Canada: Ontario Court Of Appeal Upholds Finding Of Breach Of Fiduciary Duty Respecting Executive Compensation

The Ontario Court of Appeal recently upheld a trial court decision which concluded that the CEO, who was also a director, breached his fiduciary duty to the corporation when the directors of Unique Broadband Systems, Inc. approved changes to a share appreciation rights plan (SAR Plan) and an extraordinary bonus. In Unique Broadband Systems, Inc. (Re), 2014 ONCA 538, the Court of Appeal also recognized that as a consequence of the fiduciary breach, the CEO was not only not entitled to the approved payments, but also was not entitled to indemnification under contractual or other director and officer indemnities or enhanced severance upon termination of employment. The Court emphasized that disclosure of conflicts, reliance on legal advice and the business judgment rule may not be enough to shield directors from breaching the fiduciary duties owed to the corporation.

Facts

The UBS Board of Directors (the "Board"), which included its CEO, established an incentive-driven SAR Plan for its directors and senior management. Under the SAR plan, upon certain triggering events, a SAR unit holder would be entitled to the difference between the market trading price of a UBS share and a strike price specified in the SAR Plan.

In 2009, UBS' subsidiary, Look Communications Inc., sold its primary asset.

After the sale, the Board's Compensation Committee, which consisted of the CEO and two other UBS Board members, began to review the SAR Plan. Each member of the committee had a considerable amount of SAR units; there was no member who would not have been affected by the decision it was tasked to make.

The Board resolved to treat the sale by Look Communications Inc. of its primary asset as a triggering event under the SAR Plan. On the recommendation of the Compensation Committee, the Board approved the cancellation of the SAR Plan and the making of payments to participants based on a price of $0.40 per SAR unit, which far exceeded the trading price of the Corporation's shares. The Board also approved a special bonus pool for senior executives. Prior to making such decisions, each director disclosed their conflict of interest regarding their SAR unit holdings.

At the Board meeting, counsel was not asked to opine on the decision generally, nor was he asked to opine on the quantum of the benefits being considered.

The disclosure of the SAR Cancellation awards and the bonus pool was met with resistance by the UBS shareholders. A special shareholders' meeting was held subsequent to the announcement of the SAR Cancellation awards and bonus pool, where the directors were removed and the CEO resigned.

The CEO sued the corporation for wrongful termination, enhanced severance, payment of the SAR Cancellation award and bonus, and indemnification for legal and other professional expenses.

Trial Decision Upheld by the Court of Appeal

The Ontario Court of Appeal upheld the trial court's finding that the CEO had breached his fiduciary duties, which included a "specific obligation to scrupulously avoid conflicts of interest with the corporation and not to abuse his position for personal gain," because, among other things, the decision regarding the SAR Cancellation award and bonuses were based on self-interest and not in the best interests of the corporation.

The SAR Cancellation Award

The Ontario Court of Appeal agreed with the trial decision that the SAR cancellation awards were driven by the Board's self-interest. The Court of Appeal agreed with the trial judge that there was no evidence as to how the Board came to the non-market price of $0.40/share as a basis for the SAR cancellation awards and that the Board provided no credible analysis to justify why these payments were fair and reasonable in the circumstances.

Bonus Pool

The Ontario Court of Appeal also agreed with the trial court that there was no reasonable rationale for the establishment of the bonus pool or the allocation of $1.2 million from such pool to the CEO, noting the Board neither sought nor received any expert or legal advice, nor did it refer to comparative market data, in reaching its decision.

Indemnification

The trial judge determined that the CEO was not eligible to be indemnified. In upholding that finding, the Court of Appeal stated:

         The purpose of statutory and contractual indemnity provisions is to ensure that officers and directors who are acting in good faith and in the best interests of a corporation are not exposed to legal costs. It is commercially sensible and good public policy to offer this protection. The rationale for offering the protection is eliminated, however, where the officer or director has not acted in good faith and in the best interests of the corporation.  

Business Judgment Rule

The Ontario Court of Appeal was not prepared to accept the argument that the Board's decisions were within a range of commercially reasonable decisions and, therefore, protected by the business judgement rule because the CEO could not satisfy the rule's preconditions of "honesty, prudence, good faith, and a reasonable belief that his actions were in the best interests of the company." The Court stated that:

         It must be remembered that the business judgment rule is really just a rebuttable presumption that directors or officers act on an informed basis, in good faith, and in the best interests of the corporation. Courts will defer to business decisions honestly made, but they will not sit idly by when it is clear that a board is engaged in conduct that has no legitimate business purpose and that is in breach of its fiduciary duties. In the present case, there was ample evidence upon which the trial judge could base her conclusion that the presumption had been rebutted.  

In doing so, the Ontario Court of Appeal has followed the decision of Justice Lax in the Repap case (UPM-Kymmene Corp. v. UPM-Kymmene Miramichi Inc. (2002), 214 DLR (4th) 496 (Ont SC), aff'd (2004), 183 OAC 310 (Ont CA)),  in which the executive chairman of a corporation was also found to have breached his fiduciary duty to the corporation in connection with the approval of his compensation.  Justice Lax held that the deference required by the business judgment rule is justified to the extent that directors are scrupulous in their deliberation and demonstrate diligence in arriving at their decisions. As such, "courts are entitled to consider the content of their (i.e., the directors') decision and the extent of the information on which it was based and to measure this against the facts as they existed at the time the impugned decision was made."

Enhanced Severance Award

The trial court concluded that notwithstanding the CEO's breach of his fiduciary duty to the Corporation, the Corporation was nevertheless required to pay him an enhanced severance award pursuant to the services contract between the Corporation and the CEO's personal company as such breach did not constitute a default under the contract. The Court of Appeal overturned this decision, finding that the trial judge erred in concluding that breach of a fiduciary duty did not constitute a default vitiating the enhanced severance obligation, noting that such an interpretation would eviscerate the prohibition under section 134(3) of the Ontario Business Corporations Act against any provision in any contract, the articles, the by-laws or any resolution from relieving a director or officer from their fiduciary duty or from liability for a breach thereof.

Key Learnings

The Court of Appeal's decision highlights a number of key risks for directors: 

  1. Compliance with Conflict of Interest Disclosure Requirements is not enough. The Court of Appeal noted that mere disclosure of a conflict does not relieve a director of his or her obligation to act honestly and in the best interest of the corporation.
  2. The Business Judgment Rule is a presumptive rule that does not shield a decision made in breach of a director's fiduciary responsibility. The Court of Appeal noted that the business judgment rule cannot operate to shield decisions which were not taken honestly and in the best interests of the corporation.
  3. Directors should ensure they have properly documented the underlying basis for their decisions. Both the trial court and the Court of Appeal highlighted the absence of any contemporaneous record to evidence the basis for the Board's determinations.
  4. Directors can support their decision with expert advice. While the Board considered the matter of retaining advice from outside experts, the trial court and the Court of Appeal noted that the Board ultimately did not seek expert advice on the reasonableness of its compensation decisions. By contrast, at trial a compensation expert stated that the CEO's compensation package did not pass any test of reasonableness.
  5. Statutory corporate law prohibitions against provisions relieving a corporate fiduciary of their fiduciary responsibilities will be interpreted broadly. The contract with the CEO's personal company did not expressly purport to relieve the CEO of liability for a breach of fiduciary duty. However, the Court of Appeal was prepared to conclude that an interpretation of the contract that would result in payment of the enhanced severance despite the breach of his fiduciary duty would have had that effect in substance. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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