Delaware Court of Chancery Excuses Pre-Suit Demand for Derivative Complaint Alleging Wasteful Compensation

Practical Law Legal Update w-014-3871 (Approx. 8 pages)

Delaware Court of Chancery Excuses Pre-Suit Demand for Derivative Complaint Alleging Wasteful Compensation

by Practical Law Employee Benefits & Executive Compensation

Background

Redstone, through his trust and investment vehicle, was and is the controlling stockholder of CBS. After CBS split from Viacom Inc. in 2006, Redstone served as Executive Chairman of CBS until February 2016. Redstone's employment at CBS was governed by an agreement originally entered into in December 2005 and amended in 2007 and 2008. The employment agreement was terminable by either party at will.

The board of CBS consisted of 13 directors (including Redstone), all of whom are named individual defendants, when the plaintiff first filed his action; an amended complaint added another defendant who was a director during the relevant period. The board delegated responsibility for compensation-related matters to a compensation committee consisting of four directors. Redstone's employment agreement provided that he would receive a base salary of $1 million per year and an annual bonus based on achievement of performance goals established by the compensation committee. The employment agreement also entitled Redstone to receive cash bonuses in accordance with the company's Senior Executive Short-Term Incentive Plan. The plan required the compensation committee to determine which senior executives would be eligible for the program and to set performance goals based on financial targets.

In February 2014, the compensation committee approved a set of goals for Redstone. Beginning in the spring of that year, however, Redstone's health began declining badly. Redstone's participation in board meetings was minimal that year, frequently consisting of little more than welcoming participants to the meeting. Despite this, in January 2015, the compensation committee approved a $9 million bonus for Redstone, in addition to his $1.75 million base salary (which could not be reduced under the terms of his employment agreement), for 2014.

In February 2015, the compensation committee decided that Redstone would not receive a bonus for 2015, but would continue to receive his base salary of $1.75 million. The board also re-nominated him to be a director. In 2015, Redstone only participated in board meetings by phone and did not speak at three of the four board meetings.

Throughout this period, members of the board learned of Redstone's poor health, whether through personal interaction and communication with Redstone's acquaintances, media coverage, or a lawsuit alleging elder abuse. However, no mention of Redstone's health was made in the minutes of the board's and compensation committee's meetings in late 2014 and in 2015.

In January 2016, the compensation committee decided that Redstone would not receive a bonus for 2015, but it approved a salary of $1.75 million for him for 2016. In February 2016, following a psychiatric evaluation that found Redstone lacked mental capacity, Redstone resigned as CBS Executive Chairman. The board accepted the resignation and appointed him Chairman Emeritus; the compensation committee approved an annual salary of $1 million for Redstone in his new role.

In July 2016, the plaintiff stockholder brought a derivative action against the 13 members of the CBS board of directors, alleging that as a result of Redstone's $9 million bonus for 2014, his annual base salary of $1.75 million as Executive Chairman for each of 2014 and 2015, and his annual base salary of $1 million as Chairman Emeritus for 2016:

The defendant directors besides Redstone breached their fiduciary duty through waste of corporate assets by agreeing to Redstone's compensation for virtually no service in return.
Redstone was unjustly enriched by the compensation he received throughout the relevant period.

In February 2017, the defendants filed a motion to dismiss the action under Court of Chancery Rule 23.1 for failure to make a pre-suit demand on the board and Court of Chancery Rule 12(b)(6) for failure to state a claim upon which relief may be granted. The plaintiff argued in response that demand on the board would have been futile because the defendant directors would not have pursued the claims on the behalf of the corporation given their own likely liability for breach of fiduciary duty (which, in turn, was why the defendants' motion to dismiss under Rule 12(b)(6) should be denied).

Outcome

The Chancery Court ruled that demand was not excused for the claim over the $9 million bonus payment, a decision that a majority of the board was disinterested in and able to evaluate on its own. As to the other payments, the court held that the defendant directors faced a substantial threat of personal liability for breach of fiduciary duty and (in the case of Redstone) unjust enrichment for agreeing to them and that the plaintiff's claims concerning these payments could proceed.

Legal Standards

In its memorandum opinion, the court first considered the defendants' motion to dismiss under Rule 23.1 for failure to make a pre-suit demand on the board before turning to the defendants' motion to dismiss under Rule 12(b)(6) for failure to state a claim.

Under Delaware law, a stockholder derivative lawsuit may be pursued only if the stockholder either:

Makes a pre-suit demand by presenting allegations of wrongdoing to the corporation's directors, requests that they bring suit, and shows they wrongfully refused to do so.
Pleads facts showing that a pre-suit demand upon the board would have been futile.

In this case, the plaintiff did not make a pre-suit demand on the board. The court analyzed the plaintiff's pleading of demand futility under the Rales test, in which the plaintiff must plead facts with particularity that "create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand" (Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993)).

(The court analyzed the plaintiff's claims under Rales and not Aronson v. Lewis because Rales governs accusations of board inaction. The inactions here were:

The failure to terminate Redstone's employment agreement to avoid paying Redstone $1.75 million base salaries in 2014 and 2015.
The decision to award Redstone a $9 million bonus payment for 2014 and a $1 million base salary as Chairman Emeritus for 2016, both of which were made by the compensation committee and not the full board.)

Directors are considered interested when a corporate decision would provide them with a financial benefit not available to the stockholders or when a decision would have a materially detrimental impact on them but not on the corporation and stockholders. The plaintiff claimed that the board was not disinterested because the board members faced a substantial threat of personal liability on the theory that the decision to continue paying Redstone during the relevant period could not have been a decision made in good faith and constituted waste.

As a general matter, a finding of bad faith requires showing that either:

A director intentionally failed to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.
The board's decision was so far beyond the bounds of reasonable judgment as to be essentially inexplicable on any ground other than bad faith.

Committing waste has been held to be an act of bad faith. Establishing waste requires showing that the corporation entered into a transaction in which it received consideration so inadequate in value that no person of ordinary, sound business judgment would deem it worth what the corporation paid. In the context of employee compensation, courts typically defer to a board's decision since making decisions regarding compensation is a core function of a board of directors and courts prefer not to second-guess the adequacy of a person's compensation.

Whether Demand Was Excused

The Chancery Court first examined the issue of whether the plaintiff was excused from making a demand on the board for each of his claims under Rule 23.1.

Breach of Fiduciary Duty

Regarding the $9 million bonus Redstone received for 2014, the court held that demand was not excused because the disinterest of a majority of the board had not been impugned over this payment. The decision to award the bonus was made solely by the four members of the compensation committee (as is appropriate under Section 141(c) of the DGCL), meaning that eight members of the 13-member board did not participate in the decision at all. Accordingly, a majority of the board did not face the prospect of personal liability for the bonus payment. The board therefore could have evaluated the allegation of waste concerning the bonus payment had the plaintiff brought it to the board.

However, the court did excuse demand for the plaintiff's claims regarding Redstone's $1.75 million annual salary payments from the end of May 2014 (when he allegedly became incapacitated) through early February 2016 (when he resigned as Executive Chairman). The court held that the facts in the plaintiff's complaint described with particularity a situation where the board members face a substantial threat of liability for claims of waste and bad faith by virtue of their failure to even consider terminating Redstone's employment agreement in spite of their knowledge of Redstone's failing health and the fact that he provided no meaningful service to the company throughout the relevant period. Although the compensation committee (comprising a minority of the board) was empowered by the board to terminate the employment agreement, the defendants agreed that the full board had the concurrent right to terminate it as well. The failure to do so was therefore equally ascribable to the full board.

The court also ruled that demand was excused for the plaintiff's claim regarding Redstone's compensation as Chairman Emeritus. Although the decision to award the $1 million salary was made by the compensation committee and not the full board, the court reasoned that the defendant directors could not be expected to faithfully challenge the committee's decision to pay that salary, as any arguments against it would undermine their own defense regarding the 2014 and 2015 base salary payments to Redstone.

In a footnote, the court acknowledged that by the same token, the board could perhaps not be expected to impartially challenge the compensation committee's decision to award Redstone a $9 million bonus payment for 2014, as any arguments against that payment's reasonableness would apply equally to the claims against the board for the salary payments. The court distinguished the claim over the 2014 bonus payment by pointing out that the company had met its performance goals for 2014 and that Redstone was able to perform his duties for approximately five months in 2014, which by itself may have been sufficient consideration for the bonus.

Unjust Enrichment

As with the breach of fiduciary duty claims, the court held that the plaintiff did not plead particularized facts to excuse his failure to make a demand on the board regarding the 2014 bonus payment, but that he did so regarding the Executive Chairman and Chairman Emeritus base salary payments, since the board could not impartially consider those unjust enrichment claims when 12 of its 13 members faced a sufficiently substantial threat of liability for permitting those payments.

Motion to Dismiss the Breach of Fiduciary Duty and Unjust Enrichment Claims

Turning to the defendants' Rule 12(b)(6) motion, the Chancery Court held that the plaintiff stated a claim for relief for most of the claims for which the court had held that a pre-suit demand on the board was excused.

The plaintiff stated a claim that the board members breached their fiduciary duty with respect to:

The payment of Redstone's Executive Chairman salary from May 2014 until his resignation from that position in February 2016. The plaintiff sufficiently alleged well-pled facts showing that Redstone's contributions were so limited during that time period that a salary of $1.75 million was a decision beyond the range of what any reasonable person would be willing to pay.
The payment of Redstone's Chairman Emeritus salary, because the plaintiff alleged facts that the board had long known that Redstone would not be able to contribute anything of value to CBS, yet it chose to continue paying him for services it allegedly knew he could not render.

The defendants argued that the decision to provide Redstone a Chairman Emeritus salary was appropriate in light of his past contributions to the company. In support of this assertion, the defendants referred to three cases in which the Chancery Court dismissed waste claims for executive compensation payments for past services rendered (Seinfeld v. Slager, (Del. Ch. June 29, 2012); Zucker v. Andreessen, (Del. Ch. June 21, 2012); Zupnick v. Goizueta, 698 A.2d 384 (Del. Ch. 1997)). The court rejected this argument because those cases dealt with one-time payments, typically as part of a severance or retirement arrangement. In this case, the board did not make a single payment to Redstone for past contributions but approved a salary for his new position.

The court ruled that the plaintiff did not state a claim for unjust enrichment regarding Redstone's Executive Chairman base salary payments because an employment agreement governed those payments. However, with no evidence that Redstone signed an employment agreement governing his Chairman Emeritus role, the plaintiff stated an unjust enrichment claim for Redstone's salary as Chairman Emeritus.

Practical Implications

The Chancery Court's decision in Redstone is significant for practitioners advising boards of directors on matters of executive compensation and for corporate practitioners in general advising directors on their fiduciary duties. The decision represents the rare case in which the Chancery Court has found a showing of potential liability on a theory of waste, a theory that is typically quite hard to satisfy. That this comes in a case regarding executive compensation is particularly notable because determining executive and director compensation levels is a core function of boards of directors and courts usually defer to the boards' decisions on those matters. Boards of directors, compensation committees, and their counsel should take care to avoid similar compensation arrangements if the executive in question is making little or no contribution to the company.

The decision also illustrates the benefit of taking detailed (or at least more than bare-boned) minutes and establishing a record of the board considering difficult issues. The court in Redstone did not fault the CBS board for failing to terminate Redstone's employment agreement, but for failing to even consider terminating it. It was this failure that constituted a showing of conscious disregard by the board of its duties. Had the board openly discussed the matter of Redstone's health and provided a record of doing so, it seems likely that the court would have dismissed some or all of the claims against the board.

Delaware Court of Chancery Excuses Pre-Suit Demand for Derivative Complaint Alleging Wasteful Compensation | Practical Law