business judgment rule

What happens when corporate directors approve their own awards under an equity incentive plan? Under Delaware law, so long as the plan is approved by a majority of the fully informed, uncoerced and disinterested stockholders, the awards will generally be protected by the business judgment rule and judges will not second guess them. Or will they?

Last month, the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation ruled that awards made by directors to themselves under equity incentive plans approved by the stockholders should nevertheless be subject to the more demanding entire fairness standard, requiring the directors to prove that the terms are fair to the corporation, if the plan lacks fixed criteria and gives the board discretion in granting themselves awards. The ruling represents a departure from an earlier line of Delaware cases that held that the ratification defense would be available and the business judgment rule would protect grants to directors so long as the plan approved by the stockholders contained meaningful limits on awards to directors. After Investors Bancorp, director awards under stockholder-approved equity incentive plans will only benefit from the business judgment rule if the plan gives directors no discretion in making awards to themselves.

Delaware law authorizes a board of directors to determine its own compensation. Because directors are necessarily conflicted when compensating themselves, however, such decisions generally fall outside the protection of the business judgment rule and instead are subject to the entire fairness standard, meaning that if properly challenged as a breach of fiduciary duty the directors must prove those compensation arrangements are fair to the corporation. Depending on the circumstances, however, conflicted director transactions can generally avoid application of the entire fairness standard through stockholder ratification.

Courts have traditionally recognized the ratification defense in three situations involving director awards: (i) when stockholders approve the specific director awards, (ii) when the plan is self-executing (meaning the directors have no discretion in making the awards), and (iii) when directors exercise discretion and determine the amounts and terms of the awards after stockholder approval. The first two scenarios present no real substantive problems. The third scenario is more challenging, and was the issue addressed in Investors Bancorp.

Stockholders of Investors Bancorp approved an equity incentive plan that gave discretion to the directors to allocate up to 30% of all option or restricted stock shares under the plan to themselves, but the number, types and terms of awards to be made pursuant to the plan were subject to the discretion of the board’s compensation committee. After the Investors Bancorp stockholders approved the plan, the board granted just under half of the stock options available to the directors and nearly thirty percent of the shares available to the directors as restricted stock awards.

The plaintiffs argued that the directors breached their fiduciary duties by granting themselves these awards because they were unfair and excessive. According to the plaintiffs, the stockholders were told the plan would reward future performance, but the board instead used the awards to reward past efforts which the directors had already accounted for in determining their compensation packages. Also, according to the plaintiffs, the rewards were inordinately higher than those at peer companies. The court ruled that the plaintiffs properly alleged that the directors acted inequitably in exercising their discretion and granting themselves unfair and excessive awards, and, because the stockholders did not ratify the specific awards under the plan, the affirmative defense of ratification was unavailable.

There are two key takeaways here. First, inasmuch as director grants under discretionary plans will no longer benefit from stockholder ratification after Investors Bancorp, companies contemplating adoption of equity incentive plans should think seriously about making sure those plans are self-executing and contain no discretionary elements as to grants to directors. An example of a self-executing plan would be one in which each director is granted an option to purchase “x” shares upon election to the board and an additional “y” shares on the anniversary of his or her election. Second, existing equity incentive plans should be carefully reviewed to determine whether or not they are discretionary, and any proposed grants under discretionary plans, even if ratified by the stockholders, should be carefully vetted to ensure they are consistent with information disclosed to stockholders at the time of plan approval and reasonable under objective standards such as in relation to a peer group.