The Demand Requirement: An Impediment to Successful Excessive Remuneration

The Delaware Supreme Court in Brehm v Eisner38 _{stated the benefits of the demand}

requirement, as: allowing the board of directors the chance to settle the matter within the company, thus avoiding potentially damaging litigation and giving the board the chance to determine between frivolous and meritorious suits. However, this requirement may be excused if the court, on the urging of the plaintiff has reason to believe that the making of such a demand would in the end be fruitless. The responsibility for proving the futility of a demand would invariably be on the plaintiff,

to do this he must first satisfy what is known as the Aronson’s Test39_.

The first part of the two-pronged test requires the plaintiff to provide evidence that the board was beholden to the CEO. Precedent has shown this requirement difficult

to prove as Aronson would suggest. In that case, despite the presentation of evidence

that the embattled CEO had handpicked the board members and owned large portions of the company’s shares, the court refused to consider this proof of potential foul play.

37 _{S. 7.42 of the Model Business Corporation Act, states the procedure to be followed when making a}

formal demand on the board. It is important to add that, failure to make the demand as required, would except for a few instances, inevitably lead to an outright dismissal of the case following an application by the defence. An exception would be where the plaintiff can prove the futility of making a demand on the board. See, Steven Caywood, ‘Wasting the Corporate Waste Doctrine: how the Doctrine Can Provide a Viable Solution in Controlling Excessive Executive Compensation’ Michigan Law Review, Vol.109 111, 121.

38 _{746 A.2d 244, 260 (Del. 2000).}

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Holding in effect, that in the absence of evidential proof that the close relational ties between the CEO and board members had influenced their pay decisions, the directors could not be said to have failed to meet the demand requirement.

Secondly, the plaintiff must prove that the disputed pay package was not subject to the Business Judgement rule. As noted, the requirements for a business decision to qualify for protection under the Business Judgement Rule-the stated payments must have been an exercise of a valid business judgement, must have made an informed decision, acted in good faith and in the honest belief that the said transaction was in

the company’s best interest40_{. Unless the plaintiff can prove that the directors in}

deciding to make the disputed payments failed to meet the above requirements, the plaintiff would have failed the second test. This as illustrated by the Delaware courts

in the Aronson decision. Where it stated:

“In sum, we conclude that the plaintiff has failed to allege facts with particularity indicating that the Meyers directors were tainted by interest, lacked independence, or took action contrary to Meyers' best interests in order to create a reasonable doubt as to the applicability of the Business Judgment rule”41

The second requirement, was considered in the more recent Brehm v Eisner, there the

plaintiff challenged the decision of a lower court absolving the board of entertainment firm Disney of a breach of their duty of care and loyalty and of committing a waste of corporate assets, by making certain payments to its disgraced former CEO Michael Ovitz to an employment agreement entered prior to his employment. Per the court in

40_{Kaplan v Centex Corp, Del Ch. 284 A.2d 119, [1971].} 41_{Aronson v Lewis (supra).}

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Aronson’s case, for any board decision to be protected by the Business Judgement Rule, including compensation-based decisions, the directors inter alia must have met the information requirement i.e. they must have informed themselves of all aspects

of the disputed transaction before acceding to it42_{. This issue was raised in Brehm, as}

the plaintiff tried to create reasonable doubt that the board had met this requirement and the trial judge in dismissing the claim stated that the requirement was that the

directors be “reasonably informed”, rather that they be informed of every fact in

considering the transaction43_{. On appeal, the court of chancery stated that the}

‘reasonably informed’ requirement as stated at first instance was more of an abbreviated

“attempt to paraphrase the Delaware jurisprudence that, in making business decisions, directors must consider all material information reasonably available, and that the directors' process is actionable only if grossly negligent”44_.

The Appeal Court stated that the ‘reasonably informed’ standard did not require that

the directors in exercising their judgement consider every piece of information regarding the transaction, but only those which were readily available to them, certainly not information that was beyond their reach of which there could have been

no reasonable expectation that they would be made aware of45_{. The court declared}

that the plaintiff had failed to provide sufficient evidence so as to rebut the presumption that the directors had duly informed themselves, the court had heard

42 _{Also, contained in S.180 (2) of the Australian Corporation Law Act 2001, S.8.30 of the Model}

Business Corporations Act and S.76 (4) of the South African Companies Act 71 of 2008.

43_{Brehm v Eisner (supra) at 258.} 44 _{Ibid, 259.}

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evidence by the plaintiff, that the board had no knowledge of what the financial exposure of the company would be, as none of the directors had taken the time to total the sums as laid out in Mr Ovitz contract of employment, a fact which was admitted to by the compensation expert hired by the board in his witness testimony. The claimants argued this was proof that they had failed to meet the requirements for the decision to ratify the contract, to be considered a valid business judgement, warranting protection under the rule.

However, the Delaware Court of Chancery saw it differently and the court in describing these allegations as insufficient proof of directorial negligence, declared:

“I think it a correct statement of law that the duty of care is still fulfilled even if a Board does not know the exact amount of a severance pay-out but nonetheless is fully informed about the manner in which such a pay-out would be calculated”46_{. A strange} decision considering the absurdity of the particularized facts surrounding the case. But the objective at this point is not an analysis of the merits of the court’s decision, but rather to emphasise what an uphill task it is for plaintiffs bringing waste claims even at the preliminary stages.

Statistics show the success rates at this stage of proceedings to be about 41 per cent on average, adjudged by a sample of cases which included those decided within and

outside Delaware47_{. Perhaps this single fact could be the reason for the relative}

shortage of executive compensation litigation stemming from publicly held companies in America. Such cases are more likely to initiate from private companies than they are

46 _{Veasey C.J, quoting the judge at first instance in Brehm v Eisner (supra) at 260.} 47 _{Thomas and Martins, (n37) at 580.}

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the latter as the success rates tend to be higher48_{. However, the overwhelming}

ubiquity of compensation-based litigation originating from privately held companies when pitted against publicly traded firms, as viewed by Thomas et al could be down to the fact that there is more susceptibility in the former to improprieties in the pay

fixing process49_{. Stating the dual positions held by officials in these closely held entities}

as indicative of a self-interest by the manager in fixing his own pay, where they are often able to vote on proposed pay packets. Scenarios of this nature are less likely to occur in public companies, with their better-defined management structures and hierarchies. Besides compensation related issues are usually left to the compensation

committees, which in some jurisdictions, is to be comprised mostly of ‘disinterested’

non-executive directors50_{. This and the other procedural intricacies in public}

companies grossly limit the possibility of a potential conflict of interest.

Further reasons could be the innate professionalism with which corporate boards of traded companies are run, being mainly comprised of seasoned and experienced business managers. Also, a greater allotment of the holdings in public companies are controlled institutionally, resources helping them wield considerable influence on the

board51_{. Furthermore, the lack of a personal involvement by public shareholders in the}

governance of the firm-only too willing to sell at the first sign of trouble-and the higher compensation to profit differential in traded companies, could be further reasons why

48 _{Ibid, at 585.} 49 _Ibid.

50 _{The UK Corporate Governance Code 2014, requires that the board of listed companies establish}

remuneration committees to be comprised of at least three (two in the case of smaller companies) independent directors. The committee is only to include the chairman of the board if he could have been independent at the time of his appointment, see p.22.

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there is less of an outrage than in their smaller, closely held counterparts52_{. In general,}

there is a higher conflict potential in private companies, due to the nature and composition, this could be attested to by the higher success rates in compensation-

based litigation arising from these types of companies53_.

5.5. Why have Corporate Waste Claims been largely Unsuccessful in the