Chancery Court Accepts “Novel Theory” of Liability for Directors

Gail Weinstein is senior counsel and Scott B. Luftglass and Amy L. Blackman are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Luftglass, Ms. Blackman, Donald P. Carleen, David L. Shaw, and Shant P. Manoukian, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

In Garfield v. Allen (May 24, 2022), the Delaware Court of Chancery accepted, “with admitted trepidation,” what it called a “novel theory” advanced by the plaintiff—namely, that a corporation’s directors may have breached their fiduciary duties to the stockholders by failing to reverse equity compensation awards made to the CEO after the board became aware, via the plaintiff’s litigation demand letter, that the awards violated a limitation set forth in the company’s equity compensation plan. Vice Chancellor Laster, at the pleading stage of litigation, declined to dismiss the plaintiff’s claims against the directors who approved the awards; against the other directors (who did not approve the awards); and against the CEO who received the award.

Key Points

  • The court accepted, at the pleading stage, the plaintiff’s “novel” theory that a board’s failure to act to address a problem it learns of through a litigation demand letter may constitute a breach of the directors’ fiduciary duties. Although the theory “lacked precedent,” the court found that “the logic of the…theory is sound.” The court noted that, under Caremark, directors are liable for not fixing a problem after they consciously ignore “red flags” that the problem exists. The result should not be different, the court concluded, where the source of the notice of the problem is, instead, a litigation demand. Further, the court reaffirmed that a “knowing” violation by directors of a “plain and unambiguous restriction” in an equity compensation plan can give rise, at the pleading stage, to a reasonable inference of bad faith conduct by the directors sufficient to rebut the business judgment rule.

  • Vice Chancellor Laster accepted the theory “with admitted trepidation” and suggested “caution” by the court when plaintiffs advance it in future cases. While accepting the theory, the court deemed it “disquieting” that, under this theory, a plaintiff could “manufactur[e] a claim against directors by acting as a whistleblower and then su[e] because the directors did not respond to the whistle.” Based on the “serious policy issues” the theory raises, the Vice Chancellor cautioned that, in future cases, the court should not permit a plaintiff to pursue a “strategy” of creating a new claim by sending a demand letter as part of “an artifice” to, for example, make an untimely claim or improperly bring additional defendants into the case.
  • Directors’ (even independent and disinterested directors’) violation of a “plain and unambiguous” restriction in an equity-based compensation plan can give rise to both contractual and fiduciary claims. Directors who approve clearly flawed awards under a plan may be liable for breach of contract (as an equity plan is considered to be a contract between the board and the stockholders); and all of the directors (even those who did not approve the awards) may be liable for breach of their fiduciary duties for not “fixing” flawed awards after learning about the problem. A decision about whether and how to address the problem is not subject to business judgment deference, as, first, the business judgment rule does not apply to a claim that directors lacked authority to take action under the terms of a governing document; and, second, when directors grant awards that exceed an express limitation in an equity compensation, there can be, at the pleading stage, a reasonable inference that they acted “knowingly and intentionally” (i.e., in bad faith, which rebuts the presumption of the business judgment rule).
  • The court emphasized that directors’ noncompliance with a clear restriction in a plan cannot be excused through reliance on the plan provisions granting directors sole discretion in interpreting and administering the plan. Under such provisions, directors are able to interpret only ambiguous provisions of the plan, the court stated.

Background. In 2019, the board of ODP Corporation (the “Company”) adopted, and the stockholders approved, an equity compensation plan (the “Plan”) authorizing the board to grant awards of performance shares and other equity-based compensation to officers, employees, non-employee directors, and consultants. The Plan calls for administration by a board committee (the “Committee”). The Committee was comprised of four outside directors. The Plan’s terms set certain limits on the size of awards that the Committee can grant, including a provision setting 3.5 million as the maximum number of shares of common stock that may be subject to performance share awards granted to any single individual in the same fiscal year (the “Performance Share Limitation”). In March 2020, the Committee made two grants of performance shares to the Company’s CEO (who also was a director) (the “Challenged Awards”). The Challenged Awards entitled the CEO to receive a variable number of performance shares, with the actual amount dependent on the Company’s performance against stated goals over a three-year period ending in 2023. The target number of shares subject to the Challenged Awards fell under the Performance Share Limitation; however, if the Company achieved the maximum performance payout level, the aggregate number of shares of common stock to which the CEO would be entitled under the Challenged Awards (over 4.7 million shares) would exceed the Performance Share Limitation.

The plaintiff (a Company stockholder) sent the board a demand letter claiming that the Challenged Awards violated the Performance Share Limitation and demanding that they be amended. (We note that demand letters such as this are not uncommon, and that certain plaintiffs-side firms focus on potential violations of equity compensation plans.) The Committee, relying on its authority to interpret the Plan, adopted a policy to apply a different limitation stated in the Plan (which was based on target rather than actual performance) to the Performance Share Limitation, which resulted in the number of shares issuable not exceeding the Performance Share Limitation. The plaintiff asserted a direct claim for a contractual breach of the Plan by the directors and a derivative claim for a breach of fiduciary duties by the directors and the CEO.

At the pleading stage of litigation, Vice Chancellor Laster rejected the defendants’ motion to dismiss the case. The Vice Chancellor agreed with the plaintiff that it was reasonably conceivable (the standard at the pleading stage for survival of claims) that: (i) the Committee directors contractually breached the Plan by approving the Challenged Awards; (ii) the Committee directors breached their fiduciary duties by approving the Challenged Awards; (iii) the CEO breached his fiduciary duties by accepting the Challenged Awards; and, most notably, (iv) all of the directors (including those who did not approve the Challenged Awards) breached their fiduciary duties by “not fixing the Challenged Awards after the plaintiff[‘s demand letter] brought the violation of the [Plan] to their attention.”

Discussion

The directors’ failure to address the problem after learning about it through the plaintiff’s litigation demand letter potentially could constitute a breach of their fiduciary duties. The court noted that, historically, a board’s wrongful rejection of a plaintiff’s litigation demand “has affected only the question of who controls the derivative claim” the plaintiff wishes to bring and has not “been analyzed as a separate fiduciary wrong.” The court characterized as “novel” and “lack[ing] precedent” the theory that a plaintiff, by making a litigation demand, could create a new claim. However, the court concluded that “the logic of the plaintiff’s theory is sound.” The court reasoned that “Delaware law treats a conscious failure to act as the equivalent of action, so if a plaintiff brings a clear violation to the directors’ attention and they do not act, then it is reasonably conceivable that the directors’ conscious inaction constitutes a breach of duty.” The court observed that “[t[he same logic animates a Caremark claim” that rests on the theory that the board consciously ignored notice of a problem from a whistleblower or from “proverbial red flags” that serve as notice. In this case, the notice came from the plaintiff’s demand letter, but “from an analytical perspective…the source of the directors’ knowledge should not make a difference,” as “[t]he breach lies in [the directors’] conscious failure to act based on the knowledge they possessed.”

The court acknowledged that important policy issues arise from acceptance of the theory that a litigation demand can create a new claim if the board ignores it. The court noted its concern about “knock-on effects” from accepting the plaintiff’s theory. The court observed that, for example, based on this theory, a plaintiff (i) could “undermine salutary doctrines such as laches that force plaintiffs to make claims on a timely basis” and (ii) could expose new directors, who did not approve the challenged board decision, to litigation risk “by presenting them with a problem that they did not create and asserting that they failed to fix it.”

The court indicated that, although acceptance of the theory was warranted in this case, the court should approach its application in future cases with caution. The court viewed the case at issue as presenting “one of the strongest possible scenarios for…a claim” that rejection of a litigation demand may constitute a breach of fiduciary duties. “If there was ever a time when all of the directors had a duty to take action to benefit the Company by addressing an obvious problem, it is reasonably conceivable that this is it,” the court wrote. First, the Performance Share Limitation was set forth in “plain and unambiguous” language in the Company’s plan and the maximum number of shares to which the CEO had a right under the award clearly would exceed the limit if the relevant performance goals were met. Under established Delaware precedent, the court noted, “the failure to comply with a plain and unambiguous restriction in a stockholder-approved equity compensation plan supports an inference that the directors acted in bad faith.” Second, in this case, there was an “easy fix” available to the board, as the recipient of the award (the CEO) was a “fellow fiduciary who faced the same obligation to fix the flawed grants as the other members of the Board.” The Vice Chancellor emphasized that, given the “obvious” policy implications noted above, “future decisions must consider carefully any attempts by plaintiffs to follow a similar path.”

All of the directors face potential liability for contractual breach of the Plan. The court reaffirmed that, under established Delaware law, a stockholder-approved equity compensation plan is considered to be a contract between the board and the stockholders. In this case, the Performance Share Limitation in the plan was set forth in “clear and unambiguous” language and it was clear that the maximum number of shares issuable under the Challenged Awards would exceed the limitation if the relevant performance goals were met. Therefore, the Committee directors (i.e., the directors who approved the Challenged Awards) face a breach of contract claim for exceeding a clear and unambiguous limitation on their authority under the plan.

In addition, and more notably, the court found that all of the directors (not just the Committee directors who approved the awards) face possible liability for breach of contract based on their response to the problem once they learned of it. The problem was not that they did nothing (the Plan did not require them to do anything—although, as discussed below, their fiduciary duties did require that they address the problem). Rather, their potential contractual breach arose based on their response to the demand letter, which was to “invoke[] authority they did not have” under the Plan by adopting a policy that effectively re-wrote the Plan terms. Specifically, after receiving the demand, the board adopted a policy (the “Target Policy”) that, drawing on another provision of the Plan (the “Share Pool Rule”), established a rule that the number of performance shares granted would be calculated for purposes of the Performance Share Limitation assuming target performance was achieved. However, the Share Pool Rule addresses administering the Plan limit on the maximum number of shares that can be issued over the life of the Plan. The Share Pool Rule specifically refers to target level of achievement to determine how many performance shares are counted against the “share pool” limitation at the time of grant; and that number is ultimately trued up when the actual level of performance is determined. The court noted that the Share Pool Rule and the Performance Share Limitation by their terms are not related and, moreover, “operate in different ways and serve different purposes.” Adoption of the Target Policy (which interpreted the “hard cap” on individual compensation by applying a rule that was included in the Plan for the administrative purpose of managing the total amount of shares necessary for the Plan) amounted to a “rewriting” of the Plan that was outside the directors’ authority under the Plan, the court held.

All of the directors face potential liability for breach of their fiduciary duties in not fixing the problem after learning about it from the litigation demand. The defendants argued that their decisions in respect of the Challenged Awards were subject to business judgment deference from the court. The court held that the business judgment rule was inapplicable. First, the court stated, under the logic of the court’s Caremark line of decisions, once the directors learned about the noncompliance with the equity compensation plan, they had “a duty to take action to benefit the Company by addressing an obvious problem.” Second, the court wrote: “When directors grant awards that exceed an express limitation in an equity compensation plan, the allegations support an inference that the directors acted knowingly and intentionally. That inference in turn supports a claim that the directors breached their fiduciary duty of loyalty by failing to act in good faith, which rebuts the protections of the business judgment rule.”

The court noted that, if the business judgment rule applied, the directors almost certainly would not have any liability even if they had decided to do nothing about the problem. Under that scenario, a decision to do nothing would be within the board’s business judgment. The court observed that if, for example, a third-party consultant had been the recipient of the award, the consultant (unlike the CEO) would not have had an obligation to fix the problem (and would not necessarily even have had reason to know about the Performance Share Limitation). In that hypothetical setting, “if the Board later learned about the violation, then the Board would not have [had] an easy fix available…, and the Board would face a tough decision,” with the alternatives “rang[ing] from doing nothing to asserting some kind of claim against the consultant,” and the decision by the independent and disinterested directors as to how “to address the problem would be a business judgment” under which directors might “reason that letting the issue go would be better for the Company in the long run.”

Provisions in a compensation plan permitting the board to “interpret” the terms of the plan cannot excuse a board’s noncompliance with an unambiguous restriction in the plan. The Performance Share Limitation provision in the Plan provides that “the maximum number of shares…subject to Awards” granted to any one person in any one fiscal year could not exceed 3,500,000. The Plan also provides that the Committee has “full and discretionary authority” to select who will receive awards under the Plan; to determine the form and substance of awards and the restrictions to which awards will be subject; to “interpret, construe and administer” the Plan and the awards granted; and to make such other determinations for carrying out the Plan as the Committee may deem appropriate. Further, the Plan provides that “decisions of the Committee on all matters relating to the Plan shall be in the Committee’s sole discretion and shall be conclusive, final and binding on all parties.” The defendants could not rely on these “Interpretation Provisions,” however, “to escape the plain meaning of the Performance Share Limitation,” the court stated. The Interpretation Provisions permit interpretation only of “ambiguous” provisions—and the Committee lacked the authority to take action that contravened an express, unambiguous limitation set forth in the Plan.

The court specifically rejected the defendants’ several arguments that their actions were justifiable based on their authority under the Interpretation Provisions. First, the court disagreed with the defendants’ contention that the Performance Share Limitation was ambiguous and the board therefore had to interpret what the “maximum number of shares…subject to Awards” meant. The court wrote: “It is self-evident that 4,733,840 [(the maximum number of shares that could be issued under the Challenged Awards, as pleaded by the plaintiff)] exceeds 3,500,000. The plaintiff has therefore stated a claim for [contractual] breach of the [Plan].” Second, the court rejected the defendants’ argument that they had addressed the problem raised in the demand letter by adopting the Target Policy (discussed above). The defendants could not use the Interpretation Provisions “to alter the plain terms of the [Plan]” by applying a rule in the Plan that by its terms did not apply to the Performance Share Limitation (and that operated “in a different way and for a different purpose”). Third, the court rejected the defendants’ argument that, because under the Plan the Committee had sole discretion to determine whether awards would be settled in cash, securities, or a combination thereof, it could not be determined whether the Performance Share Limitation would be violated because the Committee still might decide to settle the award in part in cash. The Plan requires that the determination as to whether stock or cash would be paid be made at the time of the grant—there was no authority for the Committee to “transmogrify the Award at some later date.” Moreover, the court stated, even if the CEO and the Committee now agree to settle part of the award in cash, the defendants still violated the Plan because the Performance Share Limitation applied as of the time the award was approved and granted. “[T]hey cannot go back in time and avoid the original violation,” the court wrote.

The CEO faces a claim for breach of his fiduciary duties in accepting the flawed compensation award. The CEO was on the board at the time the Plan was adopted; and the Company’s proxy statement described the Performance Share Limitation and identified it as a material term of the Plan. The court stated that, “[g]iven the importance of the Performance Share Limitation, and given [S]’s role as CEO and board member,” it is reasonable to infer, at the pleading stage, that the CEO “knew about the Performance Share Limitation…and that the Challenged Awards violated the Performance Share Limitation.” The CEO’s acceptance of the Challenged Awards may have constituted bad faith (and thus a fiduciary breach) given that the equity-based award “violated a clear and unambiguous limitation in the governing document.” The court noted that in its recent Knight decision it acknowledged that a plaintiff can state a fiduciary claim against defendants for accepting equity-based awards in bad faith, but concluded that, on the facts presented in that case, it was not reasonable to infer that the defendants, who had received options allegedly not in in compliance with the company’s options plan, had accepted them in bad faith. The court emphasized that Knight, unlike Garfield, “did not involve a violation of a clear and unambiguous limitation in a plan….”

The court reaffirmed that a challenge to an equity-based award is ripe when the award is made. The court held that the plaintiff’s challenge was ripe when the Committee approved the Challenged Awards, even though it will remain uncertain until the end of the three-year measuring period how many shares the CEO actually will be entitled to receive. The court noted that it is well-established that challenges to option grants, for example, are ripe at the time of the award rather than only once exercised. The court wrote: “When the Committee approved the Challenged Awards, the Committee granted a bundle of rights to [the CEO]. The plaintiff can challenge now whether that bundle complies with the [Plan].” The court noted that the agreement governing the award reinforces that the CEO “became entitled to enforceable rights” at the time the award was granted and the award agreement was executed. The agreement states that the CEO was “granted the right to earn shares…based upon satisfaction of certain performance conditions, and that, after the Committee determines the amount of Performance Shares to which he will be eligible, he will “immediately forfeit all Performance Shares other than [those to which he has been determined to be eligible].” The agreement “thus operates on the principle that [the CEO] currently possesses a contractual right to receive the shares covered by the [agreement], subject to the future forfeiture of any shares that he might become ineligible to receive.”

Practice Points

  • A board should be aware that, depending on the facts and circumstances, the directors’ fiduciary duties may require that they address the corporate problem or risk identified in a litigation demand. If alerted to a corporate problem, the board should consider carefully whether it should investigate the problem further and, depending on the facts and circumstances, whether it should act to try to remedy the problem. Based on Garfield, a board’s wrongfully ignoring a litigation demand will not necessarily affect only who controls the plaintiff’s derivative demand, but may also be analyzed by the court as a possible separate fiduciary wrong by the directors (including independent and disinterested directors and directors who did not approve the challenged decision). Importantly, the Garfield opinion strongly suggests that this risk to directors will be most acute where the problem or risk identified is clear and unambiguous and where there is an “easy fix” by the board. It remains to be seen whether future decisions expand upon Garfield and under what circumstances the Garfield plaintiff’s “novel theory” may apply to, for example, decisions by demand review committees and special litigation committees.
  • A board and its advisors should understand and seek to ensure compliance with any limitations in the company’s equity-based compensation plans. A board should not rely on its authority under a plan to interpret and administer the plan to sidestep clear and unambiguous limitations set forth in the plan. Also, the recipient of an award under an equity-based plan, if a fiduciary (such as a director or officer), may have a fiduciary duty not to accept (or, after accepting, to “fix”) an award that is noncompliant with the plan—at least if the noncompliance is clear and the fiduciary has reason to know of it. While not addressed in the court’s opinion, we note that the court’s approach conceivably could be applicable to other company agreements with directors, officers or affiliates.
  • In our view, the opinion highlights that a “kitchen sink” approach to defending against fiduciary claims may not be optimal. In this case, the court found that many of the defendants’ numerous arguments contravened the plain language of the Plan, the descriptions in the Company’s proxy statement filed with the SEC, and/or settled Delaware precedent. For example, the defendants argued that the stockholders’ approval of the Company’s general, non-binding say-on-pay resolution ratified the Challenged Awards. The court characterized this argument as “extreme” and “frivolous.” The court characterized other arguments asserted by the defendants as “irrelevant” and “unreasonable.” The court advised: “Prudence sometimes counsels against making a particular argument.” The court appeared to be exercised in particular in this case because “[t]he clear answer was [for the directors] to fix the Challenged Awards” and the “fix was readily available.”
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