Delaware Chancery Court Refuses to Dismiss Claims Alleging Breach of Contract, Breach of Fiduciary Duty, and Unjust Enrichment Related to Equity Grants | Practical Law
Practical Law Legal Update w-035-7117 (Approx. 6 pages)
Delaware Chancery Court Refuses to Dismiss Claims Alleging Breach of Contract, Breach of Fiduciary Duty, and Unjust Enrichment Related to Equity Grants
by Practical Law Employee Benefits & Executive Compensation
A company's shareholder asserted claims against the company, its chief executive officer (CEO), and its board of directors alleging breach of contract, breach of fiduciary duty, and unjust enrichment based on the company's equity awards to its CEO, which the shareholder alleged violated the company's equity compensation plan. The Delaware Chancery Court rejected the defendants' motion to dismiss.
In Garfield v. Allen, a company's shareholder asserted several claims against the company, its chief executive officer (CEO), and its board of directors based on the company's equity awards to its CEO, which the shareholder alleged violated the company's equity compensation plan (equity plan). The Delaware Chancery Court held that the plaintiff successfully pled, for purposes of surviving a motion to dismiss:
A direct claim for breach of contract against the four members of the compensation committee of the board who approved the equity awards.
Company Approved Equity Compensation Plan and Made Equity Awards to CEO
In 2019, the company's shareholders approved an equity plan. The 2019 equity plan, which is administered by the compensation committee, authorizes the board to grant equity awards to the company's officers, employees, non-employee directors, and consultants. The awards that may be granted under the 2019 equity plan include, among other types of equity awards, performance shares and performance units.
The 2019 equity plan limits:
The maximum aggregate payout with respect to performance units granted in any one fiscal year of the company to any one participant in the equity plan to $6,500,000.
The maximum number of shares subject to awards of performance shares granted in any one fiscal year of the company to any one participant to 3,500,000.
In March 2020, the compensation committee made two grants of performance shares (collectively, the equity awards) to the company's CEO based on:
The company's total shareholder return relative to its peer group (the TSR award), which entitles the CEO to receive up to 2,132,700 performance shares, with the exact number of shares earned depending on the level of the company's performance.
The company's free cash flow (the FCF award), which entitles the CEO to receive up to 2,601,140 performance shares, with the exact number of shares earned depending on the level of the company's performance.
Both equity awards were granted to the CEO in the same fiscal year. The CEO may receive a maximum of 4,733,840 shares in connection with the equity awards if maximum performance criteria are met. The actual amount of awards will be determined by the company's performance over a measurement period that ends at the end of 2022 for the FCF award and in 2023 for the TSR award. If the maximum performance criteria are met, then the aggregate number of shares that the CEO earns will exceed the limit in the 2019 equity plan.
In March 2021, the company filed its 2021 Proxy with the SEC, in which it described the CEO's equity awards. Later that month, the plaintiff sent a letter to the company in which he asked that the board:
Modify the performance share awards granted to the CEO by lowering the maximum potential payout to conform with the 2019 equity plan's performance share limitation.
Investigate whether there were additional violations of the company's equity plans and to adopt and implement internal controls and systems to prevent another violation of the 2019 equity plan.
The company informed the plaintiff that it would not take his requested actions because:
The board had adopted a policy of interpreting the performance share limitation as applying only to the TSR and FCF target scenarios, and under those scenarios, the aggregate award did not exceed 3,500,000 performance shares. The board had the authority to adopt this policy under the broad interpretative authority found in the 2019 equity plan.
The company also asserted that because the performance periods had not closed, the number of shares that may become payable to the CEO under the TSF and FCF awards was not known.
In April 2021, a majority of shareholders voted in favor of the company's say-on-pay resolution, approving the CEO's equity awards.
The plaintiff filed a complaint in Delaware Chancery Court in May 2021, asserting:
A direct claim for breach of contract against the four members of the compensation committee who approved the equity awards.
A derivative claim for breach of fiduciary duty. The plaintiff claimed that the compensation committee, the CEO, and the board breached their fiduciary duty to the company.
A derivative claim for unjust enrichment against the CEO, alleging that through the equity awards he received an unjustified benefit in the form of a right to receive a number of shares that exceeds the performance share limitation in the company's equity plan.
The defendants filed a motion to dismiss the plaintiff's claims for failure to state claims on which relief can be granted under Court of Chancery Rule 12(b)(6). They did not move to dismiss the claims under Court of Chancery Rule 23.1.
Chancery Court Holds That Plaintiff Adequately Pled His Claims
On May 24, 2022, the Chancery Court held that all of the plaintiff's claims were adequately pled and survived the defendants' motion to dismiss.
Ripeness
The defendants argued that the plaintiff's claims are not ripe because it is not yet known how many shares the CEO will retain under the equity awards. The court rejected this argument because the board granted the CEO a bundle of rights when it approved the equity awards. Therefore, the plaintiff can now challenge whether those rights comply with the 2019 Equity Plan. The court reached this conclusion based on settled law in Delaware regarding this issue.
Rule 12(b)(6)
Once the court determined that the plaintiff's claims were ripe, the court next addressed the defendants' contention that the complaint fails to state a claim on which relief can be granted.
Breach of Contract
The plaintiff made a direct claim for breach of contract against the four members of the compensation committee who approved the equity awards. He also claimed that the entire board breached the contract of the 2019 Equity Plan. This claim alleged that the 2019 Equity Plan is a contract between the board and the company's shareholders and that:
The members of the compensation committee breached the contract when they granted the equity awards.
All of the members of the board, who rejected the plaintiff's demand letter, also breached the 2019 Equity Plan by allowing the CEO to retain his rights under the equity awards.
In support of their motion to dismiss, the defendants argued that the 2019 Equity Plan is not actually a contract. They also argued that the plaintiff misinterpreted the 2019 Equity Plan's performance share limitation. Finally, the defendants argued that the plaintiff failed to plead damages stemming from the breach.
The court held that the plaintiff stated a claim that the committee breached the 2019 Plan because the performance share limitation provides a limit of 3,500,000 performance shares per participant per fiscal year, but the number of performance shares subject to the CEO's equity awards is 4,733,840. The court rejected the defendant's arguments, holding that a shareholder-approved equity compensation plan is a contract between the board of directors and its shareholders under Delaware law. Second, the court held that the plain language of the performance share limitation does not permit the committee to grant awards to a single participant in a single fiscal year where the maximum number of shares that is subject to the equity awards would exceed 3,500,000. Finally, under Delaware law, a plaintiff need not plead monetary damages to sustain a breach of contract claim; the plaintiff need only plead causally related harm, which the plaintiff can accomplish by pleading a violation of the plaintiff's contractual rights.
Regarding the plaintiff's breach of contract claim against the entire board, the defendants argued that after the plaintiff sent the demand letter, they adopted a target award policy to use in determining whether an equity award complies with the 2019 Equity Plan's performance share limitation. Under the target award policy, the performance share limitation is measured using the target benchmark in a performance share award, not the maximum benchmark. The court held that the performance share limitation in the 2019 Equity Plan does not refer to target performance. It only provides a cap of 3,500,000 performance shares that may be granted in any one fiscal year to any one participant. Therefore, it is reasonably conceivable that by adopting the target award policy and attempting to use it to validate the challenged awards, the board of directors breached the 2019 Plan.
Breach of Fiduciary Duty
The plaintiff asserted that the defendants breached their fiduciary duties in several ways. Specifically, he claimed that:
The members of the compensation committee appointed by the board of directors breached their fiduciary duties by approving the CEO's equity awards and knowingly violating the performance share limitation.
The CEO breached his fiduciary duties by accepting the equity awards knowing that they violated the performance share limitation.
All members of the board of directors violated their fiduciary duties by failing to fix the equity awards in response to the plaintiff's demand letter.
The court held that at the pleading stage, these theories state claims on which relief can be granted.
First, the court rejected the defendants' argument that the business judgment rule protects the committee and the entire board from breach of fiduciary duty claims. Under Delaware law, the business judgment rule does not apply to a claim, like the one in this case, that directors lacked authority to take action under the terms of a governing document. Delaware case law also provides that when the allegations of a complaint support a reasonable inference that a fiduciary violated a plain and unambiguous restriction on the fiduciary's authority, then the plaintiff has asserted a claim for a breach of the duty of loyalty that rebuts the protections of the business judgment rule. Therefore, the court held that the business judgment rule does not protect the committee's decision to approve the equity awards and also the board's decision to adopt the target award policy, and the plaintiff's complaint states a claim for breach of fiduciary duty against the members of the Committee and the members of the Board for those taking those actions.
Second, the court rejected the defendants' argument that the plaintiff failed to state a claim for breach of fiduciary duty against the CEO because the equity awards were legitimate compensation. It is established under Delaware law that a plaintiff states a claim against a fiduciary who accepts an equity award when the award violates an express limitation in an equity compensation plan; those facts support a claim that the recipient acted knowingly when accepting the award, thereby breaching the duty of loyalty by failing to act in good faith.
Third, although the court expressed reservations about the plaintiff's breach of fiduciary duty claim against the entire board for its failure to respond to the demand letter by fixing the challenged equity awards, the court nonetheless held that the plaintiff stated a claim that could survive the pleading stage. Despite the lack of precedent for the plaintiff's theory, as a general matter, Delaware law treats a conscious failure to act as the equivalent of action, so if a plaintiff brings a clear violation to the board's attention and the board does not act, then it is "reasonably conceivable" that the directors' failure to act constitutes a breach of duty.
Unjust Enrichment
The court held that the plaintiff met the requirements for an unjust enrichment claim. The defendants had argued that the plaintiff would not be able to show the absence of an adequate remedy at law, which is one of the elements of the claim, because the plaintiff had pled other theories of recovery. But the court held that it can exercise jurisdiction over the unjust enrichment claim under the clean-up doctrine, regardless of whether the plaintiff otherwise possesses an adequate remedy at law.
Ratification
The defendants also argued that the advisory say-on-pay vote in 2021, in which a majority of shareholders voted in approval of the CEO's equity awards, ratified the CEO's equity awards. The court rejected this argument because the vote was nonbinding and to hold to the contrary would contradict Delaware and federal law.
Practical Implications
Corporate boards of directors should be mindful of the Chancery Court's decision in Garfield and remember to closely adhere to the terms of the company's equity incentive plan, especially individual limits on equity awards, when making decisions regarding grants of equity awards.