In the recent Delaware Court of Chancery opinion styled: Knight v. Miller, C.A. No. 2021-0581-SG (Del. Ch. April 27, 2022), the court described this case as “. . . another bloom on the hardy perennial of director compensation litigation.” Slip op. at 2.
The court granted some parts of a motion to dismiss, but allowed other claims to proceed based on the application of the entire fairness standard and the difficulty in securing a dismissal of claims at the initial pleadings stage when that fact-intensive standard applies, for example, when, as here, stock option awards are challenged.
Another Memorable Quote
The opinion begins with the following eminently quotable truisms of Delaware corporate law that aptly describe how the court reviewed the allegations in this case:
“The oft-noted fact that corporate actions are ‘twice-tested’–first in light of compliance with the DGCL, second for compliance with fiduciary duties–is neatly illustrated by directors’ actions to set their own compensation. Those actions are clearly authorized by statute, and just as clearly an act of self-dealing, subject to entire fairness review.”
Slip op. at 2.
This case involved a challenge to the award of stock options to members of the board of directors, some of whom are considered to be controllers and insiders.
The court noted that Section 141(h) of the Delaware General Corporation Law authorized the board to “fix the compensation of directors.” The board in this case was implementing a stock incentive plan that vested the compensation committee with authority to award stock options in its discretion.
The court began its consideration of the claims by describing the causes of action as requiring a “somewhat convoluted analysis” as the challenge to the stock awards implicates different standards of review for different grants. Slip op. at 16. Thus, the court reviewed the claims in three categories:
(i) whether the Compensation Committee acted in bad faith as an independent breach of fiduciary duty for granting the awards;
(ii) alleged breach of the duty of loyalty for granting the awards generally; and
(iii) alleged breach of the duty of loyalty for accepting the awarded stock options.
The court rejected the bad faith claims, and instructed that: ” Bad faith is one of the hardest corporate claims to maintain.” Slip op. at 18. This version of a breach of the duty of loyalty claim typically is made when a plaintiff cannot establish lack of independence or lack of disinterestedness.
Notably, the court observed that because the stock options were granted to individuals in “varying factual postures”: “. . . different standards of review will apply to the Compensation Committee Defendants’ choices in making the grants. As in nearly all pleadings stage challenges to the viability of a breach of fiduciary duty claim in the corporate context, deciding the standard of review will be outcome determinative.” Slip op. at 20-21.
When Entire Fairness Standard of Review Applies–Absent an Exception
Because the decision by directors to determine their own compensation is necessarily self-interested, even when done pursuant to a pre-existing equity incentive plan, such decisions are subject to the entire fairness standard of review, “unless a fully informed, uncoerced, and disinterested majority of stockholders has approved the compensation decisions and therefore ratified them.” Slip op. at 21 (citing In re Investors Bank Corp., Inc. S’holder Litig., 177 A.3d 1208).
Standard for Awards to Controllers
The court explained that even if a controller of a company, such as a majority stockholder, is not actually a member of the compensation committee, the entire fairness standard still applies to compensation granted to a controller: “Because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny. The underlying risk is that the independent committee members who pass upon a transaction in question- -here the granting of equity awards- -might perceive that disapproval may result in retaliation by the controlling stockholder.” Slip op. at 20-21. This principle applies equally to outside directors as decisionmakers, given the controlling stockholder’s ability to elect directors. Slip op. at 26-27.
Nascent Standard of Review–When Accepting Compensation Allegedly is “Clearly Improper”
The court acknowledged that the standard of review for breach of fiduciary duty claims in connection with accepting compensation is “nascent in its development.” Slip op. at 32. With over 200 years of decisions in the Delaware Court of Chancery about fiduciary duty, it’s surprising that any aspect of caselaw about fiduciary duties is “nascent,” but so it is.
The court discussed this aspect of the case by beginning with the definition of the duty of loyalty. Slip op. at 29-30. The plaintiff conceded that there is a relative lack of caselaw defining what might constitute “clearly improper” to the extent that it might be a breach of fiduciary duty to accept compensation that is clearly improper. The court found that even though the caselaw is not well developed on this issue, courts have found actions for breach of fiduciary duty for accepting compensation to survive a motion to dismiss when two factors are present: (1) the compensation award was ultra vires, and the recipients knew it, or (2) where compensation was repriced advantageously in light of confidential and sensitive business information which the recipients knew, and which they accordingly used to the company’s detriment.
Standard for Accepting “Clearly Improper” Compensation
The court acknowledged that : “The ‘clearly improper’ standard, if standard it is, is nascent in its development”. Then the court asked the question: “What is the standard that must be applied to the facts when considering whether such a breach of duty has been plead?” The court concluded that:
“What is required is defendant’s knowingly wrongful acceptance of compensation, and the standard must be bad faith. That is, there must be sufficient pleading of scienter to support a bad faith claim, which serves as a claim based on breach of the duty of loyalty. But, as discussed above, there is an insufficient record to sustain even a claim that the Compensation Committee Defendants making the awards acted in bad faith, much less that the recipients’ acceptance violated that standard. All that is alleged is that option awards were made at what proved to be the bottom of the market.”
Slip op. at 32
Therefore, the court granted the motion to dismiss with respect to the cause of action alleging breach of fiduciary duty by all defendants for accepting the March 2020 awards. The court distinguished Howlan v. Kumar, 2019 WL 2479738 (Del. Ch. June 13, 2019) and Pfeiffer v. Leedle, 2013 WL 5988416 (Del. Ch. Nov. 8, 2013). Unlike the Howlan case, the instant case does not plead nonpublic facts known to the company and the defendants that give rise to an inference of “clearly improper” compensation. Unlike Pfeiffer, there is no allegation that the awards violate the stock incentive plan, let alone that the defendants were aware of the same.
The court also noted that the claim against the Compensation Committee Defendants for accepting the self-dealing awards merged with the breach of duty claim against the Compensation Committee Defendants for making the awards.
Waste Claims Dismissed
The court dismissed the corporate waste claims because in order to constitute waste, the grants must have been “without business purpose” but that cause of action was insufficiently plead.
Stock Incentive Plan Not Self-Executing
Regarding the grant of stock options to outside director defendants, the court explained that there are other cases such as Kerbs v. California Eastern Airwaves, 90 A.2d 653 (Del. 1952), which involved a self-executing stockholder-approved plan where the equity incentive plan listed grants of unissued stock in specific amounts to named executives based on the mathematical formula which left no room for discretionary decisions by the directors. No such formula constrained the directors in this case.
Key Point–Difficult to Win Motion to Dismiss When Entire Fairness Standard Applies
The court instructed that when entire fairness is the applicable standard of review, dismissal of a complaint under a Rule 12(b)(6) motion is usually precluded because: “A determination of whether the defendant has met its burden will normally be impossible by examining only the documents the court is free to consider on a motion to dismiss.”
Although the court listed at footnote 102 the many other cases that have followed this approach–it also acknowledged at footnote 103 a few cases that have granted motions to dismiss, but “generally where a plan has failed to allege any evidence of unfair process or price.”
The court found that the facts in this case were sufficient to raise a reasonably conceivable inference of an unfair transaction–but the finding does not preclude the Compensation Committee Defendants from establishing that the awards were entirely fair.
The court observed that it would allow the claims against the outside directors to proceed even though it found that: the facts alleged in this case were “not overwhelming.” Slip op at 21-25.
Standard Applicable to Officer Defendants
The third standard applied was to officer defendants and the court determined that the standard of review applicable to officer defendants was the business judgment rule unless the plaintiff pleads: (1) Facts from which it may be reasonably inferred that the board or compensation committee lacked independence (for example, if they were dominated or controlled by the individual receiving the compensation); or (2) Facts from which it may be reasonably inferred that the board or compensation committee, while independent, nevertheless lacked good faith in making the award.
The court found that the Compensation Committee Defendants did not act in bad faith in making the awards, and plaintiff did not plead facts relating to the lack of independence by the Compensation Committee for purposes of making the compensation awards. Although the business judgment rule can be dislodged by the successful pleading of corporate waste, the court explained why that was not successfully plead here. Therefore the motion to dismiss this claim with respect to the officer defendants was granted.
The author of this overview was co-counsel for all the defendants–and the intent of this short post was to provide objective highlights without any advocacy of any party’s position.