Pangloss, Delaware Law, and the Duty of Loyalty: Julian v. Eastern States Development Co.

On this Blog, we often criticize the Delaware courts, whether for an anti-shareholder bias (go here and here for examples) or what we sometimes perceive as a lack of appropriate judicial disposition.  Mostly, though, these issues are symptomatic of a larger problem, the failure to impose meaningful standards of behavior on directors.  The courts have turned the duty of loyalty into a shill, relying on procedural mechanisms, particularly approval by independent directors, to obviate any need to examine fairness.  They have done so, however, without making meaningful the very processes they have put in place.   For example, the approach to independence does not ensure at all that directors are in fact independent.  As a result, the courts have, in most instances, effectively repealed the duty of loyalty.  I have addressed this issue in greater length in the article, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  

But just for a moment, let's imagine a different Delaware, a Delaware that in fact made the requisite process meaningful.  It would be a state that deferred only to boards or, more likely, board committees, that ensured membership was truly independent.  The individuals could not be close friends of the CEO, receive fees disproportionate to their other sources of income (like the principal in Disney), or head nonprofits that receive significant contributions from the company (or its CEO).  Nor could the person with the conflict participate in the deliberations.  In this Panglossian universe, the standards would be difficult to meet and, as a result, boards would often be left with the burden of establishing why a particular transaction was fair.  Thus, executive compensation would not be a matter of process but a matter of fairness. 

With this Panglossian universe in mind, we turn to Julian v. Eastern States Development, a recent Chancery Court decision.  The case was essentially a dispute among three brothers.  As part of the case, three directors (and two of the brothers) voted to award bonuses to themselves. They asserted that the payments were a reward for "a good year" and to "reduce retained earnings."  The meeting lasted "less than half an hour and no legal or financial advisors attended." 

As the court noted, self interested transactions not accompanied by "independent protections" are subject to the entire fairness analysis.  In other words, the board can pay the bonuses but has the burden of establishing that they are fair.  In this case, the board was unable to meet that burden.  The court indicated concern with the timing of the bonuses but  was mostly concerned about the substantive fairness of the payments.  As the opinion observed: 

• Before the December 20, 2005 meeting, the [Company] board had not approved bonuses near the magnitude of $1.3 million. While the record is imperfect, it suggests [Company] paid no bonuses from 1996 through 1998. 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.
  

Even an unusually large bonus, however, wasn't automatically unfair. But in those circumstances, there needed to be a credible explanation.  This, the Vice Chancellor, did not find.  "I do not find credible Defendants’ argument that the board approved the Benchmark Bonuses as a reward for a good year in 2005 or to reduce retained earnings in the event of a lawsuit. 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, therefore, found that the directors had not met their burden of showing fairness. 

This case illustrates the type of analysis that applies when the court does not hide behind poorly developed process and forces the board to establish fairness.  The board in Julian merely needed to show that the bonus was typical or was based on some objective criteria.  Shouldn't this standard always be the case?  Shouldn't conflict of interest transactions always have to be typical or, if unusual in timing or amount, be accompanied by an explanation for the unusual terms?  But in fact its the exception not the rule.  Instead, the Delaware courts use process as a mechanism to sidestep all analysis of fairness.  Said another way, process is a mechanism by which courts uphold unfair transactions. 

Imagine if this weren't the case (our Panglossian universe again) and, in fact, boards were required to establish the fairness of their transactions.  Take the Disney case.  It was a board that lacked independence (and one found by Business Week two years running to be the worst in corporate America based on corporate governance criteria).  Nonetheless, in an astounding opinion, the Chancery Court decided otherwise.  Had the court found an absence of independence (in other words, had the court applied a meaningful definition of independence), it would have shifted the burden to the board to demonstrate that the Ovitz contract was "fair."  In other words, the board would have had to justify why it was necessary to execute a contract that resulted in the payment of $160 million after a little over one year of service.  Maybe it was, but in any event shareholders would have been owed the explanation.  Instead, the court treated the matter under the duty of care/good faith, with the case turning entirely on process.  The fairness of the agreement (and the payment) was never determined.

Imposing an obligation to establish fairness in conflict of interest situations would protect shareholders and not result in severe burdens on boards.  At the same time, aware that the transaction would be subject to review for fairness, boards would presumably be less likely to approve transactions that were not substantively fair.  Were this to be the standard, it would solve the executive compensation problem.  The board would be able to pay any amount it wanted (short of waste) but would have to justify the fairness of the payment.  This alone would temper the amounts paid.  But this is the kind of approach that, given the current race to the bottom, could only be suggested an incurable optimist like Pangloss (or this Blog).