In In re 3Com Shareholders Litigation, C.A. No. 16721 (Del. Ch. October 25, 1999), the Delaware Court of Chancery emphasized that "when the shareholders knowingly set the parameters of the plan, approved it in advance, and directors implemented the plan according to its terms ... precedent in [the Court of Chancery] clearly establishes that ... director transactions made under a stock option plan approved by the corporation's shareholders are entitled to the benefit of the business judgment rule." Accordingly, when directors issue stock or cash awards in accordance with "definite" or "sufficiently defined" terms of an employee incentive or compensation plan approved by the shareholders, their decisions are subject to protection under the business judgment rule.
In contrast, when directors issue stock or cash awards that violate the plain or unambiguous terms of an incentive or compensation plan approved by the stockholders, their decisions are not subject to protection under the business judgment rule. For example, in the seminal case, Sanders v. Wang, C.A. No. 16640 (Del. Ch. November 8, 1999) (Steele, V.C.), the Court of Chancery held that pre-suit demand in a derivative action was excused under the second prong of the Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), legal test to establish demand futility because the board's alleged violation of the unambiguous terms of an employee stock ownership plan was not a valid exercise of its business judgment.
In its recent decision, Friedman v. Khosrowshahi, C.A. No. 9161-CB (Del. Ch. July 16, 2014) (Bouchard, C.), the Court of Chancery dismissed a derivative action on the grounds that pre-suit demand was not excused under the second prong of Aronson because the board's decision interpreting a stockholder-approved incentive plan was the product of a valid exercise of its business judgment. In distinguishing Sanders and its progeny, the court reasoned that the plaintiff stockholder had not alleged that the board's decision was a clear or intentional violation of the terms of an employee incentive plan, but, rather, its interpretation was a reasonable construction of the plain terms of the stock award in compliance with the incentive plan.
Expedia Inc.'s stock and annual incentive plan was administered by the company's compensation committee. The plan authorized the committee to grant tax-deductible restricted stock awards to employees. Both the plan and the Tax Code required such awards to be contingent on one or more specified performance goals. The plan also authorized the committee to amend any awards provided the amendment did not affect the tax-deductible status of the awards, i.e., did not waive any of the specified performance goals.
The committee granted a restricted stock award to the company's chief executive officer, Dara Khosrowshahi, who was also a director, in 2006. The stock award was contingent on Khosrowshahi meeting two performance goals in addition to an operating income target. When the company and Khosrowshahi entered into a new employment agreement in 2012, the committee accelerated the vesting of his stock award. By that time, Khosrowshahi had met the two performance goals, but not the operating income target. The committee waived the operating income target in the stock award.
The plaintiff stockholder, Julie Friedman, brought a derivative action, alleging that the committee breached its fiduciary duty of loyalty by waiving the stock award's operating income target in violation of the terms of the plan.
Failure to Plead Demand Futility
Friedman was required to establish demand futility under Court of Chancery Rule 23.1. Since Friedman challenged a board transaction or decision, the parties agreed that the Aronson test for demand futility applied in this case. Under Aronson, demand may be excused if a plaintiff pleads particularized facts to create a reasonable doubt either that "(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment." Pursuant to the second prong of Aronson, the plaintiff argued that demand was excused because the board compensation committee's waiver of the operating income target in the stock award was a clear violation of the plan that could not have been a valid exercise of business judgment. Relying on Sanders and three subsequent Court of Chancery decisions, the plaintiff asserted that a board's violation of an unambiguous provision of a compensation plan ipso facto establishes demand futility under Aronson's second prong.
The court rejected Friedman's argument. Sanders and its progeny require allegations sufficient to infer "a clear or intentional violation" of a compensation plan to establish demand futility. The court reasoned that demand was not futile here under the second prong of Aronson because the plaintiff had not alleged a clear or intentional violation of the terms of the plan. The court identified the threshold issue as whether the compensation committee intended the operating income target in the stock award to be a performance goal. If the committee intended the operating income target to be a performance goal, waiving the target violated the plan because it would result in the stock award losing its tax-deductible status. If the committee did not intend the operating income target to be a performance goal, waiving the target was permissible under the plan. Based on the stock award's plain terms, which separately defined the performance goals, and the company's consistent public disclosures, describing the performance goals, the court found that the committee did not intend the operating income target to be a performance goal in the award. Therefore, the court explained that the committee's interpretation of the target as a condition, and not a performance goal, was a reasonable construction of the plain terms of the stock award that the committee was authorized to waive under the plan. Moreover, even if the plan was ambiguous on whether the committee was authorized to waive the target, the plan vested the committee with the authority to interpret and resolve ambiguities. Accordingly, the court concluded that the committee's interpretation of the plan was the product of a valid exercise of business judgment, for which demand was not excused under Rule 23.1.
Director decisions that do not clearly or intentionally violate the plain or unambiguous terms of an employee incentive or compensation plan are subject to protection under the business judgment rule.