The financial crisis raised questions about whether boards of directors of public companies were exercising appropriate oversight of corporate finances, including executive compensation practices. Stockholders sought a greater voice on compensation matters and achieved a limited right to have a "say on pay" at the federal level. At the state level, executive compensation practices have increasingly become the subject of derivative actions brought by stockholders in the Delaware courts. High-profile cases brought in the Delaware Court of Chancery include challenges to compensation practices at Citigroup in 2009, Goldman Sachs in 2011 and, more recently, Hewlett-Packard Company.
Pleading Corporate Waste
Under Delaware law, executive compensation decisions made by disinterested and informed directors are entitled to great deference. The Delaware courts' unwillingness to disturb a board's decisions on compensation matters stems from the long-held view that decisions on the expenditure of corporate funds, including the approval of salaries and bonuses of high-level officers, are quintessential board functions under section 141(a) of the General Corporation Law of the State of Delaware. As a result, plaintiffs seeking to challenge compensation decisions must satisfy a difficult pleading burden.
The sine qua non of a successful challenge to a disinterested and informed decision on an executive compensation matter is proof of corporate waste. A compensation decision is tantamount to waste if it was so egregious or irrational that the board's decision could not have been based on the corporation's best interests. Stated differently, the consideration that the corporation received for the compensation package must be so small that it could be effectively characterized as a gift serving no corporate purpose. Where the corporation has received any substantial consideration, a finding of waste is inappropriate. Because the burden for establishing waste is so high, stockholder plaintiffs are rarely successful in challenging executive compensation practices.
Compensation for Departing Executives
In June 2012, the Delaware Court of Chancery ruled on two derivative actions challenging severance/retirement packages for departing executives: (1) Zucker v. Andreessen, C.A. No. 6014-VCP (Del. Ch. June 21, 2012), and (2) Seinfeld v. Slager, C.A. No. 6462-VCG (Del. Ch. June 29, 2012). Early decisions of the Delaware courts held that compensation for services previously performed and for which compensation had already been received generally would constitute a waste of corporate assets. However, Zucker and Slager confirm that the Delaware Court of Chancery will not substitute its judgment for that of a disinterested and informed board of directors on executive compensation matters, including severance, if there is some rational basis for the board's decision.
Zucker v. Andreessen
In Zucker v. Andreessen, the Delaware Court of Chancery granted defendant Hewlett-Packard Company's (HP) motion to dismiss claims that HP's directors committed waste by approving a $40 million severance package for HP's former CEO, Mark Hurd. The court found that there was some rational basis for the HP board to conclude that the amount and the form of the severance package were appropriate and likely to be beneficial to the corporation.
In 2010, HP terminated Hurd after he was accused of sexual harassment by an independent contractor with whom he had a personal relationship. Although the board determined that Hurd did not violate HP's sexual harassment policy, it did find that he filed inaccurate expense reports to conceal the relationship. Having lost confidence in its CEO, the HP board terminated Hurd, but authorized a severance package estimated to be worth $40 million. In return, Hurd agreed to extend the term of an earlier confidentiality agreement with HP. He also executed a general release in favor of HP and agreed to cooperate with HP in connection with any investigative or legal matters involving the company.
Plaintiff brought this action and alleged that the severance agreement constituted waste because HP was not required to provide any severance to Hurd, and HP did not receive any consideration for the severance agreement. Ruling on defendants' motion to dismiss plaintiff's complaint for failure to allege a basis to excuse pre-suit demand under Delaware Court of Chancery Rule 23.1, the court found that plaintiff had failed to establish demand futility by properly pleading a waste claim. The court emphasized that Hurd was not terminated for cause, and HP received consideration for the severance agreement when Hurd agreed to extend the term of the confidentiality agreement and release all claims against HP. Additionally, the court noted that plaintiff did not allege that HP suffered significant losses during Hurd's stewardship or that Hurd was otherwise an ineffective CEO. Under such circumstances, at least some portion of Hurd's severance could represent reasonable compensation for his successful past job performance. Finally, the court noted that the HP board could have reasonably concluded that denying Hurd severance would undermine its future efforts to attract outside executive talent. The court found that these facts demonstrated that the severance agreement was the product of a bilateral exchange and therefore plaintiff failed to meet his pleading burden.
Seinfeld v. Slager
A little over a week after the decision in Zucker v. Andreessen, the Delaware Court of Chancery addressed another challenge to a board's decision to approve a payout to its exiting CEO—Seinfeld v. Slager. In Seinfeld, plaintiff alleged that the members of the board of directors of Republic Services Inc. breached their fiduciary duties by approving a $1.8 million bonus payment to Republic's retiring CEO, James E. O'Connor. O'Connor's retirement agreement with the nation's second-largest provider of waste management services contemplated a bonus payment, but did not specify the amount of the bonus.
Defendants moved to dismiss plaintiff's complaint for failure to make a pre-suit demand on the Republic board or plead demand futility. In ruling on defendants' motion to dismiss, the Delaware Court of Chancery looked to the Zucker decision for guidance. The court noted that Republic received a general release from O'Connor in consideration for the retirement bonus and that Republic may have received other intangible benefits from the bonus payment—O'Connor's retirement was amicable, and other executives may have been incentivized to work harder and remain with the company. Based on these facts, which suggested that Republic received some consideration for the bonus, the court found that plaintiff had not adequately pleaded waste and therefore dismissed the claim.
However, the court declined to dismiss a second claim that Republic's directors violated their fiduciary duties and committed waste in approving restricted stock options for themselves pursuant to a stockholder-approved stock option plan. After reviewing the complaint and the stock option plan, the court found that the stock option plan contained no effective limits on the total amount of pay that the directors could award themselves in the form of stock options. In the court's view, the absence of effective parameters on potential self-dealing by directors distinguished this plan from the stockholder-approved option plans that were upheld under the deferential business judgment rule in prior decisions. According to the court, the strictures of a plan that would be reviewed under the business judgment rule include (at a minimum) specific ceilings on the awarding of options which are based on specific categories of service as a director, such as service on a committee, position as a lead director and chairing the board. See In re 3COM Corp. Shareholders Litig., C.A. No. 16721-VC Steele (Del. Ch. Oct. 25, 1999). Because the stock plan at issue permitted the defendant directors to award themselves tens of millions of dollars in options with no effective limits, the court found that the defendant directors would have to show at trial that the awards were entirely fair to the corporation.
Compensation for Future Performance
In re The Goldman Sachs Group, Inc. Shareholder Litig., C.A. No. 5215-VCG (Del. Ch. Oct. 12, 2011), involved a challenge by stockholders of the Goldman Sachs Group Inc. to Goldman's compensation of its employees. Goldman's compensation structure was based on a "pay for performance" model that linked the compensation of its employees to the company's performance as a relatively constant percentage of total revenues. The plaintiff stockholders contended that this compensation structure led management to pursue a highly risky business strategy that benefited Goldman's employees and management to the detriment of Goldman's stockholders.
The Delaware Court of Chancery dismissed plaintiffs' claims for breach of fiduciary duty on the basis of plaintiffs' failure to make a demand or show demand futility. Here, a majority of the directors were independent and disinterested, and the plaintiffs' own pleadings indicated that the board's approval of the firm's compensation practices was the product of an informed business judgment. The compensation practices were tied to employee performance and competitors' compensation practices, information that the board reviewed prior to making compensation decisions.
Plaintiffs also alleged that the Goldman board acted in bad faith when approving the firm's compensation plan because the plan misaligned the interests of stockholders and employees by encouraging Goldman's employees to maximize their bonuses by leveraging the company's assets. Because the lion's share of Goldman's revenues were either being channeled to Goldman's employees and executives as compensation or being reinvested, Goldman stockholders received only a small percentage of net revenues as dividends. The court stated that even if plaintiffs' allegations were all true, they were irrelevant because compensation decisions are core functions of the board, and a board does not act in bad faith by choosing a compensation scheme that is tied to revenue creation. The court's rejection of plaintiffs' bad faith claim is also consistent with the Delaware courts' general philosophy regarding actions to compel dividends—the Delaware courts have consistently rejected the proposition that a board of directors has any obligation to pay its stockholders a dividend except in the limited case of a closely-held corporation with a majority stockholder who engages in fraudulent or oppressive conduct. See Litle v. Waters, C.A. No. 12155-CC (Del. Ch. Feb. 2, 1992).
Plaintiffs also alleged that the Goldman board committed waste by consistently paying its employees two to six times more than competitors Morgan Stanley, Merrill Lynch Co. Inc., Citigroup Inc., and Bank of America. Alternatively, plaintiffs asserted that the compensation schemes of Goldman's competitors were not even relevant benchmarks because Goldman was increasingly participating in proprietary trading activities and that a compensation scheme typical to hedge funds was appropriate. The court rejected plaintiffs' waste claim, finding that even if plaintiffs' allegations were all true, plaintiffs failed to demonstrate that the work done by Goldman's employees (although not "God's Work") was of such limited value that no reasonable person would have approved the level of compensation approved by the Goldman board.
Lessons from Recent Compensation Cases
Stockholders seeking to challenge compensation decisions made by disinterested and informed directors have an uphill battle in Delaware. However, stockholders are not without recourse—they have access to the ballot box. The stockholder franchise brings equilibrium to a system that vests management in a corporation's board of directors.
However, careful practitioners can take steps to minimize the risk of a challenge to executive and director compensation practices. Stockholder-approved stock option and other stockholder-sanctioned incentive plans for directors should not be viewed as sacrosanct. The plans should contain clear and effective limits based on a multi-tiered approach to director compensation or risk being challenged in the Delaware courts under the entire fairness standard of review. In addition, the lessons from Zucker are clear: (1) at a minimum, severance guidelines for top-level executives should be adopted by public companies as a matter of policy; and (2) corporations and incoming CEOs should agree to comprehensive severance packages at the outset of the relationship. Hurd's employment agreement with HP had expired in April 2009, and HP's severance policy did not apply to him. An extant contractual obligation to compensate an executive for past services to the corporation has a greater chance of withstanding a challenge in the Delaware courts than a severance package adopted on an ad hoc basis.