Last week, the Delaware Supreme Court, in In re Investors Bancorp, Inc. Stockholder Litigation (“Bancorp”), reversed the Delaware Court of Chancery and held that awards granted to directors under a stockholder-approved equity incentive plan are subject to “entire fairness” review if the plan gives the directors discretion to determine their own compensation. Bancorp, the first Delaware Supreme Court case to address ratification of director compensation since 1952, calls into question whether the “business judgment rule” applies if stockholders have not approved specific awards to directors or a formula pursuant to which such awards are made. But, it leaves open the possibility that stockholder approval of “meaningful limits” on director compensation could still defeat a claim for breach of fiduciary duty.
The Supreme Court’s decision also highlights the importance of separating nonemployee director compensation decisions from executive compensation decisions.
Directors Are ‘Twice-Tested’
According to the Bancorp complaint, in 2015, following a mutual-to-stock conversion, Investors Bancorp Inc. (“Investors Bancorp”) put to stockholder vote a new Equity Incentive Plan (“EIP”) which, if approved, would allow the directors to allocate up to 30% of all option or restricted stock shares available as awards to themselves. The stockholders approved the EIP, and shortly thereafter, Investor Bancorp’s compensation committee approved grants to all of its directors (including two executive directors). The nonemployee directors received awards averaging over $2 million, while awards at peer companies allegedly averaged $175,817. Further, plaintiffs claimed that the 2015 awards significantly exceeded the nonemployee directors’ 2014 compensation, which ranged from $97,200 to $207,005. The plaintiffs in Bancorp challenged these awards, claiming that the directors breached their fiduciary duties by granting themselves unfair and excessive compensation.
Following a review of Delaware cases considering the stockholder ratification defense with respect to self-interested compensation decisions, the Supreme Court noted that the defense had been successfully invoked where stockholders had approved:
- specific awards;
- a self-executing plan under which the directors had no discretion when making awards; and
- a plan under which directors exercised discretion in awarding compensation, consistent with stockholder-approved parameters.
The Supreme Court found that the first two situations posed were properly reviewed under the business judgment rule and consistent with Supreme Court precedent. As to the third situation, which defendants argued applied to the at-issue awards, the Court expressed greater skepticism notwithstanding recent Court of Chancery decisions that found plans that included “meaningful limits” to be properly reviewed under the business judgment rule.
Citing the decision of the Court of Chancery in Sample v. Morgan, the Supreme Court explained that simply because “stockholders have granted the legal authority to make awards” by approving “general parameters” does not mean that directors are at liberty to make awards inconsistent with their fiduciary duties. The Supreme Court went on to suggest that, if ratification could be invoked at the outset under plans that allow for discretion, the “the fiduciary duty allegations would be insulated from judicial review.” In other words, the Supreme Court explained that such “‘inequitable action does not become permissible simply because it is legally possible.’” To hold otherwise, the Supreme Court explained, would effectively insulate such discretionary and potentially abusive awards from judicial review.
As a result, the Supreme Court rejected the stockholder ratification defense in Bancorp, stating that the stockholders of Bancorp had “approved the general parameters of the [grants to directors and that the] plaintiffs have properly alleged, however, that the directors, when exercising their discretion under the EIP, acted inequitably in granting themselves unfair and excessive awards. Because the stockholders did not ratify the specific awards under the EIP, the affirmative defense of ratification cannot be used to dismiss the complaint.”
Distinction Between General and Specific Parameters
The Supreme Court’s holding that stockholder ratification of “general parameters” will not suffice to ensure application of the business judgment standard leaves open the question of what level of specificity is necessary so that director decisions are within the scope of the business judgment rule.
The at-issue proxy issued by Investors Bancorp’s 2014 proxy placed the following limits on director compensation:
The maximum number shares that may be issued or delivered to all nonemployee directors, in the aggregate, pursuant to the exercise of stock options or 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.
The proxy also 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 this approach of setting general limits and then exercising director discretion after approval of those general limits may arguably have been sufficient prior to Bancorp, annual limits of this kind may no longer be sufficient to garner the protections of the business judgment rule for board decisions on director pay. Companies that have in the past sought stockholder approval for annual limits on the equity awards that may be granted to individual nonemployee directors (either based on a dollar figure or number of shares, or a combination) may now find that more detailed approval is necessary to benefit from the protections of the business judgment rule. Further, there is no reason to assume that the Supreme Court’s holding is limited to equity awards. Companies seeking the protection of the business judgment rule should therefore consider soliciting stockholder approval of the cash portion of their director compensation programs, as well.
Nevertheless, it seems doubtful that the exercise of any discretion following stockholder approval will be fatal to asserting a stockholder ratification defense. Formula plans, for example, typically allow the board of directors to terminate the plan without seeking stockholder approval. Would grants under a formula plan constitute an exercise of discretion in a year when the board elected not to terminate the plan? That seems unlikely. Similarly, would an exercise of discretion to elect between stock options and restricted stock units in any year when the value of the individual annual grant had previously been approved by stockholders be subject to an entire fairness review? Again, it is hard to see how this would not be within the scope of a prior stockholder approval.
Operating Under the Entire Fairness Standard
Even if “meaningful limits” on board discretion imposed by the scope of stockholder approval no longer ensure the protection of the business judgment rule, such limits may nevertheless offer some practical protection from challenges to discretionary awards. As noted by the Court of Chancery in Sample, although it does not preclude a claim, “the fact of stockholder approval might have some bearing on consideration of a fiduciary claim…”
The “broad” or “general” parameters ratified by the stockholders in both Sample and Bancorp afforded the directors the ability to grant awards that plaintiffs could successfully plead were unfair and excessive. Making a credible claim when directors are required to operate within “meaningful limits” is likely to be more difficult. Further, to the extent the range of possible award values within the meaningful limits is generally consistent with peer group levels, stockholders would have a difficult time alleging the grant of those awards was not entirely fair. In Bancorp, the Supreme Court pointed to some problematic areas in Investor Bancorp’s EIP: (i) the significant increase in year-over-year payouts; (ii) the disparity between the compensation awarded at Investors Bancorp and its similarly situated peers; (iii) the total magnitude of the payouts as compared to New York finance firms; and (iv) the timing of the awards, which occurred just days after the stockholders approved general parameters.
Executive Compensation Decisions Implicated
In addition to the claims related to nonemployee director compensation, the plaintiff in Bancorp also challenged awards made to two executive directors. The director defendants attempted to have those claims dismissed for failure to make a demand on the board in accordance with Court of Chancery Rule 23.1 based on the position that these were not self-dealing transactions.
Citing to Aronson v. Lewis, the Supreme Court stated that the plaintiffs need not demonstrate a “quid pro quo” between the nonemployee directors and executive directors to prove interestedness or lack of independence. The Supreme Court then noted that following stockholder approval of the equity incentive plan, the directors held a series of “nearly contemporaneous meetings” that resulted in awards to both the nonemployee directors and executive directors. As a result, “[i]t is implausible to us that the nonemployee directors could independently consider a demand when to do so would require those directors to call into question the grants they made to themselves.” Demand was therefore excused for the claims made against the nonemployee directors for their decisions related to executive director compensation.
The Bancorp decision follows several recent Court of Chancery decisions (including Sample) that have arguably elevated the importance of the careful consideration of the substance and detail in proxy materials that seek stockholder ratification of director compensation arrangements. While the imposition of—and adherence to—“meaningful limits” on the scope of director discretion through stockholder-approval may bolster a defense against any purported claim for breach of fiduciary duty relating to director compensation, it is less clear under Bancorp the degree to which discretionary awards will benefit from the stockholder ratification defense (and therefore the business judgment rule). Companies should consider with Bancorp’s warnings in mind their approach to preparing proxy materials in connection with future requests for approval. Similarly, companies should evaluate whether director compensation decisions should be made separate and apart from decisions with respect to executive director compensation, including whether circumstances warrant delegating director compensation decisions to a separate committee.