In Julian v. Eastern States Construction Services, Inc., 2008 WL 2673300 (Del. Ch. July 8, 2008), the Delaware Chancery Court held that board members of a close corporation breached their duty of loyalty and would be required to disgorge bonuses where the directors approved self-compensation without sufficient independent protections. This case provides guidance regarding the process board members must follow in order for a self-interested directorial compensation decision to survive an “entire fairness” review.
The action centers around a dispute among three brothers (Francis, Richard and Gene Julian) who served as officers and directors of three different family-owned businesses, including Benchmark Builders, Inc. (“Benchmark”). The relations among the three brothers deteriorated over the forty years they worked together, fueled by Francis and Richard removing Gene from any active role in management. Tensions culminated in Gene’s notice of retirement from the businesses on December 9, 2005. Upon retirement, Gene owned stock in each of the companies and part of the dispute involved whether he was required to sell his shares back to the businesses.
On December 20, 2005, the Benchmark board of directors, including Francis, Richard and Steven Bomberger, approved a $1,000,000 bonus for Francis and Richard and a $300,000 bonus for Bomberger. The meeting lasted less than half an hour and the directors did not consult any independent legal or financial advisors. The bonuses represented 22.28% of Benchmark’s adjusted income in 2005, a vastly higher percentage than in prior years. Gene did not receive any of the bonus despite the fact that he worked at the company in 2005.
Gene argued that the Benchmark bonuses represented self-interested transactions that violated the directors’ fiduciary duties. Gene questioned the timing of the bonuses, the process used to approve the bonuses, as well as the unprecedented amount of the bonuses. Francis, Richard and Bomberger attempted to justify the bonuses as a reward to management “for a good year” and as a way to “reduce retained earnings so that fewer assets would be at risk in the event of a lawsuit.” Bomberger asserted an additional defense based upon the Independent Investor Test: “if the managers of a business produce economic income that exceeds the amount necessary to provide a fair return to shareholders and to compensate management for their labor, all excess profits may be allocated to management as a reward for their superior performance.”
The court agreed with Gene and held that Francis, Richard and Bomberger breached their fiduciary duty of loyalty to Benchmark. Where directors of a corporation stand on both sides of a transaction, such as where the directors approve payment of bonuses to themselves, they have “the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by the courts.” The entire fairness test involves examining “when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained,” as well as determining whether the transaction involved a fair price, which examines “the economic and financial considerations.”
Here, the court found that “the Benchmark Bonuses were the product of an unfair process.” The board approved the bonuses only eleven days after Gene submitted his letter of retirement. Francis and Richard discussed the proposal for only a few minutes, and they admitted to knowing that a bonus would decrease the value of the business, which would decrease the price at which the company would have to pay Gene for his shares. The court rejected Bomberger’s Independent Investor Test, claiming it was unreliable and unhelpful under the circumstances of this case. In addition, the court held that the price was unfair given the lack of historical precedent for the size of the bonus. Dismissing defendants’ justifications for approving the bonuses, the court concluded that the bonuses were nothing more than “a knee-jerk reaction to Gene’s precipitous retirement, which Francis and Richard considered a betrayal.”
In terms of relief, the court noted that it was entitled to “fashion any form of equitable and monetary relief as may be appropriate.” Therefore, the court ordered Francis, Richard and Bomberger to disgorge their bonuses and return the money they received with interest to Benchmark. The court also required that defendants reimburse Gene for the attorneys’ fees and costs incurred for litigating this aspect of his claim.
This decision reminds directors who are contemplating a “self-interested directorial compensation decision” that they must consider “independent protections,” such as being aware of the timing of their decision, engaging in thoughtful deliberations, consulting disinterested advisors for an independent review of their decision and taking note of the company’s prior practice of awarding bonuses. Failing to take these important, common sense steps to “demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain” will expose the decision to a court’s entire fairness review and risk disgorgement of the compensation awarded.
For further information, please contact John Stigi at (213) 617-5589.