In its first explicit clarification of Delaware law on stockholder ratification in many years, the Delaware Supreme Court provided a virtual restatement of the prerequisites for valid stockholder ratification of director actions. In doing so, Delaware’s High Court allowed a claim to proceed which challenged allegedly excessive director compensation. In the case styled: In re Investors Bancorp, Inc., Stockholder Litigation, No. 169, 2017 (Del. Supr. Dec. 13, 2017; revised Dec. 19, 2017), the High Court also made important observations about demand futility standards.
Brief Background: The context of this decision involves an equity incentive plan that provides a compensation package for directors. The stockholder approval of the plan in this case gave the directors ample discretion to determine their own compensation. Some of the compensation that the directors awarded themselves amounted to several million dollars a year each, which reportedly was substantially higher than the comparable compensation paid to directors in similar companies.
The key factual aspect of the equity incentive plan involved in this case was that the plan approved by the stockholders did not provide meaningful limitations on the amount of compensation that the directors could award themselves. In particular, in the facts of this case, the directors had discretion to allocate up to 30% of all options or restricted stock available as awards to themselves.
Key Principles and Highlights of Decision:
- Although a board is authorized to fix the compensation of directors based on Section 141(h) of the DGCL, when the board fixes its own compensation, it is a self-interested decision. If no other factors are involved, that decision will not be entitled to business judgment rule protection and when properly challenged will be subject to the entire fairness standard of review. See footnotes 34 to 36.
- Stockholder ratification generally is allowable in three situations involving equity incentive plans: (1) When stockholders approve the specific director awards; (2) When the plan was self-executing, meaning the directors had no discretion when making the awards; or (3) When directors exercise discretion and determine the amounts in terms of the awards after stockholder approval.
- Ratification cannot be used to foreclose the Court of Chancery from reviewing further discretionary actions when a breach of fiduciary duty claim has been properly alleged. This is so based on the truism that “director action is ‘twice-tested,’ first for legal authorization, and second by equity.” See footnote 81.
- Another key principle with broad application is that “inequitable action does not become permissible simply because it is legally possible.” See footnote 83.
Court’s Reasoning: In this case, the stockholders did not ratify the specific awards that directors made under the equity incentive plan, thereby requiring the directors to demonstrate the fairness of the awards to the company. Sufficient facts were alleged to support a reasonable inference in this case that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves.
Demand Futility Issue: The court also addressed a demand futility issue. As readers well know, based on Court of Chancery Rule 23.1, demand is excused as futile when reasonable doubt is pled that: (1) a majority of the board is disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. See footnote 100.
The court reasoned that because all of the directors were alleged to have awarded themselves compensation, not just the outside directors, the court explained that:
“It is implausible to us that non-employee directors could independently consider a demand when to do so would require those directors to call in to question the grants they made to themselves. In other words, it strains reason to argue that a defendant-director could act independently to evaluate the merits of bringing a legal action against any of the other defendants if the director participated in the identical challenged misconduct.”
See footnote 101.
Therefore the court concluded that demand was excused for the claims made against all the directors.