Highlights

• Delaware court decisions in recent years have led a number of companies to adopt stockholder-approved director compensation limits in order to benefit from the stockholder ratification defense, which can prove useful if director compensation decisions are challenged by stockholders as being excessive or unreasonable.

• A December 2017 Delaware Supreme Court decision should cause companies to rethink these stockholder-approved director compensation limits.

  • The decision is of heightened importance because it is the first Delaware Supreme Court case to address ratification of director compensation since 1952. The Delaware court decisions addressing director compensation in recent years have all been lower Court of Chancery cases.

• Companies that have adopted a director compensation limit in recent years should consider leaving those limits in place or updating the limit the next time the company is seeking stockholder approval for the underlying compensation plan.

• Companies that have not adopted a director compensation limit, depending on risk appetite, may want to continue without a director compensation limit or consider having stockholders approve a limit that would more likely benefit from the stockholder ratification defense under the new decision (such as formula awards for directors).

• All companies should continue to ensure that director compensation decisions are made following a robust process that takes into account market practices and that is –carefully described in each company’s annual proxy statement. The new decision makes having such a robust process as important as ever.

Director Compensation Decisions: Entire Fairness v. Stockholder Ratification

Directors typically face heightened scrutiny in stockholder litigation challenging decisions about their own compensation levels. Normally, the business judgment rule will not apply to these decisions, because directors, it is presumed, are inherently interested in decisions about their own pay. If stockholders challenge the self-interested director compensation decisions as being excessive, Delaware courts will independently review the decisions as to whether the compensation decisions were “entirely fair” to the stockholders. Because an “entire fairness” review is fact-intensive, any such claims will likely survive a motion to dismiss by the company.

Under the “stockholder ratification” defense, a company can avoid an entire fairness review if stockholders have approved the compensation decision. If the stockholder ratification defense applies, the Delaware courts will apply the business judgment rule and override the compensation decision only if the stockholders can show corporate waste. Given the practical difficulties in establishing corporate waste, if the stockholder ratification defense applies, the company can likely defeat the claims on a motion to dismiss.

For the last several years, a series of Delaware Court of Chancery cases have applied the stockholder ratification defense where the challenged director compensation awards were made under a stockholder-approved equity plan with varying degrees of compensation limits. See our Client Alert, Stockholder-Approved Award Limits for Non-employee Directors: Legal Update and Actions to Consider (May 2017). These cases established a general rule that, if stockholders approved a “meaningful limit” to director compensation awards, director compensation decisions made within those limits would have the protection of the stockholder ratification defense.

A recent Delaware Supreme Court decision, In re Investors Bancorp, Inc. Stockholder Litigation, ^[1] substantially changes this analysis. As a result of this decision, the stockholder ratification defense will now be available in much more limited circumstances. The “meaningful limit” standard has likely been eliminated or, at a minimum, significantly narrowed, although the exact reach of the decision is not entirely clear. Below we provide additional detail on the Delaware Supreme Court’s analysis and actions to consider in light of the decision.

Investors Bancorp Delaware Supreme Court Decision

Investors Bancorp considered a stockholder-approved equity compensation plan that permitted up to 30% of the total share pool to be awarded to nonemployee directors, including in a single award. Shortly after stockholders approved the plan, the directors in fact approved an award of the entire 30% pool to themselves, resulting in compensation levels many times greater than both their historical annual compensation and compensation levels at competitor banks.

The Delaware Court of Chancery determined that the director-specific limits were sufficiently clear and limiting such that the stockholder ratification defense was available. Based on that analysis, the Court of Chancery granted the bank’s motion to dismiss the stockholder claims.

On appeal, the Delaware Supreme Court reversed. The court observed three categories of scenarios where director compensation limits are approved by stockholders:

1. Stockholders approve a specific director compensation award (“Specific Award Approval”);

2. Stockholders approve a formulaic award under a “self-executing” plan that does not require director discretion (“Formulaic Plan Approval”); or

3. Stockholders approve an upper limit on director compensation awards and authorize directors to make compensation decisions up to the stated limit.

The Delaware Supreme Court noted that it had previously approved the stockholder ratification defense in the first two scenarios (last decided by the court in the 1950s), ^[2] but that the third category, which had evolved through subsequent Delaware Court of Chancery decisions, was a matter of first impression for the court. The court expressed concern about the potential reach of the third category. The court observed that the stockholder ratification defense requires the court to “balance the competing concerns—utility of the ratification defense and the need for judicial scrutiny of certain self-interested discretionary acts by directors—by focusing on the specificity of the acts submitted” for approval. ^[3] The court then held:

1. [W]hen 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.

Id. at * (pp. 3–4) (emphasis added). The Delaware Supreme Court explained that director actions are to be “twice-tested,” first for whether an action is legally authorized and second for whether it is equitable and consistent with fiduciary duties. ^[4] While stockholder approval of the “general parameters” for awards sets the “broad legal authority” for the awards, in the court’s view, stockholders continue to expect that the discretion within those legal boundaries will be exercised “consistently with equitable principles of fiduciary duty.” ^[5] Because the 30% pool award limit on the facts in the case provided only “general parameters,” and based on the remaining allegations by the plaintiffs—which the court found to demonstrate a reasonable inference that the compensation decisions were unfair and excessive (at least at the motion to dismiss stage) — the court held that the stockholder ratification defense should not have applied and that the company’s motion to dismiss should have been denied.

The holding casts doubt as to whether the stockholder ratification defense will be permitted other than in case of Specific Award Approval or Formulaic Plan Approval. But the holding is not entirely clear. Arguably, there could be stockholder-approved compensation limits that permit some degree of director discretion but are nonetheless more than mere “general parameters” for awards. Investors Bancorp considered an extreme set of facts, with a broad, aggregate pool limit, and large compensation awards made based on that design. Future cases will need to clarify whether, on a different set of facts, the stockholder ratification defense may still be successfully invoked where specific, rather than general, award parameters have been approved but some limited degree of director discretion is still permitted.

What to Do Now

In light of the Investors Bancorp decision, we think next steps should include the following:

1. Consider Your Risk Appetite. Each company should consider its risk appetite regarding potential claims of excessive director compensation. For companies that have director compensation programs that clearly fall within normal parameters for their industry and size, the issue may have little significance and may not trigger further action. For companies that pay their directors more than their market median, have unusual director compensation circumstances, or are otherwise more concerned about stockholder claims, additional action may be warranted.

1. The recent Facebook litigation, Espinoza v. Zuckerberg, should be a cautionary tale in this regard. Facebook paid its directors annual compensation (cash and stock) of about $386,000. ^[7] Of the 12 largest U.S. companies by market-cap value, this level of director compensation ranked second even though Facebook itself was ranked sixth. But the amount was close to the average director compensation for the third and fourth highest market-cap value companies, at around $365,000, and in any event, certainly not what most practitioners would consider “excessive” for a company of Facebook’s size. A plaintiffs’ firm nonetheless sued Facebook, claiming that the director compensation was excessive. Facebook settled the case, paying the plaintiffs’ firm $525,000 in legal fees and submitting its director compensation program to stockholders for further ratification and approval (which was obtained).

2. Consider Stockholder Approval for Director Compensation.

1. a. Companies with Existing Stockholder-Approved Director Compensation Limits. A growing number of companies have adopted director compensation limits in recent years in light of the case law development before Investors Bancorp. The limits are usually located in equity compensation plans that have been submitted to stockholders for approval. The plans often express the limit as a cap on the dollar value (or number of shares) of annual equity awards for each individual director or a limit on the combined dollar value of annual cash and equity awards for each individual director, with the dollar value usually set within a relatively narrow range above current compensation levels, such as 2 times to 4 times the current levels.

2. These limits are factually distinguishable from the limits considered in Investors Bancorp. But given the Delaware Supreme Court’s analysis and holding, there is a heightened risk that, if the decisions are challenged, the stockholder ratification defense will not protect director compensation decisions even within these stockholder-approved individual compensation limits. Companies with these limits will face a choice the next time they are otherwise taking their equity compensation plans to stockholders for approval (e.g., when adding new shares), informed by their risk appetite, to either:

• Leave the limit in place, as-is, until the courts further clarify the scope of the Investors Bancorp decision;

• Obtain stockholder approval of a revised compensation limit that more likely satisfies the Investors Bancorp standard, such as a formulaic plan design; or

• Eliminate any director compensation limit and trust in the director compensation process and decisions as being entirely fair to stockholders.

1. Even if the stockholder ratification defense cannot be invoked for an existing stockholder-approved limit under the Investors Bancorp standard, the existence of that limit could be a helpful factor in determining whether compensation decisions are equitable under the entire fairness standard.

1. b. Companies that Have Not Yet Adopted Director Compensation Limits. For companies that have not yet adopted a stockholder-approved director compensation limit, the choices are somewhat simpler. For more risk-averse companies, Investors Bancorp provides a roadmap for establishing a stockholder-approved director compensation plan that would more probably be shielded by the stockholder ratification defense. Likely, the best approach would be a formulaic design. Of course, this approach inherently limits director discretion, but such is the trade-off for the heightened protection against stockholder claims.

1. Alternatively, companies can continue to operate without a stockholder-approved limit and trust in the director compensation process and decisions as being entirely fair to stockholders. Investors Bancorp should not, in and of itself, create any greater risk on the issue of director compensation for companies that currently do not have stockholder-approved limits on director compensation.

3. Check Your Compensation-Setting Process and Disclosures. Regardless of whether you already have a stockholder-approved director compensation limit, Investors Bancorp highlights the importance of having a robust decision-making process for setting director compensation levels. Directors may want to obtain the advice of independent compensation consultants and to consider their compensation levels and design in light of relevant marketplace practices. Public companies may want to take a fresh look at the disclosures about their director compensation program and ensure that the disclosures clearly communicate the rationale behind the compensation program design.

_{[1] In re Investors Bancorp, Inc. Stockholder Litigation, No. 169, 2017, --- A.3d ----, 2017 WL 6374741 (Del. 2017), https://courts.delaware.gov/Opinions/Download.aspx?id=266580.}

_{[2] Id. At *6-8 (pp. 15–19).}

_{[3] Id. at *1 (p. 3).}

_{[4] Id. at *11 (p. 26).}

_[5] Id.

_{[6] Espinoza v. Zuckerberg, No. 9745-CB, 2016 WL 1259422 (Del. Ch. Mar. 30, 2016).}

_{[7] See David E. Gordon, Facebook Settlement: Litigation Over Director Compensation, HARV. LAW SCH. F. ON CORP. GOVERNANCE AND FIN. REG. (March 10, 2016), https://corpgov.law.harvard.edu/2016/03/10/facebook-settlement-litigation-over-director-compensation/.}