Navigating Rocky Shoals and Safe Harbors When Board Members Fix Their Own Compensation

by Farrell Fritz, P.C.
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Board members’ decisions to award compensation packages for themselves can present some thorny issues. In a close corporation, shareholders typically serve as officers and directors, and have a reasonable expectation of compensation in lieu of dividends or distributions. But dissenting shareholders or directors, armed with the benefit of hindsight, can, and often do, criticize a board’s compensation decisions as excessive, claiming self-dealing, looting, and waste. What statutory protections do board members have when making compensation decisions? To what extent can board members truly rely on those protections?

In Cement Masons Local 780 Pension Fund v Schleifer, 56 Misc 3d 1204 [A], 2017 NY Slip Op 50875 [U] [Sup Ct NY County June 29, 2017], Manhattan Commercial Division Justice Saliann Scarpulla considered these issues in a thoughtful opinion, in which she relied on some relatively infrequently litigated provisions of the Business Corporation Law (“BCL”). The decision is also noteworthy for its reliance on decisional law from Delaware on not one, but two important issues of law, one of which was an apparent question of first impression in New York. Although Cement Masons Local involved a public company, it addressed the same statutes that govern close corporations, and provides helpful guidance to board members, and counsel, when weighing compensation decisions.

The Facts

Cement Masons Local was a stockholder in Regeneron, a NASDAQ-traded New York biopharmaceutical corporation. Cement Mason Local brought a shareholder derivative action against 13 of Regeneron’s current and former members of the ten-member board, alleging they awarded themselves excessive compensation packages, including cash, equity, and stock options, as Regeneron’s finances were declining precipitously.

Initially, a written incentive compensation plan, adopted in 2000 without shareholder approval, governed the board’s discretion to grant compensation. In 2014, the board unanimously recommended that Regeneron’s shareholders approve a new compensation plan. After a shareholder vote, a majority of the shareholders approved the plan. But the board controlled the voting rights of a large block of common shares held by certain non-party shareholders, who were required under a written agreement to vote their shares as recommended by the board. Without those votes, a majority of the shareholders would not have approved the plan.

Board Judgment on Adequacy of Consideration for Rights and Options

The first statutory protection potentially available to the board was BCL § 505 (h), which states that in the “absence of fraud,” the “judgment” of the board of directors is “conclusive as to the adequacy of consideration” for the receipt of options or rights to purchase a corporation’s stock.

The director defendants argued that BCL § 505 (h) required dismissal of all of plaintiff’s claims. In opposition, the plaintiff admitted that “there is no New York case law applying BCL § 505 (h) to self-interested transactions,” but it argued that the court should borrow from Delaware case law interpreting a similar statute, and hold that “the statutory ‘actual fraud’ provision does not provide a defense when the underlying transaction involves unfair self-dealing proscribed by equitable fiduciary duty concepts” (Parfi Holding AB v Mirror Image Internet, Inc., 794 A2d 1211, 1235 [Del Ch 2001]). In an apparent issue of first impression, Justice Scarpulla agreed with the plaintiff, holding:

Absent a controlling New York precedent in the context of BCL § 505 (h) and self-interested transactions, I follow Delaware’s case law and find that BCL § 505 (h) does not shield the Director Defendants’ judgment in this self-interested transaction as a matter of law.

Because a majority of the directors was self-interested in the board’s post-2014 compensation decisions, the court held that BCL § 505 (h) did not shield the board from liability for issuing itself stock options in Regeneron.

Shareholder Ratification

A second statutory protection potentially available to the board was shareholder ratification of the post-2014 compensation plan under BCL § 713, which states:

No contract or other transaction between a corporation and one or more of its directors . . . shall be either void or voidable for this reason alone or by reason alone that such director or directors are present at the meeting of the board, or of a committee thereof, which approves such contract or transaction . . ..

The statute offers several safe harbor provisions, including BCL § 713 (a) (2) stating that such transactions are protected if the transaction is “approved by vote of [the] shareholders.”

The plaintiff argued that shareholder approval of the post-2014 plan did not protect the board because the board controlled a large block of voting shares, which, if excluded from voting, would have been inadequate to obtain a majority vote.

Borrowing again from Delaware law, the court explained that “Delaware courts interpreting” a similar statute “have concluded that it provides that only disinterested shareholders votes may be considered” in ratification of a board decision (citing In re Cox Communications, Inc. Shareholders Litig., 879 A2d 604 [Del Ch 2005]). The court held that because a majority of disinterested shareholders did not approve the post-2014 compensation plan, shareholder ratification under BCL § 713 (a) (2) was insufficient to shield the board from liability.

General Board Authority to Fix Director Compensation

A third statutory protection potentially available to the board was BCL § 713 (d), which states that unless otherwise restricted by the certificate of incorporation or by-laws, “the board shall have authority to fix the compensation of directors for services in any capacity.” In Marx v Akers, 88 NY2d 189 [1996], the Court of Appeals held:

a complaint challenging the excessiveness of director compensation must—to survive a dismissal motion—allege compensation rates excessive on their face or other facts which call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment.

Relying on Marx, Judge Scarpulla held that “the complaint’s detailed allegations pertaining to its excessive compensation claims call into question whether the compensation was fair to the corporation when approved and are sufficient under Marx” (quotations omitted). Among those “detailed allegations,” the plaintiff provided statistical data to show that the defendants were vastly overcompensated when compared to peers in similar positions and industries. For example, in one year, certain Regeneron directorswere the highest compensated non-employee directors in the United States.”

Demand Futility

The final statutory provision invoked by the board members — this time with partial success — was the requirement of pleading “demand futility” under BCL § 626 (c), a subject this blog has addressed many times.

Before suing, Cement Masons Local did not make a pre-suit demand that the board commence a lawsuit on Regeneron’s behalf to challenge the board’s compensation awards. Under the well-established standard for demand futility in Marx, a complaint must allege “with particularity that (1) a majority of the directors are interested in the transaction, or (2) the directors failed to inform themselves to a degree reasonably necessary about the transaction, or (3) the directors failed to exercise their business judgment in approving the transaction.”

With respect to pre-2014 compensation decisions, under the first Marx prong, the court held that Cement Masons Local failed to allege that a majority of the directors were interested in the transaction, because only three members of the ten-member board allegedly received compensation under the pre-2014 plan. With respect to the second Marx prong, the court held that the plaintiff “conclusorily” alleged that the directors “failed to inform themselves” about the transaction. As to the third Marx prong, the court held that plaintiff did “not sufficiently allege that the directors failed to exercise their business judgment in approving the executive compensation.” Thus, the court dismissed the complaint as to all compensation decisions before 2014.

With respect to post-2014 compensation decisions, however, the court held that because five members of the ten-member board had authority to set compensation for themselves, “demand was futile, under the first Marx prong.”

As a result of these holdings, the court allowed plaintiff’s two causes of action for breach of fiduciary duty and unjust enrichment to proceed with respect to the board’s post-2014 compensation decisions.

Conclusion

Much like the common-law business judgment rule, BCL §§ 626 and 713 provide important protections for board compensation decision. But as Cement Masons Local makes clear, those protections are anything but absolute, and may be lost where (i) a majority of the board is self-interested in a transaction, (ii) where the board controls a large block of shareholder votes, without which a majority of shareholders cannot be obtained to ratify a transaction, or (iii) where the complaint contains detailed allegations calling into question whether the compensation was fair.

Cement Masons Local emphasizes that, as always, board members and their counsel should do their utmost to secure at least a majority of disinterested votes in favor of a compensation decision at the board level and, if ratified, by a majority of disinterested shareholders.

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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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