Under California and Delaware law, a shareholder lawsuit against a corporation requires that a plaintiff show efforts to demand action from the corporation’s board of directors prior to filing the lawsuit. This pre-suit demand requirement may only be excused if the plaintiff shows that making a demand upon the company's board of directors would be futile (known as “pre-suit demand futility”). To show pre-suit demand futility under Delaware law requires the plaintiff to present particular facts creating reasonable doubt that the directors were disinterested and independent or that the Board’s action was the product of a valid exercise of business judgment. A recent California court decision confirms that the Delaware demand futility requirement is not met unless a plaintiff pleads particular facts on a director-by-director basis showing wrongdoing by a majority of directors.
In Charter Township of Clinton Police and Fire Retirement System v. Martin (--- Cal.Rptr.3d ----, Cal.App. 2 Dist., September 17, 2013), the Board of Directors of Jacobs Engineering Group, Inc. adopted a new executive compensation plan that was created with the assistance of consulting firm Frederic W. Cook & Co., Inc. (“Cook”). The plan increased combined compensation for five top Jacobs executives from approximately $13.5 million to nearly $17 million dollars. As required by the Dodd-FrankWall Street Reform and Consumer Protection Act (“Dodd-Frank”), the Board put the executive compensation plan to a non-binding shareholder vote. Over 55 percent of the shareholders opposed the plan.
After the Board adopted the plan, shareholders sued members of the Board, senior Jacobs executives, and Cook (collectively, “Defendants”). The lawsuit alleged that the Board members violated fiduciary duties by adopting the compensation plan even though Jacobs was losing money and even though shareholders opposed the plan. The suit also alleged that the Board had misrepresented the company’s financial performance in a proxy statement and that it was futile to make a pre-suit demand on the Board to withdraw the plan. The Defendants challenged the suit, motioning the court to find that the shareholders’ complaint failed to plead facts showing pre-suit demand futility.
The trial court agreed with the Defendants and dismissed the case.
Upholding the trial court decision, the Second District Court of Appeal noted that it was applying Delaware law to the case because Jacobs was incorporated in Delaware. The court observed that Delaware law applies a two-part test to determine whether pre-suit demand futility has been shown: the complaint must state “particularized facts creating a ‘reasonable doubt’ that: (1) the directors were disinterested and independent; or (2) the challenged transaction was the product of a valid exercise of business judgment.” Additionally, the “particularized facts” may not be general facts about the board as a whole, but instead, specific facts about each individual board member.
The court rejected the shareholders’ allegation that the Board members were responsible for a proxy statement that misrepresented Jacobs’s performance compared to similar companies. The court stated that it was a “vague allegation” that failed to explain how individual members of the board were involved in the preparation or ratification of the Proxy and that it failed to show the directors had notice of any illegality that could excuse the pre-suit demand requirement.
The court also noted that there could be a number of important business goals that could motivate a board of directors to increase executive compensation even though the corporation was performing poorly. Such reasons could include attracting and retaining top executive talent, aligning executive interests to stockholder interests, and “ensuring that performance-based compensation does not encourage excessive risk taking.”
The court also similarly rejected the shareholders’ allegations that the Board’s approval of the executive compensation plan was not a valid exercise of business judgment. The court observed that under Delaware law, boards of directors have wide latitude in decisionmaking on executive compensation, unless the “compensation is so large and disproportionate to be unconscionable and constitute waste.” The court found that the shareholders failed to present facts showing that the Board’s adoption of the compensation plan was not based on valid business reasons such as attracting and retaining qualified executives. The court also noted that the shareholders did not dispute that Jacobs had recently lost two executives and that the remaining executives were being recruited by competitors, and that these “circumstances alone constitute a valid basis for the Board's business decision to adopt the compensation plan.”