Accidents Happen: Innocent Mistakes By Board May Not Spoil Business Judgment Protection

by Orrick - Securities Litigation and Regulatory Enforcement Group
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https://jdsupra-html-images.s3-us-west-1.amazonaws.com/6c1470ff-d4b4-41a2-a0d4-a864d438ae49-iStock_000016259437XSmall-200x150.jpgRecently, the Delaware Court of Chancery in Pfeiffer v. Leedle declined to dismiss a shareholder derivative action against a board for breach of fiduciary duty, where the directors allegedly approved stock options exceeding the maximum number of options permissible under the corporation’s stock incentive plan. C.A. No. 7831-VCP (Del. Ch. Nov. 8, 2013).

The Stock Incentive Plan provided that no participant could receive options relating to more than 150,000 shares of stock in any calendar year. Nevertheless, the board of directors allegedly awarded the CEO nearly 450,000 stock options in 2011, and 285,000 stock options in 2012.

Defendants moved to dismiss the complaint for failure to make a demand, and for failure to state a claim. The Court of Chancery rejected both arguments.

Although a demand will not be excused when a plaintiff alleges only that a board of directors failed to follow the terms of a stock incentive plan, a demand will be excused where a plaintiff pleads particularized facts that indicate that the board knowingly or deliberately failed to adhere to the terms of a stock incentive plan. Even though the complaint at issue was devoid of particularized factual allegations that addressed the Board’s knowledge or intent, the demand was nevertheless excused because the plaintiff’s complaint demonstrated that the board’s actions were clear and unambiguous violations of the company’s stock incentive plan.

Because the board had awarded the CEO 450,000 and 285,000 stock options in 2011 and 2012, respectively, the Plaintiff had pled facts sufficient to support a reasonable inference that the board clearly violated the unambiguous stock options limitations prescribed in the company’s plan. A prima facie showing of such a clear violation supported an inference that the board either knowingly or deliberately exceeded its authority. Therefore, a pre-filing demand was not necessary, and would have been futile.

For the same reason, the court concluded that the plaintiff had properly stated a claim. Because the standard of showing demand futility is more stringent than the standard to survive dismissal for failure to state a claim, a plaintiff who alleges particularized facts sufficient to prove demand futility a fortiori survives a motion to dismiss for failure to state a claim. A knowing or deliberate violation of a stockholder approved stock plan implicates the duty of loyalty, and constitutes a breach of fiduciary duties.

While the plaintiff in Pfeiffer survived the board’s motion to dismiss, this decision discloses several potential defenses in other cases. A board that only negligently violates a stock option plan will receive the benefit of the business judgment rule. A knowing violation will be inferred where the stock option plan is unambiguous. On the other hand, where the plan is ambiguous, where the violation is less clear, or where reasonable directors could believe that their actions were permissible under the company’s plan, a plaintiff will have difficulty alleging particularized facts, or even creating a reasonable inference, that a violation of the plan was knowing or deliberate.

To ensure that it remains under the umbrella of the business judgment presumption, and to avoid costly and unnecessary future litigation to the extent possible, a board of directors should consider retaining independent counsel experienced in compensation matters to review proposed compensation packages, to advise the board in connection with board meetings, and to ensure compliance with company plans and policies as well as the applicable legal and regulatory framework.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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