What is the judicial standard of review applicable to an award of compensation by directors to directors under an equity incentive compensation plan that has been approved by the shareholders?  That was the question before the Delaware Chancery Court in Calma v. Templeton. The answer is, as always: it depends.

In this case, which came before the Court on a motion to dismiss, a shareholder sued derivatively on behalf of Citrix Systems challenging the award by the board’s compensation committee of restricted stock units (RSUs) under the company’s Equity Incentive Plan to eight non-employee directors. The Plan, as amended, had been approved by a majority of the company’s disinterested stockholders. The Plan permitted awards to employees, consultants, directors and others.  The only limitation on the size of grants under the Plan was the IRC 162(m) limitation providing that no one could receive more than one million shares (or RSUs) per calendar year. The Court calculated that, based on Citrix’s stock price when the action was filed, one million RSUs were worth over $55 million.  The plaintiff argued that the RSUs, together with the cash awarded to non-employee directors, was excessive relative to the compensation paid to directors at the company’s peer group. (For the 2011 to 2013 period, director compensation ranged between $303,360 and $425,570 in cash and equity, with a new director receiving $662,935.) The plaintiff sought recovery under the theories of breach of fiduciary duty, corporate waste and unjust enrichment, contending that the “entire fairness” standard applied because the grants to non-employee directors involved self-dealing.  Moreover, the plaintiff contended, the conflicted compensation decision was not “cleansed” by any shareholder vote approving the Plan because the Plan did not have any “meaningful limits” on the awards that could be granted to the non-employee directors and that the 162(m) limitation was “specious.” The defendants countered that shareholder approval of the Plan was effective to overcome the conflict.  As a result, they contended, any award of RSUs to the directors under the 162(m) limitation was subject to review under a “waste” standard (in essence, requiring that the plaintiff show only that the board’s decision cannot be attributed to any rational business purpose), and that the RSUs were not waste.

The Court agreed with the plaintiff on two of the three counts.  The Court concluded that the shareholder vote did not ratify the RSUs because, “in obtaining omnibus approval of a Plan covering multiple and varied classes of beneficiaries, the Company did not seek or obtain stockholder approval of any action bearing specifically on the magnitude of compensation to be paid to its non-employee directors. Accordingly, because the RSU Awards were self-dealing decisions, the operative standard of review is entire fairness, and it is reasonably conceivable that the total compensation received by the non-employee directors was not entirely fair to the Company. I also conclude that it is reasonably conceivable that the defendants were unjustly enriched by the RSU Awards, but not that the RSU Awards constituted waste.”

Ordinarily, directors decision are reviewed under the more lenient business judgment rule, which allows directors wide discretion to act so long as they act with due care on an informed basis, in good faith for a rational business purpose and in the belief that the action is in the best interests of the company and without personal interest in the matter.  Where the plaintiff rebuts the business judgment presumption, the directors’ decision is reviewed under the entire fairness standard, in which case the directors face a much tougher burden of establishing both fair dealing and fair price.  Here, all three members of the Compensation Committee received RSUs, enough to establish a conflict of interest and rebut the presumption.  As the Court explained, under the Delaware Supreme Court’s decision in Telxon Corp. v. Meyerson,  “director self-compensation decisions are conflicted transactions that ‘lie outside the business judgment rule’s presumptive protection, so that, where properly challenged, the receipt of self-determined benefits is subject to an affirmative showing that the compensation arrangements are fair to the corporation.’”

The defendants had argued that,  under law settled in Delaware for 60 years, informed, advance shareholder approval granting the directors discretion to exercise their business judgment was sufficient to ratify the RSUs, shifting the burden back to the plaintiffs.   However, examining the numerous cases over that period, the Court observed that they all involved either disinterested board committee approval or shareholder approval of plans that identified the amounts or specific annual ceilings for awards to be granted: “In other words, stockholder approval of the plan per force meant stockholder approval of the option awards for which the directors asserted a ratification defense.”  However, advance shareholder approval of the general terms of a plan that did not include any director-specific amounts or limits on compensation was not effective to approve the specific awards. Then Court then approvingly quoted then-Vice Chancellor Strine’s opinion inSample v. Morgan:

“[T]he Delaware doctrine of ratification does not embrace a ‘blank check’ theory. When uncoerced, fully informed, and disinterested stockholders approve a specific corporate action, the doctrine of ratification, in most situations, precludes claims for breach of fiduciary duty attacking that action. But the mere approval by stockholders of a request by directors for the authority to take action within broad parameters does not insulate all future action by the directors within those parameters from attack….Stockholders can entrust directors with broad legal authority precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty. Therefore, the entrustment to the [corporation’s compensation committee] of the authority to issue up to 200,000 shares to key employees under discretionary terms and conditions cannot reasonably be interpreted as a license for the [c]ommittee and other directors making proposals to it to do whatever they wished, unconstrained by equity. Rather, it is best understood as a decision by the stockholders to give the directors broad legal authority and to rely upon the policing of equity to ensure that that authority would be utilized properly. For this reason alone, the directors’ ratification argument fails.”

The Court drew two key principles from this caselaw review: “One principle is that the affirmative defense of ratification is available only where a majority of informed, uncoerced, and disinterested stockholders vote in favor of a specific decision of the board of directors….The second principle is well-established and non-controversial: valid stockholder ratification leads to waste being the doctrinal standard of review for a breach of fiduciary duty claim.”

Because, in this case, the Plan included only a 162(m) limitation and did not specify  or otherwise limit the amount or form of compensation to be issued to the non-employee directors, the Court concluded that the defendants did not satisfy their burden: the defendants failed “to establish a ratification affirmative defense at this procedural stage because Citrix stockholders were never asked to approve—and thus did not approve—any action bearing specifically on the magnitude of compensation for the Company’s non-employee directors.”  Nor did the recitation of director comp in the proxy statement imply that the shareholders had approved those grants.  Accordingly, the entire fairness standard (which imposes a very high threshold, especially in the context of a motion to dismiss) was applicable. In addition, the Court concluded that it was reasonably conceivable, because of the composition of the company’s peer group – which included a number of “aspirational” peers – that the compensation was not fair. Further, the plaintiff failed to state a claim for waste because the plaintiff did not plead the “rare type of facts from which it is reasonably conceivable that the RSU Awards are so far beyond the bounds of what a person of sound, ordinary business judgment would conclude is adequate consideration….”  However, the Court viewed the unjust enrichment claim as essentially duplicative of the fiduciary duty claim and allowed that claim to stand as well.

In light of the current litigation environment surrounding compensation matters generally and in view of this case in particular, the plaintiffs’ bar may well perceive a fiduciary duty claim related to directors’ equity compensation as easy pickings. While boards may be loath to limit their flexibility in compensation matters, to deter potential litigation or otherwise seek the benefit of the more lenient business judgment rule, boards may well view it as worthwhile to review their companies’ plans and director compensation arrangements to assess the fairness and reasonableness of total director compensation and consider whether it would be advisable for the board to adopt pertinent amendments and then submit them for shareholder approval.  Amendments to be considered include adding specific grant amounts for directors (similar to the automatic formula grants under the type of non-employee director plans formerly considered necessary to comply with Section 16 prior to major changes in those rules) or reasonable “meaningful” ceilings specifically applicable to non-employee directors. Companies might also consider submitting prior awards for shareholder ratification.  Another possible approach might be to adopt and submit for shareholder approval a specific director compensation program or policy, separate from any plan, that sets out explicit amounts or limitations.