In Freedman v. Adams, a "shareholder" brought derivative claims against the board of directors of XTO Energy alleging breaches of fiduciary duty and waste due to the board's alleged failure to structure over $40 million of executive bonuses over a three-year period in a manner that would have made them deductible under Code Sec. 162(m). Apparently, the board get religion after the lawsuit was filed and approved a Section 162(m) plan for cash bonuses shortly thereafter. However, the Delaware Chancery Court rejected all claims relating to Code Section 162(m), with two of many notable quotations being:

  • decisions regarding a company's tax policy are not well-suited to after-the-fact review by courts and typify an area of corporate decision-making best left to management's business judgment, so long as it is exercised in an appropriate fashion. This Court rejects the notion that there is a broadly applicable fiduciary duty to minimize taxes, and, therefore the Plaintiff's argument that the board failed to act despite a duty to minimize taxes is unavailing.
  • the Board's decision falls within the line of cases dismissing executive compensation-related waste claims and concluding that the size and structure of executive compensation are inherently matters of judgment.

Despite losing the case, the plaintiff's lawyers requested a fee award of $1 million (after all, they claimed, they had spurred the board to act). The court rejected this claim as well, because the lawyers, in their eagerness to file the lawsuit, had failed to file a pre-suit demand on the board of directors. (In my youth, after a failure of mine, my father sometimes use to say to me: "Never enter into a battle of wits only half prepared." I don't think he meant that as a compliment.)

There are several morals to this story for corporations and boards. First, plaintiffs' lawyers apparently will continue to review companies' 162(m) disclosures and bring lawsuits against those that they find unsatisfactory. Second, the business judgment rule continues to provide a high barrier to the success of such lawsuits – for now.

Finally, adopt a Section 162(m) bonus plan. It is not that hard and can be incorporated into the company's regular incentive stock plan. 

On May 10, 1940, a force of less than 85 glider-borne German troops captured Fort Eben-Emael, the largest in the world at the time and thought to be impregnable, on the Belgian-Dutch border, clearing the way for German ground forces to enter Belgium, unhindered by fire from Eben-Emael. One of the most strikingly successful uses of special forces and the doctrine of "relative superiority" in history.