Two recent Delaware cases confirm that the Court of Chancery will not substitute its judgment for that of a disinterested and informed board on executive compensation decisions, including severance, so long as there is a rational basis for the board’s decision. Reaffirming its reliance on the business judgment rule, the court decided in favor of the board’s decision in two recent derivative actions challenging severance/retirement packages for departing employees.
Zucker v. Andreessen
In Zucker, the court granted defendant Hewlett-Packard’s motion to dismiss on claims that HP’s directors committed corporate waste by approving a $40mm severance package for its former CEO, Mark Hurd. In ruling, the court found that there was some rational basis for the board of directors to decide that the amount and form of severance package were appropriate under the circumstances.
The action stemmed from a 2010 sexual harassment claim against the former CEO. The board found that Hurd did not violate HP’s sexual harassment policies, but in its investigation the board found that Hurd covered up his relationship with an independent contractor. Soon after, the board terminated Hurd and authorized the severance package that was ultimately the subject of the derivative suit. In exchange for the $40mm in severance pay, Hurd agreed to extend the terms of his confidentiality agreement with the company and signed a general release of all claims against HP.
The court ultimately found that Hurd was not terminated for cause, and HP received adequate consideration for the severance package when the former CEO extended the terms of the confidentiality agreement and signed the general release. Furthermore, the court noted that HP did not suffer significant losses during Hurd’s term as CEO and so at least a portion of the severance package could be attributable to his successful job performance at HP.
Seinfeld v. Slager
Just weeks after the Zucker decision, the Delaware Court of Chancery ruled on another challenge to a board’s decision approving a payout to an departing CEO. In Seinfeld, the plaintiff accused the board of directors of Republic Services Inc., the nation’s second-largest provider of waste management services, of breaching its fiduciary duty when it approved a $1.8mm bonus to Republic’s retiring CEO. James O’Connor had a retirement agreement that detailed a bonus upon retirement, but did not specify the amount.
In exchange for the bonus, O’Connor signed a general release and may have provided other intangible benefits. Based on this, the court found that the plaintiff had not adequately pleaded corporate waste so the claim was dismissed.
The court did not dismiss the second claim that Republic’s directors violated their fiduciary duties and committed waste when approving restricted stock options for themselves. After reviewing the stock option plan, the court ruled that the plan contained no effective limits on the total amount of pay that the directors could award themselves (in the form of stock options). With no effective limits for avoiding potential self-dealing by the board, the court distinguished this case from prior cases where shareholder-approved option plans were upheld under the business judgment rule. In order to satisfy the business judgment rule, the plan must contain specific limits on the awarding of options to directors. Because the stock option plan in Seinfeld allowed the directors to award themselves millions of dollars in options without any limits, the court ruled that the defendant directors must show at trial that the awards were fair to the corporation.
It’s difficult for shareholders to challenge a board’s decision on executive compensation matters. The Delaware courts made clear in Zucker that severance guidelines for executives should be adopted by public companies as a matter of policy in order to police severance packages and avoid derivative suits. Also, corporations and CEOs should agree to severance packages at the beginning of the relationship, rather than during the exit process.