In the case of Freedman v. Adams, et al., No. 230, 2012 (Del. Supr., Jan. 14, 2013), the Delaware Supreme Court considered on appeal whether a derivative complaint challenging a corporate board’s decision to pay certain executive bonuses without adopting a plan that could make those bonuses tax deductible states a claim for waste. 

Background

In 2008, Susan Freedman filed a derivative action on behalf of XTO Energy Inc., alleging that XTO’s board committed waste by failing to adopt a plan that could have made its bonus payments tax deductible.  From 2004 through 2007, XTO paid executive bonuses totaling more than $130 million, and those payments were not tax deductible.  The XTO board was aware that, under a qualified Section 162(m) plan under the Internal Revenue Code, bonuses could be tax deductible, but it did not think its compensation decisions should be “constrained” by such a plan.

Shortly after Freedman filed her complaint, XTO’s board approved a Section 162(m) tax deductible plan.  XTO never made use of the plan, however, because it merged with and into a subsidiary of Exxon on June 25, 2010.  Freedman agreed to dismiss her complaint, as moot, but then filed a motion seeking $1 million in attorneys’ fees, arguing that the complaint benefited XTO by causing the company to adopt a Section 162(m) plan.  On March 30, 2012, the Court of Chancery issued a memorandum opinion denying the motion, finding that the complaint was not meritorious when filed for failing to adequately allege that demand on the board would have been futile.  Thus plaintiff appealed the decision to the Delaware Supreme Court.

Analysis

The Court recited that “[i]in a derivative suit the stockholder-plaintiff must allege, with particularity, that demand on the board of directors to redress the alleged wrong would have been futile.”  Further, the Court provided that “a valid waste claim would deprive the board of the protection of the business judgment rule, and excuse demand.”

The Delaware Supreme Court upheld the Court of Chancery’s ruling that the complaint failed to allege, with particularity, that the board’s decision not to implement a so-called Section 162(m) plan was a decision that no reasonable person would have made.  Specifically, the high court held that Freedman’s complaint failed to state a claim for waste because: (i) the complaint did not allege that any of the bonuses paid to XTO’s executives actually would have been tax deductible under such a plan; and (ii) the decision of the Board to sacrifice some tax savings in order to retain flexibility in compensation decisions was, in the Court’s view, a classic exercise of business judgment.

Conclusion

Accordingly, the Supreme Court affirmed the decision of the Court of Chancery in holding that demand was not properly excused because plaintiff did not assert an otherwise valid waste claim that would deprive the board of the protection of the business judgment rule.  This case is significant in that it demonstrates that “an arguably poor business judgment, without more, does not excuse demand on the board of directors in a derivative action.”  See trial court’s slip opinion, at *3 (Del. Ct., Mar. 30, 2012).