Court of Appeal Clarifies Directors’ Fiduciary Duties and the Business Judgment Rule for Executive Compensation Matters

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Overview

The Court of Appeal for Ontario recently affirmed the nature of directors’ and officers’ fiduciary duties and clarified the application of the business judgment rule in the context of a dispute regarding executive compensation. The decision in Unique Broadband Systems, Inc. (Re) [1] (“Unique Broadband”) is significant from the perspective of corporate governance and shareholders’ rights in the following respects:

  • First, independent or third-party advice may be necessary to justify executive compensation.
  • Second, the business judgment rule has no application where directors and officers make decisions that have no legitimate business purpose and are in breach of their fiduciary duties.
  • Finally, executive compensation agreements that are inconsistent with statutory fiduciary duties will not be enforced by the courts.

Factual Background

The individual respondent (the “Respondent”) was the former CEO and a director of Unique Broadband Systems Inc. (“UBS”). The terms of a management services agreement provided him with enhanced termination benefits in particular situations. UBS instituted a share-appreciation rights plan (the “SAR Plan”) for its directors and members of senior management. Under the SAR Plan, unit holders would be compensated based on the market trading price of a UBS share after certain specified events.

After the share price failed to rise as expected, the directors of UBS unanimously resolved to cancel the SAR units and establish a SAR cancellation payment program that compensated unit holders, including the Respondent, based on a unit price of $0.40 per share. The market price was actually $0.15 per share. The directors also considered and awarded bonuses for the Respondent and other personnel.

UBS shareholders called a special shareholders’ meeting and removed the Respondent and others from their positions as directors of the company. The Respondent resigned as the CEO and commenced an action against UBS for, inter alia, the SAR cancellation payments, the bonus award, and enhanced termination benefits.

Independent Advice on Executive Compensation

The Court of Appeal determined that the Respondent breached his fiduciary duties with respect to the SAR cancellation payments and the bonus award. The Court held that directors and officers must avoid conflicts of interest with the corporation and not take advantage of their position for personal gain.[2]

The SAR cancellation payment program was adopted without any independent or third-party advice and was motivated by the Respondent’s self-interest at the expense of UBS. The bonus awards were equally problematic. The Respondent and the other directors failed to seek or receive any advice on appropriate bonus awards. They did not consider comparable marketplace data regarding executive compensation and did not document performance criteria. There was also no evidence to explain how the bonus awards were quantified.

Business Judgment Rule

The Court of Appeal rejected the Respondent’s argument that his actions were protected by the business judgment rule. The business judgement rule is a rebuttable presumption that directors and officers act in an informed manner, in good faith, and in the best interests of the corporation. “Courts will defer to business decisions honestly made, but they will not sit idly by when it is clear that a board is engaged in conduct that has no legitimate business purpose and that is in breach of its fiduciary duties.”[3]

Since the Respondent had not acted in the best interests of the corporation, the business judgment rule was of no assistance to him.

Contracting out of Statutory Corporate Obligations

The Court of Appeal overturned the lower court’s decision on the only issue that the Respondent succeeded on at trial; that is, the interpretation of the management services agreement that provided the Respondent with enhanced termination benefits notwithstanding his corporate malfeasance.

According to the Court of Appeal, the agreement had to be interpreted in light of section 134(3) of the Ontario Business Corporations Act[4] (the “OBCA”), which provides that no term in a contract “relieves a director or officer from the duty to act in accordance with this Act and the regulations or relieves him or her from liability for a breach thereof.”[5] The Court of Appeal held that a contractual provision that excluded a director’s breach of fiduciary duties as a ground for termination would “eviscerate the prohibition found in s. 134(3).”[6]

Although not necessary to its decision, the Court of Appeal noted that a contract which provided a director with enhanced termination benefits which were contrary to his or her breach of fiduciary duties may constitute oppression pursuant to section 248 of the OBCA.[7]

Comment

The Court of Appeal’s decision in Unique Broadband establishes that directors and officers will not be permitted to hide behind the business judgment rule where their conduct serves no legitimate business purpose and is in breach of fiduciary duties. Directors and officers cannot contract out of their fiduciary duties and personal employment contracts or management service agreements will be interpreted in accordance with their statutory obligations.

[1] Unique Broadband Systems, Inc. (Re), 2014 ONCA 538 [Unique Broadband].

[2] Ibid at para 45.

[3] Ibid at para 72.

[4] Business Corporations Act, RSO 1990, c B.16 [OBCA].

[5] Unique Broadband, supra note 1 at para 95.

[6] Ibid at para 96.

[7] Ibid at para 107.

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