How to Avoid Director Pay Litigation

In the last few years, Delaware courts have issued several rulings in lawsuits involving complaints of excessive compensation to non-employee directors ^[1]. The takeaways from these cases can be summarized as follows:

• Decisions by directors about their own compensation will be reviewed by Delaware courts as a self-dealing transaction under the entire fairness standard, but such decisions can gain the protection of the business judgment rule if such decisions are made pursuant to a director pay limit or proposal that is approved by a fully informed, disinterested majority of shareholders.
• Shareholder approval of an equity plan does not constitute ratification of director compensation in the absence of meaningful limits in the plan on the amount of cash and equity compensation that may be awarded to directors.
• To ensure that director compensation lawsuits cannot survive a motion to dismiss, companies should:
  • Have their compensation committees conduct an annual review of the cash and equity compensation paid to their non-employee directors.
  • Consider including a “meaningful” limit on director compensation in their equity plans that is approved by their shareholders.^[2]
  • Consider expanding the director compensation disclosure in their annual proxy statement to provide an extensive discussion of the basis for director compensation decisions.

The remainder of this article breaks down these proposed action items in greater detail.

Annual Review of Director Compensation by the Compensation Committee

• Each year, the compensation committee should review and evaluate each component of the director compensation program.
• In conducting such an annual review, the compensation committee should engage an independent compensation consultant to analyze competitive market data and advise the compensation committee on decisions regarding director compensation.
• The review process should be calendared and coordinated months in advance, and the company’s legal counsel should be closely involved in this process.
• The compensation committee should recommend any decisions regarding director compensation to the board of directors.
• The compensation committee charter should require that the compensation committee conduct such an annual review.

Meaningful Shareholder Approved Limit on Director Compensation

• To gain the protection of the business judgment rule, a company can include an overall limit on director compensation in its equity plan.
• Any limit on director compensation should cover both cash and equity, or provide an overall limit on how much compensation can be paid in a single fiscal year because director compensation lawsuits have been directed against all components of director compensation.
• Any limit on director compensation should be expressed in dollars to avoid issues that may arise if the company’s stock price increases or decreases.
• To ensure that the limit is meaningful and respected by the courts, the size of the limit should, among others things, take into account^[3]:
  • Current and future responsibilities;
    • For example, consider whether the limit should provide exceptions for either the initial year of service or performing additional duties.
  • Current market practices;
  • Peer group competiveness; and
  • Any shareholder feedback.

• Submitting an amended equity plan for approval by shareholders may result in institutional shareholder advisory firms, like Institutional Shareholder Services, and certain institutional shareholders scrutinizing other features of the plan, even if the only change to the plan is to include a limit on director compensation.

• Consequently, it may make sense in some circumstances to amend the company’s equity plan to provide for such a limit only when the plan needs to be approved by shareholders for other reasons (for example, increasing the plan’s share limit, approving the plan for 162(m) purposes, etc.).
• Alternatively, to avoid amending and submitting the company’s equity plan for shareholder approval, it may make sense in some circumstances to have shareholders approve the director compensation program itself.

Until a limit on director compensation is approved by shareholders, a company should hold off on making material increases to director compensation.

Disclosing Director Compensation

• In addition to describing the compensation earned in the last fiscal year as required by the SEC rules, the director compensation section of the proxy should describe the:

• Company’s director compensation philosophy;
• The process used to determine director compensation, including the role and analysis of the compensation consultant;
• How director compensation compares to peers; and
• The rationale behind director compensation decisions.

• Such disclosure should also be included in any proposal approving the company’s director compensation program.

Sample Director Compensation Limit in Equity/Incentive Plan

“The maximum number of shares of stock subject to stock awards granted under the Plan or otherwise during any one fiscal year to any non-employee director, taken together with any cash fees paid by the Company to such non-employee director during such fiscal year for service as an non-employee director, will not exceed $[____] in total value (calculating the value of any such awards based on the grant date fair value of such awards for financial reporting purposes), including for this purpose, the value of any stock awards that are received in lieu of all or a portion of any annual committee cash retainers or other similar cash based payments and excluding, for this purpose, the value of any dividend equivalent payments paid pursuant to any stock award granted in a previous fiscal year.”

Sample Director Compensation Disclosure in Proxy

“Decisions regarding our non-employee director compensation program are approved by our full board of directors based on recommendations by our compensation committee. In making such recommendations, our compensation committee takes into consideration the director compensation practices of peer companies and whether such recommendations align with the interests of our shareholders.

Compliments of Orrick – a member of the EACCNY