Executive Compensation and Entire Fairness: Calma v. Templeton (Part 2)

We are discussing Calma v. Templeton, a recent decision in which the Chancery Court held that the applicable standard of review for awards under a compensation plan was entire fairness.

The case took an interesting approach in addressing demand futility.  The court applied the standard from Rales.  As a result, demand excusal was met where shareholders created “a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”  The applicable standard for the absence of disinterest was whether a director “appear[s] on both sides of a transaction [or] expect[s] to derive any personal financial benefit from it in the sense of self-dealing.”

According to the allegations, all of the directors in the case benefited from the plan and were, as a result, "on both sides" of the transaction.  Nonetheless, shareholders did not assert that the amounts received by the directors were material.  Instead: 

• Plaintiff contends that where, as here, there are derivative claims challenging the compensation received by directors, those directors are interested for demand futility purposes because they “have a personal financial interest in their compensation for their service as directors,” regardless of whether the compensation they received was material to them personally.

While conceding that directors were generally not considered interested “simply because [they] receive compensation from the company”, the court found that in the context of a challenge to compensation it was enough to show that the directors received payments.  See Id.  ("in a derivative challenge to director compensation, there is a reasonable doubt that the compensation at issue—regardless of whether that compensation was material to them on a personal level—can be sufficiently disinterested to consider impartially a demand to pursue litigation challenging the amount or form of their own compensation").  

As a result, shareholders survived dismissal for failure to make demand without having to show materiality of the payments.  Nonetheless, the court viewed the analysis as limited to the compensation area.  Id.  ("But, a derivative challenge to director compensation is different because the law is skeptical that an individual can fairly and impartially consider whether to have the corporation initiate litigation challenging his or her own compensation, regardless of whether or not that compensation is material on a personal level."). 

To the extent that this become the general approach, compensation decisions will at least be more often addressed on the merits rather than dismissed as a result of a failure to show demand futility.  Moreover, the approach will likely permit more challenges to compensation to survive motions to dismiss.  The approach, therefore, is not particularly management friendly.  It will be interesting to see if the approach survives once it is reviewed by the Supreme Court.