hold mere contractual rights. Because the directors who approved the transaction were conflicted, 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. Id. at 58-62. Nonetheless, the Court ultimately held that the price 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.” Id. at 78.
Lesson: Trados established the principle that directors owe their fiduciary duties to common stockholders, not preferred stockholders. But although the sale process was unfair, and the common stockholders received nothing, the price was still fair. Notably, the use of a special committee comprised of disinterested directors may have avoided the application of the entire fairness standard and saved both the company and the individual defendants a great deal of litigation expense and heartburn.
Approval of Executive Compensation Plans
As shown by the Trados case, the very managers tasked with negotiating a corporate transaction may structure the transaction for their own personal gain. City of Fort Myers General Employees’ Pension Fund v. Haley, 235 A.3d 702, 704-05 (Del. 2020), is another example. In that matter, Towers Watson & Co. was faced with shareholder and market opposition to a potential acquisition. The acquirer then offered Towers’ CEO (Haley), a five-fold increase in his compensation if the deal went through and he took control of the post-merger company. Haley did not disclose this offer to the Towers Board. Plaintiff stockholders alleged this offer warped Haley’s incentives and caused him to seek the bare minimum deal that would gain shareholder approval.
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.” Id. at 719.
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 except one—former president Jerney—settled with the special litigation committee that took over the former stockholder derivative action. Id. at 735-36.
Jerney conceded that the entire fairness review standard applied because no independent committee of disinterested directors had approved the conflicted bonuses. Id. at 745-46. The Chancery Court held that Jerney failed to prove the fairness of either the process for awarding the bonuses or the price terms. Although Jerney was not the sole decisionmaker in negotiating the restructuring bonuses, he breached his fiduciary duties by participating in a process that lacked fairness. The bonuses were not supported by any relevant market evidence, and his reliance on expert advice was unavailing because the entire process was tainted by self-interest. The court ordered Jerney to disgorge the full amount of his $3 million bonus, plus interest, and to pay his share of the special litigation committee expenses and defense costs incurred by the company. Id. at 754-55.
Conclusion
Directors and officers of Delaware corporations are tasked with fiduciary duties of care and loyalty to their companies and shareholders. These duties are ignored or violated when compensation plans for directors or officers create conflicts of interest. Although Delaware law creates mechanisms to cleanse conflicted transactions, those tools only work when independent directors or stockholders 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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