Your Equity Plan is a Contract – Follow It, or Else

24 June 2022 Legal News: Employee Benefits Insights Publication
Author(s): Kelsey A. O'Gorman Joshua A. Agen

A recent Delaware Chancery court opinion serves as a reminder to companies and their boards that shareholder-approved equity compensation plans are contracts, and failing to follow the terms of such contract could result in costly shareholder litigation.

In Garfield v. Allen, No 2021-0420-JTL (Del. Ch. May 24, 2022), a shareholder brought claims against the compensation committee of ODP Corporation (NASDAQ: ODP) for breach of contract and breach of fiduciary duty because the committee approved an equity award that violated the terms of the shareholder-approved equity compensation plan.  Specifically, ODP’s equity compensation plan included “individual award limits” that restricted the number of shares of common stock that could be subject to awards granted to any individual during a fiscal year of the company.  In March 2020, the compensation committee approved performance share awards to the company’s CEO which, if earned above the target level, would have exceeded the individual award limits in the plan by approximately 1.2 million shares.  A shareholder sent a demand letter to ODP asking it to modify the awards to comply with individual award limit, and to investigate whether there were additional violations of the company’s equity plans.  The company responded with a letter telling the shareholder that it would not amend the awards because it interpreted the individual award limits as applying to the target number of shares granted under an award rather than the maximum number that could be earned if performance exceeded target.  The shareholder subsequently filed a claim against the compensation committee and the Board asserting, among other claims, (1) breach of contract since the awards as issued were not in compliance with the terms of the equity plan and (2) breach of fiduciary duties for approving awards in excess of the individual award limits and then failing to correct the awards when the demand letter was sent.  The defendants moved to dismiss the complaint, and the court denied the motion.

With respect to the breach of contract claim, the defendants contended that the equity plan was not a contract.  To the contrary, the court noted that it has previously expressly “held that a stockholder-approved equity compensation plan is a contract between the board of directors and its stockholders.”  (Garfield at 31.)The defendants also contended that there was an provision in the plan that permitted the compensation committee (as the administrator of the plan) to “interpret, construe, and administer” the plan and because the administrator interpreted the individual award limits as applying only to the target number of shares, the plaintiff had no claim.  However, the court found that the defendants could not rely on such language to escape the plain meaning of the individual award limit in the plan.

With respect to the breach of fiduciary duty claims, the court declined to dismiss under the business judgement rule, noting that the business judgement rule only applies to discretionary decisions that are within the Board’s authority, but does not extend to decisions that exceed the Board’s authority, and the court found that essentially rewriting the individual award limits in the equity plan to justify the March 2020 grants to the CEO exceeded such authority.  The court also found fault with the defendants’ inaction after receiving the plaintiff’s demand letter, noting that “a conscious decision to leave a violative award in place supports [an] inference that the decision-maker acted disloyally and in bad faith.”  (Garfield at 65.)

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This case is a reminder to companies—particularly public companies—that shareholder-approved equity plans are considered contracts with the company’s shareholders.  Failing to follow the plan terms can result in claims against the board for breach of contract and breach of fiduciary duty.  This case also highlights that blanket statements in an equity plan giving the administrator the ability to interpret the plan cannot be used to “rewrite” unambiguous plan terms.  As a result, it is important to take the time to read through your plans and award agreements in full, to make sure that management and the Board understand all plan terms to prevent issuing awards that violate plan terms, and to respond appropriately to any allegations that an outstanding award violates plan terms.

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