Delaware Case Raises Question About Structuring Director Compensation

Posted by Arthur H. Kohn, Cleary Gottlieb Steen & Hamilton LLP, on Thursday August 30, 2012 at 9:14 am
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Editor’s Note: Arthur H. Kohn is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Kohn, Janet Fisher and Samuel Bryant. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

A recent opinion of the Delaware Chancery Court, Seinfeld v. Slager, [1] addresses the legal standard applicable to directors’ decisions about their own pay under Delaware law, an important topic as to which there is little prior law. In an opinion by Vice Chancellor Glasscock, the Court held that a derivative claim alleging that directors breached their fiduciary duties by granting themselves excessive compensation survived a motion to dismiss. [2] In so concluding, the Court also found that the directors’ action did not have the protection of the business judgment rule and was instead subject to “entire fairness” review.

The Court’s decision to require “entire fairness” review means that the claim of excessive compensation could proceed to a full evidentiary trial on the merits. Under Delaware law, a court will not second-guess business judgments of directors if the directors acted in good faith, exercised due care and were not conflicted in the matter. When the business judgment rule does not apply, the judgments may be subject to heightened scrutiny under the entire fairness standard. To meet this standard, the directors must demonstrate that both the process undertaken by directors and the amount of their compensation are fair to the company.

In analyzing the proper standard of review, the Seinfeld Court factually distinguished Seinfeld from a similar claim dismissed in In re 3COM Corp. Shareholders Litigation, a 1999 opinion by then-Vice Chancellor Steele (who is now, of course, Chief Justice of the Delaware Supreme Court). [3]  Both cases involved stockholder-approved equity plans, but the plan in 3COM included only narrow discretion granted to the directors to determine the size of their annual awards, whereas the plan in Seinfeld included only customary individual and aggregate limits on the size of awards.

How different were the plans? The aggregate number of shares authorized under the plan in Seinfeld was 10,500,000 shares, and the individual limit was 1,250,000 shares per year. The stock had a value of approximately $25 per share at the time that the contested Seinfeld awards were granted, so that the maximum annual stock grant for directors was, technically, in the range of $30 million at the time. Clearly, these were not intended to be guidelines for actual award levels; in fact, during the two years in dispute, the board in Seinfeld decided to grant themselves restricted stock units worth about $750,000 and $215,000, respectively. By contrast, under the 3COM plan, directors were eligible to receive awards of options to purchase up to 60,000 shares (up 80,000 shares for the chairman, plus up to 24,000 shares for committee service) every two years. The 3COM stock had a value of about $40 per share at the time the contested 3COM awards were granted. The actual grants for one of the fiscal years at issue in 3COM ranged from 22,500 shares to 70,000 shares per director, which the opinion states had a Black-Scholes value alleged to be at least $650,000 per director.

The generic limits in Seinfeld were not sufficient to overcome plaintiffs’ assertion that the self-interest of directors called for heightened scrutiny. The Seinfeld Court found that the plan at issue “lacked sufficient definition” for the rule in 3COM to apply, stating that “there must be some meaningful limit imposed by the stockholders on the Board for the plan to be consecrated by 3COM and receive the blessing of the business judgment rule, else the ‘sufficiently defined terms’ language of 3COM is rendered toothless. A stockholder-approved carte blanche to the directors is insufficient.” [4]

Directors of course routinely set their own compensation [5] and, in the post-SOX era, director compensation has generally increased in line with director responsibilities. [6] Seinfeld suggests that additional care in making director compensation decisions may be appropriate to mitigate litigation risk in an area that inherently involves self-interested dealings. It also raises the obvious question of whether companies should adopt and seek shareholder approval of plans that specify, in sufficient detail to be likely to qualify for business judgment rule protection, the amount and type of compensation to be paid to their directors. That approach requires 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. Regardless of the approach taken, board members should be aware of the scrutiny that their compensation decisions will draw as compensation continues to be a focus for investors and governance gadflies.

Endnotes

[1] Seinfeld v. Slager, 2012 WL 2501105 (Del. Ch. Jun. 29, 2012).
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[2] The Court dismissed four other claims for corporate waste and breach of fiduciary duty in connection with executive compensation paid by Republic Services, Inc., the nominal defendant corporation. Plaintiffs did not make a demand on the board in respect of any of the claims. In respect of the excessive director compensation claim, demand futility was not argued by the defendants, presumably on the basis that the directors were clearly interested in the transaction. See Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
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[3] In re 3COM Corp. Shareholders Litigation, 1999 WL 1009210, at 1 (Del. Ch. Oct. 25, 1999). For a similar claim involving cash, rather than equity-based, compensation, in which the Delaware Supreme Court also held that an entire fairness analysis would be applicable to directors’ decisions about their own compensation, see Telxon Corp. v. Meyerson, 802 A. 2d 257, 265 (Del. 2002). For various reasons, including listing standards, public company equity plans are typically submitted for shareholder approval, whereas director cash fee plans and arrangements are typically not.
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[4] Seinfeld, at 12.
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[5] See D.G.C.L. § 141(h) (“Unless otherwise restricted by the certificate of incorporation or bylaws, the board of directors shall have the authority to fix the compensation of directors.”). See also NYSE Listed Company Manual § 303A.09, which provides that listed companies must adopt corporate governance guidelines that must address, among other things: “Director compensation. Director compensation guidelines should include general principles for determining the form and amount of director compensation (and for reviewing those principles, as appropriate). The board should be aware that questions as to directors’ independence may be raised when directors’ fees and emoluments exceed what is customary. Similar concerns may be raised when the listed company makes substantial charitable contributions to organizations in which a director is affiliated, or enters into consulting contracts with (or provides other indirect forms of compensation to) a director. The board should critically evaluate each of these matters when determining the form and amount of director compensation, and the independence of a director.” We note also that director compensation has not so far been a significant factor in proxy advisory firm voting recommendations.
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[6] See, e.g., Frederick W. Cook, Inc. 2011 Director Compensation: Non-Employee Director Compensation Across Industries and Size, at http://www.fwcook.com/alert_letters/2011_Director_Compensation_%20Non-Employee_Director_Compensation_Across_Industries_and_Size.pdf (“As companies gain a better understanding of the increased responsibilities and perceived personal risk for directors, we anticipate that director compensation levels may increase at [a] more rapid pace over the next several years.”).
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  1. [...] full article via Delaware Case Raises Question About Structuring Director Compensation — The Harvard Law School For…. Share OptionsPrintEmailMoreFacebookLinkedInStumbleUponTwitterPinterestRedditDiggTumblrLike [...]

    Pingback by Delaware Case Raises Question About Structuring Director Compensation — The Harvard Law School Forum on Corporate Governance | Accounting and Small Business /Beverly Shares — August 30, 2012 @ 3:55 pm

  2. While the Seinfeld vs. Slager case raises the question of the legal ethics of directors granting their own compensation, the case raises a much greater concern. It matters little whether the participants were legally egregious or gluttonous in the bonus structuring. In truth, the precedent of the case ruling is not terribly important. The greater debate strikes at the heart of what we are as a nation. Are we to follow the free market teachings of Adam Smith, or the government managed capitalism touted by the Keynes?

    The argument by those that believe that an unfettered market will solve all of society’s ills, is that restriction of salaries will create a brain drain on a particular industry and force the best and brightest to seek opportunities elsewhere. They also contend that all markets regulate themselves through competition. We know, however, that that is not true, as evidenced by the excessiveness that created the 30s era depression.

    The counter argument that an artificial governor to be placed on compensation structures to ensure fairness, is also specious. The anger at bloated CEO compensation packages too often seems to be rooted in jealousy and envy.

    The real debate should center on what will strengthen the nation and allow for the greatest amount of prosperity for the greatest amount of its citizens. Through historical experience we now know that promoting policies aimed at creating jobs and making services more affordable, empowers the entire constituency. Let us hope that Seinfeld vs Slager leads to a debate that helps us reach those goals.

    Comment by Elizabeth S — October 3, 2012 @ 10:06 pm

 

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