Financial Reporting & Accounting

• SEC Enforcement Of Accounting Requirements

• Earnings Management: Swept Away?

• Financial Reporting For International Joint Ventures

M&A

• Applying The New M&A Filing Rules

• How To Succeed In Selling Your Business

Securities Offerings

• What To Do Now That Our Offering Has Aborted

Executive & Directors

• Delaware Cases Affecting Executive Compensation

• Dual Role Of Non-Executive Directors

Download a .pdf of this issue

Surveys recent Delaware cases on conflicts between stockholders and directors over options plans and executive employment contracts. Provides guidelines by which directors can protect themselves.

When directors compensate themselves. Four recent Delaware cases deal with stockholders’ challenges to directors’ development, approval, and activation of option plans and employment contracts for executives. In re 3Com Corp. Shareholders Litigation concerned a stockholders’ suit to invalidate the directors’ grants of stock options to themselves. The Court of Chancery reviewed the grants under the business-judgment rule, rather than the entire-fairness standard applicable to an “interested transaction,” because the stockholders had approved the option plan. Accordingly, the plaintiff/shareholders could prevail only by proving corporate waste. A waste claim, the court said, could not succeed merely by alleging that the company had received inadequate (as opposed to no) consideration for the option grants. Nor was the court persuaded by a precedent in which waste was found in the grants of options with a smaller present value per director.

What the plan permits. In Sanders v. Wang, the stockholders challenged option grants by a directors’ compensation committee to directors who were also key executives. Under the option plan, which the stockholders had approved, some of the grants were contingent upon the stock reaching certain price targets. The plan specifically permitted the committee to adjust the price targets to account for stock splits, but it was silent on adjusting the number of options subject to grant. After three splits, the compensation committee adjusted both. Although the plan gave the committee the power to interpret the plan, the chancery court held that the committee could not adjust the number of options and thereby change the plan’s substantive terms. Wagner v. Selinger held that directors did not commit waste by entering into a separation agreement with a departing CEO who already had an employment agreement, even though the newer agreement gave greater benefits. Because the CEO had given some additional consideration, the chancery court refused to question the directors’ decisionmaking process or even to determine if the consideration had been adequate.

Great deference to boards. In Brehm v. Eisner, which concerned Michael Ovitz’s departure from Disney, the Supreme Court held that a board’s decision about executive compensation should receive great deference and that a board acts properly as long as it does not unconscionably or irrationally squander corporate assets. Therefore, an employment agreement does not constitute waste just because the employee would earn more by engineering a premature termination without cause than by fulfilling the contract terms. The court also refused to function as super-directors and question the board’s decision not to fire the executive for cause, finding that the stockholders challenging the deal had failed to demonstrate no reasonable person in the circumstances would have decided as the board had.

Guidelines for directors. The cases show that a board has a lot of flexibility in awarding executive compensation. A board that retains and properly relies on an expert is entitled to the presumption that it used its business judgment. The business-judgment rule generally protects the board’s decisions made under an employment agreement or a shareholder-approved option plan. As the severe holdings in Sanders and another chancery case indicate, a board should stay within the terms of a stock option plan or executive employment contract, because Delaware courts tend not to look outside the four corners for the drafter’s intent. Shareholder approval of a plan or contract, while not required in Delaware, provides two advantages. First, absent waste, the business-judgment rule will protect directors’ grant of options to themselves. Second, the shareholders could well be precluded from later alleging that the directors did not use due care in devising the contract or plan.