Recent lawsuits have challenged director compensation under Delaware law at several public companies. The issue at the core of these lawsuits is that outside directors are viewed as interested parties with respect to their own compensation (cash or equity). Therefore, any compensation program that applies to outside directors runs the risk of losing protection of the business judgment rule under Delaware law because of arguable self-interest. Without the protection of the business judgment rule, the outside director compensation plan would be subject to scrutiny under the “entire fairness” doctrine of Delaware law. Although any particular compensation plan may survive review under the “entire fairness” standard, most companies do not want to subject their compensation arrangements to such a review or run the risk of defending a claim on the merits at trial. As a result, when such an arrangement is challenged, the company involved may choose to settle the matter.

Recent settlements indicate the direction in which these settlements are headed. Although the set of cases actually settled to date is not large enough to form the basis of confident generalization, the following items may be part of the mix.

  • A hard cap on director equity—This provision would typically be implemented through an amendment to the equity plan and would be expressed as a dollar amount limit, not as a number of shares. Accordingly, the limit is a hard cap (which diminishes in value with inflation).
  • Submission of the cap amendment for a shareholder vote—Although an amendment to add a limitation on outside director equity does not generally require shareholder approval under NYSE or NASDAQ rules, to secure the protection of the business judgment rule under Delaware law, it appears that a separate shareholder vote is needed. Because of the amendment’s hard-cap nature (as opposed to, for example, a dollar amount with a percentage escalator), the provision will need to be resubmitted for a shareholder vote each time a company seeks to increase it.
  • Role of an independent consultant to the compensation committee—The compensation committee would commit to hire an independent consultant to advise annually on the cash and noncash compensation for outside directors.
  • Amendment to the compensation committee charter—The compensation committee charter would be amended to require the committee to annually review outside director cash and noncash compensation based on input from the independent consultant and to make a recommendation to the full board for review.
  • Enhanced disclosures on outside director compensation—A company’s proxy disclosure would be enhanced to include a description of (a) the compensation philosophy with respect to outside director compensation; (b) the process that the company, committee, and board followed to arrive at the compensation amounts developed for the year; and (c) the specific annual award for each outside director.

Companies that have not faced challenges to their outside director compensation practices may consider whether it is advisable to undertake any of the above actions at this time. Certainly, it is appropriate to perform a thorough review of outside director compensation practices as a way of anticipating a defense to potential claims that outside director compensation practices are inappropriate. The recent lawsuits present unique challenges to a board, and, at the very minimum, suggest a review to evaluate how a company’s outside director compensation practices compare to its peers’ practices.