Director compensation litigation
August 2014 | PROFESSIONAL INSIGHT | BOARDROOM INTELLIGENCE
Financier Worldwide Magazine
Litigation trends suggest that public company boards of directors should consider having their non-employee director cash and equity fee arrangements approved routinely by shareholders. Illustrating the risks, in a June 2014 decision challenging cash and equity fees paid to non-employee directors of Unilife Corporation, the Delaware Chancery Court held that pre-suit demand was excused and permitted claims related to cash fees paid to non-employee directors to proceed, resulting in the company having the burden to demonstrate the fairness to the company of the amount of fees paid. Claims related to the equity awards were dismissed because they were made subject to shareholder approval.
The Unilife case follows a decision in June of 2012, in Seinfeld v Slager, in which the Chancery Court also took up the issue of director compensation. In that decision, the Chancery Court rejected a motion to dismiss a claim that director equity awards were excessive, even though they were approved by shareholders, because the Court held that the shareholder approval was not specific enough. In response to that case, a number of commentators concluded that companies should consider whether to seek shareholder approval of director compensation. At the time, we noted that the decision to obtain shareholder approval involves “a judgment about the trade-off between the greater legal certainty to be obtained through shareholder approval against the loss of flexibility such approval entails, which judgment would be made against an historical backdrop of few shareholder claims alleging excessive director compensation”. The new decision, in Cambridge Retirement System v. Unilife, together with the continued incidence of an historically high number of Delaware law fiduciary claims focused on executive compensation over the last few years, suggests that the balance has likely tipped in favour of shareholder approval.
Director compensation can be a factor in compensation litigation in two ways. First, and most simply, director compensation can be challenged as being excessive or otherwise inappropriate. That was the nature of each of the claims in Unilife. Second, director compensation can be a factor in connection with the issue of ‘demand futility’. Generally, when derivative claims are sought to be initiated by shareholders on behalf of a corporation, Delaware law requires that the plaintiffs first demand that the corporation’s board of directors bring the claims directly. If a majority of the directors are ‘disinterested’ in the claim, then their decision is subject to ‘business judgment rule’ protection, which means that the courts generally will not second guess their decision not to bring a claim. As discussed by the Chancery Court in Unilife, where the board decision being challenged is the directors’ decision to grant themselves compensation as directors, there is no materiality threshold in terms of the amount of compensation in respect of the demand futility issue. A director’s decision to grant her or himself cash or equity compensation is an interested party transaction. If there is not a disinterested majority, then demand is excused as futile, and the plaintiffs can bring the claims indirectly as derivative suits in the name of the corporation without obtaining board approval.
It is notable, in connection with the demand futility issue, that claims concerning director compensation are often accompanied by claims about excessive executive compensation, as was the case in Seinfeld and in Steiner v. Meyerson, a 1995 case concerning claims of excessive director compensation that was cited in the Unilife decision. However, the Chancery Court has been very clear over many years that demand futility is analysed on a claim-by-claim basis, so that if a single complaint contains claims alleging a breach of duty in respect of a decision to award director compensation as to which a majority of the directors are not disinterested and claims concerning executive compensation as to which a majority of the directors are disinterested, then demand is not excused for the executive compensation claims even if it might be excused for the director compensation claims. Moreover, the Chancery Court has been clear that the interest of a director in a decision must be direct, and not attenuated, indirect or contingent. In Unilife, for example, the Chancery Court noted a 1988 Delaware Supreme Court decision, in Grobow v Perot, which held that the interest of a director in the receipt of director’s fees alone, without more, did not render the director interested in a share repurchase from a major stockholder.
When demand is excused, directors have the burden of proving the fairness of their compensation under the ‘entire fairness’ doctrine. The doctrine requires consideration of all of the facts and circumstances related to the fairness of the compensation paid to directors. Those considerations might include – depending on the facts – how much directors of a company are paid compared to director compensation paid by peers and relative to the revenues of the company. The factual nature of the inquiry can result in a somewhat burdensome imposition on directors in the context of litigation discovery.
Soliciting shareholder approval of directors compensation does not necessarily mean that shareholders must be asked to approve the exact level of director compensation every year. Rather, shareholders can be asked to approve the grant of annual compensation up to an amount that, using the terminology of the Chancery Court in Seinfeld, represents “some meaningful limit imposed by the stockholders on the Board”, taking into account of course the likely shareholder reaction to the proposal. In this regard, a little historical background may be useful.
As discussed in Unilife, Delaware corporate law specifically provides that “[u]nless otherwise restricted by the certificate of incorporation or bylaws, the board of directors shall have the authority to fix the compensation of directors”. That provision, enacted in 1969, was adopted in response to earlier suggestions in Delaware cases that directors of Delaware corporations were not empowered by law to award themselves compensation for their services as directors. The New York Stock Exchange governance requirements also reflect an assumption that director compensation will be set by directors. Nevertheless, until 1996 there was a reason for companies to compensate directors pursuant to formulas dictating the limits of director equity awards, which formulas were frequently placed before shareholders for approval. That reason was based on an exemption from the short-swing profit disgorgement rules (Section 16) of the securities laws. The exemption permitted directors who received equity compensation from an issuer to approve grants to executives (in a way that made the executive grants exempt from matching for profit disgorgement purposes) if the director equity was paid pursuant to a ‘formula plan’. No similar history exists concerning the payment of director compensation in cash, but there do not appear to be substantial impediments to adopting a similar approach.
In sum, in light of the current overall regulatory and litigation environment, it is in our view prudent for companies to consider carefully whether to have their non-employee director cash and equity fee arrangements approved by shareholders. While director compensation has not received the same degree of public attention as executive compensation, recent cases have focused on claims concerning director compensation. The two recent cases discussed above, Seinfeld and Unilife, suggest perhaps the beginning of a trend in this regard. Many companies will, we suspect, wish to proactively avoid getting caught up in these issues.
Arthur H. Kohn is a partner at Cleary Gottlieb Steen & Hamilton LLP. He can be contacted on +1 (212) 225 2920 or by email: email@example.com.
© Financier Worldwide
Arthur H. Kohn
Cleary Gottlieb Steen & Hamilton