Freedman v. Adams, et al., C.A. No. 4199 (Del. Jan. 14, 2013)

In this en banc opinion, the Delaware Supreme Court affirmed the Court of Chancery’s decision in Freedman v. Adams, et al., C.A. No. 4199-VCN (Del. Ch. Mar. 30, 2012), denying the plaintiff’s motion for an award of attorney’s fees and expenses because her derivative complaint, which challenged non-tax-deductible executive bonuses and had been dismissed by stipulation as largely moot, failed to plead facts sufficient to excuse demand and therefore would not have survived a motion to dismiss.

The appeal arose out of a derivative action brought by the plaintiff, then a stockholder of XTO Energy, Inc. (“XTO”), filed against XTO and the members of its board of directors, challenging the fact that cash bonuses paid to certain XTO executives were not tax-deductible, as such bonuses did not meet the requirements of Section 162(m) of the Internal Revenue Code (“Section 162(m)”).  The plaintiff alleged that the defendants’ approval of the non-tax-deductible bonuses constituted waste and a breach of their fiduciary duties, and that the defendants also caused XTO’s proxy statements to contain material omissions and misstatements concerning these bonus payments.  The plaintiff did not make a demand upon XTO’s board pursuant to Court of Chancery Rule 23.1 before filing suit.

On February 17, 2009, less than three months after the plaintiff filed the complaint, XTO’s board approved a Section 162(m) plan for cash bonuses, thereby mooting most of the plaintiff’s derivative claims.  XTO’s shareholders approved this Section 162(m) plan on April 17, 2009.  The plaintiff sold her XTO stock in early 2010.  On June 25, 2010, XTO was merged with and into a subsidiary of ExxonMobil Corporation (the “Exxon Transaction”).  Due to the timing of the Exxon Transaction, XTO received no tax benefits from its adoption of the Section 162(m) plan.  The parties ultimately agreed to a stipulated order of dismissal on April 6, 2011.  Shortly thereafter, the plaintiff moved for an award of $1 million in attorneys’ fees and reimbursement of approximately $5,000 in expenses, premised in large measure upon the prospective tax savings that XTO would have purportedly attained but for the Exxon Transaction.

Applying the corporate benefit doctrine, the Court of Chancery denied the plaintiff’s motion, finding that the complaint was not meritorious when filed because it did not adequately allege that demand on the XTO board would have been futile.  The plaintiff appealed the Court of Chancery’s ruling, arguing that demand was excused because the complaint stated a valid claim for waste based on the board’s failure to structure executive bonuses to meet the requirements of Section 162(m), resulting in approximately $40 million in lost tax deductions.

The Supreme Court acknowledged that a valid waste claim would have deprived the board of the protections of the business judgment rule and excused demand, but agreed with the Court of Chancery that the complaint failed to allege such a claim. The Supreme Court determined that the complaint failed to state a claim for waste because it did not allege facts that showed that the “directors irrationally squandered[ed] or g[a]ve away corporate assets.”  Rather, the Supreme Court noted that the XTO board was aware of the tax law issue, but intentionally chose not to implement a Section 162(m) plan because the board did not want the requirements of Section 162(m) to “constrain” the compensation committee in its determination of appropriate bonuses.  The Supreme Court explained that this “decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment.  Even if the decision was a poor one for the reasons alleged by [the plaintiff], it was not unconscionable or irrational.”  Moreover, the Supreme Court disagreed with the plaintiff’s contention that the benefits of having a Section 162(m) plan were “obvious,” noting that the complaint failed to allege that any of the bonuses paid to XTO’s executives actually would have been tax deductible under such a plan.  The Supreme Court thus affirmed the judgment of the Court of Chancery.

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