What's Market: Revisiting Director Share Limits and the Entire Fairness Standard

Practical Law Article w-022-3227 (Approx. 5 pages)

What's Market: Revisiting Director Share Limits and the Entire Fairness Standard

by Practical Law Employee Benefits & Executive Compensation

Background

Under Delaware corporate law, there are three standards of review for courts evaluating the decisions and actions taken by a board of directors. The two standards of review that are relevant for decisions made by directors in setting their own compensation are:

The business judgment rule. A deferential standard of review, which typically applies to decisions made by directors where the majority of the directors are disinterested and independent.
Entire fairness. The most onerous standard of review under Delaware law, which typically applies to decisions made by directors where the majority of the directors are interested.

The business judgment rule protects directors by presuming that they acted in the best interests of the business. The business judgment rule places the burden of proof on plaintiffs to show that a majority of the board did not act on an informed basis, in good faith, and in the best interests of the corporation.

The entire fairness standard of review requires a judicial determination of whether a transaction was objectively fair to the stockholders. If the entire fairness standard applies, the burden of proof is on the defendant directors to establish that the transaction was the product of both fair dealing and fair price.

Because directors are inherently interested in their own compensation, the entire fairness standard presumptively applies to director compensation decisions. However, Delaware corporate law generally allows the business judgment rule to apply instead if the company’s shareholders ratify the decisions made by the board (this is knowns as the shareholder ratification defense).

Developments Covered in the 2017 Article

In the years before the 2017 article, the Delaware Chancery Court decided several noteworthy director compensation cases. In Seinfeld v. Slager (, No. 6462–VCG (Del. Ch. June 29, 2012)) and Calma v. Templeton (, No. 9579-CB (Del.Ch. April 30, 2015)) shareholders challenged grants of restricted stock unit (RSU) awarded to directors under shareholder-approved plans. In each case, the Delaware Chancery Court applied the entire fairness standard, reasoning that the directors were interested parties in regards to their own compensation and that the governing plans lacked meaningful director-specific share limits. Where there are meaningful limits on director compensation in a shareholder approved or ratified plan, the courts have generally instead applied the business judgement standard on the theory that the shareholder ratification defense applies.

In In re Investors Bancorp, Inc. Stockholder Litigation, (, No. CV 12327-VCS (Del. Ch. Apr. 5, 2017)), the Delaware Chancery court examined the nature of an equity plan’s meaningful director share limit. The case involved an equity plan under which the maximum number of shares that could be issued to non-employee directors was equal to 30% of all stock options and restricted stock shares available for awards. Soon after the plan was approved by shareholders, the directors awarded themselves equity awards that were significantly in excess of the directors' prior compensation and director pay at peer companies. The court granted the directors' motion to dismiss the lawsuit and applied the business judgment standard because the plan included meaningful, shareholder-approved limits on awards to non-employee directors.

Developments After the 2017 Article

The plaintiffs in In Re Investors Bancorp appealed the decision. On appeal, the Delaware Supreme Court reversed the Chancery Court's decision and remanded it for further proceedings (In Re Investors Bancorp, Inc. Stockholder Litigation, (De. Dec. 13, 2017)). In its decision, the Delaware Supreme Court recognized three scenarios that involve the shareholder ratification defense in connection with awards made under shareholder-approved equity plans:

When the shareholders approve the specific director awards.
When the plan is "self-executing," meaning that the directors have no discretion when making the awards.
When the directors exercise discretion and determine the amount of the awards after shareholder approval, which is where the Chancery Court’s generic versus meaningful limits test applies.

In its decision, the Delaware Supreme Court ruled that the shareholder ratification defense cannot be used when a breach of fiduciary duty has been properly alleged by plaintiffs, even when the case involves a shareholder-approved equity plan with meaningful limits. Shareholder approval of equity plans is given with the expectation that the board must exercise its authority consistently with its fiduciary duties. In this case, the Delaware Supreme Court applied the entire fairness standard, holding that the plaintiffs had raised a pleading-stage reasonable inference that the directors had breached their fiduciary duties by making unfair and excessive discretionary awards to themselves.

The Delaware Supreme Court decision seems to cast aside the meaningful limits approach and an approved settlement, filed on March 6, 2019, means that there will not be additional Chancery Court guidance on these facts. Since Investors Bancorp, there have not been many published opinions on director compensation. This is in part because director compensation lawsuits have generally been settled outside of court in the wake of the Delaware Supreme Court's decision. However, the Chancery Court recently rejected a settlement related to director compensation, which is an unusual occurrence indicating that the court may begin taking a harsher line on director compensation (Stein v. Blankfein et al., Civil Action No. 2017-0354-SG).

Given the more limited protection that director-specific share limits in equity plans now provide, market practice may shift regarding their inclusion, although executive compensation counsel typically still recommend that clients include director-specific share limits in plans under which director compensation awards are granted. The following table uses What’s Market, Equity Plans to examine three recently filed equity plans, including summary plan provisions covering total share limit, total share limit as a percentage of outstanding shares, eligible award recipients, and director share limits. To view additional equity plan summaries and create custom comparison reports for analysis, see What's Market, Equity Plans.

EQUITY PLAN	Chewy, Inc. 2019 omnibus incentive plan Effective June 13, 2019	Wells Fargo & Company amended and restated long-term incentive compensation plan Effective April 23, 2019	Humana Inc. stock incentive plan (amended and restated) Effective April 18, 2019
TOTAL SHARE LIMIT	31,864,865 shares of common stock. Section 3(a)	On or after January 1, 2019, 352,307,259 shares of common stock. Section 4.1	16,000,000 shares of common stock. Section 4.1
NUMBER OF SHARES AS A PERCENTAGE OF OUTSTANDING	Pre-IPO	Approximately 7.7%. *The number of total shares outstanding came from the company’s Form 10-K as filed on February 27, 2019.	Approximately 11.8%. *The number of total shares outstanding came from the company’s Form 10-Q as filed on May 1, 2019.
ELIGIBLE AWARD RECIPIENTS	Current and prospective employees, directors, consultants, advisors, and contractors that have received an offer of service, with awards conditioned on the commencement of services. Section 5	Employees, officers, directors, and former employees. Section 5	Employees, directors, and consultants. Section 2.12 Section 5
DIRECTOR LIMITS	A total value of $1,000,000 per director per calendar year, which includes both cash-based payments and the aggregate grant date fair value of awards. Section 3(a)	See Individual limits for annual participant limits on different types of equity compensation. The plan does not include a separate annual aggregate director limit on equity compensation or equity compensation combined with cash fees.	Total compensation may not exceed $1,000,000 per director per calendar year. This limit is increased to $1,500,000 for a non-employee chairman of the board. Directors are also subject to individual limits (see Individual limits). Section 4.4(iii)

What's Market comparison reports are a powerful tool for analyzing market trends, including those related to director share limits. For access to additional What’s Market summaries and comparison reports, see What's Market.

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