Delaware Supreme Court Narrows the Stockholder Ratification Defense for Director Self-Compensation Decisions
The Delaware Supreme Court has refined Delaware law regarding shareholder ratification of director self-compensation plans for the first time in more than 60 years. In In re Investors Bancorp, Inc. Stockholder Litigation, CA No. 12327-VCS (Investors Bancorp), decided on December 13, 2017, the court ruled that when directors make discretionary equity awards to themselves under the general parameters of a stockholder approved equity incentive plan (EIP), the stockholder ratification defense is unavailable to dismiss a properly alleged suit against said directors for improperly exercising their discretion. Instead the directors will have to demonstrate that their self-interested actions were entirely fair to the company. 1
Prior to Investors Bancorp, Delaware courts recognized a stockholder ratification defense for stockholder-approved EIPs in three situations—when stockholders approve the specific director awards, when the plan was self-executing, or when directors exercised discretion and determined the amounts and terms of the awards after stockholder approval. While the defense remains available in the first two situations post-Investors Bancorp, the court has severely limited the availability of the defense in the third.
Overview of Delaware Case Law on Ratification Defense for Director Compensation
The Delaware Supreme Court first recognized a ratification defense by directors when reviewing self-compensation decisions in the 1952 decision Kerbs v. California Eastern Airways, Inc., 90 A.2d 652.2 The stock option plan at issue in Kerbs was self-executing, meaning the directors had no discretion in implementing the awards once they were approved by the stockholders. The court held that the stockholder ratification cured any voidable defect in the actions of the board in that case. Therefore the awards would be judged by the more lenient business judgment rule, instead of the stricter entire fairness test. The next day, the court decided the case Gottlieb v. Heyden Chemical Corp., 90 A.2d 660, where, prior to ratification of a stock option plan, the board disclosed to the stockholders the names of the officers receiving the awards, the number of shares and the price per share.3 The stockholders approved the plan. The court held that, in this situation, stockholder ratification shifted the burden of proof to the objectors, and that the decision by the board of directors would be subject to the business judgment rule.
While Gottlieb was the last case in which the Delaware Supreme Court considered ratification of director self-compensation decisions, the Court of Chancery continued to develop this area of law. In In re 3COM Corp. Shareholders Litigation, C.A. No. 16721, 1999 WL 1009210, and Criden vs. Steinberg, C.A. No. 17082, 2000 WL 354390, the Court of Chancery recognized the ratification defense when the plans approved by the stockholders set upper limits on the amounts to be awarded, but gave directors discretion to decide the specific awards or change conditions of the awards after shareholder approval. 4
However, in Sample v. Morgan, 914 A.2d 647, the Court of Chancery refused to recognize the ratification defense when non-employee directors awarded shares to the company's employee directors under a management stock incentive plan.[[(Del. Ch. 2007)]] The plan in Sample authorized up to 200,000 shares, but had no further limits on how the shares should be awarded. The court saw the authorization of the plan as "a decision by the stockholders to give the directors broad legal authority," but said that the stockholders could still rely on the policing of equity to ensure that authority would be used properly. Finally, in Seinfeld v. Slager, C.A. No. 6462-VCG, 2012 WL 2501105 the Court of Chancery ruled that directors could retain their discretion to make awards after stockholder plan approval, but "the plan had to contain meaningful limits on the awards the directors could make to themselves before ratification could be successfully asserted." 5
Following the completion of a second-step mutual-to-stock conversion in 2014, the directors of Investors Bancorp, Inc. (Company) submitted an EIP for approval by the stockholders. The EIP reserved 30,881,296 common shares for different types of awards for the Company's 1,800 officers, employees, non-employee directors and service providers. The EIP set limits on the number of shares that could be awarded in each category, and further broke down the limits for employee and non-employee directors. In the proxy sent to stockholders, the Company stated that the "number, types and terms of awards to be made pursuant to the [EIP] are subject to the discretion of the Committee…and will not be determined until subsequent to stockholder approval." The EIP was approved by 96.25% of the voting shares at the 2015 annual meeting.
Following approval of the EIP, the Compensation and Benefits Committee (Committee) began meeting with a compensation consultant and outside counsel to begin to determine the allocation of shares. In these meetings, the Committee considered the awards granted by other companies that underwent mutual-to-stock conversions in the last 20 years. After four meetings, the entire board approved equity awards to each of the directors, including the Chief Executive Officer and the Chief Operating Officer. As the Investors Bancorp second step conversion involved one of the largest common stock offerings in US history for such a transaction, the awards granted significantly exceeded the average for awards granted to directors of converting thrift institutions.
After the awards were disclosed, stockholders filed three separate suits, later consolidated in the Court of Chancery, alleging breach of fiduciary duty by the directors for awarding themselves excessive compensation. The defendants moved to dismiss for failure to state a claim and for failure to make a demand. The Court of Chancery granted both motions and dismissed the complaint because the EIP contained "meaningful, specific awards to all director beneficiaries." The court also dismissed claims directed to the executive directors because the plaintiffs failed to make a pre-suit demand on the board.
Delaware Supreme Court's Decision
In reversing the Court of Chancery, the Delaware Supreme Court disagreed with the Court of Chancery's previous decisions that permitted the ratification defense when directors retained discretion to make awards under an EIP as long as there are "meaningful limits." According to the court, "when it comes to the discretion directors exercise following stockholder approval of an equity incentive plan, ratification cannot be used to foreclose the Court of Chancery from reviewing those further discretionary actions when a breach of fiduciary duty claim has been properly alleged."
According to the court, stockholders have granted directors the legal authority to make the awards, but exercise of that authority by directors must be done consistent with their fiduciary duties. Finally, the court held that "when a stockholder properly alleges that the directors breached their fiduciary duties when exercising their discretion after stockholders approve the general parameters of an [EIP], the directors should have to demonstrate that their self-interested actions were entirely fair to the company."
The court also reversed the Court of Chancery's dismissal for failure to make a pre-suit demand, stating that demand was futile because "it is implausible to us that the non-employee directors could independently consider a demand when to do so would require those directors to call into questions the grants they made to themselves."
What is the status of the stockholder ratification defense post-Investors Bancorp?
The stockholder ratification defense remains available in cases where the stockholders approved the specific director awards or when the plan is self-executing. In these situations, the awards will be judged under the more lenient business judgment rule. However, when directors exercise discretion and determine the amounts and terms of awards following stockholder approval, the ratification defense will no longer be available and the directors will be required to show that the awards were entirely fair to the Company.
What should companies do?
The Investors Bancorp case is a clear invitation to plaintiff's class action attorneys to pursue lawsuits against public companies that have adopted director equity plans providing for future discretionary grants. Compensation Committees of such companies should consult with counsel as to whether to continue such plans or replace them with self-executing or "formula plans", where the amounts and terms of the future grants are fixed or are the subject of a clear formula. For companies that wish to retain discretionary grant plans, compensation committees should re-evaluate with counsel their procedures for determining future grants. Such evaluation may benefit from the use of independent counsel to help defend a challenge under the new standards set forth in Investors Bancorp.
*Tyler Fink contributed to this Advisory. Mr. Fink is a graduate of Washington University School of Law and is employed at Arnold & Porter Kaye Scholer LLP's New York office. Mr. Fink is not admitted to the practice of law in New York.
© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. NOTICE: ADVERTISING MATERIAL. Results depend upon a variety of factors unique to each matter. Prior results do not guarantee or predict a similar results in any future matter undertaken by the lawyer.