The Delaware Chancery Court recently refused to extend the protections of the business judgment rule to directors in a stockholder’s challenge of directors’ compensation, including equity awards made to non-employee directors under a stockholder-approved equity incentive plan. In its ruling, the court rejected defendants’ motion to dismiss two of plaintiff’s three claims, determining that the directors’ decisions to award equity compensation to non-employee directors are subject to review in accordance with the more stringent entire fairness standard.1
The decision is significant because under Delaware law compensation decisions of directors are generally protected by the business judgment rule and this decision, viewed in conjunction with other Delaware precedent, could result in an increase in stockholder actions challenging director compensation awards where such awards are issued pursuant to an equity incentive plan that lacks meaningful limits on grants to non-employee directors.
The company’s Compensation Committee approved restricted stock unit (RSU) awards for issuance to eight non-employee directors, including themselves, under the company’s 2005 Equity Incentive Plan (Plan) as part of the director’s annual compensation. The challenged awards, which were granted in 2011, 2012 and 2013, ranged in annual value from $253,360 to $339,320 per director.
The Plan, including subsequent amendments, had been approved by the company’s stockholders. The Plan’s only limit on compensation paid to an eligible beneficiary is a cap of one million shares or RSUs per calendar year. Based on the company’s share price when the suit was filed, one million RSUs were worth over $55 million. The Plan does not otherwise specify or limit the value of the RSUs to be awarded under the Plan to a non-employee director in any year or otherwise limit the compensation non-employee directors receive annually. The Plan, as approved, gives the Compensation Committee and the Board discretion to determine the amount and form of awards to be granted under the Plan, including to non-employee directors.
A stockholder filed a derivative action challenging the RSU awards alleging breach of fiduciary duty (“by awarding and/or receiving excessive and improper compensation at the expense of the [c]ompany”2), waste of corporate assets and unjust enrichment.
The decision, which was procedural in nature, held that the Compensation Committee’s approvals of the RSU awards, including the RSU awards made to the non-employee directors who were not members of the Compensation Committee, were conflicted decisions because the members of the Compensation Committee also received a part of those awards (and were, therefore, not disinterested directors). Citing Delaware Supreme Court precedent, the court noted 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.”3
To avoid entire fairness review, defendants argued that the RSU awards were made in administration of, and in full compliance with, the stockholder-approved Plan and, therefore, such RSU grants had been ratified by stockholders. The court held that stockholder approval of the Plan did not constitute stockholder ratification of the non-employee director awards under the Plan because 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.”4 As the court noted, “[t]he Delaware doctrine of ratification does not embrace a ‘blank check’ theory” and the mere stockholder approval 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.”5
Defendants argued the awards were fair because they were in line with similar awards of equity compensation made by companies in the company’s self-selected peer group as disclosed in its SEC filings. The court, however, felt that the plaintiff “raised meaningful questions” about whether the company’s peer group used to determine the fair value of compensation of the company’s non-employee directors was appropriate, as that peer group included companies with “considerably higher” market capitalization, revenue and net income than the company.
As the presumption of the business judgment rule had been rebutted and the affirmative defense of stockholder ratification was not available, the awards were subject to the entire fairness standard of review. As a result, plaintiff’s breach of fiduciary duty claim and unjust enrichment claim (which the court viewed to be duplicative of the breach of fiduciary duty claim) survived the directors’ motion to dismiss. The directors will now bear the burden to establish that the award decisions were the product of fair dealing and fair price. The corporate waste claim was dismissed because the plaintiff could not show that the RSU awards were “so far beyond the bounds of what a person of sound, ordinary business judgment would conclude is adequate consideration to the [c]ompany.”6
This decision, when coupled with the court’s similar 2012 Seinfeld v. Slager decision,7makes it clear that stockholder approval of an equity compensation plan that merely provides a “blank check” to the board in approving an award will not be sufficient to entitle the board to the protections of the business judgment rule should the awards be challenged. Delaware companies seeking to shield director compensation decisions of interested directors regarding director compensation from an entire fairness review should either:
- include in plans submitted to stockholder approval specific limits on the amount and form of annual director compensation awards under the plan that approximate the amount and form of compensation the directors are anticipated to receive and that will be similar in value to the value of the equity awards made by the companies in an appropriate peer group to their directors; or
- have stockholders specifically approve (1) director compensation awards over a period of years that fall within limits on the amount and form of those awards approved by the stockholders or (2) the specific compensation awards to the directors for each year.
Delaware companies should consider reviewing their equity incentive plans that include directors as participants to determine whether existing limitations on the board’s discretion to grant director awards could be enhanced. Such companies should also determine if their assumptions regarding any prior stockholder ratifications of equity awards to their directors remain valid. When reviewing the plans, and when drafting new plans, companies should heed the court’s advice in Slager that “[t]he more definite a plan, the more likely that a board’s compensation decision will be labeled disinterested and qualify for protection under the business judgment rule.”8
Although this decision and the decisions recited by the court in its decision relate to equity awards made under equity incentive plans, directors of Delaware companies should also be wary of the amount of cash and other compensation they approve for themselves as the standards applied by the court in this decision could also be imposed in the review of any claim of a breach of fiduciary duty or unjust enrichment asserted by a stockholder in a challenge of the directors' cash compensation.