A recent Delaware court decision validates the trending practice to add specific limits on non-employee director pay in public company “omnibus” incentive compensation plans, to be approved by shareholders.
Non-employee directors at public companies face heightened risk of shareholder claims challenging decisions they make about setting their own pay levels. There have been a number of cases in Delaware courts over the last several years where these challenges have survived a motion to dismiss, raising the legal stakes for companies and directors.
Normally, decisions by directors regarding ordinary business matters like compensation are protected by the business judgment rule. If the business judgment rule applies, courts will generally defer to the decisions of the directors, and shareholder challenges are more easily defeated at a motion to dismiss stage of litigation.
But in order to have the protection of the business judgment rule, the directors must be both independent and disinterested with respect to the decision being made. When non-employee directors set their own pay levels, they are obviously not disinterested. If the business judgment rule does not apply, courts will review the “entire fairness” of the decision. In that case, the court will review the facts and reach its own conclusions about the fairness of the decision. Defeating such claims on a motion to dismiss is unlikely.
The Shareholder Ratification Defense
The “shareholder ratification” defense that has developed under Delaware case law provides a means for director compensation decisions that are not otherwise eligible for the business judgment rule to be “blessed” by shareholders. If shareholders approve the decision, then any subsequent shareholder challenge must prove that the compensation decision amounted to “corporate waste.”
Waste defines the “outer limit” of the board’s discretion to set executive or director compensation, “at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste.” To show that a compensation decision constitutes waste, the shareholder plaintiff must show that the corporation received no consideration for the compensation. Therefore, if a company can establish the shareholder ratification defense, it is likely to defeat the shareholder claim altogether, since the shareholder must then meet the “extreme” standard for waste, which is “very rarely satisfied.”
In the context of decisions about director compensation, the question becomes what specifically shareholders must approve to trigger the shareholder ratification defense? The decision in Calma on Behalf of Citrix Systems, Inc. v. Templeton (“Citrix”) provides an excellent recitation of the case law history of the shareholder ratification defense as applied to director compensation decisions. As the Citrix court notes, when shareholders approve specific director compensation awards, the defense clearly applies. In similar fashion, the shareholder ratification defense should apply if shareholders approve a “formula” plan where specific levels of awards are specified in the future.
More commonly, however, directors receive compensation, especially stock-based compensation, under “omnibus” plans that broadly authorize compensation awards to both employees and non-employee directors. The omnibus plans are shareholder approved, but usually do not authorize specific individual or formula awards. The question becomes whether shareholder approval of an omnibus plan is sufficient to raise the aegis of the shareholder ratification defense.
The “Meaningful Limit” Standard
In both Citrix and Seinfeld v. Slager, Delaware courts considered challenges to director stock awards under omnibus plans where the only limits on individual awards were the so-called “162(m)” individual limits. Omnibus plans include 162(m) individual limits so that certain awards under the plan can qualify as “performance-based” compensation that escapes the $1 million deduction limit that can otherwise apply under Section 162(m) of the Internal Revenue Code. Companies intentionally set these limits at very high levels in order to provide maximum design flexibility while preserving tax deductibility. The 162(m) limits often apply to all award recipients, including both employees and non-employee directors.
In both Citrix and Seinfeld, the courts found that the 162(m) limits were essentially blank checks and, even though approved by shareholders, did not give rise to the shareholder ratification defense. The court in Seinfeld adopted, and the court in Citrix seems to have followed, a “meaningful limits” standard for this purpose. In other words, the courts seemed to be saying that if a shareholder-approved plan does not include specific or formulaic awards for directors, it must include a limit that “meaningfully” restricts the discretion of directors in awarding compensation to themselves in order for the shareholder ratification defense to apply.
After Seinfeld in 2012and Citrix in 2015, a number of companies adopted specific limits on awards to non-employee directors and had those director award limits approved by shareholders. These director award limits were intended to create a shareholder-approved “meaningful limit” on the discretion of directors to grant awards to themselves, so that the shareholder ratification defense could be deployed if the director compensation decisions within those limits were later challenged. However, given the undefined and untested nature of the “meaningful limit” standard, no one knew for sure whether the director award limits being approved would, in fact, meet the standard.
Investors Bancorp Decision
In April 2017, the Delaware court in In re Investors Bancorp Inc. Stockholder Litigation, delivered helpful guidance on the “meaningful limits” issue left open by Citrix and Seinfeld. The case considered a stock plan that included the following director-specific award limit:
The maximum number of shares that may be issued or delivered to all non-employee directors, in the aggregate, pursuant to the exercise of stock options or grants of restricted stock or restricted stock units shall be 30% of all option or restricted stock shares available for awards, “all of which may be granted in any calendar year.”
This award limit is interesting because (1) it is not an individual limit and (2) it leaves discretion to grant a large award in any one year. The directors in fact awarded the entire 30% pool of available shares to themselves in a single year following completion of a transaction. This resulted in the directors receiving significantly more pay than had been typical for them — 10 to 20 times what they had received the prior year — which was also significantly above typical peer company practices.
The court decided that, because this limit expressly applied to non-employee directors, was fully disclosed to shareholders and was in fact approved by shareholders, it was a “meaningful, specific” limit on director awards. As a result, the court held that the shareholder ratification defense was available and dismissed the claim that directors received excessive compensation.
Investors Bancorp thus strongly validates the use of specific shareholder-approved limits on director awards as an effective defense against claims by shareholders challenging director compensation decisions.
What to Do Now
We have been advising clients for several years to consider adding to their omnibus incentive plans a separate award limit for non-employee directors in connection with obtaining shareholder approval of the plan. For companies that have not yet adopted an award limit for non-employee directors, the decision in Investors Bancorp makes the case for such a limit even more compelling. We generally recommend an award limit that:
- is an individual, rather than an aggregate, limit;
- is set at a level that is within a reasonable range above the company’s current non-employee director pay level (e.g., three to five times above the current level);
- takes into account both annual cash retainers and annual equity awards; and
- includes a separate limit for the non-employee chairman position, if the company pays its non-employee chairman at a different level than other non-employee directors.
We believe expressing the award limit in this manner should easily meet the standard articulated by the court in Investors Bancorp.
The next time shareholder approval for a plan is being requested—whether for a new plan, an amendment to an existing plan (such as to add shares) or a 162(m) five-year reapproval—companies should also consider including a non-employee director award limit (or refining an existing award limit to take into account the oft-changing landscape of director compensation lawsuits).
Of course, having a shareholder-approved limit on director awards is no substitute for having a robust governance process in deciding director pay levels. With or without plan award limits, directors should engage in a prudent compensation-setting process, including possibly seeking advice from of an independent compensation consultant, considering market practices, and creating a solid document trail that evidences a thoughtful decision-making process.