United States: Recent Trends In Challenges To Compensation: Directors In The Crosshairs

Last Updated: April 12 2013
Article by F. Douglas Raymond and Remy Nshimiyimana

Public company boards and their advisors should be aware of a recent trend of challenges to the sufficiency and adequacy of the proxy statement disclosures. These challenges have been brought as class actions contesting compensation decisions and related disclosures as soon as companies file their proxy statements. These suits often include preliminary injunction motions that seek to enjoin the annual meetings unless the proxy disclosures are expanded. This litigation tactic can create pressure for the targeted company to settle quickly, to avoid potentially having to delay the annual meeting; especially now that, as a recent Delaware case illustrates, directors potentially face a challenging standard of scrutiny in litigation questioning their own compensation. The trend illustrates the particular difficulties directors can face when structuring their own compensation, even on matters that would not have raised eyebrows a few years ago, such as increasing share reserves in stock plans or making stock awards under stockholder-approved incentive plans.

Until recently, there had been a handful of lawsuits challenging compensation decisions of companies that had lost "say-on -pay" advisory votes. However, a recent litigation trend involves efforts to enjoin annual meetings and say-on-pay votes on the grounds that the underlying proxy disclosures are insufficient or misleading. Generally, these lawsuits allege that the company's proxy statement omits material information regarding (i) the analysis provided by compensation consultants to the board of directors on the plan being proposed to the shareholders, (ii) the rationale for the particular mix of salary, cash incentive compensation, and equity incentive compensation chosen by the board, (iii) the financial or compensation metrics of peer companies identified by the company, and (iv) the reasons behind the company's choice of peers for benchmarking purposes. The timing of such lawsuits can leave companies with only a short time to act if they are to hold their annual meetings on schedule, and some of these companies may opt to settle these lawsuits and pay significant sums in attorneys' fees, rather than vigorously defend against the claims. The companies that choose to settle generally agree to supplement the proxy disclosures and to pay the plaintiffs' legal fees.

The recent litigation trend is a reminder of just how challenging corporate directorship has become. Indeed, a recent Delaware case highlights the difficulty that directors may face in defending against challenges to their own compensation. In Seinfeld v. Slager, the Delaware Court of Chancery recently denied business judgment deference to a decision by the board of Republic Services, Inc., a public company that provides waste management services, to grant equity incentive awards to board members under a stockholder-approved equity incentive plan. As a consequence, the defendant directors would have to establish at trial that the awards they granted themselves were entirely fair to the company—a level of judicial scrutiny more challenging, and surely more expensive to defend in litigation, than the traditional business judgment rule.

For many years, the business judgment rule has protected directors against challenges to their actions. Under this doctrine, in general, courts will not second-guess the decisions of corporate boards unless a decision is potentially influenced by a conflict of interest or the gross negligence of the board. This well-established corporate principle has been central to court rejections of notable challenges to extremely generous executive compensation packages. However, the Seinfeld Court let stand a claim that the directors of Republic Services had breached their fiduciary duties by giving themselves awards under the company's equity incentive plan. The case illustrates the pitfalls of today's governance environment, particularly in the area of board compensation, where boards historically had significant latitude in structuring their own compensation packages.

The result in Seinfeld came as a surprise to many. In 1999, the Chancery Court had dismissed a similar claim in In re 3Com Corp. Shareholders Litigation, holding that corporate directors who administer a stockholder-approved director stock option plan are entitled to the protection of the business judgment rule, provided there has been "no waste, a total failure of consideration." The Court distinguished the two cases on the basis that the Republic Services equity incentive plan gave the directors virtually unbounded discretion over how to compensate themselves, subject to certain quantitative restrictions, while the 3Com stock plan had better defined terms, with parameters that confined the 3Com board's discretion to issue awards. The plan relied upon by the Republic Services board had two quantitative restrictions: the awards could not exceed an aggregate maximum of 10.5 million shares or an individual limit of 1.25 million shares. The court noted that:

  • even if the directors stayed within plan's limits, the plan gave the Republic Services directors "the theoretical ability to award themselves as much as tens of millions of dollars per year, with few limitations;"
  • where a plan gave a board the freedom "to use its absolute discretion, with little guidance as to the total pay that can be awarded" the board's decision could not be "labeled disinterested and qualify for protection under the business judgment rule;" and
  • the board that exercised such discretion would "ultimately have to show that the transaction is entirely fair" to the company and do so in a courtroom.

While not discussed in the opinion, it is not clear how this differs from the practice of boards setting their own cash compensation for board service, which, like the plan in Seinfeld, is done entirely at the discretion of the board, absent corporate waste or a total failure of consideration.

A great benefit of the business judgment rule is the freedom it gives boards to operate without being second-guessed in a courtroom, and putting the burden on the board to demonstrate that its actions are "entirely fair" inevitably creates an incentive for some to litigate these issues. Combined with the recent litigation trend involving say-on-pay votes, it is becoming increasingly difficult for directors to navigate potential conflicts of interest, particularly in the current environment, where many are sceptical of the loyalty of directors to the best interests of stockholders.

Boards should develop a comprehensive record to support compensation decisions with an eye towards ensuring that it is detailed and clear in order to protect against breach of fiduciary duty claims. In particular, directors should be cautious in making decisions regarding their own compensation, and should consider whether to submit specific limitations on their own compensation programs, both cash and equity, to the stockholders for approval. With respect to proxy statements, boards should consider directing that the compensation discussion and analysis is as extensive and detailed as reasonably feasible so as to limit their exposure to litigation that may delay annual meetings and could result in significant legal fees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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