COMPENSATION IN CONTEXT
RECENT SETTLEMENT PROPOSAL PUTS PROCESS FOR SETTING OUTSIDE DIRECTOR COMPENSATION IN THE SPOTLIGHT
April 4, 2016
Our friend Broc Romanek of Compensation Standards let us know that a recent settlement agreement in litigation challenging the compensation paid to a company’s outside directors is attracting considerable attention. The settlement in the Espinoza case (C.A. No. 9745, Del. Ch.) was filed in a shareholder lawsuit alleging that a company’s board had breached its fiduciary duties, committed corporate waste and caused unjust enrichment by paying excessive compensation to non-employee directors. Among its most notable provisions, the proposed settlement calls for the company to obtain shareholder approval of the pay of its outside directors.
BACKGROUND
In 2013, the company’s board approved a compensation plan for the board’s non-employee directors, including an annual $300,000 grant of restricted stock units and a set annual cash retainer. The company moved for dismissal of the shareholders’ corporate waste claim and asked for summary judgment on the issues of breach of fiduciary duty and unjust enrichment, arguing that, because the 2013 compensation plan was ratified by the board and shareholders, the board's actions were entitled to protection under the business judgment rule. That rule provides a strong presumption that the board acted appropriately.
While the Delaware Court of Chancery dismissed the corporate waste claim, it denied the motion for summary judgment and ruled that the decision of the board is not entitled to protection under the business judgment rule. In so doing, the court reasoned that the company’s process for setting outside director pay — which involved a disinterested controlling stockholder ratifying a transaction approved by an interested board of directors — did not follow the formalities of Section 228 of the Delaware General Corporate Law governing shareholder ratification. As a result, the court concluded that the board’s action must be reviewed under the entire fairness standard, under which the burden is on the defendants to establish that the transaction was the product of fair dealing.
SETTLEMENT AGREEMENT
Following the court’s October 2015 ruling, the parties entered into settlement negotiations, resulting in the January 25, 2016 proposed settlement. Under the proposal, which is subject to court approval, the company agreed to implement and maintain the following corporate governance reforms for a period of five years:
- The board will amend the charter of the compensation and governance committee to provide that the committee will conduct an annual review and assessment of all compensation, and will engage an independent compensation consultant to advise the committee about compensation payable to non-employee directors.
- The board will conduct an annual review of the compensation payable to non-employee directors, including any recommendation by the committee as to any change in compensation.
- The company will include proposals at the 2016 annual meeting for shareholder approval of non-employee director compensation, encompassing both the 2013 grants and the annual director compensation program, which includes a specific amount for annual equity grants and sets out the annual retainer fees for non-employee directors.
KEY TAKEAWAYS
This lawsuit and the proposed settlement serve as yet another reminder that companies should be diligent in developing and periodically evaluating their non-employee director compensation programs. Recall that two other recent Delaware cases (Seinfeld v. Slager and Calma v. Templeton) also involved challenges to non-employee director compensation. In both of those cases, the Delaware Chancery Court denied summary judgment and required the cases to be reviewed under the entire fairness standard (instead of the business judgment rule) because the companies’ equity plans did not impose “meaningful limits” on director compensation.
While Calma and Seinfeld focus on the content of the shareholder-approved plan (i.e., were there meaningful limits on director compensation in the plan such that shareholders could understand the magnitude of compensation to be paid), Espinoza focuses on the approval process.
While the factual circumstances surrounding Espinoza were unique, the settlement still serves as a reminder that companies should evaluate the limits in their plans with respect to the amount of compensation that directors can award to themselves. If the plan does not impose any “meaningful limits” on director compensation, the company should consider adding them. Companies may also consider whether benchmarking their director cash and equity compensation programs against their peer group is warranted and, if so, they need to be certain that the peer group is appropriate.
Furthermore, companies should review their committee charters and make changes to the process for evaluating and approving director compensation, if necessary. Shareholder ratification of a self-dealing transaction (such as when directors award themselves pay) must be accomplished formally by a vote or by written consent in order to shift the standard of review from the entire fairness standard to the more favorable business judgment rule.
