By: Rex Hood
Juris Doctor & M.B.A. Candidate, 2015
Valparaiso University School of Law
The Seventh Circuit recently reviewed Donnawell v. Hamburger to establish whether a corporation could use the business judgment rule in correcting a contract. The business judgment rule is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.
The case is a share-holders’ derivative suit against current and former members of DeVry‘s board of directors. An incentive plan adopted by the company in 2005 authorized the award of stock options to key employees, including the company’s CEO. The plan limited the awards to 150,000 shares per employee per year. Yet the company granted Daniel Hamburger, who became its CEO in 2006, options on 184,100 shares in 2010, 170,200 in 2011, and 255,425 in 2012. After discovering its mistake, Devry reduced each grant under the 2005 plan to 150,000 shares while at the same time it allocated Hamburger 87,910 additional shares available under the company’s 2003 incentive plan. As a result Hamburger received options in 2012 far above the 150,000 that were the most he could receive under the 2005 plan. All these grants were proposed by the company’s Compensation Committee to the company’s independent directors. The independent directors approved the award of the additional shares to Hamburger.
The plaintiff argues that the award is improper because only the company’s Plan Committee, and not the Compensation Committee, was authorized to grant stock options under the 2003 plan. But there was no Plan Committee in 2012. Likewise no harm was done by allowing the Compensation Committee to do over, in effect, the erroneous grant of stock options under the 2005 plan, by invoking the 2003 plan. The court held that drafters of contracts are not omniscient; they are not gifted with exact knowledge of what the future holds and, furthermore, literal interpretation can produce absurdities when applied to unforeseen occurrences. The nonexistence of the Plan Committee created an unforeseen hole in the 2003 incentive plan, and the company plugged the hole by substituting the Compensation Committee a substitution that might well make the shareholders better off, and would be very unlikely to make them worse off, than if there had been a Plan Committee. It makes no sense to allow a harmless error to drive a judicial decision.
This court in their ruling has avoided a company suffering from an unforeseen effect but, has this court decision created a corporate do over or “mulligan” provision? By allowing a company to use the business judgment rule in this manner you can expect we will see companies attempt to utilize this rule in other unforeseen ways in the future.