Federal Court Applies Delaware Law to Dismiss Shareholder Proxy Claim that Executive Pay Plans Not 162(m) Deductible

Applying Delaware corporation law, a federal judge dismissed a shareholder derivative action alleging that a proxy statement falsely stated that performance-based compensation under a stock incentive plan and a long-term performance plan would be tax-deductible under I.R.C. § 162(m). The shareholder’s duty to make a demand on company directors was not excused as futile. (Abrams v, Wainscott, DC Del., CA No. 11-297, RGA, Aug. 21, 2012)

The Delaware Supreme Court has characterized the exercise of determining demand futility as deciding whether a reasonable doubt is created that: ( 1) the directors are disinterested and independent; and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. As to the first prong, the federal court said that pleading that the outside directors were interested in the proxy statements' representations about restricted stock did not create a reasonable doubt as to whether the outside directors were interested in the proxy statement's representations about performance-based compensation under the stock incentive plan and the long-term performance plan.

As to the second prong, the shareholder did not allege particularized facts to create a reasonable doubt as to whether the protections of the business judgment rule are available to the board of directors. The court rejected the blanket proposition that a shareholder need only allege violation of a compensation agreement to excuse demand, without additional allegations of knowledge and intent. Similarly, the cases did not support the proposition that derivative claims based on a proxy statement nondisclosure do not need to meet the second prong of the Delaware test in this context. If shareholders could elect to sue on behalf of a corporation without consulting the board of directors whenever they deemed a proxy statement to contain materially false information, shareholders could effectively usurp the board's decision as to whether litigation was merited

Finally, the federal judge rejected the contention that demand should be excused because the claim of waste, based on the inability to take tax deductions under the stock incentive plan and long-term performance plan, did not invoke the business judgment rule. A claim of waste still requires pleading particularized facts to create a reasonable doubt that the board's decisions were the product of a valid exercise of business judgment in order to excuse demand.