In an important recent opinion, the Delaware Supreme Court ruled in In re Investors Bancorp, Inc. Stockholder Litigation that certain director compensation decisions would be reviewed under the “entire fairness” standard rather than the more deferential “business judgment rule” standard of review.
The Investors Bancorp suit was initially filed in Delaware Chancery Court in 2016 by stockholders who alleged that the company’s directors breached their fiduciary duties by granting themselves grossly excessive equity awards. The total grant-date fair value of the contested awards was $51.5 million, divided among 10 nonemployee directors and two executive directors.
The defendants filed a motion to dismiss, alleging that the self-compensation decisions were entitled to the deferential protection of the business judgment rule. The plaintiffs’ position was that, because board determination of its own compensation is a self-dealing transaction, the appropriate standard of review is the fact-intensive entire fairness standard. The defendants’ position was that the awards were ratified by the company’s stockholders because the stockholders approved an equity plan that contained certain limits, giving rise to an affirmative defense that entitles the self-compensation decisions to business judgment rule protection.
The Chancery Court granted the motion to dismiss, ruling that the defendants were entitled to business judgment rule review as a result of the stockholder ratification defense. Specifically, the stockholder-approved equity plan under which the director awards were granted contained what the Chancery Court viewed as “meaningful, specific” director compensation limitations: (i) a pool of available shares, with caps on the number of shares that could be granted as stock options, and as restricted stock/restricted stock units/performance shares, and (ii) a cap on the total number of shares that could be granted to nonemployee directors in the form of stock options and restricted stock (30 percent of the authorized share pool). (For more information on the Chancery Court ruling, see our previous client alert at http://www.pepperlaw.com/publications/boards-should-consider-adopting-director-specific-limits-in-compensation-plans-2017-05-03/).
Delaware Supreme Court Ruling
On December 13, 2017, the Supreme Court of Delaware reversed the Chancery Court’s ruling, holding that the directors must prove that the awards are entirely fair to the corporation. The Delaware Supreme Court reasoned that the stockholder ratification defense only applies when directors (i) submit their specific compensation decisions for approval by the stockholders or (ii) grant awards under a self-executing plan (i.e., a plan that makes awards over time based on fixed criteria, with the specific amounts and terms approved by stockholders). In other words, the stockholder ratification defense is appropriate when the awards do not result from an exercise of director discretion. Here, however, the stockholders merely approved an equity plan giving directors discretion to make grants to themselves within general parameters. Because the directors exercised discretion in the self-compensation decisions, the Delaware Supreme Court held that, in the face of a shareholder challenge, the directors must prove that the awards meet the entire fairness standard.
Furthermore, the Delaware Supreme Court reversed the Chancery Court’s dismissal, holding the plaintiffs had pled sufficient facts to support claims that the self-compensation decisions failed the entire fairness standard, including, among other things, that the awards were used to reward past director performance despite the proxy disclosure stating the awards were intended to reward future performance, significantly exceeded director compensation in prior years, and were excessively higher than peer company director compensation.
As the 2018 proxy season approaches, consider whether your company has increased its director compensation significantly in recent years, and how the director compensation compares to peer companies. Assess the company’s risk tolerance in this area, and determine whether it would be judicious to implement any immediate changes. In the wake of the Investors Bancorp opinion, we expect to see more shareholder suits challenging director compensation. To be sure, the Investors Bancorp case had bad facts: extraordinarily high director compensation that was out of line with the company’s previous awards and peer companies. The extent to which the case will impact companies with more middle-of-the-road director compensation practices is still an open question. However, it would be prudent for companies to consider the following:
Process. In all cases, make sure to have a good process to determine director compensation. Seek input and peer group data from independent compensation consultants to create a record of prudence and reasonableness. Document the process thoroughly. In addition to being good corporate governance practice, thorough documentation will prove essential if the company must defend a director compensation suit on the merits.
Formula Plan. Consider whether a formula-based director compensation provision should be included in a shareholder-approved equity plan in lieu of continued grants determined in the discretion of the board of directors (or compensation committee). While a formula-based provision limits the board’s flexibility and curtails specific adjustments that may be desired from time to time, it would enable the company to take advantage of the shareholder ratification defense under Investors Bancorp. We increasingly expect to see public companies taking this approach with respect to director equity compensation, if not to both equity and cash compensation. This will reflect a return to common practices of the early 1990s, when formula-based provisions were often included in director compensation plans.
Extraordinary Grants. If there are unique circumstances making extraordinary director compensation grants appropriate, such as upon a transaction or following the work of a special committee, consider seeking shareholder approval of such grants. This approval would enable the company to take advantage of the shareholder ratification defense under Investors Bancorp.