Non-employee director equity awards which are not specifically approved by shareholders or are awarded pursuant to a shareholder-approved and self-executing equity plan formula are “self-interested decisions” and will not have the protection of the business judgment rule if challenged in court, according to a new ruling by the Delaware Supreme Court. In In re Investors Bancorp, Inc. Stockholder Litigation the court overturned a lower level Delaware Court of Chancery decision which held that discretion granted to non-employee directors in an equity plan to approve awards to themselves was eligible for the protections of the business judgment rule so long as the plan was ratified by shareholders and had a "meaningful limit" on director compensation. In the case, shareholders of Investors Bancorp had approved the company’s equity plan which set a maximum number of shares which could be issued to all non-employee directors in the form of options and in the form of performance shares or restricted stock as well as an absolute total cap of 30% of all options or restricted stock available for director equity awards. Pursuant to the plan and the discretion afforded to the board, the directors approved equity awards to themselves having an aggregate value of over $51 million – $4.4 million for each of the 12 members of the board. Shareholders of the company sued alleging the award was unreasonable due to its excessive levels compared to its peers and constituted a breach of fiduciary duty. The Delaware Supreme Court agreed, determining that the compensation decisions were “self-interested” and not saved by the fact that shareholders had ratified the plan. According to the court, for the shareholder ratification defense to work, shareholders must be informed of what they are approving. In the case, shareholders approved giving the authority to directors to determine the equity awards but not the $51 million in grants. The lack of meaningful limits on the exercise of discretion – what the board could award themselves – was found to render the shareholder approval insufficient as a defense. Thus, the court ruled that the board’s compensation decisions were not eligible for business judgment protection and instead would be judged under the "entire fairness" doctrine. Under that doctrine, the company has the burden of proving that the compensation decisions were reasonable, and the fact that the awards were made for prior year performance, compared to future performance as disclosed in the proxy, were significantly higher than previous years' director awards and were also considerably higher than peers' director awards led the court to rule in plaintiffs' favor.
Even though this is a case in which the facts are outside the mainstream for most companies, the decision has implications on board processes and equity plan approval. First, the court is clear that non-employee director compensation decisions will deemed self-interested unless shareholder approve the specific award. This would appear not to include a range within which the directors have discretion to determine actual award amounts. Alternatively, non-employee director awards can be approved by shareholders and receive business judgment protections if the award is determined without any director discretion pursuant to a self-executing formula. There are some questions as to how this alternative approach would work in practice, given the role of the members of the compensation committee – non-employee directors – in designing the equity program.
More practically speaking, in lieu of rushing major design changes which remove the discretionary elements to director pay, the more important step is for companies to review the amount of director pay to ensure it is reasonable, especially compared to peer companies. The standard of review adopted by the Delaware Supreme Court in the case -- which will be applied to awards which involved director discretion--will require companies to explain why the award is reasonable and the process used to make that determination.