Director Compensation – Steps to Avoid Liability

A corporate board in Delaware is authorized to set the compensation the directors receive from the company through a properly passed board resolution. But, as fiduciaries, directors face an inherent conflict of interest in setting such remuneration. As a fiduciary, the board’s ability to set their own compensation is the archetype conflict of interest. The director’s financial interest and that of the corporation are directly opposed. The director has an interest in maximizing compensation; the company has an interest in attracting and retaining the best talent possible, but also wants to pay no more than is necessary in cash and/or stock. Corporations use a number of mechanisms to try and strike the proper balance and to avoid stockholder lawsuits.

This article provides an overview of how director compensation is approved, the standard of review that may be imposed if that pay is challenged as excessive or unauthorized, and steps a company can take to protect directors from a lawsuit and even liability in setting fair director compensation.

Highest Scrutiny of Compensation for Unmitigated Conflict Decision

Ordinarily, directors are entitled to the protections of the Business Judgment Rule in Delaware. The Rule is an initial standard of pleading which, if applicable, means that Court initially presumes that the board acted in accordance with its fiduciary duties and, absent the plaintiff overcoming that presumption, the Court will not second-guess the board's business decision.

In the context of the board setting its own compensation, however, the Court will use its strict “entire fairness” standard. Directors’ fixing their own compensation is an inherently conflicted transaction and, thus, the “business judgment rule” applies. The determination of which standard will apply is critical and often determinative of the outcome of the case.

Ordinary Scrutiny – Business Judgment Rule for Independent Director Approved Compensation

There is a middle road option that restores the ordinary initial application of the Business Judgment Rule but does not turn the burden of providing corporate waste to the plaintiff. Under this method, the compensation determination is made by an independent subset of the board (either as a committee or through a quorum of the board excluding those whose compensation is being set). The board’s consideration of the compensation of individual directors is often broken into two parts and conducted at different times. This allows one group of directors to approve the compensation of the others, with analysis and documentation, and then the parties’ roles reverse at another fixed date in the future. In this context, “independent” means simply that the director is not approving his or her own compensation or part of a group whose compensation is being determined.

The following shows the breakout of the foregoing from the company’s perspective: 

Pre-Determination Limitations Approved by Stockholders

Generally, compensation decisions are made pursuant to an equity compensation plan governing such determinations, such as the manner in which options are granted and the high-level terms thereof (with details handled in a grant agreement to a greater or lesser extent). Such a plan often applies to directors (including officer-directors), officers, employees, and consultants. This plan, which must be approved by stockholders to be of benefit in liability terms, can and should provide limitations that circumscribe the board’s discretion in compensation decisions.

If such a plan is approved by the stockholders, then the business judgment rule applies and a plaintiff in a derivative action would be required to prove the elements of corporate waste, one of the most difficult and rarely successful claims a plaintiff can pursue.^[1] In order to gain the benefit of this approval, the board must provide stockholders with sufficient information to permit them to make an informed decision and the plan must be sufficiently specific to place some meaningful restrictions on the board’s discretion.

Limitations on Board Discretion Found Too Vague

In Calma v. Templeton, the Court of Chancery refused to dismiss the plaintiff’s case (in a derivative action) alleging the board of Citrix, a multi-national cloud computing and virtualization company, violated its fiduciary duty to the company in its grant of restricted stock units (“RSUs”) to the directors.^[2] The board made the RSU grant pursuant to a pre-approved equity incentive compensation plan, but that plan included only a maximum per person equity compensation limit which was absurdly high and gave no sense as to the potential range of actual grants. The limit allowed for no more than 1 million RSUs to be issued per participant, including directors, with such a number of RSUs worth approximately $55 million at the time the plaintiff’s action was filed.

The board did not issue that large an equity award, of course, but the Court pointed out the feckless limitation in illustrating the lack of actual stockholder consent to something like the grants at issue in Calma. In short, the consent was good only as far as it went – approving an extravagant cap on a per-individual basis that provided no true check on the directors’ overreach. As a result, the approved plan provided no protection to the directors. Had the plan been deemed by the Court to be validly approved and sufficiently specific, the stockholders would have been forced to prove corporate waste, a hard, uphill slog.^[3]

Check Your Documents and Methods Now

Board compensation is an inherently tricky area if not addressed correctly. Check to ensure your equity incentive plan covers specific categories of individuals with limitations, caps, or express grants of discretion to ensure directors can be adequately compensated without later exposure to a derivative suit.