United States: Directors Must Exercise Business Judgment in Approving an Executive Compensation Transaction; Excessive Deference to Officers in Such Matters Will Risk Shareholder Scrutiny

Originally appeared in Kaye Scholer's Spring 2016 M&A and Corporate Governance Newsletter.

In a recent Chancery Court decision, Vice Chancellor Laster considered a shareholder's Section 220 request for "books and records" of Yahoo! Inc. in connection with the hiring and later termination of an executive officer.[1] The court's analysis of the compensation committee and board's consideration of the executive's compensation package and termination provides some helpful reminders of the duties of directors and officers in negotiating and reviewing compensation and executive employment decisions. The decision also highlights key factors in the record which, if present, will help directors and officers defend against stockholder claims of wrongdoing in connection with such business decisions regarding executive compensation and termination.


In 2012, the Yahoo board hired Marissa Mayer as CEO; Mayer had previously worked at Google Inc. as a Vice President of Local, Maps and Location Services. Soon thereafter, Mayer commenced discussions with Henrique de Castro, who was serving as President of Media, Mobile and Platforms at Google, to join Yahoo as her number two executive. Mayer told the Yahoo compensation committee that she was in discussions with a candidate for the number two position, without disclosing de Castro's identity. She described a significant compensation package—$15 million per year (with $40 million of that up front in a four-year grant) and a $16 million or more make-whole payment. She explained that a package of this size would be required because of the candidate's talents and the compensation he would forfeit if he left his current employer. The compensation consultant advised the committee that the proposed compensation was "more than the data supported for a number two executive in peer companies." However, although the consultant didn't know the identity of the candidate, he further opined that the compensation could be justified "regardless of the data." The committee authorized continued negotiations, apparently without inquiring further about the candidate's identity or credentials.

Subsequently, Mayer presented a term sheet and a draft offer letter to the compensation committee concerning de Castro's hiring. The committee did not receive any materials that illustrated the interrelationships among the various compensation components or the total compensation generated in various scenarios, despite the complexity of the proposed scheme. The bulk of the compensation was in three different proposed awards of equity compensation: incentive restricted stock units, performance stock options and make-whole restricted stock units. The total target value of the equity awards was $56 million. The offer letter contemplated a termination with or without cause. In a termination with cause, de Castro would forfeit all unvested equity awards. If the termination were without cause, de Castro would keep not only the vested equity awards through his termination date, but also a portion of his unvested awards, vesting on an accelerated basis. The terms of such acceleration were complex and differed for each type of equity award.

Under this original offer letter, the total incentive RSUs and options that could vest on an accelerated basis was limited to those that could have vested in the six months following the termination; the incentive RSUs and options had different vesting schedules, so this six-month tail operated differently for each type of award. The six-month tail established an eligible pool that could be accelerated for each type of award, and then, under the letter, the eligible awards were multiplied by a specified percentage, which varied depending on the time de Castro would have been at Yahoo, with 25 percent for a termination before November 23, 2013, 50 percent for a termination before November 23, 2014, 75 percent for a termination before November 23, 2015 and 100 percent for a termination thereafter. The make-whole grants were treated differently. All of the make-whole grants were in the eligible pool and the cutback percentage increased at a more favorable rate to de Castro—50 percent for a termination before November 23, 2013, 75 percent for a termination before November 23, 2014 and 100 percent thereafter. In any case, the specified percentage operated to limit the acceleration of equity awards otherwise in the "eligible pool."

The implications of these varying vesting schedules and acceleration provisions were "not self-evident." To support this conclusion, the court provided several charts it had generated to analyze the effect of terminations in different time periods. The opinion points out that the committee had no such charts or other written aids to summarize the interrelationship of the provisions and the impact of timing on the value of awards received. Moreover, the Vice Chancellor notes that the committee spent only 30 minutes considering the offer letter. Counsel briefed the Yahoo board after the committee's review, but, based on the minutes describing the meeting, the court concluded that "the description the Board received did not capture the implications of the accelerated vesting for various termination scenarios." The board and committee authorized further negotiations.

As a result of subsequent negotiations with de Castro, Mayer then proposed changes to the offer letter favorable to de Castro to induce him to join the management team. When she briefed the committee about the proposed changes, she described the prior committee approval incorrectly, indicating the original letter contained a 12-month tail (not the six-month tail noted above) and proposed eliminating the "specified percentage" based on the incorrect proposition that the committee had approved a 12-month tail.[2] Again there were no written materials provided to the committee to quantify the effect of the proposed changes in the offer letter; such a summary might have highlighted the error. The committee approved the elimination of the "specified percentage."

Mayer then revised the offer letter further, making three changes—she increased the tail from six to 12 months, she eliminated the specified percentage, and she eliminated the time-weighted schedule for accelerated vesting for the make-whole RSUs, providing that on a termination without cause de Castro would receive 100 percent. The last change was never discussed with the committee, and the first change was presented to the committee as already being in the original offer letter, which error served to minimize the cumulative impact of the elimination of the specified percentage, which was the only change the committee did approve. Further, Mayer reallocated the target value conveyed by the different types of equity awards, increasing the target value of the make-whole RSUs from $16 million to $20 million, and decreasing the value of the incentive RSUs and options by the aggregate $4 million, without ever discussing these changes with the committee.

As the court explains, "Mayer's changes did not affect the target value of the aggregate grant, which remained at $56 million, but they did affect de Castro's incentives and the size of the payout" on a termination without cause.

These were significant impacts; the court notes that for the payout on a termination without cause after 12 days of service, the changes resulted in a 263 percent increase in compensation from the original letter, and for a termination after one year and 12 days, the increase was 94 percent from the original terms proposed. The Committee never received any summary of the value of the changes, or the aggregate effect of all of these changes. The letter was executed and de Castro's hiring was announced on October 15, 2012.

De Castro was the eighth highest paid executive in Silicon Valley in 2013, his first year with Yahoo; he actually made more than Mayer, and only eight CEOs of public companies in the United States made more than him that year. Fourteen months after de Castro started with Yahoo, Mayer decided to fire him. The Committee did not meet in person or by phone to consider this termination, but simply approved the termination "without cause" via an action by written consent on January 12, 2014. Three weeks later, the Committee met, and only then heard Mayer's explanation of the reasons for the termination, and determined not to award him a bonus under the Executive Incentive Plan. The total severance paid was $59.96 million, including $9.62 million in value from the accelerated Incentive RSUs, $16.02 million from the accelerated options and $31.18 million from the accelerated make-whole RSUs.

The Section 220 Demand and Possible Wrongdoing

Amalgamated Bank, a Yahoo shareholder, made a Section 220 demand for various books and records relevant to the hiring and termination of de Castro. After some wrangling, Yahoo produced some materials and withheld others. The parties then wound up before Vice Chancellor Laster to adjudicate the remainder of the Section 220 request. The Vice Chancellor ruled on what was sufficient to meet the statutory "form and manner" requirements under Section 220, holding that, as to proof of ownership, Amalgamated could provide "documentation sufficient in time to the date of the demand as to be consistent with and corroborate the averment of stock ownership made in the demand itself" and need not provide an ongoing stream of ownership records to confirm continuous ownership.

The Vice Chancellor confirmed that a stockholder's desire to investigate wrongdoing or mismanagement is a proper purpose. A stockholder "need only show, by a preponderance of the evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement that would warrant further investigation." This credible-basis standard is the lowest burden of proof, and a showing sufficient to conduct an investigation ultimately may "fall well short of demonstrating that anything wrong occurred."

The court concluded that the shareholder established possible wrongdoing under either theories of breach of fiduciary duty or waste. In explaining that the facts could support a claim of breach of fiduciary duty, Vice Chancellor Laster drew obvious parallels to the facts in the very famous Disney case, where the plaintiffs filed a 220 action eventually, and the Chancery Court determined the facts gave rise to the:

"cognizable question whether the defendant directors... should be held personally liable to the corporation for a knowing or intentional lack of due care in the directors' decision-making process regarding Ovitz's employment and termination... Allegations that Disney's directors abdicated all responsibility to consider appropriately an action of material importance to the corporation puts directly in question whether the board's decision-making processes were employed in a good faith effort to advance corporate interests."

In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 278 (Del. Ch. 2003) (emphasis added; quotation marks and footnote omitted).

After reviewing the facts, the court concluded that there was a credible basis to investigate possible claims of breach of duty by the Committee and the Board, with respect to both the hiring and firing of de Castro. The Vice Chancellor also found a credible basis for further investigation of a claim of waste, noting that, despite directors' discretion in

setting executive compensation, "there is an outer limit," and also citing Mayer's unilateral changes to the offer letter increasing de Castro's compensation, and the fact that de Castro was terminated without cause, resulting in a large payout, without any discussion on the record of a possible termination for cause. Further, the court affirmed as a proper purpose the investigation of director disinterestedness and independence. The Vice Chancellor explained that the possible exculpation of directors did not cut off the Section 220 requests because the breach of a duty of loyalty by failing to act in good faith is not exculpated, and also there was possible liability for Mayer, who has no exculpation as an officer.

The court proceeded to permit the Section 220 inspection, "tailored to the stockholder's stated purpose." Vice Chancellor Laster required production of Mayer's emails and other files related to de Castro's hiring and firing, including all electronic documents, and including her emails from any personal account she used to conduct company business. The court also ordered production of emails and electronic documents in possession of the compensation committee related to de Castro's hiring or termination, and as to director recruitment (relevant to an inquiry as to the directors' disinterestedness and independence).

In a case of first impression, the Vice Chancellor also agreed to Yahoo's request that the further production of 220 documents be conditioned on the incorporation of all documents so produced into any derivative action complaint filed by Amalgamated. The court explained that "the Incorporation Condition protects the legitimate interests of both Yahoo and the judiciary by ensuring that any complaint that Amalgamated files will not be based on cherry picked documents."

Lessons Learned

Beyond the procedural nuances of the court's rulings on the Section 220 requests, this case reminds us of some basic rules of the road that directors and their advisors should keep in mind when dealing with executive compensation and hiring and firing decisions, which are common across all industries:

  • Officers have a risk of personal liability for a breach of the duty of care without exculpation. Vice Chancellor Laster reminds us that officers do not have the benefit of exculpation for the breach of the duty of care. Officers have a duty to comply with board directives and to provide the board with information they need to perform their fiduciary roles. This precept then argues for officers obtaining board authority for important decisions, after providing to the directors all relevant information reasonably available. Going it alone can create significant risk of liability for officers.
  • Directors who accept management's statements uncritically, particularly with respect to executive compensation or employment actions, risk scrutiny and possible liability. The court notes that here the involvement of the Committee and the Board on the hiring and firing of de Castro was "tangential and episodic." The court explains that a board "cannot mindlessly swallow information, particularly in the area of executive compensation." The board must exercise business judgment. Where there is a lot of money at stake, and the provisions are out of the norm, directors protect themselves by asking questions and understanding the provisions they are approving, rather than simply relying on management. In cases involving executive compensation, hiring and firing, a board or committee may need to exercise more scrutiny than usual about the decisions being made, given possible self-interest of the executives. Lack of curiosity on obvious points, such as a candidate's identity and credentials, or the financial impact of a complex compensation scheme, gives rise to concerns that the directors simply abdicated their responsibilities in a critical area.
  • Complex provisions, particularly those with significant monetary impact on the corporation, can be summarized in writing and distributed to the directors to demonstrate for the record the board or committee understanding. Where contract provisions create multiple scenarios with varying impact on the corporation and significant dollar exposure is possible, it is prudent to provide the board or committee with a written summary of the impact of the provisions in various likely scenarios, to spend time discussing the impact of those various provisions and to memorialize the discussion to evidence due inquiry. This case offers one example of such provisions, but many bonus and equity compensation provisions have complex terms and interrelationships and varying results depending on timing, and it is helpful to have evidence that the committee or board had a summary showing these impacts and had discussed the same. If such discussions took place here, they were not captured in the minutes, creating an issue about which further investigation was deemed warranted.
  • There is a value in discussing the pros and cons of a decision within a board or committee meeting; the record of a board or committee meeting can reflect the directors' inquiry in formulating a business judgment, while a unanimous written consent typically only conveys conclusions. There is a benefit to directors engaging in a discussion about the merits of a significant hiring or firing decision, or other business decision that may have significant impact on the corporation. Further, there is merit in reflecting in the record that a discussion about the merits and risks of the action being considered took place. As an example, in this case a discussion about whether to pursue a "for cause" termination for de Castro may in fact have taken place, but perhaps outside the board or committee setting. There may even have been an interchange with individual committee members about that topic, but there was no meeting to consider the termination grounds, and therefore there was no record of the reasoning in support of the business judgment being made. Meetings allow real-time dialogue and consensus after an interchange considering different views; this process is valuable and can lead to better decision-making. In contrast, a unanimous written consent typically would not demonstrate that pros and cons were weighed, and that a business judgment was reached as a result of that process since only the conclusions are set down in a normal unanimous written consent. Where a decision has significant impact and material pros and cons to be considered, a meeting is advisable, and then the record in the minutes can reflect the key factors discussed and demonstrate that a business judgment was made.
  • The time spent on a topic will be evidence of the level of attention and consideration the board or committee gave to the topic; complex topics typically require a reasonable amount of time. It was clear that the court didn't believe a committee or board could understand the financial implications of the complex acceleration provisions in the de Castro offer letter in the 30 minutes the committee met. A director may need to request additional time or postpone a decision to permit thorough understanding of a complex topic.

» See the entire newsletter (PDF).

[1] Amalgamated Bank v. Yahoo! Inc., C.A. No. 10774-VCL (Del. Ch. Feb. 2, 2016).

[2] Vice Chancellor Laster noted that it isn't clear why Mayer conveyed this inaccurate information; "[s]he may have made an innocent mistake, and if this case ever proceeds on the merits, it might be shown to be inconsequential." Alternatively, she may have been negligent to some degree or had an improper motive. "It may be that Mayer's conduct did not constitute a breach of fiduciary duty, but it is worthy of investigation."

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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