Boards and committees that grant themselves awards under company equity plans should review those plans in light of a 2012 Delaware Chancery Court case.
In Seinfeld v. Slager,1 a shareholder brought five derivative claims alleging breaches of fiduciary duties in the awarding of compensation to the board and officers. The only claim to survive the summary judgment motion of the defendant directors was a claim that the board had awarded itself excessive compensation when it granted each of the directors restricted stock units with a value of $743,000 and $215,000 per award in 2009 and 2010, respectively. The defendants argued that the awards did not violate the terms of the stockholder approved Stock Plan under which the awards were made and, therefore, were protected by the business judgment rule. However, the judge rejected the directors' contentions because, although the Stock Plan set limits on the size of the awards, it did not set forth "meaningful" limits in the judge's view, and therefore was subject to the more stringent requirements of the "entire fairness" doctrine.
Directors' actions generally are protected by the business judgment rule. In a lawsuit alleging a breach of the fiduciary duty of care, the court presumes the directors exercised proper business judgment unless the plaintiff can show the directors did not act on an informed basis, in good faith and in the reasonable belief that their action was in the best interests of the company. However, when the director is on both sides of a transaction, the "entire fairness" standard applies, which shifts the burden of proof to the directors to prove that the transaction is entirely fair to the company, a high hurdle.
The Stock Plan at issue provided that the Board could grant awards for a total of up to 10,500,000 shares and could grant up to 1,250,000 restricted stock units per year to an "Eligible Individual" (an employee, officer or director). The judge did not consider these limits meaningful because, in theory, the Board could have awarded itself one-time grants worth $21 million per director at the then current market value of the stock. This limitation, in the Court's view, did not satisfy the test previously laid down in an earlier decision in In re 3Com Corp. Shareholders Litigation.2
In 3Com, the Court held that directors who granted themselves awards under a stockholder approved plan with "sufficiently defined terms" did not breach their duties and were entitled to the protections of the business judgment rule. Although not discussed in the 3Com decision, an examination of the plan at issue in 3Com shows that the plan contained the following limits on awards to directors:
- annual grants for services as a director not to exceed 60,000 shares per director (80,000 shares in the case of the Chairman); and
- annual grants for services as a member of a standing committee, not to exceed 24,000 shares per director.
In the Seinfeld decision, the Court gave the following guidance to directors:
A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely a board's compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair.3
The problem for directors (and their counsel) is determining exactly what is a sufficient or meaningful limit under the Seinfeld rubric. Many plans have general limitations on the number of shares or units that can be awarded to participants, including directors. Under the court's decision in Seinfeld, these general limitations are not sufficient to provide the protections of the business judgment rule. Directors that award equity to themselves under plans that do not have meaningful limits will have to defend the grants under the more rigorous "entire fairness" standard.
We recommend that directors carefully review the plans under which they grant themselves equity awards. We believe that the following types of provisions in stockholder approved plans will be more likely to be found to be "meaningful" and entitle the board to the protections of the business judgment rule:
- specific annual limitations on the number of shares that can be awarded to directors (and not just generic limitations on the number of shares that can be awarded to participants, as was the case in Seinfeld) that are far less than all of the shares that can be awarded under the plan; or
- formula provisions (e.g., awards based on a prescribed dollar value).
If these types of limitations are not in director equity plans, directors should act now to amend the plans to include them and submit them to stockholders for approval; otherwise, to paraphrase the "Seinfeld" show, there may be "no stock options for you.
1. Seinfeld v. Slager, 2012 Del. Ch. LEXIS 139 (Del. Ch. June 29, 2012), available at http://courts.delaware.gov/opinions/download.aspx?ID=174870.
2. In re 3COM Corp. Shareholders Litigation, 1999 Del. Ch. LEXIS 215 (Del. Ch. Oct. 25, 1999).
3. See Seinfeld at 41.
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