Last December, in In re Investors Bancorp Stockholder Litigation, C.A. No. 12327-VCS (Del. Dec. 19, 2017), the Delaware Supreme Court revived concerns about how boards set their own compensation. For years, boards and their advisers have sought to manage the inevitable conflict that arises when directors approve their own compensation. Although the corporation laws of both Delaware and Pennsylvania give boards the authority to set their own compensation (Delaware Gen. Corp. Law Section 144(h). Pa. Business Corp. Law Section 1730) this statutory grant of authority does not eliminate this inevitable conflict between the directors’ own interests and that of the corporation and its owners.
Until recently, many commentators believed that the Delaware Court of Chancery had solved this problem, but boards now have reason to reconsider their compensation plans. In several recent cases prior to Investor Bancorp, the Delaware Chancery Court had approved a process that appeared to adequately address this conflict, at least with respect to equity compensation such as stock options and restricted stock units, see, e.g., Calma v. Templeton, C.A. No. 9579-CB (Del. Ch. April 30, 2015); Seinfeld v. Slager, C.A. No. 6462-VCG (Del. Ch. June 29, 2012). As was described in the 2015 case, Calma v. Templeton, and the 2012 case, Seinfeld v. Slager, most public companies, as required by the NYSE and NASDAQ rules (as well as for other reasons), submit their officers’ equity compensation plans for stockholder approval. These plans often also include provisions for director equity compensation and general parameters that govern the amount of compensation. As such, in cases where plaintiffs claimed that the directors’ had breached their fiduciary duties in approving their own compensation, the Chancery Court focused on whether the plans contained general parameters or “meaningful limits.” The Chancery Court reasoned that breach of the duty of loyalty challenges to these plans could be defeated by stockholder approval of the plans. As long as the stockholder-approved plan included “meaningful limits” on director compensation, even if the “meaningful limits” were quite broad, such stockholder approval constituted ratification of the board action. The Delaware Supreme Court, however, changed this approach in Investors Bancorp.
In Investors Bancorp, stockholders brought a derivative suit against the company’s board for a breach of the directors’ duty of loyalty, alleging that the directors had awarded themselves excessive compensation. Relying on the existing chancery court cases, the directors raised the stockholder ratification defense. They argued that the stockholders had both approved the equity plan and ratified the “meaningful limits” applicable to director compensation. These limits, however, were not very restrictive—the directors could allocate up to 30 percent of all option or restricted stock available under the entire plan to themselves. According to the stockholders’ complaint, the total value of the awards to the directors was almost $52 million, and certain directors’ individual awards were over 2,500 percent higher than the average awards at peer companies.
The court reviewed the approach taken in the earlier cases and held that stockholder ratification applies only where the stockholders have specifically approved the board action. It is not enough for the stockholders merely to authorize the directors to use their discretion within a broad range, as approved by the stockholders, to determine their own compensation. Instead, the ratification defense would only be available if the stockholders had approved the specific amount of director compensation or the formula for determining compensation, leaving no discretion to the board as to the amount. The court held that if the board retains discretion in setting its own compensation, even within parameters approved by the stockholders, the compensation decision will be subject to entire fairness review. Entire fairness review has both procedural and substantive components. Specifically, directors have the burden of proving both fair dealing and fair price, and this standard requires objective fairness. Under entire fairness review, directors effectively must show that both the process used to set their compensation, and the actual amounts approved, were entirely fair to the corporation. As the court observed, although the stockholders “granted the directors the authority to make awards,” the directors must still “exercise … that authority … consistent[ly] with their fiduciary duties.”
In Pennsylvania, this problem is compounded. To start, the Pennsylvania Business Corporation Law (the “BCL”) Section 1730, which authorizes boards to fix their own compensation, does not establish a standard of review for evaluating these compensation decisions. Moreover, there is limited Pennsylvania case law on this issue. A 1950 Pennsylvania Supreme Court case, Hornsby v. Lohmeyer, merely explained that directors may not award themselves “compensation which is excessive, unreasonable and out of proportion to the value of the services rendered.” A 1958 Pennsylvania Supreme Court case, Chambers v. Beaver-Advance, McGrew and Morris, 140 A.2d 808, 811 (Pa. 1958), emphasized that shareholders can ratify board action, including board compensation, as long as the compensation does not “dissipate or waste [the corporation’s] funds.” But what exactly constitutes “excessive” compensation? And how, if at all, should courts review compensation decisions? These questions raise duty of loyalty issues, and Pennsylvania courts and practitioners frequently turn to Delaware case law for duty of loyalty guidance, see Potok v. Rebh, 2014 Phila. Ct. Com. Pl. LEXIS 318, at *54-*60 (discussing the entire fairness standard). As such, both Pennsylvania and Delaware corporate boards should pay close attention to Investors Bancorp.
After this case, more shareholders may bring derivative suits challenging director compensation as a breach of the directors’ duty of loyalty. Accordingly, boards should be prepared to demonstrate the entire fairness of compensation plans where directors retain discretion in setting their own compensation. This preparation should, among other things, require boards to undertake a thoughtful, careful, and well-documented process because courts will typically focus first on the adequacy and fairness of the process used. Specifically, boards should consider who their compensation consultants are, how they selected the consultants, and whether the consultants do other business with the corporation or are truly independent and disinterested. Boards should also pay attention to the guidelines given to the consultants, the time spent deliberating over the compensation, and the peer companies chosen for comparative purposes. The Investors Bancorp Court paid close attention to peer companies, observing that the directors’ compensation at issue was much greater than that of many peer companies. There, the board, after first considering director compensation at 164 companies that had (like Investors Bancorp) undergone a mutual-to-stock conversion, relied upon its consultant’s analysis of a much smaller group of those companies. This smaller sample was chosen based on the size of the company, the size of the equity sold in the second step offering, and the size of the equity plan itself. The plaintiffs alleged that the first two criteria were arbitrary and the third “driven by self-selection bias” and that as a consequence the compensation “far surpassed” the median compensation at both “similarly sized” and “much larger” companies.
In Pennsylvania, derivative suits challenging these compensation plans for breach of the duty of loyalty often never make it to the court. Under BCL Section 1783, shareholders must first make a demand on the board, which in turn can appoint a special litigation committee to review the claim. Often, the decisions of these special litigation committees will then foreclose the derivative suit. Nevertheless, Pennsylvania boards should have a thorough and well-documented process in place in case their judgement is challenged and reviewed by a judge.
Additionally, Pennsylvania corporate boards have another reason to pay careful attention to how Investors Bancorp narrowed the shareholder ratification defense. BCL Section 1728, which is almost identical to the corresponding interested director provision of the Delaware General Corporation Law, appears to provide something similar to Delaware’s stockholder ratification defense. Specifically, BCL Section 1728 states that self-interested actions will not be void if “the material facts as to [the] relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon and the contract or transaction is specifically approved in good faith by vote of those shareholders,” Pa. Business Corp. Law Section 1728 (2018). Unlike a derivative suit, however, a special litigation committee does not first review a direct claim, and the lack of a special litigation committee to foreclose a demand leaves the board more vulnerable. Accordingly, boards can expect that shareholders will point to Investors Bancorp and argue that the stockholder approval under Section 1728 is limited to the narrow circumstances described in that case. Compensation plans that continue to grant directors broad discretion in setting their pay may then be subject to possible invalidation under BCL Section 1728 as well as breach of fiduciary duty claims.
After Investors Bancorp, corporate boards should anticipate the possibility of greater scrutiny if shareholders challenge their director compensation awards. With a little forethought and preparation, most boards should be able to satisfy these new standards. Doing so will be in the directors’ best (and self) interests.
Douglas Raymond III is a partner at Drinker Biddle & Reath. As a member of the firm’s corporate and securities group, he advises clients on mergers and acquisitions, securities offerings and joint ventures. He can be contacted at firstname.lastname@example.org.
Ashlee A. Paxton-Turner is an associate at the firm. She is a member of the firm’s corporate and securities group and can be contacted at email@example.com.