What the waste standard meansEdit
The courts sometimes apply a waste standard when analyzing a transaction. The waste standard:
- Generally means that what the corporation received in a transaction was so inadequate in value that no person of ordinary sound business judgment would deem it worth what the corporation paid. In essence, waste would involve an exchange so disproportionately small that a reasonable person would not make the trade.
- Waste can also involve transactions for an improper or an unnecessary purpose. Thus, to be wasteful, the transaction would have to be a gift, or for no real consideration, or unnecessary.
- It would be a very rare occurence for disinterested directors to approve of a wasteful transaction.
- A waste of corporate assets is never protected by the Business Judgment Rule.
- Disadvantage - plaintiffs have a difficult burden of proof given the high standard for waste,
- Advantage - claim of waste has the advantage of rarely being dismissed before trail by summary judgment and requires some scrutiny of the substance.
Plaintiffs will often allege waste in executive compensation cases.
Delaware courts have generally held that shareholder ratification of stock options has the effect of limiting judicial review of the compensation under a waste standard with the burden of proof on the plaintiff. While the waste standard would seem to mean minimal scrutiny, the Delaware courts, in some earlier decisions, created confusion about what kind of scrutiny was available when applying the waste test. These decisions looked carefully at the consideration for the options and used a two-prong test.
First, there needed to be a reasonable relationship between the value of consideration flowing both ways, and second, there had to be a determination that a benefit to the corporation was received. These cases suggested that the courts were using the waste standard but at the same time scrutinizing compensation more closely when they applied the two-prong test. The courts seemed to be using an intermediate review (between fairness and the business judgment rule) that woudl look at substance and assess the reasonableness of consdieration (that is, a proportionality test). In the later case of Beard v. Elster, the Delaware court still looked at consideration, but its focus shifted away from the two-prong test. Instead, its main focus was on the process of approval rather than assessment of whether the corporation had received proportionate value.
In Lewis v. Vogelstein, the Delaware Chancery Court finally moved away from the two-prong test, indicationg that a more modern view would be that stock options with disinterested shareholder ratification implicate the traditional waste standard for judicial review. In order to ratify, the shareholder need full disclose both under federal proxy rules and fiduciary standard. The court held that if there was an informed, uncoerced and disinterested sharehodler ratification of an interested director transaction, such as compensation, then waste is the only basis for judicial review. The court partially justifed the use of a waste test because there is more sharehodler activism among institutional shareholders so voting has become more important.
At least one Delaware court has called into question the use of a waste test when there is a majority of disinterested shareholders (i.e., no controlling shareholder) voting to ratify the transaction. In Harbor Finance Partners v. Huizenga, the Delaware Chancery Court in dicta questioned whether a waste standard was really necessary when disinterested sharehodler constituting the majority of shares and with full disclosure approved of a transaction. Although wate is very difficult to prove, the use of the test still allows some judicial scrutiny of substance. The rationale for the waste test is that shareholders cannot ratify a waste transaction. A wasteful transaction was traditionallty viewed as a void transaction (such as illegal, fraudulent or ultra vires) and thus not subject to ratification by shareholders. The court suggested that it is highly unlikely a majority of disinterested sharehodler are further protected by the requirement that those seekign ratification must prove that the vote was fair, fully ifnormed and uncoerced. Thus, sharheodler can always challenge the vote on that basis. The corut hfelt that the use of a waste standard in this content did not relally protect shareholder but amy allow unnecssary litigation to proceed. The corut found it hard to imagine that a majority of disinterested sharehodler would ever ratify a transaction that no person of oridinary sound business judgment woudl find it to be a fair exchange (i.e., waste) and called for a reexamination of the use of the waste test in this context.
In summary, executive compensation cases in publicly traded corporations are difficulty. The use of independent directors in setting compensation will usually mean the business judgment rule will apply and shareholder approval of stock option plans result in the waste test. Both tests put a difficult burden on the plaintiff to overcome. In addition, plaintiffs have to satisfy procedural requirements, such as the demand requirement in a derivative litigation, that make it difficult to bring an actino. And most publicly traded corporations have exculpatory provisions in their ariticles that eliminates damages in duty of care cases.