Two seemingly disparate recent Delaware court opinions provide an intriguing contrast in the approach to judicial review of fiduciary conduct. In its very brief opinion of January 14, 2013 in Freedman v. Adams,, et al, the Delaware Supreme Court affirmed the dismissal of a claim that the directors of XTO Energy breached their fiduciary duty by awarding $130 million in executive bonuses without doing so through a stockholder-approved plan (a Section 162(m) plan) that might have permitted the company to save $40 million by deducting the cost of the bonuses for income tax purposes. The board recited the belief that insistence on granting bonuses through a Section 162(m) plan “would constrain the compensation committee in its determination of appropriate bonuses.” And, according to the Supreme Court’s opinion, “The decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment. Even if the decision was a poor one for the reasons alleged by Freedman, it was not unconscionable or irrational.” The opinion does not indicate that XTO provided any explanation of what constraints the stockholder-approved plan would have imposed, or why the company chose not to pay the bonuses through such a plan.
Eleven days earlier the Court of Chancery’s opinion in the Novell shareholder litigation denied a motion to dismiss claims that a disinterested, independent board of directors acted in bad faith in selling the company, because of the absence of explanation for the decision to inform the successful bidder of a sale of a line of patents while not informing a competing bidder of that sale. The court’s opinion noted:
Why the Novell Defendants did not tell Party C about the proceeds of the Patent Sale has no apparent answer in the record before the Court. That conduct, coupled with the fact that Novell kept Attachmate fully informed, is enough for pleading stage purposes to support an inference that the Board’s actions were in bad faith.
So to editorialize a bit, the Delaware Supreme Court in Freedman might have similarly said:
Why the [XTO] Defendants did not [pay the bonuses through a Section 162(m) plan] has no apparent answer in the record before the Court. That conduct, coupled with the fact that [the Board did not explain in any specific way how use of such a plan could have constrained the determination of bonus awards], is enough for pleading stage purposes to support an inference that the Board’s actions were in bad faith.
But of course, the Supreme Court didn’t say that. Were they wrong? Was the Court of Chancery wrong in Novell? Or neither – are the two opinions consistent? In which case should the courts have been more inclined to defer to board judgment?
On a clean slate, I would have thought that the executive compensation decision at issue in Freedman would be more suspect than the conduct of an arm’s length sale of the company to a third party. In Freedman, one of the recipients of the bonuses was the company’s CEO, who was also a member of the Board. Not to put too fine a point on it, the bonus payments to him were a self-dealing transaction – one perhaps well considered and justified by an independent compensation committee, but one in respect of which the motives that implicate the duty of loyalty were present. In contrast, in Novell none of the directors had any direct conflict of interest.
It’s challenging to think of a doctrinal structure in which these two opinions can co-exist.