Oregon Court Holds Exorbitant Executive Compensation For Past Services Raises Doubt That Directors Exercised Valid Business Judgment
ATTORNEY: DARYA KAPULINA-FILINA
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2016
In a recent victory before the Circuit Court of Oregon, the court upheld Pomerantz’s shareholder derivative complaint against the board of directors of Lithia Motors, Inc. The case stems from an agreement approved by the board for exorbitant compensation to be paid to Lithia’s founder and CEO, Sidney DeBoer, following his resignation. The compensation package entailed annual payments of $1,050,000 for the remainder of DeBoer’s life, a $42,000 car allowance, and continued reimbursement for premiums on DeBoer’s insurance policies. None of these payments were required by DeBoer’s existing employment agreement and, therefore, amounted to a going-away present from the company. The complaint we filed alleged that by approving this giveaway, the board breached its fiduciary duties of care and loyalty and committed waste of corporate assets, resulting in DeBoer’s unjust enrichment.
This is a derivative case, brought by shareholders on behalf of the corporation. Under Oregon law, which is analogous to Delaware law, a complaint in a derivative action must allege either that, prior to commencing the lawsuit, shareholders made a demand on the board to take corrective action to avoid litigation, or that demand was excused because it would be “futile” or an “idle gesture.” Plaintiffs are typically excused from making a demand if they can show specific facts demonstrating that there was reasonable doubt that (1) the majority of directors are disinterested or independent; or (2) the transaction was a valid exercise of business judgment (more on business judgment below). The plaintiff shareholders in Lithia did not make the pre-litigation demand on the board, but included facts in the complaint which we contended showed that demand would have been futile.
The board moved to dismiss our case, arguing that pre-suit demand was not excused and that, in any case, the complaint failed to state a claim for breach of fiduciary duties, corporate waste, or unjust enrichment. The court upheld each of our claims. It held that there is reasonable doubt as to the independence of three out of the seven Lithia directors named in the lawsuit, but three out of seven did not make up a majority. The court went on to analyze whether there was reasonable doubt that the challenged transaction was otherwise the product of a valid exercise of business judgment. The court found that plaintiffs met their “heavy burden” through “particularized facts” in the complaint showing that:
(1) DeBoer would receive his benefits in consideration of his prior services. The court agreed with plaintiffs that past services are not valid consideration for these payments.
(2) The board chose not to retain a compensation consultant and provided no analysis of what other departing executives typically receive.
(3) The board delegated full authority to director William Young to approve the final agreement, and Young had to practically force other members of the Compensation Committee to review the Transition Agreement.
(4) DeBoer’s Transition Agreement was not approved by the company’s audit committee.
(5) DeBoer’s compensation was disproportionately higher than designated in Lithia’s “Change of Control Agreement” which specifies compensation payable to him in the event of a sale of all or substantially all of the assets of Lithia, any merger, consolidation or acquisition, or any change in the ownership of more than fifty percent (50%) of the voting stock.
Given these facts, the court found that “plaintiffs have plead particularized facts in their complaint which create a reasonabledoubt that the transaction was a product of validbusiness judgment . . . [and] plaintiffs raise a reason to doubt that the directors were adequately informed in making their decision.” As a result, the shareholders were excused from making a pre-litigation demand on the board.
The court went on to uphold each of plaintiffs’ substantive claims. As for our claims against DeBoer, It held that just because he did not personally vote on whether to approve his compensation, he was nonetheless potentially liable for a breach of fiduciary duties claim for “indirectly engaging in the transaction.” The court relied on the shareholders’ allegations that:
(1) DeBoer, owning 52% of the votes, admittedly can cause the company to enter into agreements with which other stockholders do not agree.
(2) DeBoer engaged in a self-dealing transaction.
(3) The board “generally failed to cleanse the taint of self-interest and should have obtained shareholder approval.”
The court upheld the waste of corporate assets claim, relying on plaintiffs’ allegations that the compensation in question was in exchange for past services and was beyond what the compensation committee deemed fair. It found that plaintiffs’ allegations “suggest an unreasonable exchange” because according to Lithia’s Change of Control Agreement, the Transaction Agreement over compensated DeBoer by 1,000%.
Finally, the court upheld plaintiffs’ unjust enrichment claim on the basis that DeBoer’s compensation was for past services rendered, for which DeBoer had already been compensated.
The Lithia decision is instructive to other shareholders who need to overcome the test for demand futility but are not able to establish that the majority of the board of directors were conflicted. Shareholders can overcome business judgment and establish doubt as to the board’s informed decision-making and valid exercise of judgment by detailing the insufficient manner in which directors handled the questioned transaction. Some aspects to highlight in a derivative complaint include:
• Were draft agreements presented to the board or committees (compensation committee, audit committee, special committee)?
• Were questions raised by the board or was the transaction rubber stamped for approval?
• What was the review process and duration of the evaluation of the transaction?
• Did the board retain an outside expert or consultant?
• Was a legal advisor retained to review the propriety of the transaction? The Lithia court cited a case involving executive compensation of the president of the Walt Disney Company where the compensation committee met for less than an hour, asked no questions, gave no presentations, did not engage an expert consultant, and approved the exorbitant payments.
• How does the transaction compare with others? Was any comparable transactions analysis made?
• What benefit does the transaction provide to the company and shareholders?
• Was shareholder approval obtained?
Although shareholders still face a heavy burden to overcome the business judgment rule in the context of a demand futility issue, the Lithia decision gives hope to shareholders that courts will not just assume the board took adequate measures in approving a questionable transaction such as excessive executive compensation payouts, but may scrutinize the board’s review process.
In doing so, they can even allege defendants’ federal-law violations for similar conduct.