The Advisors' Blog

Yikes! Vice Chancellor Laster issued a 115-page opinion this week that should have you running to double check your equity grant ledgers & records. The facts of the case relate to a performance share award that could exceed plan limits if the performance is achieved:

The 2019 Plan limits the number of performance shares that the Committee canaward to any single individual in the same fiscal year. In March 2020, the Committee made two grants of performance shares to the Company’s chief executive officer (“CEO”), defendant Gerry P. Smith (the “Challenged Awards”). Each of the Challenged Awards entitled Smith to receive a variable number of performance shares, with the actual amount determined by the Company’s performance over a three-year measurement period that will end in 2023. If the Company performs well, then the aggregate number of shares that Smith is entitled to retain will exceed the limit in the 2019 Plan.

The plaintiff is a stockholder, and is asserting a claim for breach of the Plan. But there’s more. The plaintiff also appears to have successfully turned that claim that the grant was defective into a Caremark-like claim against the entire board. Here’s an excerpt:

In contrast to the preceding issues, which are governed by settled law, the plaintiff also advanced a novel theory. According to the plaintiff, all of the directors—including the directors who did not approve the Challenged Awards—breached their fiduciary duties by not fixing the obvious violation after the plaintiff sent a demand letter calling the issue to their attention. There is something disquieting about a plaintiff manufacturing a claim against directors by acting as a whistleblower and then suing because the directors did not respond to the whistle.

Nevertheless, the logic of the plaintiff’s theory is sound: Delaware law treats a conscious failure to act as the equivalent of action, so if a plaintiff brings a clear violation to the directors’ attention and they do not act, then it is reasonably conceivable that the directors’ conscious inaction constitutes a breach of duty. The same logic animates a Caremark claim that rests on the theory that the board consciously ignored proverbial red flags, although the source of the notice that the board receives is different.

Vice Chancellor Laster notes that this type of claim presents “obvious policy issues” – but:

The plaintiff, however, has pled what seems like one of the strongest possible scenarios for such a claim. The limitation in the 2019 Plan is plain and unambiguous. Under established precedent, the failure to comply with a plain and unambiguous restriction in a stockholder-approved equity compensation plan supports an inference that the directors acted in bad faith. The recipient of the Challenged Awards was a fellow fiduciary who faced the same obligation to fix the flawed grants as the other members of the Board. If there was ever a time when all of the directors had a duty to take action to benefit the Company by addressing an obvious problem, it is reasonably conceivable that this was it.

With admitted trepidation about knock-on effects, this decision permits the claim to survive pleading-stage analysis. In light of the policy implications that claims of this sort present, future decisions must consider carefully any attempts by plaintiffs to follow a similar path.

The defendants’ motion to dismiss was denied, and the case moves forward. Not legal advice, but this opinion suggests that if you get a demand letter, it’s worth taking this decision into account and fixing the identified issue – even if the plaintiff leverages that clean-up reaction for a settlement. The even better approach is to try to avoid the issue in the first place, through regular equity plan audits. See our checklist with step-by-step guidance on share counting.

If you find yourself exceeding plan limits, we also have an issue-spotting thread in our “Q&A Forum” (#177). Also see this blog about a 2013 Delaware case, and this blog about the “inducement grant” alternative.

– Liz Dunshee