A recent ruling by the Delaware Supreme Court could have far-reaching consequences for how companies set their director compensation limits. Dentons' Venture Technology and Emerging Growth Companies team examines what the decision means, what impact it may have and how companies should respond.
- Delaware court decisions in recent years have led a number of companies to adopt stockholder-approved director compensation limits in order to benefit from the stockholder ratification defense, which can prove useful if director compensation decisions are challenged by stockholders as being excessive or unreasonable.
- A December 2017 decision by the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation should cause companies to reconsider whether stockholder-approved director compensation limits are a viable defense.
- Companies that have adopted a director compensation limit in recent years should retain those limits or consider updating them the next time they are seeking stockholder approval of their underlying compensation plans.
- Companies that have not adopted a director compensation limit in their plans should approve limits with the understanding that the courts will review, or retain the right to review, those limits based on the "entire fairness" standard, as was evidenced by the court's actions in Investors Bancorp.
- Irrespective of the board's judgment regarding whether to have director compensation limits or formula awards, all companies should continue to ensure that director compensation decisions are made following a robust process that takes into account market and peer group practices and that such decisions are carefully described in the annual proxy statement.
- The Investors Bancorp decision makes having a robust process critical, as well as observing a robust disclosure regimen that gives stockholders a clear sense of award limits and disbursements necessary.
Historically, if stockholders challenged director compensation decisions as being excessive, Delaware courts independently reviewed whether such compensation decisions were "entirely fair" to the stockholders. Because an "entire fairness" review is fact-intensive, any such claims were likely to survive a motion to dismiss by the company and therefore place settlement pressure on companies.
Under the "stockholder ratification" defense, a company could seek to avoid an "entire fairness" review if stockholders had approved the director compensation decision. If stockholders had approved the decision, then any subsequent stockholder challenge would have to prove that the compensation decision resulted in "corporate waste." In 2015, the Delaware Court of Chancery in Calma on Behalf of Citrix Systems, Inc. v. Templeton held that when stockholders approved specific director compensation awards, the defense clearly applied. If the stockholder ratification defense applied, the Delaware courts would apply the business judgment rule and override the compensation decision only if the stockholders could show corporate waste.
In the 2015 Facebook litigation Espinoza v. Zuckerberg, Facebook paid its directors annual compensation (cash and stock) of about US$386,000. Of the 12 largest US companies by market-cap value, this level of director compensation ranked second. While the amount was not what most would consider "excessive" for a company of Facebook's size, the social network was nonetheless sued under claims that the director compensation was excessive. Mark Zuckerberg, who indisputably held a majority of the voting power of Facebook's common stock, had not approved the director compensation at the time of award but had attempted to approve the director compensation retroactively by virtue of statements he made in an affidavit and deposition after the action was filed.
The attempt to retroactively approve the award ultimately failed, as the court held that in this instance it would not be sensible to deviate from formal mechanisms available in the Delaware General Corporation Law (DGCL) for stockholder approval when seeking to ratify directors' actions. Ultimately, Facebook settled the case and submitted its director compensation program to stockholders under the formal ratification methods of the DGCL for approval.
For the last several years, the Delaware Court of Chancery has applied the stockholder ratification defense where the challenged director compensation awards were made under a stockholder-approved equity plan with varying degrees of director compensation limits. In Citrix (2015) and Seinfeld v. Slager (2012), the Delaware Court of Chancery established a general rule that, if stockholders approved a "meaningful limit" to director compensation awards, then director compensation decisions made within those limits would have the protection of the stockholder ratification defense, and more generally the business judgment rule, as stockholders approving the plan would know the contours of the awards that would be possible. The customary approach taken by companies to achieve the "meaningful limit" standard has been for companies to implement specific caps on compensation applicable to non-employee directors.
However, the recent Delaware Supreme Court decision in Investors Bancorp suggests that the "meaningful limit" analysis alone may not provide a sufficient defense.
Investors Bancorp Delaware Supreme Court decision
Investors Bancorp considered a stockholder-approved equity compensation plan that permitted up to 30 percent of the total share pool to be awarded to non-employee directors, including in a single award. Almost immediately after stockholders approved the plan, the directors approved an award of the entire 30 percent pool to themselves, resulting in compensation levels many times greater than both their historical annual compensation and compensation levels at competitor banks. The Delaware Court of Chancery, applying the "meaningful limit" standard, determined that the director-specific limits were clear and dismissed the stockholder claims.
The Delaware Supreme Court reversed the Delaware Court of Chancery's ruling. It held that "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." The Delaware Supreme Court denied summary judgment for the defense and remanded the case to the Delaware Court of Chancery to review the company's director award limits based on the "entire fairness" standard.
The court's ruling asserted that the stockholder ratification defense requires a balance between the utility of the ratification defense and the need for judicial scrutiny of self-interested director discretionary actions. The decision ultimately limited the circumstances under which the stockholder ratification defense would be available, based not only on the process of formulating director equity compensation awards but also on the disclosure of such awards to the stockholders ratifying them.
The facts of the case present an egregious picture on the part of Investors Bancorp. The average compensation paid to the Investors Bancorp non-employee directors in 2014 was US$133,340, which was in line with the average at peer companies. The average paid to each member in 2015 under the new equity incentive plan with a 30 percent pool award limit was more than US$2 million—while the average at peer companies was less than US$176,000 per director.1
While stockholder approval of the "general parameters" for awards sets the "broad legal authority" for the awards, stockholders continue to expect that the discretion within those boundaries will be exercised "consistently with equitable principles of fiduciary duty." In Investors Bancorp, the 30 percent pool award limit provided only "general parameters." Together with the additional allegations, the court found that the compensation limit decisions were unfair and excessive.
The plaintiffs further alleged that the disclosure relating to the approval of the equity incentive plan was flawed. The stockholders were told that "by approving the equity incentive plan, stockholders will give the Company the flexibility it needs to attract, motivate and retain highly qualified officers, employees and directors." The plaintiffs alleged that this statement was "forward-looking"— that stockholders would have understood that awards under the equity incentive plan would incentivize future performance, not reward past services.
After stockholders approved the equity incentive plan, however, the board approved the award of about half of the stock options and one-third of the restricted shares available to the directors, vesting over five years—which, the plaintiffs alleged, rewarded past efforts in connection with the company's mutual-to-stock conversion. Further, notice of the award grants to take place, all at once, and immediately after stockholder approval was never given to stockholders. The insufficiency of a robust disclosure regimen, coupled with the potentially inequitable exercise of director discretion, led the court to hold that the stockholder ratification defense should not have applied. On remand, the Delaware Court of Chancery will determine whether the 30 percent pool award limit is an unfair and excessive compensation grant.
As a result of this decision, the stockholder ratification defense will now be available in more limited circumstances. In the event of a challenge to an issued director compensation plan, if the facts alleged indicate that it is reasonably conceivable that the directors breached their fiduciary duty when exercising their discretion in making the awards, then the directors will have to prove that the awards were "entirely fair" to the corporation. As a sole defense, the "meaningful limit" standard has been significantly narrowed (and may have been eliminated), although the exact reach of the Delaware Supreme Court's decision is not yet entirely clear. Nonetheless, the "meaningful limit" standard, coupled with traditionally robust compensation decision processes and substantial disclosure to stockholders voting on such awards, should continue to serve as an adequate defense.
It should be noted that Investors Bancorp consisted of an extreme set of facts, with a broad, aggregate pool limit, and large non-market compensation awards made based on that design. The board in Investors Bancorp made awards shortly after the stockholders had approved the limit, with no notice that the entire director pool would be granted at such time, rather than over several years, as is the normal approach for option pool grants amongst peer companies. Future cases will need to clarify whether the stockholder ratification defense may still be successfully invoked on a different set of facts, where specific, rather than general, award parameters have been approved and some limited degree of director discretion has been applied.
Next steps for companies
Companies should consider their risk appetite regarding potential claims of excessive director compensation and best practices for determining director compensation. For companies that have director compensation programs that clearly fall within normal parameters for their industry and size, the issue may have little significance and may not trigger further action. For companies that pay their directors more than their market median, have unusual director compensation circumstances or are otherwise more concerned about stockholder claims, additional action may be warranted.
Consider stockholder approval for director compensation
Companies with existing stockholder-approved director compensation limits: As mentioned earlier, a growing number of companies have adopted director compensation limits in recent years in light of the case law developments. The limits are usually located in equity compensation plans that have been submitted to stockholders for approval. The plans often express the limit as a cap on the dollar value (or number of shares) of annual equity awards for each individual director or a limit on the combined dollar value of annual cash and equity awards for each individual director, with the value usually set within a relatively narrow range above current compensation levels, such as two times to four times the current levels.
While companies may set limits that are factually distinguishable from those considered in Investors Bancorp, given the Delaware Supreme Court's analysis and holding, there is a heightened risk that, if the decisions are challenged, the stockholder ratification defense alone will not protect director compensation decisions even within these stockholder-approved individual compensation limits. Companies with these limits will face a choice the next time they are otherwise taking their equity compensation plans to stockholders for approval (e.g., when adding additional shares), informed by their risk appetite, to either:
- Retain their current compensation limit until the courts further clarify the scope of the Investors Bancorp decision and rely on a robust process and disclosure taking into account solid market data and good business judgment, or
- Obtain stockholder approval of a revised compensation limit that more closely follows the Investors Bancorp standard, such as a formulaic plan design approved by stockholders, together with a robust disclosure regimen
Even if the stockholder ratification defense cannot be invoked for an existing stockholder-approved limit under the Investors Bancorp standard, we continue to believe it likely that the existence of that limit and stockholder approval as well as good processes should be a helpful factor in determining whether compensation decisions are equitable under the "entire fairness" standard.
Companies that have not yet adopted director compensation limits: The best approach for these companies would be to establish a robust and thoughtful director compensation plan design and process. Investors Bancorp should not, in and of itself, create any greater risk on the issue of director compensation for companies that currently do not have stockholder-approved limits on director compensation. However, we advise companies to establish a robust process that takes into account market and peer group practices and that is carefully described in the annual proxy statement, including a robust disclosure regimen that gives stockholders a clear sense of award limits and disbursements. This approach provides potentially heightened protection against stockholder claims.
Check your compensation-setting process and disclosures
Investors Bancorp highlights the importance of having a robust decision-making process for setting director compensation levels and establishing a record that documents what standards are applied to determine awards. Directors should obtain the advice of independent compensation consultants and consider their compensation levels and design in light of relevant marketplace practices. Public companies may want to take a fresh look at the disclosures about their director compensation program and ensure that the disclosures clearly communicate the rationale behind the compensation program design. It is critical to record how awards compare to past compensation and peer companies' compensation, as well as the foundation for any possible differences.
In general, it is recommended that award limits:
- Are directed towards the individual (per director), rather than aggregate, limits
- Are set at a level that is within a reasonable range above the company's current non-employee director pay level (e.g., approximately two to four times above the current level)
- Take into account both annual cash retainers and annual equity awards
- Include 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