The Unreviewability of Compensation Decisions in Delaware (Part 2)

We are discussing Freedman v. Adams, C.A. No. 4199 (Del. Jan. 14, 2013), the Delaware Supreme Court's most recent pronouncement in the area of executive compensation.

The facts are straightforward.  According to the allegations made by the plaintiff, XTO Energy paid to executive officers bonsues totalling more that $130 million from 2004 to 2007.  The board had not approved a plan under Section 162(m) that was submitted to shareholders for approval.  As a result, the compensation was not deductible, resulting in the company paying "approximately $40 million" in additional taxes.  As the opinion stated, "The XTO board was aware that, under a qualified Section 162(m) plan, bonuses could be tax deductible, but it did not think its compensation decisions should be 'constrained' by such a plan."

Plaintiff brought a derivative suit alleging that the board committed waste.  Plaintiff alleged, according to the Chancery Court, that "by failing to structure the cash bonuses as tax-deductible compensation, the Board Defendants had breached their fiduciary duties and committed waste."  After the complaint was filed, the XTO board approved a plan under Section 162(m) that was approved by shareholders.  XTO, however, merged with a subsidiary of Exxon Mobile and, as a result, the plan was never actually utilized. 

The shareholder agreed to dismiss her complaint as moot but sought attorneys fees.  The Chancery Court denied the fees, concluding that the complaint did "not adequately allege that demand on the board would have been futile."  The court found that Plaintiff had not stated a claim for waste.  

The Supreme Court affirmed the reasoning, using extraordinarily broad language.  Waste required a showing that:

the exchange was so one sided that no business person of ordinary, sound judgment would conclude that the corporation has received adequate consideration. A claim of waste will arise only in the rare, unconscionable case where directors irrationally squander or give away corporate assets. This onerous standard for waste is a corollary of the proposition that where business judgment presumptions are applicable, the board’s decision will be upheld unless it cannot be attributed to any rational purpose.

The company explained the failure to rely on Section 162(m) in its company in its proxy statement:

While the compensation committee monitors compensation paid to our named executive officers in light of the provisions of Section 162(m), the committee does not believe that compensation decisions should be constrained necessarily by how much compensation is deductible for federal tax purposes, and the committee is not limited to paying compensation under plans that are qualified under Section 162(m).

The Court found that this expanation was sufficient:

the XTO board was aware of the tax law at issue, but intentionally chose not to implement a Section 162(m) plan. The board believed that a Section 162(m) plan would constrain the compensation committee in its determination of appropriate bonuses. The decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment. Even if the decision was a poor one for the reasons alleged by Freedman, it was notunconscionable or irrational.

In other words, it was enough for the Court that a board wanted to be free of constraints in making compensation decisions.  There was no need to explain why the particular constraints (performance based compensation and shareholder approval) were necessary.

The decision makes clear that the courts in Delaware will not require that boards have a link between the amount of compensation and performance.  To the extent such a link is necessary, it will require federal intervention.