Delaware Court Explains Requirements for "Stockholder Ratification" Defense to Derivative Suit Alleging Payment of Excessive Equity Compensation to "Interested Directors"
May 19, 2015
Executive Compensation Alert
On April 30, 2015, the Delaware Court of Chancery, in Calma v. Templeton, a shareholder derivative suit challenging compensation paid to non-employee directors in the form of restricted stock units ("RSUs") as being "excessive," issued an opinion addressing the "stockholder ratification" exception to treating equity compensation grants to "interested" non-employee directors under the "waste" doctrine, rather than under the "entire fairness" doctrine.
By way of background, Citrix Systems, Inc. ("Citrix") adopted an equity compensation plan (the "Plan") in 2005. The Plan provided for grants of various types of equity compensation, including RSUs, to a variety of individuals, including non-employee members of Citrix's board of directors (the "Board"). In setting the limit on annual grants of equity, the Plan provided that no participant could receive equity compensation awards in any calendar year exceeding 1 million shares. The Plan did not specify a separate limit for non-employee directors.
In 2011, 2012 and 2013, the compensation committee (the "Committee") of the Board, comprising three members of the Board, approved RSU grants to eight of the nine members of the Board, all of whom were non-employee directors. A shareholder derivative suit against the directors with respect to approving and/or receiving these grants followed, alleging (1) breach of fiduciary duty, (2) waste of corporate assets and (3) unjust enrichment.
The court first addressed the issue of whether the non-employee directors were "interested directors." Under prior Delaware case law cited by the court, a director generally is considered “interested” with respect to compensation awards made to him or her if the facts indicate that his or her ability to “fairly and impartially consider whether to have the corporation initiate litigation challenging [his or her] compensation” should be viewed with “skepticism.” Applying this test, the court held that the non-employee directors who received the RSU awards were "interested directors" because their awards were not approved by a majority of directors who were "disinterested directors" (i.e., who did not receive any equity awards).
The court next addressed the claim of breach of fiduciary duty. It began by noting the relevant standard: Director decisions as to compensation are first analyzed under the "business judgement standard," pursuant to which such decisions are respected by the courts, i.e., accorded a rebuttable presumption of reasonableness, if made in good faith, with prudence and in a manner reasonably believed to be in the best interests of the corporation. In order to rebut this presumption, the stockholder must demonstrate that "the board's decision cannot be attributed to any rational business purpose - which, in effect, is the standard for waste under Delaware law." (Emphasis added.)
However, where a stockholder rebuts the business judgement standard - for instance, as in this case, by showing that at least half of the directors who approved the RSU awards were not disinterested directors, the court reviews director decisions as to compensation under the "entire fairness standard." Under this standard, the burden then shifts to the directors to prove that the decisions were the product of both fair dealing and fair price.
From a director's standpoint, preserving the business judgment standard certainly is preferable to having his or her decisions scrutinized under the entire fairness standard. The Delaware courts permit a director to combat the entire fairness standard by raising the affirmative defense of "stockholder ratification." Under this defense, a director's decisions are evaluated under the "waste" standard, a very difficult standard for the stockholder suing derivatively to overcome.
As a practical matter, “stockholder ratification” of an equity compensation plan takes one of two forms: (1) deemed prior ratification of a grant to a director because the stockholders previously approved the plan pursuant to which the grant is being made; or (2) subsequent approval by the stockholders of an individual grant approved by the directors. This case addressed the circumstances in which the former type of ratification could work.
Getting back to the facts, as noted above, the court held that a majority of the non-employee directors approving and/or receiving RSU awards were not disinterested directors. Accordingly, the inquiry shifted to whether the stockholder ratification defense was available to the directors.
The court held that such defense was not available. In particular, the court held that stockholder ratification of the RSU grants under Plan awarded years after the stockholders approved the Plan did not work because the Plan, as approved by the stockholders, did not contain a limit on the annual awards (expressed as a number of shares) that could be made to non-employee directors. As stated more generally by the court, "the affirmative defense of ratification is available only where a majority of informed, uncoerced, and disinterested stockholders vote in favor of a specific decision of the board of directors." (Emphasis added.)
The court next addressed the claim of waste of corporate assets. Noting that the grants of the RSUs were the sole equity grants to the nonemployee directors in 2011, 2012 and 2013, the court concluded that there was sufficient evidence that Citrix received adequate consideration, in the performance of director services, for the grants. Therefore, the court held that the doctrine of waste did not apply.
Had there been additional, one-time equity grants, however, the court might have reached a different conclusion, depending on the size of such grants. For instance, in reaching its conclusion in this case, the court distinguished another case in which it found that annual, one-time equity grants of as much as three times the size of the regular annual grants supported a finding of waste.
The court then addressed the claim of unjust enrichment. It began by noting the required elements of the claim under Delaware law: "(1) an enrichment, (2) an impoverishment, (3) a relation between the enrichment and the impoverishment, (4) the absence of justification, and (5) the absence of a remedy provided by law." However, it also noted that the unjust enrichment claim in this case was "entirely duplicative" of the breach of fiduciary duty claim and, therefore, denied the directors' motion to dismiss.
Lessons from this Case for the Granting of Equity Awards to Non-Employee Directors: (1) If practical, and in many cases it will not be, have a majority of the disinterested non-employee directors approve the grants; (2) If the equity compensation plan does not contain an annual limit on shares that can be granted to nonemployee directors, consider amending the plan to provide for such a limit; and (3) Avoid large one-time grants that supplement regular grants except under extraordinary circumstances - absent such circumstances, large irregular grants may be viewed as not being based on sufficient consideration benefiting the corporation.
If you would like more information, please contact your Chiesa Shahinian & Giantomasi PC attorney or the author listed below.
Adam B. Cantor
Chair, Employee Benefits & Executive Compensation Group | firstname.lastname@example.org | (973) 530-2020