The subject of director compensation awards has been moving up the corporate governance agenda of many public companies since December 2017. The Delaware Supreme Court ruled then in In re Investors Bancorp, Inc. Stockholder Litigation that, except under limited circumstances, a Delaware court may not apply the deferential business judgment standard in reviewing challenges to director awards granted by the board or a board committee under stockholder-approved equity incentive plans, including plans that contain limits on awards that may be made to directors. Instead, where directors retain the discretion to grant awards to themselves after stockholders approve the plan, and stockholders file a lawsuit claiming the directors breached their fiduciary duties by making unfair and excessive awards, the directors will be required under the exacting "entire fairness" standard of judicial review to prove that the awards were fair to the corporation.
This decision should encourage public companies to review their equity incentive plans and their process for making director awards under those plans. Such a review could minimize stockholder challenges to those awards and, if the awards are challenged and tested under the entire fairness standard, enhance the chances that directors will meet their burden of demonstrating fairness of the awards to the company. In re Investors Bancorp defines more rigorous judicial review of certain director compensation awards for Delaware corporations. The decision, however, deserves careful consideration by public companies incorporated in other states, since courts across the country often consult Delaware opinions in fashioning their own jurisprudence on fiduciary duties.
Delaware case law before new decision.
In In re Investors Bancorp, the Delaware Supreme Court reviewed the evolution of the standard of judicial review Delaware courts have used to evaluate challenges to director compensation approved by directors themselves.
Business judgment standard.
Under Delaware law, a claim involving director conduct generally is subject to judicial review under the business judgment rule. A Delaware court applying this permissive standard will presume that directors acted on an informed basis, in good faith and in the honest belief that the decision at issue was in the corporation’s best interest.
Entire fairness standard.
Except in limited circumstances, a court will not apply the business judgment standard if a majority of directors are interested in the decision or would derive a personal financial benefit from the decision, such as a decision relating to the directors’ own compensation. Unless the circumstances convince a court to afford such director action the protection of the business judgment rule, the court will require the directors to establish that the compensation was entirely fair to the company. To meet the stringent burden of an entire fairness showing, the directors must demonstrate that the compensation decision was the product of both "fair dealing" in terms of the award process and "fair price" in terms of the financial and business considerations relating to the decision.
Stockholder ratification defense.
The Delaware courts have recognized a "stockholder ratification defense" to a claim that directors inequitably exercised their discretion in making awards to themselves under a stockholder-approved plan. This affirmative defense, which may be raised in support of a motion to dismiss the stockholder claim, asserts that the stockholders in effect have approved or "ratified" the director awards at issue, either by approving the specific awards or by approving an equity plan that sufficiently constrains director self-compensation decisions. If the defense is available, the directors can obtain dismissal of the claim under the business judgment standard and will not be required to demonstrate that the awards were entirely fair to the company. In a line of cases identifying the requirements of the stockholder ratification defense, the Court of Chancery previously held that stockholder approval of an equity incentive plan could constitute ratification of future discretionary awards to directors under the plan if the plan contained "meaningful limits" on director compensation. Under those cases, if the discretionary plan does not contain meaningful limits, the awards, if challenged, would be subject to an entire fairness standard of review. In response to these cases, many companies have structured their stockholder-approved incentive plans to include a limit on director compensation awards, typically expressed as an annual limit in dollars or shares.
Director awards by Investors Bancorp
Stockholders of Investors Bancorp alleged in the Court of Chancery that the company’s directors had breached their fiduciary duties by granting themselves large awards under the company’s stockholder-approved equity incentive plan. The directors successfully asserted the stockholder ratification defense to obtain dismissal of the claims under the business judgment standard. According to the allegations in the complaint, Investors Bancorp had received stockholder approval of a plan that reserved for awards to non-employee directors up to 30% of all option and restricted stock shares reserved for issuance, all of which could be granted in any calendar year. The company disclosed to its stockholders that the number, types and terms of the awards made to plan participants, including directors, would be subject to the discretion of an independent board committee. After stockholders approved the plan, the company’s board, acting on the recommendation of the committee, granted directors awards with a total value of approximately US$51.7 million for all 12 directors, including approximately US$21.6 million for the ten non-employee directors. The plaintiffs alleged that the discretionary awards were unfair and excessive when measured against prior awards and against awards made by peer companies. The Court of Chancery acknowledged the substantial size of the director awards, but dismissed the case on the basis that the plan as approved by stockholders contained "meaningful, specific limits" on awards to directors and the actual awards fell within those limits. As a result, the Court of Chancery concluded that the stockholder approval of the plan was sufficient to allow defendants to invoke the stockholder ratification defense and insulate the awards from review under the entire fairness standard. The Court of Chancery’s decision thus followed the line of cases that held that prior stockholder approval of a plan with meaningful limits was tantamount to ratification of future grants of specific awards made within those limits.
Delaware Supreme Court ruling
The Delaware Supreme Court reversed the Court of Chancery’s decision. It held that the discretion granted to the company’s directors in the equity plan to approve specific awards precluded reliance of the stockholder ratification defense to dismiss the stockholder lawsuit. The Delaware Supreme Court characterized the Investors Bancorp plan as creating “a pool of equity awards that the directors can later award to themselves in amounts and on terms they decide.” The Court found that the grants were “self-interested decisions” and subject to the entire fairness standard of review, and returned the case to the Court of Chancery to determine if the directors could demonstrate that the awards were entirely fair to the company.
Judicial review after In re Investors Bancorp
In explaining its remand order, the Delaware Supreme Court declared that “[b]ecause the [Investors Bancorp] stockholders did not ratify the specific awards the directors made” under the company’s plan, “the affirmative defense of ratification cannot be used to dismiss the complaint” and “the directors must demonstrate the fairness of the awards” to the company. The Court thus indicated that where a compensation plan includes stockholder-approved limits on director awards, challenges to those awards will warrant review under the entire fairness standard if (1) the plan leaves the directors discretion to determine their own awards within the limits and (2) a plaintiff can plead facts sufficient to show a possible breach of fiduciary duties. Based on this decision, which appears to call into question the “meaningful limits” basis for reliance on the stockholder ratification defense, we believe that companies should expect judicial review under the entire fairness standard of any decisions in which directors exercise discretion in determining their own compensation. The Delaware Supreme Court’s ruling significantly increases the likelihood that a plaintiff will defeat a motion to dismiss a lawsuit challenging the compensation paid to directors. Consequently, some companies may find themselves involved in protracted and costly litigation, including discovery, over director compensation claims. Under In re Investors Bancorp, except in limited circumstances, directors are likely to bear the burden of proving that their compensation decisions were entirely fair to the corporation. In In re Investors Bancorp, the Delaware Supreme Court affirmed the continuing vitality of two methods directors may use to obtain the business judgment standard of review. Directors generally may invoke the stockholder ratification defense to seek dismissal of stockholders claims challenging:
– Specific director awards approved by stockholders; and
– Director awards made over time based on fixed criteria pursuant to a self-executing equity plan, with specific amounts and terms approved by the stockholders (under which directors have no discretion in making awards to themselves).
In those two situations, commented the Court, “stockholders know precisely what they are approving.” After In re Investors Bancorp, however, if directors retain discretion to make awards under the general parameters of a plan — even when the parameters are specific to directors — prior approval of “meaningful limits” may not be used to foreclose a breach of fiduciary duty claim where the plaintiff properly alleges that the directors inequitably exercised their discretion.
Considerations for plan design and administration
Public companies can take a number of steps to enhance their director compensation process in light of In re Investors Bancorp.
Review the process to reaffirm that director compensation is reasonable.
Boards should consider working with their independent compensation consultants to conduct a peer review of their director compensation programs in order to determine whether both cash and equity components of their director compensation are reasonable. The peer review should be more than a cursory benchmarking exercise, and should use multiple peer and benchmark comparisons. For example, the peer review should include a benchmark against the company’s own self-selected compensation peer group, and may include other peer groups such as ISS’s chosen peers and, if applicable, close industry peers. Wider benchmarks, such as indexes, are also relevant. This process should be carefully documented. The goal is to establish a record on which the directors can rely to show entire fairness if such a showing is required in a court challenge.
Consider enhanced disclosure of the director compensation process.
Companies should consider the extent to which it may be advantageous to describe the director compensation process in their annual proxy statement. That disclosure, to the extent it demonstrates benchmarking and careful consideration of awards, coupled with reasonable director compensation, may deter a plaintiff from targeting the company.
Consider the two paths to the business judgment standard outlined by the Delaware Supreme Court.
Companies may wish to consider whether to follow either of the two paths to the business judgment standard of review affirmed by the Delaware Supreme Court: (1) approval by stockholders of specific director cash and equity compensation awards through a binding director “say on pay” vote; or (2) awards of director compensation made over time based on fixed criteria pursuant to a self-executing stockholder-approved plan, with specific amounts and terms approved by the stockholders (under which directors have no discretion in making awards to themselves).
Consider including “meaningful limits” in new plans.
Companies that are considering adopting a new plan without a self-executing mechanism for director grants should still consider including meaningful limits on director compensation in the plan. Even though the Delaware Supreme Court indicated in In re Investors Bancorp that awards under such a plan would not be tested under the business judgment standard (at least in the circumstances of that case), more specific and tighter limits that minimize discretion may assist the directors in demonstrating entire fairness and should mitigate litigation risk.