Reprinted with permission from the February 22, 2018 edition of the Delaware Business Court Insider. © 2018 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. (ALMReprints.com, 877.257.3382).
Over the past several years, the Delaware Court of Chancery has applied the stockholder ratification defense in challenges to director compensation awards made pursuant to stockholder approved equity incentive plans (EIPs). As a general rule, those cases have held that where stockholders approved a “meaningful limit” on director compensation awards, directors’ decisions to award equity within the scope of those limits would be protected by the defense.
A recent Delaware Supreme Court case, however, In re Investors Bancorp Stockholder Litigation, No. 169, 2017 (Dec. 19, 2017), impacts that analysis. In that case, the Supreme Court materially narrowed the application of the stockholder ratification defense, potentially leaving board compensation decisions open to challenge under entire fairness review (rather than the more permissive business judgment rule), although the full impact of the court's ruling will likely be determined through future challenges to director actions.
According to the complaint, in 2015, a year after completing a mutual holding company-to-stock conversion, Investors Bancorp sought stockholder approval of a discretionary EIP, which limited potential awards by specifying a number of shares of common stock that were reserved for restricted stock awards, restricted stock units, incentive stock options, and non-qualified stock options for the company's officers, employees, nonemployee directors, and service providers. The EIP allowed the company's directors (including two employee directors — the company's CEO and COO) to allocate up to 30 percent of all options or restricted stock shares available for awards to themselves, all of which could be awarded in any calendar year.
Three days after stockholders approved the EIP, the board held the first of four meetings over the course of a month, during which it determined to issue to the directors half of the available stock options and one-third of the available restricted shares, which had a combined fair value of $51.7 million. The nonemployee directors received awards averaging over $2 million (an increase from 2014 average compensation of approximately $133,000), while director compensation at peer companies averaged approximately $176,000. The CEO's total compensation package was seven times higher than in 2014, and the $16.7 million value of the stock options and restricted stock he was awarded was 1,759 percent higher than peer companies' average compensation for highest paid executives. Similarly, the COO's total compensation package was nine times higher than in 2014, and his $13.4 million stock and RSU award was 2,571 percent higher than peer companies' average compensation for second highest paid executives.
Shortly after the board made these awards, several company stockholders sued, asserting that the directors had breached their fiduciary duties. The Court of Chancery determined that the director-specific limits in the EIP sufficiently limited the board, enabling directors to assert the stockholder ratification defense, and dismissed the consolidated complaint.
The Supreme Court's Ruling
On appeal, the Supreme Court reversed. Analyzing a series of Delaware cases considering the stockholder ratification defense with respect to self-interested compensation decisions, the Supreme Court identified three scenarios where director compensation limits are approved by stockholders:
- Stockholders approve a specific director compensation award
- Stockholders approve a self-executing plan under which the directors have no discretion when making awards
- Stockholders approve a discretionary plan with an upper limit on director compensation awards.
The Supreme Court noted that it had previously found the stockholder ratification defense available in the first two scenarios, but expressed skepticism about the potential scope of the third scenario. The court explained that the stockholder ratification defense requires courts to "balance the competing concerns-utility of the ratification defense and the need for judicial scrutiny of certain self-interested discretionary acts by directors-by focusing on the specificity of the acts submitted to the stockholder for approval."
The court then held: When stockholders have approved an equity incentive plan that gives the directors discretion to grant themselves awards within general parameters, and a stockholder properly alleges that the directors inequitably exercised that discretion, then the ratification defense is unavailable to dismiss the suit, and the directors will be required to prove the fairness of the awards to the corporation.
Even where stockholders approve "general parameters" for discretionary director awards under an equity compensation plan, and allow directors to exercise their "broad legal authority," the stockholders still expect that the directors will exercise that authority "consistently with equitable principles of fiduciary duty," or have their actions be subject to judicial review.
Because the 30-percent pool limit in the company's EIP provided only "general parameters" to guide the board's award of equity grants, and because plaintiffs had alleged facts sufficient to constitute a reasonable inference (at the pleadings stage) that the grants were excessive and unfair to the company, the Supreme Court held that the stockholder ratification defense was not available to the directors, that the board's decision to award the grants was subject to entire fairness review, and that the Court of Chancery erred in dismissing the complaint.
Takeaways: Finding the Distinction Between General and Specific Parameters
Investors Bancorp reinforces several recent Court of Chancery rulings that have highlighted the importance of the specific limitations approved by stockholders before the ratification defense may be available to boards. But the ruling leaves unanswered the question of what level of specificity is required to bring director decisions within the scope of the business judgment rule, rather than the more demanding entire fairness standard. The company's EIP limited the percentage of shares that could be awarded to different groups of awardees, including nonemployee directors, and disclosed to stockholders that "the number, types and terms of awards to be made pursuant to the [EIP] are subject to the discretion of the committee and have not been determined at this time, and will not be determined until subsequent stockholder approval." Although Investors Bancorp does not establish a bright-line rule to guide boards in their compensation decisions, it is apparent that such broad and general limitations are no longer sufficient to ensure application of the permissive business judgment rule for board decisions on director compensation. To increase the likelihood that a transaction will be subject to business judgment protection, companies should consider seeking more specific stockholder approval or director compensation-both cash and equity awards-before making such awards to directors.