Delaware Court Rules Against Directors In Challenge To Director Equity Awards; Is There Good News Here?
Directors of public company boards set their own compensation, which has long been a source of concern for shareholders. A recent Delaware Chancery Court (the “court”) ruling casts new light on how directors can fulfill their fiduciary duties when setting their own pay.
Unlike in prior cases, in Seinfeld v. Slager1 the court refused to apply the “business judgment rule” to dismiss a challenge to directors who had approved large equity awards for themselves under a shareholder-approved plan. In the early stages of the litigation, the court refused to dismiss the shareholder’s claim under the business judgment rule given that the shareholder-approved equity plan did not impose “meaningful limits” on the maximum size of an award that could be made to a director. The court focused less on the actual size of the challenged awards and more on the almost unlimited size of the awards that could be made under the shareholder-approved equity plan.
Although the court denied the directors’ motion to dismiss, we believe that the guidance from this decision will benefit public company directors. The decision will likely lead to additional limits on director equity awards in shareholder-approved equity plans, which will better protect director pay decisions from shareholder legal challenges. Such director-award limits in plans can still be relatively high, and so ultimately should not place tight constraints on boards as they grant director equity awards. Although Seinfeld directly applies only to directors of Delaware corporations, the Delaware court is often seen as a leading court on corporate governance issues.
Basic Facts of Seinfeld v. Slager
In Seinfeld v. Slager, a shareholder challenged large equity grants to non-employee directors of Republic Services, Inc. (“RSG”), a Fortune 500 company in the waste hauling business. The RSG board approved grants of restricted stock units (“RSUs”) to each non-employee director with a grant-date value of $743,700 in 2009 and $215,000 in 2010 (total compensation per director ranged from $843,000 to $891,000 in 2009 and from $320,000 to $345,000 in 2010). All members of the RSG board were non-employee directors except for the chief executive officer.
The total RSG director compensation was, in 2009, more than 3.6 times the median compensation levels among the top 200 US companies (based on the director compensation survey completed annually by Steven Hall & Partners) and, in 2010, was 1.3 times the median level.
Business Judgment Rule Refresher
What are a Director’s Fiduciary Duties?
The business judgment rule is based upon a director’s two fundamental fiduciary duties under Delaware corporation law:
- Duty of Loyalty – requires the director not to unfairly favor his or her own interests over the interests of the corporation
- Duty of Care – requires the director to act with diligence and prudence
Shareholders can ask a Delaware court to intercede to prevent a breach of these fiduciary duties or to hold directors liable for damages for not fulfilling these duties.
When can a Director Rely on Protection under the Business Judgment Rule?
Every director should understand the “business judgment rule.” In simple terms, the rule is that a court will not interfere with a decision of the board of directors, even if the court believes that the board’s decision was a bad one, if:
- Directors did not act based on “self-interest” (i.e., did not breach their duty of loyalty); and
- Directors acted in good faith and gathered adequate information on which to base a decision (i.e., they fulfilled their duty of care)
Even if Some Directors are Self-Interested, Can the Business Judgment Rule Apply?
Yes. Even if one or more directors are found to be “self-interested”, the court will still not interfere with the board’s decision if it was:
- Approved by a board majority made up of directors who had no interest in the decision or transaction and were aware of the relevant facts;
- Approved by the shareholders; or
- “Entirely fair” to the company
In shareholder litigation, the time for proving that the decision met one of these tests is critical. Approval by disinterested directors or by shareholders can be established at the time of a motion to dismiss a shareholder action, which is to say at an early stage of litigation. If the directors have to rely on “entire fairness,” that can only be proven at a later stage of the litigation, after intrusive discovery, mounting legal fees and the bad publicity resulting from the lawsuit.
Why Didn’t the Business Judgment Rule Protect Directors Here?
In Seinfeld v. Slager, the RSG directors asked the court to apply the business judgment rule and dismiss the shareholder’s claim that the directors granted themselves excessive compensation. The shareholder argued that the directors’ approval of their large equity awards was, inherently, a “self-interested” transaction. Conceding this, the defendant directors argued that the prior shareholder approval of RSG’s 2007 Stock Incentive Plan was sufficient to confer the protection of the business judgment rule on the board’s 2009 and 2010 discretionary grants under the plan. A 1999 case, In re 3COM Shareholders Litigation, seemed to support the directors’ argument.
But in this case, the Seinfeld court made an important distinction. In 3COM, the court had concluded that business judgment rule protection applied under a shareholder-approved plan with “sufficiently defined terms.” That court noted that “[3COM] shareholders knowingly set the parameters of the [equity] Plan, approved it in advance, and the directors implemented the Plan according to its terms.” Unlike in 3COM, the Seinfeld court found that the RSG plan lacked sufficiently defined terms limiting the permissible size of equity awards to directors. The RSG plan authorized up to 10.5 million shares for equity awards, with annual grants of restricted stock and RSUs to any one person capped at 1.25 million shares. The Seinfeld court pointed out that the RSG plan’s cap would have allowed a grant of RSUs to each non-employee director with a grant-date value of $21.7 million. In view of the potential for such large equity awards, the court concluded that, despite the shareholder approval of the RSG plan, there was effectively no limit on the board’s discretion. Therefore, shareholder approval of the RSG plan did not confer the “blessing of the business judgment rule” on the RSG directors, so the litigation could not be dismissed on that basis. (If the litigation proceeds to trial, the directors might still prevail if they can show that the equity awards were “entirely fair” to the corporation.)
Following this Decision, How Strict Must Limits Be on Director Equity Awards?
Seinfeld and 3COM, read together, give us some answers. We now know that the approved RSG plan, which set a per-participant maximum of 1.25 million shares for the challenged equity grants (allowing grants with a value exceeding $21 million), was insufficient to limit a board’s discretion.
Reviewing 3COM’s proxy statement and Form 10-K from 1999, we discover that the limits in its shareholder-approved plan were much higher than the actual level of grants to directors. Under the approved 3COM plan, a director could receive annual awards of up to 60,000 options (estimated fair value of $897,000 using 3COM’s 1999 Black-Scholes values), plus 20,000 options for service as Chairman of the Board (estimated fair value of $299,000), plus 24,000 options for service on a board committee (estimated fair value of $358,800). The actual 3COM option grants to directors ranged from 30,000 to 45,000 per year.
If a plan were to set a limit on director equity awards equal to the dollar value of the basic 3COM option limit – approximately $897,000 at the time 3COM shareholders approved it – that limit would be nearly seven times the median 2011 director equity grant for top 200 US companies (based on the director compensation survey completed annually by Steven Hall & Partners). Not surprisingly, no top 200 US company made equity grants in 2011 to directors that even came near that amount. Ironically, had the RSG plan itself imposed grant limits at the levels found in the 3COM plan, the RSG board would have been able to grant its 2009 RSUs valued at $743,700 and, presumably, still have been protected by the business judgment rule.
Although the defendant directors lost in Seinfeld, we see mostly good news in it. Seinfeld shows that directors of a Delaware corporation can gain valuable protection under the business judgment rule for their discretionary decisions in granting equity awards to directors, through shareholder approval of well-drafted plans. It is fair to say that, before Seinfeld, the availability of this protection was not widely known. Even for companies incorporated in states other than Delaware, it is possible that business judgment rule protection may apply if shareholders approve meaningful limits on director equity awards.
We recommend that plans authorizing equity awards to directors in the discretion of the board or a board committee include limits on equity awards grantable to each non-employee director, so that shareholder approval will confer the protection of the business judgment rule. Based on the fact that the Delaware courts found the 3COM limits acceptable, as a rule of thumb the director award limits should be no higher than the award-limit values under the 3COM plan. Company boards will need to decide whether these limits should be set as a cap on the number of awards or on the dollar value of awards, and whether company size, prevailing director compensation levels in a particular industry or shareholder views on the company’s compensation program would dictate setting limits that may be higher or lower than the values that appear to be permissible under 3COM. The Delaware cases indicate that plan award limits can be high enough that boards will retain substantial discretion in granting equity compensation to directors.
Fortunately, because shareholder legal challenges to director compensation are somewhat rare, companies with equity plans that currently do not “sufficiently define” limits probably can wait to add such limits until the next time shareholder approval of a plan or plan amendment is needed.
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About Steven Hall & Partners
Steven Hall & Partners is an independent compensation consulting firm, specializing exclusively in the areas of executive compensation, board remuneration, non-profit compensation and related governance issues. By focusing solely on this critical and complex segment of the human resources arena, we are able to provide our clients with the highest quality expertise and best counsel available on a practical basis. For more information, please visit www.shallpartners.com and follow us on Twitter @SHallPartners.
Contacting Steven Hall & Partners
This publication is provided by SH&P as a service to clients and colleagues. The information contained in this publication should not be construed as legal, tax or accounting advice. We can assist in developing effective equity award plans and setting key terms. Please call any of our consulting staff listed below, or any member of our staff with whom you have consulted in the past. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Kathie Mulroe (212-488-5400; firstname.lastname@example.org).
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1 Seinfeld v. Slager, C.A. No. 6462-VCG (Del. Ch. June 29, 2012) (Glasscock, V.C.).