The recent decision from the Delaware Court of Chancery in Williams v. Ji, C.A. No. 12729-VCMR (Del. Ch. June 28, 2017), provides important insights into the Delaware law applicable to challenges to voting agreements among stockholders, as well as to director compensation packages. (By the way, Happy July 4th to all my loyal readers. We should all stop to reflect on the blessings of liberty we enjoy on this Independence Day holiday.)
Background Facts: The allegations were based on a plan in which directors granted themselves options and warrants for the stock of five subsidiaries over which the corporation has voting control. Around the time those options were granted, the board transferred valuable assets and opportunities of the corporation to the subsidiaries. A stockholder challenged the grants as a breach of fiduciary duty due to the excessive value that was given in the form of compensation. The complaint also alleged that the voting agreements amounted to illegal vote buying to the extent that a stockholder was required to vote its shares in a manner that the board of directors instructed.
Issues Addressed: The key issues addressed included whether the business judgment rule or the entire fairness standard would apply to the decisions by the board to grant themselves options as a form of compensation, and whether or not the voting agreements were deficient in some manner. The court also addressed the issue of ripeness and whether or not the issues relating to the voting agreement were hypothetical because the voting agreement only represented a small percentage of the voting shares and did not determine the outcome of any elections to date.
Key Legal Principles Addressed: The court relied on a recent Delaware Supreme Court decision that defined ripeness to include claims that have “matured to a point where judicial action is appropriate.” Moreover: “a dispute will be deemed ripe if litigation sooner or later appears to be unavoidable and where the material facts are static.” (citing XL Specialty Ins. Co. v. WMI Liquidating Trust, 93 A.3d 1208, 1217 (Del. 2014), highlighted on these pages.) In this instance, the court found sufficient static material facts to determine whether entering into the voting agreement constituted a breach of fiduciary duty, and distinguished the decision in In re: Allergan, Inc. Stockholder Litigation, 2014 WL 5791350 (Del. Ch. Nov. 7, 2014), highlighted on these pages, because in that case the court dealt with an interpretation of a bylaw in a hypothetical situation that had not yet come to fruition.
Regarding the standard applicable to executive compensation decisions, the court explained the well-settled Delaware law that: “Self-interested compensation decisions made without independent protections are subject to the same entire fairness review as any other interested transaction.” (citing Valeant Pharm. Int’l v. Jerney, 921 A.2d 732, 745 (Del. Ch. 2007), highlighted on these pages). The court explained the well-known aspects of the entire fairness standard that include both fair dealing and fair price. The court also observed that application of entire fairness review typically precludes dismissal of a complaint on a Rule 12(b)(6) motion to dismiss. Where a complaint is adequately plead that the board lacks independence, and alleges a claim for excessive compensation, the plaintiff “only need allege some specific facts suggesting unfairness in the transaction in order to shift the burden of proof to defendants to show that the transaction was entirely fair.” (citing In re: Tyson Foods, Inc., 919 A.2d 563, 589 (Del. Ch. 2007), highlighted on these pages.) In this case, the court determined that the complaint satisfied that standard by pleading “some specific facts suggesting unfairness” in the options involved–thereby shifting to defendants the burden of proving that the grant of the options was entirely fair.
Regarding the unfair process analysis, the complaint alleged that noone other than the interested directors ever approved the challenged grants. The grants were also timed around the transfer of valuable assets or opportunities to subsidiaries and the grants were not disclosed as compensation but rather were disclosed in a proxy statement as “related-party transactions.” The court reasoned that those allegations gave rise “to at least a reasonably conceivable inference of unfair process.”
Regarding the fair price element, the court referred to an allegation where one of the defendants alone was granted the right to 18% of the economic value of one of the subsidiaries which was estimated to be worth $178 million, thereby making his interest worth over $30 million. The court cited to the 1995 decision in Steiner v. Meyerson, 1995 WL 441999 at * 7 (Del. Ch. July 19, 1995), which refused to grant a motion to dismiss when merely $20,000 per year compensation for director service was challenged under the entire fairness standard. [Of course, most readers will be familiar with the Delaware decision involving the Disney Company where the court found that a payment of approximately $140 million for severance pay to an executive named Ovitz, who was only at the company for about one year and whose performance was less than stellar, was not found to be in violation of the board’s fiduciary duty. Therefore, specific facts and circumstances matter, and the amount of compensation is not necessarily determinative.]
Regarding the voting agreement issue, DGCL Section 218(c) explicitly authorizes certain voting agreements to be entered into. The Court of Chancery in unrelated decisions in the past, previously ruled that the transfer of stock voting rights without the transfer of ownership is not per se illegal. See footnote 31. In order to be illegal, a vote-buying agreement must have as its primary purpose either to defraud or in some way to disenfranchise other stockholders. In a prior decision involving voting agreements, the court explained that two of more stockholders may “do whatever they want with their votes, including selling them to the highest bidder.” See footnote 35. However, the counter balance to that statement is that: “management may not use corporate assets to buy votes unless it can be demonstrated, as it was in Schreiber, that management’s vote-buying activity does not have a deleterious effect on the corporate franchise.” See footnotes 35 and 36.
In this case, corporate assets were used to buy the votes and based on the facts of this case, the burden shifted to the defendants to prove that the agreement was intrinsically fair and not designed to disenfranchise other stockholders. Making reasonable inferences in favor of the plaintiff at this early stage, the complaint adequately alleged a disenfranchisement purpose.