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Court of Chancery Finds Breach of Oral Contract Regarding Executive Compensation and Breach of Fiduciary Duty for Failure of Such Compensation to Satisfy Entire Fairness Test

Carlson v. Hallinan, C.A. Nos. 19808, 19466, 2006 WL 771722 (Del. Ch. Mar. 21, 2006). This case involved a direct and derivative action arising out of a dispute between two men engaged in the business of making short term, unsecured loans. Plaintiffs asserted direct claims for breach of contract and derivative claims for breach of fiduciary duties. Specifically, plaintiffs alleged that defendant Hallinan breached an oral contract with plaintiffs by paying himself and another defendant executive compensation. Plaintiffs also asserted that the defendants breached fiduciary duties they owed nominal defendant CR Services Corp. by paying themselves an excessive amount of executive compensation. The Court of Chancery found, among other things, that Hallinan breached the oral contract with plaintiffs and defendants committed multiple breaches of their fiduciary duties to CR because they failed to meet the entire fairness standard regarding their compensation.

Plaintiffs argued that defendants entered into an oral agreement concerning executive compensation and the distribution of CR's profits. Defendants responded by arguing that the parol evidence rule barred the admission or consideration of extrinsic evidence to modify or amend the parties' Shareholders' Agreement. The Court of Chancery found that the Shareholders' Agreement was only partially integrated, and therefore parol evidence was not barred with respect to the terms contained in the writing. In finding the existence of an oral contract, the burden was on the plaintiff to prove, by a preponderance of the evidence: (1) the intent of the parties to be bound by the contract; (2) sufficiently definite terms; and (3) consideration. The court found that defendants entered into an enforceable oral agreement concerning the compensation and the distribution of profits. In addition, the court found that this agreement survived the execution of the Shareholders' Agreement. Plaintiff proved that Hallinan breached the oral agreement because paying himself a salary violated the contractually imposed duty not to pay directors or officers. As a result, plaintiffs suffered damages because the money paid to Hallinan as salary was not available for pro rata distribution to CR's stockholders. Plaintiffs additionally argued that defendants breached their fiduciary duties to CR as a minority stockholder by paying themselves executive compensation. Because defendants were on both sides of the decision to cause CR to pay them executive compensation, they had the burden of proving entire fairness: fair dealing and fair price. The court pointed out that these requirements also apply in a nonmerger context. The director defendants failed to show that any of the decisions to pay themselves executive compensation were the product of fair dealing. Likewise, the director defendants failed to satisfy their burden of showing that their compensation was entirely fair in light of CR's economic and financial circumstances. Authored by: Fotini Antonia Skouvakis 302.888.5202 fskouvakis@morrisjames.com