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From Securities Regulation Daily, June 26, 2014

Directors' compensation was "classic self-dealing," excusing pre-suit demand

By Rodney F. Tonkovic, J.D.

The Delaware Chancery Court found that demand was excused in derivative claims for breach of fiduciary duty. The court concluded that the claims involved self-dealing transactions implicating a majority of the members of Unilife Corporation's board of directors at the time suit was filed. The court went on to dismiss the claim to the extent it related to outside directors' equity awards for failure to state a claim. A claim relating to cash compensation paid to the directors for their services as directors, however, survived (Cambridge Retirement System v. Bosnjak, June 26, 2014, Bouchard, A.).

Background. Unilife, a manufacturer of injectable drug delivery systems, has failed to turn a profit or generate significant revenues since its formation in 2002. During its last three fiscal years, Unilife’s revenues declined from $6.7 million in fiscal year 2011, to $2.7 million in 2013. Unilife incurred losses of $40.7 million in fiscal year 2011, $52.3 million in fiscal year 2012, and $63.2 million in fiscal year 2013. The plaintiff challenged the compensation paid to Unilife’s outside directors from November 2010 until November 2012.

Unilife's outside directors were compensated through a combination of equity awards and cash compensation. At shareholders' meetings in 2010 and 2011, Unilife's shareholders approved grants of stock based awards to six outside directors; the directors also received cash compensation. In fiscal year 2012, the outside directors received cash and equity awards totaling approximately 25% of the company's revenues that year, and a similar percentage was received in 2013.

The complaint alleged that these amounts were not only an extraordinary percentage of Unilife's revenues, but were also excessive when compared to similar companies. The complaint asserts claims against the director defendants for breach of fiduciary duty and for waste of corporate assets. The defendants moved to dismiss both claims for failure to make demand.

Self-dealing. The plaintiff's asserted that demand was excused under the first prong of Aronson because five of the six board members were personally interested in their own compensation, which was the subject of the claims here. The court agreed and concluded that demand was excused, noting precedent excusing demand based on a similar challenge to outside director compensation. "The transactions at issue here, the Unilife directors’ payment of compensation to themselves," the court said, "are classic forms of self-dealing." The court rejected the defendants' arguments for the application of a materiality standard or that the compensation was the product of a valid exercise of business judgment.

Breach of fiduciary duty: cash compensation. Next, the defendants did not seek to dismiss the fiduciary duty claim concerning the cash compensation paid to the directors for their services as directors. The court accordingly concluded that because demand was excused, this aspect of the claim survived. Because directoral self-compensation decisions lie outside the business judgment rule’s presumptive protection, the defendants will have the burden of demonstrating the fairness of the cash compensation.

Breach of fiduciary duty: equity awards. The court then dismissed for failure to state a claim the breach of fiduciary duty claim as it related to the outside directors' equity awards. The court agreed with the defendants' argument that they were protected by the business judgment rule because the awards were approved by a disinterested majority of Unilife’s shareholders. The plaintiffs were unable to call into question either the validity of the shareholders' approval or rebut the presumption of valid business judgment.

Waste. Finally, the court found that the claim for corporate waste failed to state a claim and dismissed it. The court acknowledged that the allegations that the compensation paid to Unilife's directors was excessive raised questions concerning the fairness of the outside directors’ compensation, but concluded that "they do not rise to the level necessary to establish a complete failure of consideration or that the director defendants authorized an exchange that was so one-sided that no reasonable business person could conclude that Unilife received adequate consideration."

The case is No. 9178-CB.

Attorneys: Christine S. Azar (Labaton Sucharow LLP) for Cambridge Retirement System. M. Duncan Grant (Pepper Hamilton LLP) for Slavko James Joseph Bosnjak.

Companies: Cambridge Retirement System

MainStory: TopStory CorporateGovernance DelawareNews DirectorsOfficers

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