Delaware Supreme Court Increases Risk for Boards in Making Discretionary Director Compensation Awards

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Background

Under Delaware law, corporate directors are authorized to set their own compensation. Absent stockholder approval, if such director compensation decisions are challenged, they are subject to entire fairness review as self-interested decisions. Under the entire fairness standard, the directors bear the burden of showing that the award process and amounts were objectively fair to the corporation and its stockholders. In contrast, if director compensation awards are approved by a majority of disinterested stockholders in a fully informed vote, the awards will be reviewed using the deferential business judgment rule standard of review. As a practical matter, awards could be attacked only if they amounted to “waste.” Claims that compensation constitutes waste are rarely successful as they require showing that the compensation paid was so unequal in relation to the services or other benefit received that no rational person could have determined that it was appropriate.

In Investors Bancorp, the plaintiffs alleged that the directors of Investors Bancorp, Inc. breached their fiduciary duties by awarding themselves equity compensation. The Company’s equity compensation plan, which had been approved by a stockholder vote, granted the directors discretion to award themselves up to 30 percent of the options or shares of restricted stock authorized under the plan. Although the director awards were below that limit and otherwise consistent with the plan, the awards were allegedly excessive in amount.

The Delaware Court of Chancery dismissed the plaintiffs’ claims, concluding that the challenged awards were subject to business judgment rule review because the prior stockholder approval of the equity compensation plan (and the discretion it conferred on the board over compensation decisions) effectively constituted stockholder approval of the board’s discretionary grant decisions consistent with the plan’s terms. 

Delaware Supreme Court Decision

The Delaware Supreme Court reversed, holding that the challenged awards were not protected by the business judgment rule even though there was no dispute that the awards did not exceed the range within which the board was authorized to grant compensation to directors and otherwise complied with the terms of the stockholder-approved plan. The Court explained:

When the directors submit their specific compensation decisions for approval by fully informed, uncoerced, and disinterested stockholders, ratification is properly asserted as a defense in support of a motion to dismiss. The same applies for self-executing plans, meaning plans that make awards over time based on fixed criteria, with the specific amounts and terms approved by the stockholders. But, 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.

Given the plaintiffs’ allegations that the challenged awards were excessively large in comparison to both previous awards at Investors Bancorp and awards at peer companies, the Court concluded that “[t]he plaintiffs have alleged facts leading to a pleading stage reasonable inference that the directors breached their fiduciary duties in making unfair and excessive discretionary awards.” The Court then held that, under the entire fairness standard, the directors were required to prove that the challenged awards were objectively fair to the corporation and its stockholders.

Investors Bancorp represents a significant development in Delaware director compensation law. This decision increases the potential exposure of corporate directors. That risk can be minimized where the equity compensation plan is approved by a majority of disinterested stockholders in a fully informed vote (presumably in connection with an annual stockholder meeting) and contains a non-discretionary formula regarding how much compensation directors may be awarded or otherwise specifically dictates how much directors may receive, thereby taking away any discretion from the board. Alternatively, companies can choose to have specific director awards ratified after the fact by a fully informed disinterested stockholder vote. One thing seems certain – the Delaware Supreme Court’s decision is likely to lead to increased stockholder derivative litigation challenging director compensation awards as excessive.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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