As the pages of the Wall Street Journal fill with reports of lucrative compensation packages awarded to high-flying executives, frustrated stockholders turn to filing derivative cases challenging such largess as corporate waste. Always skeptical of waste claims, which “police the outer boundaries of the broad field of discretion afforded directors under the business judgment rule,” two recent decisions of the Court of Chancery remind stockholders of the extremely high bar one must meet to plead a waste claim and affirm the deference Delaware Courts give to boards of directors in setting executive compensation. Issued in June, the Court of Chancery in both Seinfeld v. Slager (the “Republic Services Case”) and Zucker v. Andreessen (the “HP Case”) dismissed at the pleading stage waste claims challenging generous compensation packages awarded to outgoing executives.
In the Republic Services Case, Seinfeld challenged, among other actions, the board’s decision to pay a $1.8 million severance payment and a $1.25 million incentive payment to the company’s outgoing chief executive because the payments were made without consideration and the board failed to minimize the tax impact of the incentive payment. Following motions to dismiss pursuant to Court of Chancery Rule 12(b)(6) for failure to state a claim upon which relief can be granted and Court of Chancery Rule 23.1 for failure to make a demand on the corporation or adequately plead demand futility, Vice Chancellor Glasscock dismissed plaintiff’s waste claims. The Court denied defendants’ motion to dismiss an unrelated breach of fiduciary duty claim relating to the board’s decision to award itself certain stock options under a vaguely-defined, stockholder approved, employee compensation plan.
As Vice Chancellor Glasscock explained in the Republic Services Case, to state a claim under Delaware law, a plaintiff must pass a minimal burden and the Court will not grant a motion to dismiss “unless the plaintiff would not be entitled to recover under any reasonably conceivable set of circumstances.” Recognizing the broad discretion of the board of directors of a Delaware corporation to manage the affairs of the company, and thus decide whether to “initiate or refrain from initiating legal actions,” Court of Chancery 23.1 imposes a “more arduous pleading standard” and requires that a derivative plaintiff either make a pre-suit demand that the board bring the action or allege “sufficient particularized facts showing that a demand on the board would have been futile.” To meet this burden under the seminal Aronson v. Lewis test, a derivative plaintiff must allege particularized facts that give the Court a reason to doubt that the directors are disinterested and independent or the challenged transaction was the product of a valid exercise of business judgment.
The Court then outlined the high standard a plaintiff must plead to state a waste claim under Rule 23.1. To state a claim for waste, the plaintiff must allege that the defendant directors authorized a transaction that is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation received adequate consideration. If the corporation receives any substantial consideration and the board made a good faith, albeit ill-advised, judgment that the transaction was worthwhile, a waste claim must fail. By definition, a plaintiff who successfully alleges a waste claim will by definition satisfy the second prong of the Aronson demand futility test.
Before turning to the substantive claims in the Republic Services Case, and without considering the factual predicate for the claim, the Court rejected Seinfeld’s unsupported contention that the board’s failure to minimize the tax consequences of the incentive payment constitutes a per se waste of corporate assets. Noting the variety of reasons why a company might decline to take advantage of certain tax savings, the Court concluded that a company’s adoption and execution of tax strategy “typifies an area of decision-making best left to management’s business judgment.” While the Court did not foreclose the possibility that an improvidently approved transaction, resulting in a higher than necessary tax burden, could theoretically result from a breach of fiduciary duty, the Court declined plaintiff’s invitation to sustain a corporate waste claim based simply on an allegation that defendant directors failed to pursue a tax minimizing strategy.
The weakness of plaintiff’s argument was further compounded by his concession that the board intended to minimize the tax liability from the challenged incentive payment of $1.25 million. Only by assuming that a revenue ruling issued by the Internal Revenue Service upon which the board relied is wrong and would be superseded by a correct ruling or court order could plaintiff even allege that the incentive payment caused the company adverse tax consequences. The Court declined to sustain plaintiff’s waste claim based on alleged tax ramifications that have not actually occurred, especially where the record is devoid of any evidence “suggesting when, if ever, they will occur.”
The Court also dispatched with plaintiff’s claim that the $1.8 million severance payment was retroactive compensation unsupported by adequate consideration (and therefore waste) because it “is clear from its explicit terms that it provided the cash bonus as part of a package intended to secure a general release, to provide continuity in the board, and to ensure that [the former CEO’s] separation from the Company was amicable. While retroactive payments can conceivably form the basis of a waste claim, the Court recognized that a company may have a variety of reasons for awarding a severance or retirement bonus. In reaching this conclusion, the Court observed that severance payments may encourage other employees to work hard in exchange for the possibility of extra compensation at the end of their tenures, ensure a smooth and harmonious transfer of power, secure a good relationship with the outgoing executive, and avoid embarrassing disclosures and expensive lawsuits – all of which provide value to the corporation. The Court also emphasized that retroactive bonuses are not per se impermissible where the amount awarded is not unreasonable in view of the services rendered. As a result, the Court refused to sustain a waste claim based solely on plaintiff’s allegation that the severance payment was not contractually required (i.e. voluntary) and lacked adequate consideration.
The HP Case addressed the propriety of a severance package paid to the company’s former chief executive officer valued at over $42 million. The circumstances surrounding Mark Hurd’s departure from the company are well documented. In June 2010, a HP contractor alleged that Hurd sexually harassed her and accused Hurd of falsifying expense reports and disclosing to her the company’s then-prospective and confidential acquisition of Electronic Data Systems. The board promptly hired counsel to investigate the allegations. Though the internal investigation did not find evidence of sexual harassment, it did reveal that Hurd falsified expense reports in order to hide his relationship with the consultant in violation of the company’s standard of business contact. As a result of these findings, members of the board expressed uncertainty about Hurd’s ability to continue to lead the company.
Hurd reached a confidential settlement with the consultant, but the damage was done. Though two members of the board were hesitant, the board unanimously decided to terminate Hurd as the company’s chief executive. Contemporaneously with his termination, HP and Hurd entered into a severance agreement worth approximately $42 million. In exchange for the severance payment (in the form of cash and stock options and grants), Hurd agreed to extend certain confidentiality agreements with the company, not to disparage the company, to cooperate with the company regarding the transition and possible future legal issues, and to release any claims he ever had, then had, or may have in the future against the company. The HP Case followed the public announcement of the severance agreement, which challenged (without making pre-suit demand) the board’s approval of the severance agreement as waste.
Vice Chancellor Parsons explained the difficult standard a plaintiff must meet to plead a waste claim under Rule 23.1: “Pleading waste requires a showing that the board’s decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation’s best interests.” Alleging waste requires a particularized showing that the consideration was so disproportionately small that it could not serve any corporate purpose. In granting the motion to dismiss, the Court again deferred to the business judgment of the independent board. As the Court explained, “while the discretion of directors in setting executive compensation is not unlimited, it is the essence of business judgment for a board to determine if a particular individual warrants large amounts of money, whether in the form of current salary or severance provisions.”
Applying this precedent, the Court rejected plaintiff’s characterization of the severance payment as a gift, noting the company obtained “at least some consideration” from Hurd in the form of expanded confidentiality agreements, a non-disparagement agreement, cooperation in transitioning to a new chief executive, and a release of claims relating to Hurd’s termination. The Court also explained that the company could have awarded the severance payment to Hurd as compensation for past performance and emphasized that his departure was not related in any way to the company’s operational performance or financial condition, both of which remained strong. Finally, the Court speculated that the severance agreement overcame certain directors’ reluctance to terminate Hurd, making the termination decision unanimous when unanimity was particularly important to the company from an investor relations perspective. Considering all of these factors, the Court dismissed the waste claim because the plaintiff could not raise a reasonable doubt that the severance payment was the product of a valid exercise of the board’s business judgment.
The Republic Services and HP cases are emblematic of the difficulties derivative plaintiffs will face when challenging compensation decisions made by an independent board as waste. Believing that market should determine executive compensation, and that informed directors are better able to assess market trends than Courts, Delaware law will continue its deferential approach to compensation review. While directors should remain mindful of potentially adverse stockholder reactions to excessive compensation awards, especially for out-going executives whose on-going value is less than clear, Delaware courts will not lightly second guess compensation decisions. Rather than waste their time (and their company’s money), stockholders frustrated with excessive compensation should look to other remedies (say on pay initiatives and similar ballot initiatives) to prevent perceived largess because the hurdles to plead a waste claim successfully are simply too high.
Reprinted with permission from the August 8, 2012 issue of Delaware Business Court Insider. (c) 2012 ALM Media Properties, LLC. Further duplication without permission is prohibited.