Although the Delaware General Corporation Law allows corporate boards of directors to set their own compensation (see 8 Del. C. § 141(h)), Delaware courts have found that, because those decisions are self-interested, they are subject to the stringent entire fairness standard of judicial review when challenged by stockholders. See Telxon Corp. v. Meyerson, 802 A.2d 257, 262 (Del. 2002). However, it has long been established that director self-compensation decisions can be “ratified” by an informed, uncoerced vote of disinterested stockholders, in which case they are reviewed under the deferential business judgment standard. See Kerbs v. Cal. E. Airways, Inc., 90 A.2d 652 (Del. 1952); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1960). Following recent opinions by the Delaware Court of Chancery, directors have been able to assert a ratification defense to claims of unfair compensation not only where the amounts were specifically approved by a stockholder vote, but also where the amounts were awarded under a stockholder-approved plan that set “meaningful limits” on director compensation. See Seinfeld v. Slager, 2012 Del. Ch. LEXIS 139, at *41 (Del. Ch. June 29, 2012).
In In re Investors Bancorp, Inc. Stockholder Litigation, 2017 Del. LEXIS 517, at *25 (Del. Dec. 13, 2017) (revised Dec. 19, 2017), the Delaware Supreme Court overruled the “meaningful limits” standard and reversed the Court of Chancery’s ruling in favor of the corporation’s directors, holding that where directors are given discretion to award their own compensation under a stockholder-approved plan, they must exercise that discretion in keeping with their fiduciary duties. Where a stockholder complaint adequately alleges a breach of fiduciary duty in the exercise of discretion after stockholder ratification of a plan, the complaint will survive a motion to dismiss.
The corporation, Investors Bancorp, Inc., was a publicly held bank holding company. The complaint asserted derivative claims against the corporation’s ten non-employee directors and two executive directors. It alleged that the non-employee directors were awarded an average of $2,100,000 each in stock options and restricted stock in 2015, compared with total compensation of between $97,200 and $207,005 each in 2014, and that their compensation “eclips[ed] director pay at every Wall Street firm.” The 2015 equity awards were made under an incentive plan that reserved approximately 9.3 million shares specifically for outside directors. In 2014, the company had sold approximately 220 million shares to the public at $10.00 per share. The plan provided that all of the reserved shares could be granted to the non-employee directors in any one year. The total value of the 2015 awards for all 12 non-employee and executive directors was approximately $51.5 million.
The Court of Chancery found that the plan contained “meaningful limits” because it contained limits specific to the non-employee directors. 2017 Del. Ch. LEXIS 53, at *23 (Del. Ch. Apr. 5, 2017). While acknowledging that the awards were “quite large,” the Court of Chancery rejected the plaintiffs’ argument that the Court should determine when limits set by a compensation plan are “meaningful,” stating that such a test “would propel the court into a position where it was second-guessing the informed decision of stockholders to approve compensation for the company’s directors and officers.” Id. at *25 n.33. Where fully informed stockholders ratify director compensation, the complaint will be dismissed unless the plaintiffs can invoke “the vestigial waste exception [which] has long had little real-world relevance, because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.” Id. (quoting Singh v. Attenborough, 137 A.3d 151, 151-52 (Del. 2016)).
The Delaware Supreme Court disagreed with the Court of Chancery, finding it “reasonably conceivable” based on the allegations of the complaint that the directors breached their fiduciary duties. The plaintiffs alleged that the awards were excessive compared to those made at peer companies and that, although the proxy statement suggested that the awards were to be made prospectively, the board made the awards based on past performance that had already been compensated. Based on those allegations, the Delaware Supreme Court found that the complaint stated a claim “that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves” and concluded “[b]ecause the stockholders did not ratify the specific awards the directors made under the [equity compensation plan], the directors must demonstrate the fairness of the awards to the Company.”
After Investors Bancorp, it is not sufficient that a stockholder-ratified plan sets “meaningful limits” or that it contains limits specific to outside directors. For directors to avoid entire-fairness review, stockholders must either ratify the “specific awards” or the awards must be made under “self-executing plans, meaning plans that make awards over time based on fixed criteria, with the specific amounts and terms approved by stockholders.” To avoid entire fairness review, either the specific amounts must be approved or the plan must leave no discretion to the directors in making awards.
Comment from my partner Mike Halloran:
“It should not be suggested that stockholder approval or ratification of compensation paid to directors is either commonplace or necessary, because it is not. I recommend that, as directors cannot now rely on general wording to describe director compensation in compensation plans, they should be careful to consider appropriate information, such as compensation paid to directors of comparable companies, when approving compensation for themselves, to avoid the risk of having it reversed in an entire fairness trial.”
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.
