Corporate Governance

Wayne County Employee's Retirement v. Corti: The Conflict of Interest that Wasn't (Part 2)

By J. Robert Brown

We are discussing Wayne County Employees' Retirement System v. Corti, a recent Delaware case that concluded that directors simultaneously negotiating over the sale of the company and subsequent employment arrangements did not have a conflict of interest.  The court gave a myriad of disjointed reasons for dismissing the existence of the conflict. 

For one thing, it apparently mattered that there was no current move afoot to dismiss either of the two officials. 

• Significantly, the factual allegations in the Complaint do not suggest that Kotick and Kelly's jobs were ever in danger. There is no allegation that there was a bidder threatening to take over Activision and replace management.  There is no allegation that Kotick and Kelly would be removed as managers if Activision did not pursue a transaction with Vivendi. Moreover, plaintiff alleges that from the start of negotiations Vivendi assumed Kotick and Kelly's roles in the combined company.  That Kotick and Kelly did not have to pursue the transaction with Vivendi in order to retain their positions as managers significantly alleviates the concern that Kotick and Kelly were acting out of an impermissible "entrenchment" motive. When Vivendi's assumption regarding Kotick and Kelly's roles is added to the analysis, plaintiff's "entrenchment" theory fails completely. 

But of course, entrenchment wasn't the only possible conflict.  The conflict was the opportunity to obtain a more lucrative employment agreement (one where the two officials received "substantial benefits" as the Chancery Court obliquely described), an issue almost completely glossed over by the court.

Another was that the contract was ultimately approved by two committees of the Activision board that consisted of independent directors.  Id.  ("Moreover, before approving the Combination, Activision's compensation committee and the NCGC met in a joint session to approve employment agreements for Kotick and Kelly, that replaced agreements scheduled to expire on March 31, 2008.").  Approval established, according to the court, that the agreements were not "kept secret" from the board. 

True enough but irrelevant.  At this stage of the proceedings, the issue was whether the two officials negotiating the deal had a conflict of interest.  A conflict of interest doesn't necessarily mean a violation of fiduciary duties but it does suggest the need to analyze the transaction under stricter standards such as entire fairness.  The fact that the board committees approved the agreement does not eliminate the presence of a conflict of interest in the transaction.

Perhaps aware that these arguments entirely sidestepped the conflict issue, the court added two almost conflicting points.  The first was that in fact the two officials "waived some benefits" by agreeing to the new contract.  The reference perhaps was meant to suggest that in fact the new agreement was not as good as the old.  In addition, the court added that the two officials owned 7.5% of Activision's stock, which gave them "an incentive to obtain a higher price for Activision shares."  In other words, the new employment contract was better than the old but the ownership of shares overcame any conflict of interest.

The weakness of the analysis was made even more suspect by the omission of the benefits actually received under the new employment contracts.  The complaint, however, did set them out and from all appearances, they look lucrative.  With respect to Kotick, for example, he would receive:

• 1.25 million performance shares that vested in 20% increments, para. 101
• 363,637 "restricted stock units and two cash payments of $5 million each on the date of the signing of the replacement bonus agreements"  para. 102
• a salary of $950,000, with the possibility of a bonus up to 200% of his salary and options to buy up to 1.85 million shares of Activision, para. 103; and
• "substantial severence and change of control compensation"

The omission was not just an oversight.  By noting that the two officials waived some benefits (certain undefined "change of control benefits" according to para. 102 of the complaint), the court suggested that the two officials actually made sacrifices during the negotiation process.  Yet a more complete discussion of the facts would have at least raised the possibility that the benefits sacrificed were insignificant compared to the additional benefits received.  Yet the court did one without the other.

Similarly, the Delaware courts have, in the past, sometimes asserted that conflicts of interest were largely eliminated where directors were also large shareholders.  Presumably the high level of equity eliminates any incentive to engage in transactions that are otherwise harmful to the corporation.  In this case, the court noted that the two officials owned 7.5% of the shares of Activision, suggesting that something like this had taken place.  Yet this would not be true economically where the benefits received from the employment agreements were greater than any harm to the value of the equity position.  To make that assessment required an analysis of the benefits obtained in the employment agreement.  The court, however, chose not to provide the information.  Nor was there any mention of the increase in equity position that resulted from the units, shares and options provided in the new agreement.

This was a case resolved on a motion to dismiss.  Two officials negotiated an acquisition that could be argued was very favorable to the acquirer (one in which "no control premium was paid" to shareholders of Activision, para. 3) while obtaining what appeared to be highly favorable employment benefits.  In other words, there was a potential conflict of interest that deserved additional examination. 

But not, apparently, in Delaware. 

For the opinion and assorted filings in this case, go the the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on August 24, 2009 (boomark / email).