The Delaware Supreme Court held that the Chancery Court erred in finding that a proposed compensation package that would substantially increase a CEO’s compensation post-merger was not material to the other directors’ approval of the merger.
The Delaware Supreme Court recently reversed a 2019 Delaware Chancery Court decision that dismissed claims made by stockholders of a professional services firm against the firm’s chairman and chief executive officer (CEO) for breaching his fiduciary duty of loyalty while negotiating the 2016 merger of equals between the professional services firm and an insurance broker and risk management advisory firm. City of Fort Myers General Employees’ Pension Fund v. Haley (Del. June 30, 2020). After the merger was announced and when approval of the transaction by the professional services firm’s stockholders remained uncertain, a large stockholder of the insurance broker proposed a compensation package to the CEO that would substantially increase (i.e., by more than five times) his maximum equity compensation post-merger. The CEO did not disclose the existence nor the magnitude of this proposal to the professional services firm’s stockholders or board. The CEO subsequently renegotiated an increased special dividend to be paid to the professional services firm’s stockholders in connection with the merger, and they approved the transaction.
Certain stockholders of the professional services firm filed suit in the Delaware Chancery Court alleging that the CEO breached his duty of loyalty by failing to disclose the proposal to the board. The Chancery Court dismissed the suit, finding that the proposal was not material to the other directors’ approval of the merger because (1) the board knew the CEO would receive a larger salary at the combined entity; (2) the CEO kept the board generally apprised of the merger negotiations; and (3) the proposal was not binding. The plaintiff stockholders appealed the decision to the Supreme Court. The Supreme Court, by a 4-1 vote, held that the Chancery Court erred in finding that the compensation proposal was not material and reversed and remanded the lower court’s dismissal of the fiduciary duty claims.
The Supreme Court applied a materiality standard that evaluated whether the proposal was “relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decision making.” The Court concluded that the plaintiff stockholders rebutted the presumption of the business judgment rule by adequately pleading that (1) the CEO was “materially self interested” in the merger; (2) the CEO failed to disclose his interest in the proposal to the board; and (3) “a reasonable Board member would have regarded the existence of [the CEO’s] material interest as a significant fact in the evaluation of the merger.” The board’s knowledge that the newly merged company would result in a compensation increase for the CEO and that the CEO kept the board generally apprised of merger negotiations did not negate the materiality of the proposal. The Court further determined that “the fact that that the proposal was not a concrete agreement and had milestones requiring ‘Herculean’ efforts did not relieve the CEO of his duty to disclose to the … Board the deepening of the potential conflict, particularly in an atmosphere of considerable deal uncertainty.”
This decision serves as a reminder that directors and officers negotiating an M&A transaction on a company’s behalf must fully disclose any material conflicts that arise to the full board to benefit from the presumption of the business judgment rule. Board minutes should reflect that any such conflicts were disclosed to, and considered by, the board before approving the transaction.