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CALIFORNIA CORPORATE & SECURITIES LAW

No Calm In Delaware After Calma v. Templeton

In derivative suits, cases are essentially lost and won at the motion to dismiss stage.  Unless the defendants succeed in winning dismissal, they must confront an unhappy choice between continued litigation with all of its costs and risks or a settlement that “feeds the bulldog”.  Thus, the Delaware Court of Chancery’s rulings in Calma v. Templeton, 114 A.3d 563 (Del. Ch. 2015) and Seinfeld v. Slager, 2012 Del. Ch. LEXIS 139 (June 29, 2012) should be particularly unnerving to those concerned about excessive litigation.

Both cases involved challenges to equity awards made to non-employee directors under stockholder approved plans.  Although directors are interested in their own compensation, Delaware has historically not subjected these decisions to the burdensome entire fairness standard.  As former Delaware Supreme Court Justice Jack Jacobs recently explained:

Since the 1950s, it had been black-letter law that where boards of Delaware corporations, pursuant to authority conferred by executive compensation plans approved by the shareholders, grant compensation awards, those awards, if challenged in court, are reviewed under the business judgment rule.

Jack B. Jacobs, “Delaware Tightens Scrutiny of Director Compensation”, Law360 (June 22, 2015).

That has changed with the Court of Chancery’s rulings in Calma and Seinfeld.  In both cases, the defendant directors moved to dismiss based on the defense of shareholder ratification.  If successful in that defense, the awards would be evaluated under the business judgment rule.  The Court in each case, however, ruled that because the plans included no “meaningful limit” on the number of awards that could be made to a single director, stockholder approval of the plan did not amount to ratification.  Therefore, the awards must be evaluated under the entire fairness standard.

Former Justice Jacobs described these rulings as a “seismic change” in the Court of Chancery’s approach to director compensation.  He’s right.  It is also likely to foster still more litigation.  In response, many companies will amend their equity award plans to include specific limits on awards to directors.  However, the Court of Chancery’s rulings provide virtually no guidance on what constitutes a “meaningful” limitation.  The stockholder approved plans in both cases included limitations but apparently these were too large in the eyes of the Court.  When does a limitation change from being meaningful to meaningless?  Companies will have to guess.  In the meantime, the vagueness of the standard practically invites plaintiffs’ lawyers to challenge the determination.

This ruling exemplifies a problem with Delaware law, the courts will announce a broad standard and then refine it through a long line of cases.  While this has the virtue of flexibility, it fosters litigation as both plaintiffs and defendants struggle to find exactly where the lines are.  How many battles, for example, have been fought over whether the business judgment rule or entire fairness standard applies in acquisition transactions?  The rulings in Calma and Seinfeld are likely to have the same effect.

Nevada takes a much more straightforward approach.  NRS 78.140(5) provides:

Unless otherwise provided in the articles of incorporation or the bylaws, the board of directors, without regard to personal interest, may establish the compensation of directors for services in any capacity.  If the board of directors establishes the compensation of directors pursuant to this subsection, such compensation is presumed to be fair to the corporation unless proven unfair by a preponderance of the evidence.

Nevada’s rule is clear whereas the Court of Chancery’s is not.  Nevada’s rule allows stockholders to challenge director compensation but does not invite it.  Nevada’s approach to director compensation makes sense.  Delaware’s approach does not.

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