The Delaware Supreme Court delivered an early holiday gift to the plaintiffs' bar with its recent opinion reversing the Court of Chancery's decision in In Re Investors Bancorp, Inc. Stockholder Litigation. This decision, the first Delaware high court opinion to review the "meaningful limits" doctrine articulated by Chancery decisions reviewing director compensation, muddies the seemingly clear water relied upon by boards of directors in determining their compensation.
Historically, the Delaware courts have recognized that although a board of directors is statutorily authorized to set its own compensation, that act remains an interested director transaction that involves self-interest. Accordingly, director compensation decisions are potentially reviewable under the exacting entire fairness standard rather than the nearly outcome determinative business judgment rule standard. Numerous Chancery Court decisions have recognized, however, that if a director compensation decision is ratified by the fully informed, uncoerced approval of a majority of the disinterested stockholders, then the "ratification defense" will be available at the motion to dismiss stage of a suit challenging the compensation.
The ratification defense has been applied in a variety of situations involving director compensation, including where stockholders have ratified specific awards, ratified compensation plans containing nondiscretionary provisions such as specific formulas that are self-executing or ratified plans that provide the directors with discretion to fashion their own awards but contain "meaningful limits" on those awards. The Investors Bancorp equity plan at issue (Plan), was a discretionary plan, but contained a "meaningful limit" that provided that awards to the directors could not exceed 30 percent of the total Plan shares. The Plan had been approved by the company's stockholders.
Relying, it appears, on the ratification defense doctrine, the Investors Bancorp board awarded itself significant equity awards in the wake of its successful conversion from mutual ownership to publicly traded stock corporation form. These special grants, which were about 83 percent of the Plan limit, averaged $2.16 million per director or approximately 16.2 times more than the prior year compensation package. Disclosure of the awards was met by three separate stockholder derivative actions, later consolidated into a single action. The defendants moved to dismiss the complaint asserting the ratification defense, among other things.1 The Chancery Court granted the motion citing prior Delaware precedent that accepted the ratification defense on the basis that the Plan's director-specific limit of 30 percent of available Plan shares satisfied the "meaningful limits" test. The Chancery Court distinguished the Plan's specific limit on awards to directors from those in other cases where the plans had only generic limitations on awards to all potential participants, including directors.
On appeal, the Delaware Supreme Court, by unanimous opinion, reversed the lower court's decision. The court's opinion noted that ratification of specific awards or nondiscretionary formula plans presented few issues but that discretionary plans create "difficulties" in the context of existing precedent regarding stockholder ratification. Noting that the "meaningful limits" doctrine was an effort to harmonize the decisions, the Supreme Court nevertheless held that where directors exercise discretion, "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. . . . Given that the actual awards are self-interested decisions not approved by the stockholders, if the directors acted inequitably when making the awards, their 'inequitable action does not become permissible simply because it is legally possible under the general authority granted by the stockholders.' " As the Supreme Court noted, when directors exercise discretion, it is "twice tested," first by the law and second by equity.
The Supreme Court further found that the plaintiffs had raised a pleading stage reasonable inference that the Investors Bancorp directors had breached their fiduciary duties in making unfair and excessive discretionary awards to themselves even though the awards were within the limits under the stockholder approved Plan. Moreover, because the stockholders had not ratified the specific awards, the directors had the burden of demonstrating the fairness of the awards to the Company. The Justices apparently took into account not only the size of the awards but also the disclosure in the proxy statement pursuant to which the Plan was approved by the stockholders to the effect that the Plan was intended to award future performance. The challenged grants, however, were ostensibly approved to reward past performance in connection with the mutual to stock corporation conversion.
Notably, the opinion did not address whether the limits on director awards in the Plan failed to constitute "meaningful limits" nor does the decision expressly reject the application of the ratification defense to a stockholder approved discretionary plan containing meaningful limits. As a result, a pall of uncertainty over that line of cases now exists. On its face, however, the opinion at a minimum appears to stand for the simple proposition that despite stockholder ratification, discretionary awards must be fair to the Company and directors cannot assume that all awards that fall within the limit of their discretion will be free from scrutiny. In addition, the case indicates that a corporation must be careful in its description of a compensation plan's purposes when seeking stockholder approval, as well as, the alignment of awards granted relative to that disclosure.
The Investors Bancorp decision raises the stakes when directors award themselves other than ordinary course amounts of compensation. Given the lack of clarity on the "meaningful limits" doctrine, it is now insufficient simply to ensure that discretionary director compensation plans have limits that are more restrictive than the total number of shares that are available under the plan. The decision suggests that under the right circumstances, almost any quantum of compensation is reviewable where stockholders have not approved the specific award or a self-executing formula plan. As a result, boards of directors considering significant compensation grants that are likely to draw plaintiff scrutiny would be well advised to build strong factual predicates regarding the fairness of the awards or consider subjecting the specific awards to stockholder approval. Unfortunately, given the Delaware Supreme Court's decision, almost any award under a discretionary plan is open to challenge and the stockholder plaintiffs' bar may seize upon this case as creating an opportunity to do just that.
1 The Court of Chancery also granted the motion to dismiss on the basis of the failure of the plaintiffs to make a demand on the board before filing their derivative action. The Supreme Court also reversed this aspect of the lower court's decision.
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