Corporate Finance Lawyer & Attorney : Davis Wright Tremaine Law Firm

In Julian v. Eastern States Construction Service, Inc. (Del. Ch. July 8, 2008), the Delaware Chancery Court ordered the disgorgement of director compensation bonuses after its determination that the bonuses did not pass the entire fairness standard.

"Self-interested directorial compensation decisions made without independent protections, like other interested transactions, are subject to entire fairness review.  Directors of a Delaware corporation who stand on both sides of a transaction have “the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by the courts.”  They “are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.”  The two components of entire fairness are fair dealing and fair price. Fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.”  Fair price “assures the transaction was substantively fair by examining ‘the economic and financial considerations.’”"

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In CA, Inc. v. AFSCME Employees Pension Plan, No. 329, 2008 (Del. July 17, 2008), the Delaware Supreme Court held that a stockholder proposed bylaw that would require the company to reimburse a stockholder's reasonable proxy expenses in event that the stockholder succeeded in having at least one director elected pursuant to a proposed short slate would violate Delaware law.

"This case involves a binding bylaw that the shareholders seek to impose involuntarily on the directors in the specific area of election expense reimbursement. Although this case is distinguishable in that respect, the distinction is one without a difference. The reason is that the internal governance contract—which here takes the form of a bylaw—is one that would also prevent the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to deny reimbursement to a dissident slate. That this limitation would be imposed by a majority vote of the shareholders rather than by the directors themselves, does not, in our view, legally matter."

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In Ryan, et al. v. Gifford, et al., the Delaware Chancery Court held that the attorney-client privilege between a special committee and its law firm hired to investigate stock option backdating was waived when the committee's report was shared with the entire board.

"The presentation of the report constitutes a waiver of privilege because the client, the Special Committee, disclosed its communications concerning the investigation and final report to third parties--the individual director defendants and [.....]--whose interests are not common with the client, precluding application of the common interest exception to protect the disclosed communications."

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On August 15, 2007, the Delaware Chancery Court, Chancellor Chandler, in a case called In Re Tyson Foods, Inc. Consolidated Shareholder Litigation,  refused to dismiss a complaint alleging breach of fiduciary duty for granting so-called "spring-loaded" stock options.

("Spring-loaded" stock options are options priced at fair market value on the date of grant, but granted immediately before or close in time before the release of good news, which can be expected to drive the price of the stock up, making the options more valuable.  "Bullet dodging" stock options, in contrast, are options granted at fair market value, but immediately after the release of bad news, after the market has marked down the value of the stock to take into account the bad news.)

Chancellor Chandler's recent decision reaffirms his earlier decision that under certain circumstances the grant of spring-loaded options can constitute the breach of fiduciary duty. 

The practical implication of this decision?  Boards should evaluate their stock option grant practices to make sure that they are above reproach in terms of their timing and pricing to avoid the arguments made in the Tyson case.  In the words of Chancellor Chandler:  "[I]f a board of directors candidly discloses why and when it awarded options, and accounted for them in a lawful manner consistent with the actual facts, the board has, absent unusual circumstances, insulated itself from fiduciary liability for misleading investors or regulatory authorities.  What the directors would remain subject to was a well-pled claim that the compensation awarded was actionably excessive because, for example, it involved self-dealing and was not fair to the corporation."

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Broc Romanek blogs about this opinion ("Delaware Chancery Court Addresses Cancellation Value of Stock Options in Mergers").  The opinion is also available online.   In a cash merger, out-of-the-money options were rendered worthless.  The question was whether the terms of the stock option plan governing the options prohibited this treatment and instead required that the former officers and directors be compensated for the full value of their options.  The court found for the plaintiffs and awarded them a sum of money equal to the full economic value of their options.

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