(Article from Securities Law Alert, August/September 2019)
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On September 20, 2019, the Delaware Chancery Court held that the business judgment standard of review did not apply to a board’s decision to award sizable incentive compensation to a controlling stockholder, even though a majority of the disinterested stockholders voted in favor of the award. Tornetta v. Musk, 2019 WL 4566943 (Del. Ch. 2019) (Slights, V.C.). The court held that “stockholder ratification, without more, does not counterpoise the risk of coercion” by the controlling stockholder. The court found that “MFW provides the answer” to protecting against this risk.[1] The court held that if a board preconditions a compensation award to a controlling stockholder on the satisfaction of MFW’s dual procedural safeguards, “[b]usiness judgment deference at the pleadings stage would then be justified.”
The court recognized that “[a] board of directors’ decision to fix the compensation of the company’s executive officers” is generally “entitled to great judicial deference,” particularly if “the board submits its decision to grant executive incentive compensation to stockholders for approval, and secures that approval.” However, the court stated that its “earnest deference to board determinations relating to executive compensation does not jibe with [its] reflexive suspicion when a board transacts with a controlling stockholder.” The court observed that “[b]ecause the conflicted controller, as the 800 pound gorilla, is able to exert coercive influence over the board and unaffiliated stockholders, [Delaware] law has required that transactions with conflicted controllers be reviewed for substantive fairness even if the transaction was negotiated by independent directors or approved by the minority stockholders.”
The court rejected defendants’ contention that this “concern is less pressing, and less worthy of protection, in transactions, like the [a]ward, that do not alter the corporate contract.” The court found “[t]he controlling stockholder’s potentially coercive influence is no less present, and no less consequential, in instances where the board is negotiating the controlling stockholder’s compensation than it is when the board is negotiating with the controller to effect a ‘transformational’ transaction.” The court held that “[i]n [both] circumstances, stockholder approval of the conflicted controller transaction, alone, will not justify business judgment deference.”
The court then considered whether “the [b]oard could have structured the approval process leading to the [a]ward [at issue] in a way that provides a feasible way for defendants to get cases dismissed on the pleadings.” The court acknowledged that “neither the Chancery nor Supreme Court opinions in MFW can be read to endorse an application of MFW beyond the squeeze-out merger.” Nevertheless, the court found this did “not mean that MFW’s dual protections cannot be potent neutralizers in other applications.” The court determined that “[j]ust as in the squeeze-out context, preconditioning a controller’s compensation package on both the approval of a fully functioning, independent committee and an informed, uncoerced vote of the majority of the minority stockholders will dilute the looming coercive influence of the controller.” The court reasoned that with these procedural protections in place, “the minority stockholders will have far less reason to fear that the controller will retaliate if the committee or minority stockholder votes do not go his way.”
Although the board conditioned the compensation award on the approval of a majority of the minority stockholders, the board did not condition the award on the approval of an independent special committee. The court therefore reviewed the allegations under the entire fairness standard of review. The court found it “reasonably conceivable” that the award was unfair because plaintiff alleged that “[t]he [a]ward has a potential value that is orders of magnitude higher than what other highly paid CEOs earn.” The court therefore denied defendants’ motion to dismiss the plaintiff’s breach of fiduciary duty claims.
[1] In Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014) (MFW), the Delaware Supreme Court held that the business judgment standard of review applies to a controlling stockholder transaction if the transaction “is conditioned ab initio upon the approval of both an independent, adequately-empowered Special Committee that fulfills its duty of care, and the uncoerced, informed vote of a majority of the minority stockholders.” Please click here to read our discussion of MFW.