Preparing for Challenges to Director Equity Compensation

One of the most difficult fiduciary issues facing boards is director compensation, since it is essentially and unavoidably a self-dealing transaction. The trend in recent years has been to increase the amount and proportion of director compensation that is comprised of equity. However, director stock compensation has also developed as a new frontier in stockholder litigation, and in response to successful challenges from stockholders to equity pay that has been viewed as excessive, several companies have been forced to modify director pay practices, including Facebook.

When challenged, board decisions are usually entitled to the protection of the business judgment rule, and will be dismissed unless the stockholder challenger can produce evidence of director bad faith or gross negligence. However, because directors have an interest in their decision as to their own compensation, business judgment protection is unavailable, and the burden is placed on the board to demonstrate that the award of compensation was fair, which means that stockholder challenges will rarely be dismissed at the pleadings stage.

Recent Delaware court decisions have provided important guidance for companies in terms of structuring equity compensation programs for directors. Directors can avail themselves of the protection of the business judgment rule, and challenges to director equity compensation will be dismissed under Delaware law, if disinterested stockholders have approved the payment of equity compensation for directors based on a fully informed and uncoerced vote. If the business judgment rule applies, a board’s decision as to its own compensation will be upheld if it can be attributed to any rational business purpose. As these court decisions further explain, however, not all stockholder approval is of equal effect.

In the 2014 lawsuit Calma v. Templeton, the board of software company Citrix Systems had annually awarded directors individual equity compensation of $250,000 to $350,000, in addition to annual cash compensation, over a multi-year period in accordance with the terms of a stockholder-approved equity plan. The equity plan allowed directors to participate in a plan to distribute up to 16 million shares as options, restricted stock awards, or restricted stock units (RSUs), of which up to 11 million shares could be awarded as RSUs, and authorized the compensation committee at its discretion to make all determinations with respect to awards granted, including to directors. The only limitation contained in the plan as to individual awards related to IRC Section 162m, and provided that no individual could receive more than 1 million shares in any one calendar year. The limit had an aggregate value of $55 million at the time of the litigation. The plaintiff claimed that the stock compensation paid to the directors, when combined with the annual cash compensation, was excessive, in breach of the board’s fiduciary duties. The Delaware Chancery Court declined to apply the business judgment rule and dismiss the stockholder challenge based on stockholder approval of the plan because the plan did not include any meaningful limit “bearing specifically on the magnitude of compensation to be paid” to the non-employee directors. The generic individual limit was insufficient for this purpose. The company settled the case, imposed annual dollar limits on the value of equity that annually could be granted to directors, and agreed to pay up to $425,000 to plaintiff’s counsel.

In another case, the Delaware Chancery Court this year dismissed a challenge to equity awards made to directors at Short Hills, New Jersey-based Investors Bancorp, which the court acknowledged were “quite large,” but which were made in accordance with the terms of the stockholder approved plan that included director-specific limits. Following stockholder approval of a stock benefit plan, the board of directors of the $23 billion asset Investors Bancorp had granted stock options and restricted stock awards to directors having an aggregate grant date value of approximately $2 million, which vested predominantly over a five-year period. The court noted that the compensation committee followed a diligent process involving four meetings and included input from an independent compensation consultant. The plan allowed for up to 30 million shares to be granted to officers, employees and directors. Of these shares, up to 17 million could be granted as stock options, and up to 13 million shares could be granted as restricted stock awards and RSUs. Importantly, the plan stipulated that no more than 30 percent of the shares reserved for issuance as stock options or restricted stock awards could be granted to outside directors, all of which could be granted in any one year. The court noted that this limit was unlike the “generic” limit for all beneficiaries found in the Citrix case, and that the plan meaningfully informed stockholders of the magnitude of the stock compensation that could be granted to directors.