In an era of intense investor scrutiny and SEC rulemaking regarding executive compensation, a recent decision by the Delaware Court of Chancery raises questions as to the protections afforded to directors when granting themselves equity incentive awards under stockholder-approved incentive plans. In the case, Seinfeld v. Slager, the Court reaffirmed the application of the business judgment rule in the context of a stockholder derivative claim challenging numerous compensation-related decisions as wasteful; however, for one claim the Court refused to apply the business judgment rule to a board’s decision to award equity bonuses to directors under a stockholder-approved incentive plan and, instead, ruled that the awards in question may want to be evaluated under the entire fairness standard.
The director equity awards at issue were granted under the company’s stockholder-approved compensation plan, which gave the directors authority to grant stock options to themselves subject to certain plan-wide limits on the number of shares that could be granted and annual caps on grants to eligible recipients. In its decision, the Court distinguished a similar case, In re 3COM Corp. Shareholders Litigation, in which the Court had granted business judgment protection to a board’s decision to grant itself equity awards under a stockholder-approved incentive plan. The Court noted that in 3COM, the board’s discretion was limited by a stockholder-approved incentive plan that placed specific limits on the number of shares that could be granted in various contexts. In Seinfeld, however, the Court held that application of the business judgment rule was not appropriate because there was essentially “no effective limits on the total amount of pay that can be awarded.” Instead, the Court held that decisions in this context are to be evaluated for entire fairness to the company of both the decision-making process and the decision itself.
In the near term, the Seinfeld case raises several questions and provides few answers. While it is clear that a board’s decision to grant equity awards to itself under a broad-based equity compensation plan, with only plan-wide limitations on the number of shares that can be granted, will be subject to the entire fairness standard, it is not clear how specific the restrictions on director equity grants must be in a plan to afford the board the benefit of the business judgment rule. Although precise limits and standards for director equity grants will act as insurance against shareholder litigation relying on the entire fairness standard, they will limit a company’s ability to adapt to company-specific needs and evolving director compensation models in the broader market. Going forward, companies may need to carefully consider and balance their need for flexibility in director compensation with the need to minimize the potential for shareholder litigation by establishing meaningful limits on the board’s discretion to compensate its directors.