On April 27, 2022, Vice Chancellor Sam Glasscock of the Delaware Court of Chancery issued an opinion, on a motion to dismiss, addressing several important governance topics about director and officer compensation—including where some members of management might constitute controlling stockholders. In this case—Knight v. Miller ¹ —the plaintiff, a stockholder of Universal Health Services, Inc. (UHS or “the Company”), brought a derivative lawsuit against certain directors and officers of UHS challenging stock option awards granted to them by the compensation committee of the UHS board of directors (the “Compensation Committee”). The plaintiff alleged that the Compensation Committee member defendants breached their fiduciary duties by granting compensation awards despite knowing that the awards were issued with exercise prices that did not reflect the real value of UHS and that other defendants breached their fiduciary duties by accepting the awards.

Regarding the claims that the defendants breached their fiduciary duties by accepting the challenged awards, the court held that the plaintiff was required to plead that the defendants acted in bad faith, and the plaintiff failed to satisfy that standard. The court did allow certain claims to proceed against the members of the Compensation Committee for granting the awards, on the rationale, in part, that directors are inherently conflicted when they grant compensation to themselves. The court also determined, assuming for the motion to dismiss that all facts should be construed for the plaintiff, that the chairman and president of UHS were controlling stockholders by virtue of holding 88 percent of the corporation’s voting power and that their compensation awards could be challenged on the basis that they involved a controlling stockholder conflict of interest. The court otherwise dismissed the claims against the non-controller officer defendants, concluding that directors’ decisions in such context are generally protected by the business judgment rule. Given its many facets, this decision provides a useful overview of how Delaware courts evaluate compensation-related fiduciary duty challenges in various contexts.

Background of the Decision

The stock option grants at issue were made in March 2020, at the onset of the COVID-19 pandemic, during a time of significant market volatility. Before the COVID-19 pandemic, UHS’s stock price was relatively stable, trading between $123.74 and $147.78 per share from December 2019 through February 2020. However, from February to March 2020, the price of UHS stock dropped by over 50 percent, reaching its lowest point on March 18, 2020, when the closing price was $67.69 per share (interestingly, on March 17, 2020, the closing price was $80.76 per share and on March 19, 2020, the closing price was $84.84 per share). On that date, before the stock market opened, the Compensation Committee held a pre-planned meeting and adopted resolutions approving its annual stock option grants to certain directors and officers of UHS, with an exercise price set at that day’s closing price (i.e., $67.69 per share). Among the recipients of the equity grants were Alan and Mark Miller, the chairman and chief executive officer of UHS, respectively, who together held approximately 88 percent of the Company’s voting power. The Compensation Committee received advice from a compensation consultant regarding these grants.

By March 30, 2020, the federal government had passed its third-phase COVID-19 relief package, and the Company’s stock price rebounded to a closing price of $100.13 per share. According to the plaintiff, the defendants breached their fiduciary duties when they granted and received, as applicable, the challenged equity awards, because the defendants wrongly took advantage of what they understood to be a temporary pandemic-related dip in UHS’s stock price, which was unrelated to changes to the Company’s fundamentals or business prospects, so they could enrich themselves or other UHS insiders.

The Court’s Conclusions

In addressing the plaintiff’s claims that the defendants breached their duty of loyalty by accepting the allegedly unfair compensation awards, the court noted that Delaware courts have held that a director or officer can breach their fiduciary duties by accepting compensation that is “clearly improper.” However, the court noted that this area of the law “is nascent in its development,” and there is only limited case law fleshing out what might constitute “clearly improper” compensation. In particular, the court identified two cases—Howland v. Kumar ²  and Pfeiffer v. Leedle ³  —where Delaware courts found that an action for breach of fiduciary duty for accepting compensation could survive a motion to dismiss. The court explained these cases involved circumstances where (1) the compensation awarded was ultra vires (that is, outside of a corporation’s authority—for example, by violating a corporation’s equity plan) and the recipients knew it, or (2) the compensation was repriced advantageously in light of confidential and sensitive business information that the recipients knew, and that they used to the corporation’s detriment.⁴ The court therefore concluded that to plead a breach of fiduciary duty claim in this context, a plaintiff must plead that the defendant knowingly accepted wrongful compensation and that the acceptance of the compensation amounted to bad faith. In the case at hand, the court noted that the plaintiff merely alleged that the option awards were made at what proved to be the bottom of the market, but nothing in the record created an inference that the defendants acted in bad faith when accepting the awards.

Regarding the claims that the members of the Compensation Committee breached their fiduciary duties by granting the challenged equity awards to the defendant UHS officers and directors, the court explained that because the award recipients were situated differently, the court needed to evaluate the individual grants under different standards of judicial review. In conducting its analysis, the court divided the equity grants into three categories: (1) awards granted to the UHS officers other than Alan and Mark Miller (the “Non-Controller Officers”), (2) awards granted to the Company’s outside directors, and (3) awards granted to Alan and Mark Miller (the “Controller Defendants”).

The court granted the motion to dismiss the claims against the members of the Compensation Committee related to their approval of the equity grants to the Non-Controller Officers. The court explained that the equity grants to these officers would be evaluated under the business judgment standard of review, because the plaintiff failed to adequately plead facts from which it could be inferred that the Compensation Committee members either lacked independence or acted in bad faith in approving the awards. The court noted that the business judgment rule can be rebutted when a plaintiff successfully pleads that a fiduciary has committed corporate waste, but the plaintiff failed to do so in this case because the awards had a clear business purpose, and although the plaintiff alleged that the compensation paid was “excessive on its face,” that conclusory statement was only determinable in hindsight based on the stock price movement because at the time of grant (pre-market opening) the Compensation Committee did not know that the closing price that day would reach its lowest point, a fact that would only be knowable later that day.

The court declined to dismiss the claims against the members of the Compensation Committee related to the grants of equity awards to the outside director defendants (including themselves), holding those grants were inherently self-interested transactions subject to stringent entire fairness review. The entire fairness standard of review is essentially the opposite of the deferential business judgment rule and requires a court to examine the fairness of the terms of a decision and the board’s underlying process to determine if there has been a breach of the duty of loyalty. Relying on Delaware Supreme Court precedent, the court explained that directors’ self-compensation decisions will be subject to entire fairness review unless the challenged award was approved by a stockholder vote that gave the directors no further discretion when setting the award (for example, where stockholders approve specific amounts of the awards or self-effectuating formulas for the awards). Because the equity awards were granted under an incentive plan that afforded the Compensation Committee considerable discretion in making awards, the court held that prior stockholder approval of the incentive plan could not be given ratifying effect, and the grants to the outside director defendants must therefore be reviewed under the entire fairness standard.

The court also addressed the requirement that a plaintiff must plead in some way that the compensation was unfair. The court noted that the pleading burden on a motion to dismiss is low, and the plaintiff adequately alleged “some facts” to imply that the awards to the outside director defendants lacked entire fairness, even if those facts were “not overwhelming.” Specifically, the court held that the plaintiff stated a claim by alleging that: (1) the Compensation Committee ignored certain considerations related to the emergence of the COVID-19 pandemic when setting the awards, (2) directors at peer companies received lower compensation, (3) the Company’s CFO had described UHS stock as a “buy” at a price higher than the awards’ strike price, (4) at least one analyst forecast a significantly increased year-end stock price, and (5) the Company’s chairman, by virtue of his lobbying efforts, would have known that federal pandemic relief was impending when the awards were granted.

Similarly, the court also declined to dismiss the claims against the members of the Compensation Committee related to the grants of equity awards to the Controller Defendants. The court explained that, given their controlling stake in the Company, Alan and Mark Miller were controlling stockholders of UHS, and they each received “a non-ratable benefit” in the form of compensation that was not shared equally among the Company’s stockholders. The court noted that, even when a committee of independent directors—such as the Compensation Committee—is utilized, a transaction will nevertheless be evaluated under the entire fairness standard if a controlling stockholder will receive a unique benefit that is not shared ratably with the stockholders generally. To avoid such a result, a board would need to properly obtain approval of both an independent board committee and disinterested stockholder approval. Accordingly, the court evaluated the equity grants to the Controller Defendants under the entire fairness standard, and for the reasons stated above with respect to the outside director defendants, the court found that the plaintiff pled sufficient facts to impugn the entire fairness of the transaction at the pleading stage.

Takeaways

This decision illustrates that Delaware courts will evaluate director and officer compensation decisions under different standards of review depending on the circumstances surrounding each individual award. As a general matter, Delaware courts consider it to be a classic business judgment decision of a board of directors to determine how to compensate members of company management. Because of this, Delaware courts will not second-guess the compensation awarded by directors to company management unless there is evidence that (1) the directors lacked independence from the individual receiving the compensation or (2) the directors, while independent, nevertheless lacked good faith in making the award. Pleading a claim of bad faith is extremely difficult under Delaware law, and it generally requires a showing that a director has knowingly acted in a manner that is inconsistent with his or her fiduciary duties.

When directors set their own compensation, Delaware courts generally scrutinize the awards closely due to the self-interested nature of the transaction. However, if the board can show that the challenged award was ratified by a vote of fully informed stockholders, the business judgment rule will apply to the compensation decision notwithstanding the conflict of interest at the board level. The Delaware Supreme Court, in its Investors Bancorp⁵  decision, has held that ratification is a permissible defense only when (1) stockholders approve specific director awards or (2) stockholders approve a self-executing equity incentive plan, and directors have no discretion in granting awards to themselves.

In contrast to the usual deferential business judgment review applicable to awards to company management, where directors approve a compensation award to a member of management that is a controlling stockholder, Delaware courts will generally evaluate the compensation award with significantly more scrutiny on the rationale that a threat of coercion inheres in such a transaction. Unless the compensation award is conditioned upon the approval of an independent, fully functioning committee of the board of directors and a majority of the unaffiliated stockholders, the court will move to an entire fairness review that requires the court to conduct a fact-intensive inquiry into the transaction and evaluate both the fairness of the board’s process and the terms of the award. These claims generally will not be disposed of on a motion to dismiss and are likely to proceed past the discovery phase of litigation and become time consuming and costly for the corporation.

Finally, to state a claim that a director or officer breached his or her fiduciary duties by accepting improper compensation, a plaintiff must plead that the applicable defendant acted in bad faith. This area of the law is less developed, but at a minimum, it is clear from this decision that a plaintiff must make a sufficient pleading of a wrongful state of mind to establish a breach of fiduciary duties by accepting improper compensation.

What Should We Do? Practical Process Suggestions

A recitation of risks without guidance as to how to limit those risks is impractical, so we’ve set out some process steps to limit risk in decision-making. Because of the potential conflicts of interest involved when a board of directors sets its own compensation or sets the compensation of an influential controlling stockholder, it is important for a board of directors to take appropriate process steps when making such a determination. The appropriate level of process will depend on the specific facts surrounding the grant and what may be feasible as a practical matter when compensation is being considered.

• Stockholder approval of compensation. Although it is fairly unusual for public companies to seek stockholder approval of discrete equity awards to outside directors (or a formula providing for the same), companies may consider this process measure in order to “cleanse” the conflict of interest inherent in director self-compensation decisions. If a corporation obtains such a vote, this may preclude a potential plaintiff from bringing an entire fairness claim and would certainly increase the likelihood that any potential litigation is dismissed at the pleadings stage, which combine to make the corporation a less attractive target for the plaintiffs’ bar. Note that another recent decision, referenced above, concluded that a “say-on-pay” vote cannot have such a cleansing effect.⁶ Similarly, in the context of a compensation award to a controlling stockholder, a claim challenging the award generally would be reviewed by a Delaware court under the entire fairness standard of review unless, before substantive economic discussions and negotiations of a compensation package begin, the compensation package is conditioned on both a vote of the unaffiliated stockholders and approval by a special committee of independent directors.

  Although the Delaware case law provides that a stockholder vote provides the “gold standard” from a process protection perspective, a board may determine that it is neither necessary nor advisable to seek a specific ratifying vote of the corporation’s stockholders. Although such a decision could result in entire fairness review of any challenge to director compensation, or compensation to a controlling stockholder, there are other process steps that a board of directors can take to mitigate the risk of a fiduciary duty challenge and defend against claims of an inadequate process.

  • Award of “Market” Compensation. When a corporation awards compensation that is below or in line with the compensation that is awarded by its peers, this can be helpful for establishing that the compensation is not excessive and that it is fair to the corporation and its stockholders. Delaware case law has recognized the possibility that, even without a stockholder vote, challenges to compensation awards can be dismissed at the pleadings stage if they are sufficiently modest or comparable to a corporation’s peers, such that a plaintiff cannot realistically plead that the awards are unfair. Note, however, that the question of what group of peers is appropriate is something that could be open to challenge and a plaintiff could allege in a complaint that the appropriate peer set is something other than that relied upon by the board. As such, the selection of the peer group deserves careful consideration.
  • Tie Compensation to Performance Benchmarks. It can indicate fairness for a board of directors to structure compensation awards with various performance-based components (e.g., the grantee will receive greater compensation when the corporation’s stock price exceeds certain thresholds or when other metrics are achieved). This structure, as one example, aligns the grantee’s incentives with those of the corporation’s other stockholders, and the structure can help to ensure that a corporation is only paying out the highest level of compensation when the corporation is receiving a “return on investment” in the form of the corporation reaching various milestones.

• Use of a Strong Board or Committee Process. Using an independent compensation consultant can be good evidence of a fair decision-making process where the consultant helps to establish the appropriate group of peer companies for compensation decisions, assists in assessing the compensation of the corporation’s peer group, and assists in designing the structure and quantum of the awards. A board of directors or board committee should also consider engaging outside counsel (potentially the corporation’s regular outside counsel and potentially different counsel if the board or committee believes that the corporation’s regular outside counsel is conflicted) to assist with reviewing materials, documenting meetings, and advising on issues related to conflicts of interest. Should an entire fairness challenge to compensation arise, good minutes that document a thoughtful process are critical to show that the compensation was fair or in otherwise mounting a strong defense to the challenge.

[1] Knight v. Miller, C.A. No. 2021-0581-SG (Del. Ch. Apr. 27, 2022).

[2] Howland v. Kumar, C.A. No. 2018-0804-KSJM (Del. Ch. June 13, 2019).

[3] Pfeiffer v. Leedle, C.A. No. 7831-VCP (Del. Ch. Nov. 8, 2013).

[4] Interestingly, shortly after the decision at hand was issued, Vice Chancellor Travis Laster of the Delaware Court of Chancery issued a separate decision—Garfield v. Allen, C.A. No. 2021-0420-JTL (Del. Ch. May 24, 2022)—grappling with this same test and concluding that, in that case, the defendant had knowingly accepted equity compensation that was issued in violation of a corporation’s equity plan.

[5] In re Investors Bancorp, Inc. Stockholder Litigation, 177 A.3d 1208 (Del. 2017).

[6] Garfield v. Allen, C.A. No. 2021-0420-JTL (Del. Ch. May 24, 2022).