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In a recent decision by the Delaware Supreme Court in In re Investors Bancorp Stockholders Litigation, the court found that director equity grants based on director discretion are subject to an entire fairness standard of review irrespective of whether stockholders have previously approved the equity incentive plan.

According to the court, “when stockholders have approved an equity incentive plan that gives the directors discretion to grant themselves awards within general parameters, and a stockholder properly alleges that the directors inequitably exercised that discretion, then the ratification defense is unavailable to dismiss the suit, and the directors will be required to prove the fairness of the awards to the corporation.”

Accordingly, the Delaware Supreme Court reversed the Court of Chancery’s decision which found that the stockholder ratification defense applied because the plan provided for “meaningful, specific limits on awards to all director beneficiaries.” The Court of Chancery had reasoned that the stockholders’ approval of the plan reflected their ratification of all of the specific awards later approved by the board. Hence, the Court of Chancery found that the director grants should be subject to the business judgment standard of review.

From the Delaware Supreme Court (citations omitted):

[D]irector action is “twice-tested,” first for legal authorization, and second by equity. When stockholders approve the general parameters of an equity compensation plan and allow directors to exercise their “broad legal authority” under the plan, they do so “precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty.” The stockholders have granted the directors the legal authority to make awards. But, the directors’ exercise of that authority must be done consistent with their fiduciary duties. 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.

The Delaware Supreme Court’s decision implies that directors will be entitled to a ratification defense and the business judgment standard of review in only the following situations:

  • When the directors submit their specific compensation decisions for approval by fully informed, uncoerced, and disinterested stockholders
  • When stockholders approve self-executing plans, meaning plans that make awards over time based on fixed criteria, with the specific amounts and terms approved by the stockholders

It is worth noting that the equity plan under which the director grants were made provided directors a considerable amount of latitude in making awards. The directors could allocate to non-employee directors, in a single year or over multiple years, up to 30 percent of all of the options and restricted stock available under the plan.

We surmise that the decision will result in increased litigation regarding equity grants and perhaps other compensation provided to directors. While practice and the understanding of the decision will evolve over time, public companies, even those whose shareholders have approved compensation plans with well-considered, specific limits for directors, should nevertheless make sure that equity grants to directors are based on a developed record and supported by the facts to demonstrate fairness.