Corporate Governance

Delaware Courts and the Influence of Federal Preemption (part 3)

By J. Robert Brown

We are discussing whether we will see, as we did in the aftermath of SOX (take a look at footnote 382 in The Irrelevance of State Corporate Law in the Governance of Public Companies), a shift in the Delaware courts that suggests it will temporarily reduce its pro-management bias in an effort to head off possible federal preemption.

This summer, a Delaware court actually struck down bonuses paid to executive officers.  Rather than apply the business judgment rule, the court subjected the payments to the "entire fairness" standard.  Julian v. Eastern States Development, Civil Action No. 1892-VCP (Del. Ch. July 8, 2008), involved a dispute among three brothers conducting business together.  Two sat on the board of Benchmark and, after a meeting of “less than a half an hour” attended by “no legal or financial advisors,” they voted themselves substantial bonuses. In the ensuing litigation, the directors had the burden of showing the fairness of the payments.

The directors argued that bonuses were ordinary and that the amounts were in return for the company’s “good year.” The court conceded a preexisting practice of paying bonuses but viewed the amounts as uncharacteristically large. 

• From 1999 through 2004, [Company's] bonuses as a percentage of adjusted income hovered between 3.30% and 3.36%. In contrast, the challenged 2005 bonuses constituted 22.28% of adjusted income. Additionally, 2005 marked the first time [the non- brother director] received a bonus beyond the performance-based compensation set forth in his Employment Agreement.

These amounts were not sufficiently explained by the company’s “good year.” “Regarding the reward for a good year, Benchmark had a better year in 2004 than 2005, and the bonuses in 2004 were still only 3.36% of adjusted income." The court held that the board had not met its burden of showing fairness.

In other words, the Delaware court merely made the board justify the payments.  Had the court applied the more standard approach (the business judgment rule), it would merely have asked whether the board was informed.  Based on the absurdly low standards set out in Disney, these same payments likely would have been upheld.  In other words, the Delaware courts use the business judgment rule to shield unfair payments made to fiduciaries.  But at least in Julian, the court had the temerity to apply modest but meaningful standards to the board of directors in connection with executive compensation.  Perhaps this portends a shift in the law in Delaware, one that will entail a return of an examination of fairness to the determination of executive compensation.  Or, perhaps, the decision is nothing more than an attempt to head off federal preemption in the area.

Full post as published by The Race to the Bottom on December 16, 2008 (boomark / email).