On December 13, 2017, in Re Investors Bancorp, Inc. Stockholder Litigation (“Bancorp”), the Supreme Court of Delaware held that when stockholders have approved an equity incentive plan that gives the directors discretion to grant themselves awards within a shareholder approved plan limit, and a stockholder properly alleges that the directors improperly exercised that discretion, then the stockholder ratification defense is unavailable to dismiss the suit, and the directors will be required to prove the entire fairness of the awards to the corporation. The Bancorp case involved a generous shareholder approved plan limit and upholds the adage that bad facts make bad law.
In Bancorp, the company’s stockholders approved an equity plan for employees and directors that gave Bancorp Inc.’s board of directors discretion to allocate up to 30% of all option or restricted stock shares available under the plan as awards to themselves. After stockholders approved the equity plan, the board approved grants to themselves of just under half of the stock options available to the directors and nearly thirty percent of the shares available to the directors as restricted stock awards.
Each director’s grant far surpassed the median pay at similarly sized companies and the median pay at much larger companies. The awards were also over twenty-three times more than the median award granted to other companies’ non-employee directors after mutual-to-stock conversions. The court determined that the plaintiffs alleged facts that the directors breached their fiduciary duties by awarding excessive equity awards to themselves under the equity plan and that a stockholder ratification defense was not available for a motion to dismiss.
The upshot of the Bancorp decision is that if a plaintiff alleges “facts leading to a pleading stage reasonable inference that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves after stockholder approval of the [equity plan],” then the defendant independent directors will not prevail on a motion to dismiss.
In addition, the court in Bancorp held that companies can only receive the benefit of the business judgment rule at the pleading stage in instances where stockholders approved the specific director awards or where the equity plan is “self-executing, meaning the directors had no discretion when making the awards.” This represents a departure from prior case law holding that a meaningful stockholder approved limit, within which directors could exercise discretion in making awards to themselves, was sufficient to avail the directors of the business judgment rule.
Whether the Supreme Court’s opinion extends to director compensation decisions other than equity grants is not addressed by the case. However, based on earlier cases treating challenges to director equity and cash compensation in the same manner, we would also expect the courts to deny the stockholder ratification defense in cash compensation cases where the directors retained discretion in making cash awards to themselves.
What Should Companies Do
In our prior Alert on director compensation litigation, consistent with the cases up to that point, we recommended that clients have shareholders approve meaningful limits on the amount of equity and cash that directors may pay themselves each year. The Bancorp case now suggests that this may not be enough, particularly for companies that are at higher risk for challenges to their director pay (i.e., where director pay is substantially higher than director pay at peer companies). Accordingly, companies that (i) are at risk based on their levels of director pay, (ii) are contemplating materially increasing director pay or (iii) desire more generally to eliminate risk in this area should carefully follow post-Bancorp litigation of this issue and consider adopting shareholder approved “formula plans” where the annual amounts of cash and equity compensation are fixed and automatic.
Regardless of how a company decides to go forward with director pay, all companies should provide enhanced director compensation disclosure in their proxy statements to show that their director compensation practices are reasonable. Such disclosure should describe:
- The company’s director compensation philosophy;
- The process used to determine director compensation, including the role and analysis of the compensation consultant;
- How director compensation compares to peers;
- The rationale behind director compensation decisions and each element of director compensation; and
- Whether directors are subject to any stock ownership guidelines.
Such disclosure should also be included in any proposal approving the company’s director compensation program.