Freedman v. Adams, C.A. No. 4199-VCN (Del. Ch. March 30, 2012).

Issue Addressed

The Court of Chancery addressed the standard for awarding attorneys’ fees when there has been a stipulated dismissal of a derivative action which was largely mooted by measures taken by the defendant board of directors shortly after the complaint was served.

Background

The complaint in this case consisted of eight pages and it was filed in November 2008, challenging the executive compensation plan approved by the board of XTO Energy, Inc.  The specific objection was based on the fact that cash bonuses paid to key officers were not tax-deductible because they did not meet the requirements of Section 162(m) of the Internal Revenue Code.  The cash bonuses did not meet the definition in Section 162(m) of “other performance-based compensation,” which must be contingent upon achieving performance goals meeting certain statutory requirements.  As a result, the plaintiff alleged that the company was not eligible for approximately $75 million in tax deductions over a two-year period.  Shortly after the complaint was served, the board adapted a tax-deductible cash bonus plan which mooted most of the plaintiff’s claims.  Between the time that most of the plaintiff’s claims were mooted, and the complaint’s eventual dismissal, the defendants filed two motions to dismiss.

Short Summary of Holding

All requested fees were denied because the Court reasoned that the complaint would not have survived the motion to dismiss, and because:  “An arguably poor business judgment, without more, does not excuse demand on the board of directors in a derivative action.”

Legal Analysis

The theoretical basis for the requested attorneys’ fees was the “corporate benefit doctrine,” in light of the argument that the complaint was the cause of the board subsequently approving the compensation plan that satisfied the tax deductibility requirements of Section 162(m).  The Court reviewed the familiar prerequisites in order for attorneys’ fees to be awarded under the corporate benefit doctrine.  See footnotes 30 to 31 and accompanying text. 

That is, in order to be entitled to an award of attorneys’ fees and expenses under the corporate benefit doctrine, when claims in the complaint are mooted, one must show that:  (1) The suit was meritorious when filed; (2) The action that provided the benefit to the corporation was taken by the defendant before judicial resolution was achieved; and (3) The result in corporate benefit was causally related to the lawsuit.  Because the futility of demand issue in this matter is dispositive, the Court determined that it was only necessary to address the first issue regarding whether the suit was meritorious when filed. 

Demand Futility Under Court of Chancery Rule 23.1

The Court reviewed the familiar standard for demand futility under Aronson v. Lewis, 473 A.2d 805 (Del. 1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000).  The Court also included a helpful comparison between Court of Chancery Rule 23.1 and the different analysis applicable to a motion to dismiss pursuant to Court of Chancery Rule 12(b)(6).

Director Disinterestedness and Independence

The Court observed that when assessing the independence and disinterestedness of directors under Rule 23.1, the Court considers the composition of the board at the time the plaintiff brought the complaint and not when the alleged wrong occurred. 

The Court provided a very helpful definition of “disinterested,” and discussed the well-established case law explaining those definitions.  See footnotes 42-44 and accompanying text. 

This 51-page decision also included a helpful definition of the well-established standard for “independence” of directors.  See footnotes 45-48 and accompanying text.  In connection with this analysis, the Court referred to the cases that addressed the standard of Delaware law that “director fees could have a disqualifying effect if they exceeded materially what was commonly understood and accepted to be a usual and customary director’s fee.”  See footnotes 51 and 52 and accompanying text.  Footnote 53 refers to a paragraph in the complaint that describes outside director compensation ranging from approximately $460,000 to $517,000 in 2006 and in 2007 ranging from $679,000 $793,000. 

Despite those amounts, the Court explained that the complaint did not allege “any particularized facts from which this Court could infer that this compensation materially exceeded what is commonly understood and accepted to be a usual and customary director’s fee.  Outside board members also received health benefits, retirement plans and severance. 

Valid Exercise of Business Judgment and the Second Prong of the Aronson Test

The Court recited the well established Delaware law that “when a majority of the board is independent and disinterested under Aronson’s first prong, the plaintiff has a ‘heavy burden’ to satisfy the second prong.”  The Court begins its analysis presuming that the business judgment rule applies, and the plaintiff must establish facts rebutting this presumption.  To do so, she must plead particularized facts to create a reasonable doubt that either:

“(1) the action was taken honestly and good faith, or (2) the board was adequately informed in making the decision.”  See footnotes 89 to 91.

Bad Faith

The Court explained that the second prong of Aronson may be met by pleading particularized facts that raise a reasonable doubt as to whether the actions of the board were taken in good faith.  Prior caselaw has established three salient examples of what constitutes bad faith:

“(1) Intentionally acting for a reason other than advancing the best interest of the corporation; (2) Acting with the intent of violating applicable positive law; or (3) Intentionally failing to act in the face of a duty to act, demonstrating a conscious disregard of the fiduciary’s duties.”  See footnotes 93 and 94.

The Court rejected the argument that actions “in violation of general public policy” constitute an action taken in bad faith.  The Court also rejected the argument that the board failed to act despite a duty to do so.

In rejecting other arguments by the plaintiff, the Court relied, at footnote 117, on the seminal treatise by Stephen Radin entitled The Business Judgment Rule, for the general principle that directors are, in most cases, more qualified to make business decisions than are judges.

In sum, the Court determined that the claims based on waste and inadequate disclosure would not survive a motion to dismiss.  Therefore, the Court concluded that the motion for attorneys’ fees and expenses would be denied.