chevron-down Created with Sketch Beta.
February 24, 2015 Articles

Meaningful Limits on Director Compensation

The Delaware Court of Chancery has created a new legal standard for this controversial issue

By Thomas Welk and Peter Adams

“A cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business affairs of the corporation.” Orman v. Cullman, 794 A.2d 5, 19 (Del. Ch. 2002). This deference to directors and their decision making is reflected in the business judgment rule, which is the default standard of judicial review for director conduct. Under the business judgment rule, a reviewing court presumes that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interest of the company.” In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 52 (Del. 2006) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)). For that reason, the rule “operates to preclude a court from imposing itself unreasonably on the business and affairs of a corporation.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360 (Del. 1993).

The business judgment rule does not, however, protect directors who are interested in the challenged decisions—i.e., who “appear on both sides of a transaction” or expect to derive a “personal financial benefit from [the transaction] in the sense of self-dealing.” Aronson, 473 A.2d at 812. For example, a board’s decision to award itself compensation necessarily involves self-dealing because the directors stand on both sides of the transaction. See, e.g., Cambridge Ret. Sys. v. Bosnjak, 2014 WL 2930869, at *5 (Del. Ch. June 26, 2014)(“The transactions at issue here, the Unilife directors’ payment of compensation to themselves, are classic forms of self-dealing.”). In such circumstances, the business judgment rule is rebutted and the directors will bear the burden of proving that their compensation decision was entirely fair to the company. McMullin v. Beran, 765 A.2d 910, 917 (Del. 2000). (“If the shareholder plaintiff succeeds in rebutting the presumption of the business rule, the burden shifts to the defendant directors to prove the ‘entire fairness’ of the transaction.”). Entire fairness is the court’s most onerous level of scrutiny. Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 459 (Del. Ch. 2011).

Nonetheless, in the director compensation context, a board can avoid entire fairness review and reinstate the business judgment rule if the challenged decision was ratified by a fully informed stockholder vote. In re 3COM Corp. S’holders Litig., No. C.A. 16721, 1999 WL 1009210, at *1 (Del. Ch. Oct. 25, 1999) (holding that prior stockholder approval of a stock option plan reinstates the business judgment rule). In 3COM, the plaintiff alleged that the directors’ decision to grant themselves options under a stock plan was a self-interested one and therefore should be reviewed under the entire fairness standard. Id. at *2. Then-Vice Chancellor Steele disagreed, holding that directors who “administer a stockholder approved director stock option plan are entitled to the protection of the business judgment rule, and in the absence of waste, a total failure of consideration, they do not breach their duty of loyalty by acting consistently with the terms of the stockholder-approved plan.” Id. at *1. Since then, courts have routinely applied the business judgment rule to director compensation decisions made pursuant to a stockholder-approved compensation plan. See, e.g., Desimone v. Barrows, 924 A.2d 908, 934 (Del. Ch. 2007) (“[I]n a situation where directors are expressly permitted under the terms of a stockholder-approved option plan to issue below-market options, it would be well within the realm of business judgment to choose to issue all options to a set of similarly-situated employees at a uniform strike price reflecting the stock’s low point for the quarter.”); Cruden v. Steinberg, 2000 WL 354390, at *4 (Del. Ch. Mar. 23, 2000) (“Carrying out a predetermined stock option plan, approved by shareholders, entirely consistently with the plan can hardly be characterized as an act of a ‘disloyal’ fiduciary.”).

Seinfeld v. Slager
In 2012, the Chancery Court altered this landscape in Seinfeld v. Slager, 2012 WL 2501105 (Del. Ch. June 29, 2012). In Slager, the plaintiff accused the directors of Republic Services, Inc., of breaching their duty of loyalty and wasting corporate assets by awarding themselves excessive compensation under an equity plan. Id. at *1. In 2009, the directors awarded themselves, as “eligible” participants in the plan, between $843,000 and $891,000 in total compensation per individual director. Id. at *11. In 2010, each director’s annual compensation was between $320,000 and $345,000. Id. The plaintiff alleged that this compensation constituted waste because it far exceeded that paid by Republic’s peers. Relying on 3COM, the defendants argued that, because the plaintiff did not allege that the awards violated that stockholder-approved equity plan, the board’s decisions were protected by the business judgment rule. Id. at *11. Vice Chancellor Glasscock did not agree, holding: “Here, even though the stockholders approved the plan, the Defendant Directors are interested in self-dealing transactions under the Stock Plan. The Stock Plan lacks sufficient definition to afford the Defendant Directors protection under the business judgment rule.” Id. at *12. In reaching this conclusion, Vice Chancellor Glasscock focused on the board’s “sole discretion” to set awards under the plan and the individual limit of 1,250,000 shares per year. Id. at *10. The board “could theoretically award each director” up to $21,691,250 worth of equity compensation, “and the total value would be $260,295,000.” Id. at *11. According to the court, this limit was not “meaningful,” thereby robbing the directors of the business judgment rule’s protection despite ratification of the plan by Republic’s stockholders.

The sufficiency of definition that anoints a stockholder-approved option or bonus plan with business judgment rule protection exists on a continuum. Though the stockholders approved this plan, there must be some meaningful limit imposed by the stockholders on the Board for the plan to be consecrated by 3COM and receive the blessing of the business judgment rule, else the “sufficiently defined terms” language of 3COM is rendered toothless. A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board’s compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair.

Id. at *12 (emphasis in original).

The Slager decision has effectively created not only a new legal standard for reviewing director compensation but also an opportunity for shareholder plaintiffs (and their counsel). In two recent cases, plaintiffs have attempted to capitalize on the new “meaningful limit” standard articulated in Slager.

Recent Cases
In June 2014, a shareholder plaintiff filed a derivative action against the directors and several officers of Facebook. Complaint, Espinoza v. Zuckerberg, C.A. No. 9745 (Del. Ch. filed June 6, 2014). In that case, the plaintiff alleges that the Facebook board of directors unjustly enriched themselves, breached their fiduciary duties, and wasted the company’s assets by awarding themselves excessive compensation under Facebook’s 2012 Equity Incentive Plan. In 2013, Facebook’s nonemployee directors received, under the plan, an average of $461,000 in equity compensation, which the plaintiff claims was excessive relative to the company’s peers. The plaintiff also contends that the plan’s individual limit (of 2.5 million shares) is not meaningful because, at Facebook’s then-current stock price, the board could theoretically grant each director up to approximately $145 million worth of equity.

A few months later, in October 2014, a similar derivative action was filed against the directors and officers of Celgene Corporation. There, as in the lawsuit against Facebook, the complaint asserts claims for breach of fiduciary duty, waste, and unjust enrichment stemming from allegedly excessive director compensation in 2012 and 2013. In 2012, the Celgene nonemployee directors received, under the company’s stock plan, average total compensation of $502,484. In 2013, that average was $833,119. The plaintiff claims these awards were excessive relative to the company’s peers, who averaged approximately $320,000 and $350,000 in per-director compensation in 2012 and 2013. The plaintiff also attacks the stock plan’s 1.5-million-share individual limit as “illusory” and not “meaningful” because, at the company’s then-current stock price, the board could theoretically grant each director up to about $145 million worth of equity.

The Facebook and Celgene cases have not yet been decided on the merits. In Zuckerberg, the defendants filed a motion to dismiss and for summary judgment, but that motion has not yet been fully briefed and decided. In Celgene, the defendants have not yet answered or moved to dismiss the complaint. It is unclear whether these cases will spawn a new wave of compensation litigation in 2015. Nonetheless, companies—especially those that are amending an existing equity plan or adopting a new one in which directors are eligible participants—should consider whether it makes sense to submit to shareholders for approval a meaningful limit on director compensation.

Practical Considerations

Who will be targeted? It’s difficult to predict whether claims relating to director compensation will become the next wave of compensation litigation and, if it does, how the plaintiffs’ bar will decide whom to target. It would seem that the plaintiffs’ bar would target companies with director compensation that is most likely to be viewed as unreasonably high (e.g., director compensation that is above the 90th percentile, and significantly more than the median director compensation, of its peer group), without a compelling rationale for such pay. Companies should evaluate director compensation, especially in light of that paid to peers’ directors, to determine whether they are likely to become a target. Companies should also explain in the annual proxy statement any special circumstances or attributes of the board that would justify special pay.

What is a “meaningful limit” on director compensation? The Slager court noted that “[t]he sufficiency of definition that anoints a stockholder-approved option or bonus plan with business judgment rule protection exists on a continuum.” 2012 WL 2501105, at *12. Many equity plans will include per-person grant limits to enable compensation to be treated as performance-based compensation under section 162(m) of the Internal Revenue Code. However, as in the Slager case, these limits are quite high and may be disregarded by the court as not being “meaningful.” Companies setting such limits will want to ensure that they are set low enough to be “meaningful,” yet high enough so that they will not be exceeded inadvertently. Because director compensation is likely to increase each year (and as the company grows), the company should anticipate such growth in director compensation in setting limits and submitting them to shareholders. Companies should also be sure to revisit the limit on an annual basis to ensure that it continues to be meaningful and will not be exceeded. Also, companies adopting a limit on director compensation should institute procedures at the time director compensation is set to ensure that the director compensation will not exceed the limit approved by shareholders.

How should the limit be described? There are a number of ways to present a limit (e.g., a fixed dollar amount limit, a limit relative to peer companies or an index/industry median, or a limit relative to historic director compensation), and there are advantages and disadvantages to the various approaches as we balance flexibility with administrative difficulty. While many companies have set the limit to apply to equity compensation only, others have included cash compensation. A meaningful limit that applies to both equity and cash compensation can preclude a shareholder claim on the entirety of the director compensation. Such a limit could, for example, provide that the maximum number of shares of common stock subject to awards that are granted during a single fiscal year to any nonemployee director, taken together with any cash fees paid to such nonemployee director during the fiscal year, shall not exceed X dollars in total value. The total value should be based on an objective formula, such as the grant date fair value of such awards for financial reporting purposes.

What form should the shareholder proposal take? If the company is otherwise submitting equity plan proposals to stockholders this year (e.g., because of an equity plan share increase or a pre–initial public offering approval), the simplest approach would be to include a meaningful limit on director compensation in the plan submitted to stockholders. However, if the company is not otherwise submitting equity plan proposals to stockholders, the company might consider a stand-alone proposal (similar to a “say on pay” proposal), so as to limit the unnecessary disclosure relating to other aspects of the equity plan. In either case, two of the larger proxy advisory firms (Institutional Shareholder Services and Glass Lewis) are likely to support such proposals, but this may depend on the facts and circumstances—such as whether the proxy advisory firm would view the proposal as a mechanism to pay excessive director compensation.

To deflect potential litigation and defend against it if a claim were to be filed, companies should evaluate whether it would be wise to submit a proposal to stockholders this year seeking approval for a “meaningful” limit on nonemployee director compensation. Such evaluation would entail, for example, a determination of whether the company is likely to be targeted by the plaintiffs’ bar, whether the company’s director compensation is fair (both in terms of aggregate value and as compared with peer companies), the uncertainty of the recommendations by the proxy advisory firms, and the potential unanticipated and unintentional consequences of instituting a stockholder-approved limit. At a minimum, companies should examine the existing individual limits in their equity plans and assess whether those limits, when valued at the company’s current stock price, imply exorbitant compensation for each director (as in Slager, Facebook, and Celgene).