Delaware Business Litigation Report

Court of Chancery Finds Change of Control Payments are Reasonable if a Majority of a Board of Directors Ceased to be "Existing Directors"

California Public Employees' Retirement System v. Coulter, 2005 WL 1074354 (Del. Ch. April 21, 2005). Defendant Lone Star Steakhouse & Saloon, Inc. agreed to make change of control payments to certain employees if a majority of its board of directors ceased to be "Existing Directors." "Existing Directors" were those directors in office at the time of the change of control agreements and those new directors who were approved by Existing Directors. The views of new directors who were not approved as Existing Directors would not be considered in determining whether subsequent new directors would be considered Existing Directors. The question is whether such a provision contravenes the teachings of Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch.1998), which concluded that directors may not be granted distinctive voting powers unless they are authorized by the certificate of incorporation, something Lone Star's certificate of incorporation does not do.

Lone Star maintained that, in order to encourage its senior management to remain with the company during challenging times with the possibility of a material change in the composition of its Board of Directors, it agreed to pay additional compensation to those employees in the event a change of control were to occur. A "change of control" that would require additional compensation could occur in several ways: a shift in shareholder voting power, a change in the composition of the board, a merger or similar transaction, or liquidation. Plaintiff California Public Employees' Retirement System ("CalPERS") alleged that the Existing Directors provision in the Change of Control Contracts violated 8 Del. C. - 141 and, thus, was adopted in violation of defendant directors' fiduciary duties because it illegally conferred upon directors differential voting powers based on a classification not present in Lone Star's Certificate of Incorporation. The Court of Chancery found it was reasonable that a change of control agreement have some mechanism by which the corporation's obligation to make payments can be avoided if the composition of the Board has changed in name only. The definitional approach adopted by Lone Star was an acceptable methodology. More importantly, CalPERS failed to demonstrate that the Delaware General Corporation Law precluded, or should preclude, a flexible approach that acts to protect a corporation's interests, to the detriment of the favored employees who would otherwise benefit, perhaps unfairly, from a simple change in personnel on the Board.

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