Metcalf v. Zoullas: Derivative Action for Excessive Director Compensation

In Metcalf v. Zoullas, No. 11 Civ. 3996 (S.D.N.Y. Jan. 19, 2012), the plaintiffs, John Metcalf et al., brought a derivative shareholder action on behalf of Eagle Bulk Shipping Inc. (“Eagle”), against Eagle’s Board of Directors (“Board”) and certain executive officers, including Eagle’s CEO, Sophocles Zoullas.  Eagle is a Delaware corporation located in the Marshall Islands.  The court denied the defendants’ motion to dismiss under Federal Rule of Civil Procedure (“FRCP”) 23.1 and 12(b)(6). 

The plaintiffs alleged a quid pro quo arrangement in which Eagle’s Board excessively increased director compensation and executive compensation following a change in ownership.  plaintiffs described the amount of   director compensation as  “reach[ing] levels that were generally three to four times” previous amounts despite the absence of  any corresponding change in duties.  They likewise alleged that “hand in hand with the extraordinary rise in director compensation came skyrocketing executive compensation awards, bearing no relationship to Company performance”.  In addition, Eagle allegedly entered into a service agreement with Delphin, a company run by Eagle’s CEO, and Delphin did not provide Eagle with reasonable compensation for its services.  The defendants moved to dismiss the plaintiffs’ complaint on two grounds. First, the defendants claimed the plaintiffs failed to plead demand futility with particularity in accordance with FRCP 23.1.  Second, the defendants argued that they were protected by the business judgment rule, and they moved to dismiss the complaint for failure to state a claim under FRCP 12(b)(6).  

The defendants moved to dismiss the plaintiffs’ complaint on two grounds. First, the defendants claimed the plaintiffs failed to plead demand futility with particularity in accordance with FRCP 23.1.  Second, the defendants argued that they were protected by the business judgment rule, and they moved to dismiss the complaint for failure to state a claim under FRCP 12(b)(6).  

The court first analyzed the defendants’ motion to dismiss under FRCP 23.1.  Under Delaware law, a derivative action allows an individual shareholder to sue directors and executives on behalf of the corporation so long as the shareholder first demands action from the board and executives.  Absent a sufficient demand, the shareholder must prove the demand would be futile.  To prove futility, the court must find a reasonable doubt that either “the directors are disinterested and independent [or] the challenged transaction was otherwise the product of a valid exercise of business judgment.”  It is also possible for the court to treat a related sequence of transactions as a single transaction in order to find reasonable doubt.

In examining the independence and disinterest of the board, the court considered the plaintiffs  “quid pro quo” allegations.  In alleging a sufficient inference of a causal link between the director self- compensation and the compensation paid to the executives, plaintiffs were not limited to a single board meeting.  “If an inference of a quid pro quo arrangement could never arise from non-contemporaneous transactions, those engaged in such misdeeds could too easily render their malfeasance immune from the disinfecting sunlight of shareholder derivative actions, simply by spreading the transactions across multiple board meetings.”

The court found that plaintiffs had alleged the requisite inference.  “Considering the Directors' decisions together and given the particularized factual allegations in Plaintiffs' Complaint, the quid pro quo arrangement alleged by Plaintiffs is a reasonable inference and creates a reasonable doubt as to the disinterestedness of a majority of the Directors with respect to their decisions regarding executive compensation and Delphin.”  Therefore, the court denied the defendants’ motion for dismissal under FRCP 23.1.

The court then analyzed the defendants’ motion to dismiss under FRCP 12(b)(6).  In order to survive a FRCP 12(b)(6) motion to dismiss, a claim must be “plausible on its face” and must allow “the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.”  With respect to claims concerning director compensation, plaintiffs must allege “compensation rates excessive on their face or other facts which call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment”. 

The court found that the allegations were sufficient to “call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment.”  Moreover, the court noted that  “[l]ike any other interested transaction, directoral self-compensation decisions lie outside the business judgment rule’s presumptive protection….”  As a result, the “’initial burden’” of establishing fairness rested with defendants.  As a result, the court declined to dismiss the case under Rule 12(b)(6). 

The primary materials for this case may be found on the DU Corporate Governance website.