The Delaware courts have recently rendered a series of decisions, culminating with the Delaware Supreme Court’s December 2017 holding in In re Investors Bancorp, Inc. Stockholder Litigation, No. 169 (Del. 2017) (“Bancorp”), limiting the extent to which the business judgment rule protects directors when determining their own compensation. Although the law is still developing, the Bancorp decision has already led some Top 100 Companies to change their director compensation approval processes.
Impact on Stockholder Ratification
In Bancorp, the Delaware Supreme Court 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. According to the Bancorp complaint, the stockholders of Investors Bancorp Inc. approved an equity incentive plan (“EIP”) that allowed the directors to allocate up to 30% of all shares available under the EIP in the form of director awards. Shortly thereafter, the company’s compensation committee granted awards to its non-employee directors with grant date fair values that averaged over $2 million each, even though awards at peer companies purportedly average $175,817. The plaintiffs challenged these awards, claiming that the directors breached their fiduciary duties by granting themselves unfair and excessive compensation.
The approval by non-employee directors of their own compensation is a conflicted transaction that enables a plaintiff to rebut the business judgment standard of review. Therefore, unless the directors could assert the affirmative defense of stockholder ratification, the decision would be subject to “entire fairness” review and the directors would have the burden of establishing that the transaction was the product of both fair dealing and fair price.
Unlike the business judgment standard of review, which places the burden on the plaintiff to prove that the directors did not act “on an informed basis, in good faith, and in the honest belief that the action was in the best interest of the Company” (Aronson v. Lewis, 473 A.2d. 805, 812 (Del. 1984)), the entire fairness standard of review places the burden on the directors to show that their decision was the product of fair dealing and fair price (Weinberger v. UOP, Inc. 457 A.2d 701, 711 (Del. 1983)).
Following a review of Delaware cases considering the stockholder ratification defense with respect to self-interested compensation decisions, the Delaware Supreme Court noted that the defense had been successfully invoked where stockholders approved:
- Specific awards
- A self-executing plan under which directors had no discretion when making awards
- A plan under which directors exercised discretion in awarding compensation, consistent with stockholder- approved parameters
In Espinoza v. Zuckerberg (124 A. 3d. 47 (Del. Ch. Oct. 28, 2015)), the board of Facebook approved non-employee director compensation that shareholders later challenged as excessive. Following the filing of the action, Facebook’s controlling shareholder, Mark Zuckerberg, expressed his approval of the non-employee directors’ compensation in a deposition and affidavit. The Delaware Chancery Court held that this did not constitute valid stockholder ratification. Rather, valid stockholder ratification must be accomplished formally through a vote at a stockholders’ meeting, or by written consent in compliance with Section 228 of the Delaware General Corporation Law.
The director defendants in Bancorp argued that the business judgment standard should apply as they had exercised discretion within the parameters approved by the company’s stockholders. The Court, however, expressed skepticism notwithstanding recent Court of Chancery decisions (such as Calma v. Templeton, 114 A. 3d. 53 (Del. Ch. Apr. 30, 2015)), which found that awards granted pursuant to stockholder approved plans with “meaningful limits” were properly reviewed under the business judgment rule. The Delaware Supreme Court rejected the stockholder ratification defense in Bancorp, stating that the stockholders had “approved the general parameters of the [grants to directors]…Because the stockholders did not ratify the specific awards under the EIP, the affirmative defense of ratification cannot be used to dismiss the complaint.”
Prior to Bancorp, the exercise of director discretion after stockholder approval of general (but meaningful) limits in plans became a standard practice for U.S. companies. Now, companies that previously obtained stockholder approval for annual limits on the equity awards that may be granted to individual non- employee directors (either based on a dollar figure or number of shares) may find that more specific approval is necessary to benefit from the protections of the business judgment rule. Further, it should not be assumed that the Delaware 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.
Changes in Response to Bancorp
In the 2018 proxy season, shareholders of one Top 100 Company approved an amended equity incentive plan that provides that each director will receive an annual retainer of $350,000, which the board is authorized to increase by up to $25,000 before getting additional approval. The plan also sets lead independent director retainers and committee chair retainers, with the board authorized to increase these retainers by up to $5,000. These discretionary increases may not take place prior to January 2020. Finally, the board has discretion to provide directors with other fees for service on a specific purpose committee or for any other special service.
In addition, shareholders of another Top 100 Company approved a new director compensation plan that includes an annual retainer of $100,000 and an annual restricted stock unit grant with a value of $100,000. New directors will also receive a grant of 2,000 restricted stock units, but in no event will any director receive awards in excess of $500,000 in any year.
The lack of widespread change to stockholder ratification practices following the Bancorp decision may be evidence of the fact that companies are confident that their non-employee director awards are entirely fair. To that end, even if “meaningful limits” no longer ensure the application of the business judgment rule, such limits may continue to offer some protection from challenges to discretionary awards. For example, to the extent the range of possible award values within the “meaningful limits” is generally consistent with peer group levels, stockholders would have difficulty alleging the grant of those awards was not entirely fair. Further, enhanced disclosure of the reasons for the director compensation program, including a comparison to peers, may deter litigation. Bancorp, where the awards diverged significantly from peer group levels (and the previous year’s award levels), is a good example of bad facts making bad law.
This post comes to us from Shearman & Sterling. It is based on the firm’s memorandum, “Director Compensation and the Delaware Courts,” dated September 28, 2018, and available here.