A recent decision by the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation has narrowed legal protections in connection with awarding discretionary equity compensation to nonemployee directors. The Court reversed a lower court ruling allowing the board to rely on the protection of the business judgment rule if the approved equity plan gives directors discretion to determine their own compensation, and established a new legal standard of “entire fairness” by which discretionary equity compensation to directors will be judged if the stockholder-approved plan has no “meaningful limits.” While the Investors plan had a cap of 30 percent on director equity awards, which the Delaware Chancery Court previously held to be a meaningful limit, the Delaware Supreme Court determined that the broad discretion given to directors within the parameters of the cap allows stockholders to challenge whether that discretion has been exercised properly or inequitably. Previously, the Court has held that the business judgment rule will apply if stockholders ratified the director compensation. The “stockholder ratification” defense was rejected by the Court in Investors. The Court held that the stockholder ratification defense, and hence the business judgment rule, will now apply only in cases where (i) the stockholder-approved equity plan is self-executing and does not give the directors the discretion to determine the amount of their awards, or (ii) the stockholders approve the specific amounts of equity awards to each director.

In light of this decision, discretionary equity awards to directors under stockholder-approved plans which have no meaningful limits will be scrutinized by the Delaware courts (and likely other courts around the country) pursuant to the entire-fairness standard. This standard requires directors to prove that their compensation is entirely fair to the company, which must be supported by data and peer-group analysis provided by outside consultants. It may become necessary or desirable for the company to obtain an independent fairness-type opinion from a third-party consultant which concludes that the compensation paid to the directors is entirely fair to the company.

The Court’s ruling in Investors will likely have broad implications with respect to the terms of new equity plans and the process by which decisions regarding director compensation are made. In addition, companies may want to review, and possibly amend, existing equity plans to conform to the Investors decision by setting forth a specific formula in the plan for awards or including specific grants of equity awards to directors in the plan. Companies may also be well advised to work more closely with outside consultants in the design of equity plans which provide for discretionary compensation to directors.