Locke Lord QuickStudy: Litigation Threat Means Public Companies Should Review Director Compensation Process

Corporate directors are permitted to, and regularly do, set their own compensation. This has not been controversial because boards have typically taken seriously their responsibility to set compensation that is reasonable and fair in the circumstances. Recent cases suggest, however, that a new phase of shareholder litigation may focus on the “self-dealing” involved. We do not believe that the landscape has changed sufficiently to justify wholesale institution of the shareholder approval requirements for director compensation that are being widely advocated. Companies that have established a thorough process for setting director compensation, and that follow it conscientiously, should have little concern. However, this is a good time for all companies to evaluate their director compensation process and criteria to make sure they are both procedurally and substantively fair.

In several recent lawsuits challenging director compensation, Delaware courts have denied the directors’ motions to dismiss and have allowed the cases to move forward. The companies involved had no meaningful safeguards to control the compensation directors awarded to themselves and that compensation appeared to the plaintiffs to be excessive. These cases only call attention to what has been settled law. As with other transactions in which directors have a conflict of interest, compensation directors award themselves can be overturned unless it is approved by other directors who are disinterested or by the shareholders, or it is “fair” to the company. If the company has obtained such approval, the directors’ decisions will be afforded the presumption of the protective “business judgment rule.” If it has not, the directors will need to defend the fairness of their compensation when challenged.

Setting Director Compensation
Although much attention is currently being paid to whether or not companies should establish a shareholder approval regime, the procedural and substantive fairness of director compensation is most important and must be addressed in any event. Decisions on director compensation should be made in light of all relevant information, including the special features of the company, the time commitment required and any special demands placed on the board and/or members of specific committees. The amount and composition (both cash and equity) of compensation paid by companies that are true peers is very important. Given the challenge of gathering reliable information and the complexity of modern pay schemes, boards – at least those at more prominent companies – are well-advised to engage an independent compensation consultant to assist. The process should be conducted by a committee that has the bandwidth to handle the job, and the results – which should be reasonable in light of the relevant factors – should be approved by the full board.

We believe that courts are not eager to get into the business of evaluating director compensation and will set the bar high for shareholders challenging the fairness of director compensation in all but the most egregious situations. If the considerations described above have been reasonably addressed, the company should prevail.

Additional Procedural Safeguards
That said, courts have less leeway with the litigation issue that arises first – the motion to dismiss. If a company has implemented an approval structure that meets the statutory test for conflict of interest transactions, a court will apply the favorable presumption of the business judgment rule and the claim for breach of fiduciary duty will be dismissed. (The plaintiff would still be able to assert that the director compensation constituted “waste” of corporate assets, but its burden of proof on this would be nearly insurmountable.) If the company has not implemented such a structure, the plaintiff will most likely get past the directors’ motion to dismiss and force them to settle or defend on the merits.

The Most Recent Litigation
The recent Delaware case, Calma v. Templeton, is a good example. It involved a claim that the members of the Citrix System, Inc.’s board of directors breached their fiduciary duties by awarding themselves large amounts of restricted stock units (RSUs) under the company’s equity incentive plan. The plan provided, to satisfy tax code requirements, that no participant could receive more than one million shares (or RSUs) per calendar year, but otherwise did not impose any limits on grants. (Based on Citrix’s stock price at the time the suit was filed, one million RSUs were worth over $55 million.) The plan had received routine shareholder approval for purposes of the Nasdaq and tax code requirements.

The awards of RSUs to the Citrix directors were below one million shares each, and so consistent with the plan, but the plaintiffs argued that they were excessive and not fair to the company. The court rejected the directors’ primary defense that the Citrix shareholders’ approval of the overall plan had ratified the directors’ specific awards because that approval did not cover “any action bearing specifically on the magnitude of compensation for the Company’s non-employee directors.” Accordingly, the case was cleared for further litigation over the fairness of the compensation.

What Approval Structure Would be Effective?
To prevail against a motion to dismiss and get the benefit of the business judgment rule, director compensation must be approved or ratified either by disinterested directors or the shareholders.

The first approach is likely to be unrealistic: unless the board compensation committee is compensated under a shareholder-approved plan that is separate from that for the rest of the board, none of the directors will be disinterested.

The shareholder approval approach may take several forms, such as a formula that specifies the amount and other terms of a compensation award or a ceiling on the amount within which the compensation committee could exercise discretion. Such a ceiling would need to be carefully determined in light of the “fairness” factors mentioned above to have comfort that it would be meaningful. And companies seeking shareholder approval of any such formula or ceiling must take account of the criteria that the proxy advisors wish to see. For example, the proxy voting guidelines of Institutional Shareholder Services (ISS) call for minimum three-year vesting for director equity awards. We presume that merely adding limitations on director awards to an existing plan, without seeking to increase the share pool, would not invite strict ISS scrutiny, but these criteria would presumably be taken into account the next time the company sought to increase the pool.

The formula and ceiling approaches are more commonly used with equity grants, but they could also be applied to cash compensation. It seems unlikely, however, that companies will wish to subject all cash compensation – which is easily adjusted to deal with new situations that arise – to the rigidity of shareholder approval.

Conclusion
That trade-off, between the rigidity of protection and the flexibility desirable in managing a complex organization, of course, permeates the analysis. Each company should consider whether, in light of its particular situation, the benefits of implementing such safeguards outweigh the costs.

Most importantly, every company should take this opportunity to examine its director compensation process and criteria to make sure they are both procedurally and substantively reasonable and fair.

For more information on the matters discussed in this Locke Lord QuickStudy, please contact the authors.