In Valeant Pharmaceuticals International v. Jerney, (Del. Ch., March 1, 2007), 2007 WL 704935, read opinion here, the Delaware Chancery Court required a former president and director to disgorge a $3 million dollar bonus. This opinion answers the question that some have posed as to whether or not the Delaware courts would address claims of allegedly excessive compensation. The topic of executive compensation has been extensively discussed recently in the popular press and the trade press. For example, Professor Ribstein discusses the topic here, and Professor Bainbridge has a post here about recent testimony before Congress on the issue. Also, here is a post on the ISS Corporate Governance Blog with a link to a paper prepared by Institutional Shareholder Services on the topic of executive compensation.
Essential to an understanding of this case is the procedural context which required the former director and president to prove the entire fairness of the decision of the board which resulted in a bonus being paid to him in the amount of $3 million. He did not successfully carry that burden. It is not the amount, ipso facto, that was a problem, but the context in which the amount was given that was the focus of this case. (Remember that the Delaware courts did not invalidate a severance payment of $140 million to Michael Ovitz after only a year of work–with checkered performance.)
In this Chancery Court decision, the court determined after a thorough analysis that a $3 million bonus was excessive under the circumstances–and the expert compensation consultants called as experts at trial did not pursuade the court very much. Not only did the court order disgorgement of the $3 million bonus, but the court also required a return of attorneys’ fees advanced by the corporation in the amount of $1.875 million, as well as payment of ½ of the special litigation committee fees and costs (which were not quantified, but one can assume a substantial amount.) Thus, on the whole, it was an entirely unprofitable and expensive decision for the director to participate in that board decision that has now exposed him to personal liability. This is a case where the rubber hits the road when it comes to the concrete impact of corporate governance principles. It appears that this director gambled (incorrectly) that he would prevail despite all other defendants (members of the board that made the challenged decision), settling before the court rendered its opinion.
The case started as a derivative action challenging the unanimous decision of directors to pay large cash bonuses to themselves and other employees in connection with a proposed corporate restructuring. All of the other directors settled, leaving Jerney as the only remaining defendant after trial. The court found that Jerney was an interested director and that he did not satisfy his burden to prove both fair process and fair price in the amount of the bonus that was awarded.
Notable was the absence of independent advisors for the compensation committee, as well as the absence of independent compensation committee members. The court also found that the advisors that were used by the committee relied on incorrect assumptions and the other factual bases for the decision of the advisors were determined by the court to be unreasonable.
Importantly, the court emphasized that its role to review the entire fairness of an interested transaction under DGCL Section 144(a)(3), as here, cannot be displaced simply because DGCL Section 141(e) allows reliance by directors on experts.
Because the director failed to satisfy his burden of proving the entire fairness of the interested transaction, the court observed that there were two remedies available in such a self-dealing situation: (1) The transaction can be voided, as here, resulting in disgorgement; and (2) Damages resulting from a breach of the fiduciary duty of loyalty would also be appropriate.
This is key: the court reasoned that DGCL Section 144 only refers to avoiding the invalidation of certain enumerated interested transactions, but it does not address whether the interested transaction violates fiduciary duties, as that determination is left to common law for which compliance with Section 144 does not necessarily suffice.
The court also noted parenthetically that neither the Delaware Chancery Court nor the Delaware Supreme Court have addressed whether the Uniform Contribution Among Tortfeasors Act, 10 Del. C. Section 6301, et seq., applies to damage claims for breach of fiduciary duties, even though the court did not need to decide that issue here. Although it was not necessary for the court’s decision, the court also remarked about situations where issues arise concerning the liability of a director who was absent from a meeting where a challenged decision was made.
In sum, this decision makes it clear that when called upon to analyze the entire fairness of an interested transaction regarding the compensation of directors and officers, the Delaware Chancery Court will address whether the compensation that interested directors awarded themselves was appropriate in the circumstances.
This decision also emphasizes the importance of independent compensation committees being established and the benefit of those committees using both independent financial advisors and independent counsel. If a truly independent compensation committee recommended the bonus at issue here, and if that recommendation was approved by a majority of independent directors, it is unlikely that the Chancery Court would have been put in the position of examining the entire fairness of the amount of a bonus given to an executive.
UPDATE: By chance, I was speaking with one of the attorneys for the plaintiff, Gary Traynor, who agreed that it was unusual for a corporation to "take over" and pursue a case that started out as a derivative action. He also shared with me that one of the reasons the last remaining defendant may have been so cavalier about settling, is that the sole remaining defendant now lives in Bulgaria, and in addition to openly repudiating his undertaking for advancement of fees, he clearly "suggested "that he does not expect the plaintiff to be able to collect on their judgment in Bulgaria.
UPDATE II: Prof. Larry Hamermesh provides insightful commentary on the case here.