ExecutiveLoyalty.org

Shareholder Derivative Litigation
 - challenges to Director Compensation

 

2018.09.20  Beware "Entire Fairness": It Sets a High Bar for Decisions about Director and Officer Compensation.  In contrast to the fizzle that followed failed say on pay litigation, shareholder derivative claims of excessive compensation have legs - and momentum.  Within past weeks, one pharma company settled such litigation, and another was sued based on fairly typical allegations (namely: above-market compensation and below-market corporate performance). A sense of those cases appears in the bullet points below. 

     More importantly, excessive compensation claims should provide a wake-up call for boards of directors. In a nutshell, the business judgement rule has long provided corporate decision-makers with a near iron-clad defense against being second-guessed for their executive compensation decisions. That protection can disappear when boards make decisions about their own compensation, as well as CEO compensation if that is not determined by disinterested directors.

      Absent shareholder approval for self-interested compensation, "entire fairness" becomes the judicial standard that boards need to meet. This requires a showing not only that such compensation decisions are fair on a peer group basis, but also that they resulted from a fair diligence process.  Overall, smart boards will act either within shareholder-approved boundaries, or will act based on a corporate record designed to satisfy judicial review under an entire fairness test. 

     Given the risks to board members, independent counsel for compensation committees is worth considering -- because there can be significant protections, at modest company cost.  

  • Law360 reported on Sept. 17th that "Investors in biopharmaceutical company Abeona Therapeutics Inc. sued the company’s nonemployee directors and top officers on the company’s behalf Monday, alleging in Delaware Chancery Court that nonemployee board members are “grossly” overcompensated despite woeful business performance."
  • A few weeks earlier, Law360 reported that iOvaSciences settled shareholder derivative litigation alleging that its directors paid themselves excessive compensation. This decision is discussed in the following paragraph.


​2018.09.04  Director Compensation: $300K Price-tag to Settle.  It cost OvaSciences more than $300,000 of attorneys' fees to settle shareholder derivative litigation alleging that its directors paid themselves excessive compensation. The company also had to agree both to cap the annual cash and stock compensation of its outside directors, and to pay them according to a shareholder-approved plan that is binding for at least three years.  See Meridien Update (also covering a similar settlement to litigation against Clovis Oncology). For precautions that boards should consider, see Director Compensation Homepage.


2017.12.22  Directors Lose Stock Award in Settlement.  In Williams v. Sorrento Therapeutics, a DE Chancery Court accepted the settlement of shareholder derivative litigation "alleging that the Individual Defendants breached their fiduciary duties by granting to themselves a series of options and warrants in Sorrento’s subsidiaries, either shortly before or shortly after they had caused Sorrento to transfer valuable assets to the subsidiaries."  


2017.12.19  From Delaware's Supreme Court: Dramatic Change in Shareholder Approval Rule.   Gone is Delaware precedent under which the business judgement rule protected directors who made equity awards to themselves within "meaningful limits" that stockholders had previously approved. Delaware's Supreme Court enunciated the following new standard in deciding In re Investors Bancorp:

  • ​As ratification has evolved for stockholder-approved equity incentive plans, the courts have recognized the defense in three situations—when stockholders approved the specific director awards; when the plan was self-executing, meaning the directors had no discretion when making the awards; or when directors exercised discretion and determined the amounts and terms of the awards after stockholder approval. The first two scenarios present no real problems. When stockholders know precisely what they are approving, ratification will generally apply. 
  • As the Court of Chancery emphasized in Sample, using an expression coined many years ago, director action is “twice-tested,” first for legal authorization, and second by equity.81 When stockholders approve the general parameters of an equity compensation plan and allow directors to exercise their “broad legal authority” under the plan, they do so “precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty.”

Overall, only shareholder approval of exact awards will insulate directors from shareholder derivative litigation.  Here are steps that are recommended for corporate directors to follow when making decisions about their own compensation: 

  1. Start with a compensation consultant.  Peer data provides the best indicia of reasonableness, and helps to fashion discussion of what forms of compensation to consider and how much to pay.  All of this can begin at the compensation committee level.
  2. Act through more than one meeting, in order to build a record that indicates a thorough level of procedural diligence. Decisions made at a single meeting are often second-guessed as having been rushed or inadequately reviewed. 
  3. Consider having shareholders approve precise levels of annual awards, or a particular dollar value for each director's compensation (most likely to lock-in a suitable amount for a multi-year period).  Automatic escalators that preclude director discretion are worth careful consideration in order to minimize the need for future shareholder votes. This is because, as now held by Delaware's Supreme Court, "when it comes to the discretion directors exercise following stockholder approval of an equity incentive plan, ratification cannot be used to foreclose the Court of Chancery from reviewing those further discretionary actions when a breach of fiduciary duty claim has been properly alleged."

Overall, directors risk costly litigation if they lose business judgment protection because courts will then apply an entire fairness standard (discussed in several of the cases below) when evaluating shareholder claims alleging director compensation is excessive.


  • [REVERSED on 2017.12.19] 2017.04.10  Chancery Court Had Dismissed the Litigation due to Meaningful Plan Limit.  Here is the holding - rejected above - from the Delaware Chancery Court in In re Investors Bancorp: I conclude that the fully informed stockholder vote that approved the plan extended to the awards themselves, which indisputably fell within the limits set by the plan. Accordingly, the propriety of these awards will be reviewed under the business judgment rule which defaults to a waste standard.


2016.09.09  Settlement of Citrix Director Compensation Litigation.  Law360 reports that a Delaware Chancery Judge approved the settlement of shareholder derivative litigation under which Citrix agreed to limit annual stock awards to directors to $795,000 (roughly two times the highest past levels), to submit that limit to a shareholder vote next year, to make enhanced proxy statement disclosures about the determination of director compensation, and to use an independent consultant to assist with peer data and the annual determination of proper cash and equity-based compensation. 


2015.Sept.24  Director Compensation - What to Limit to Defuse Litigation?  

In a well-publicized Citrix decision earlier in 2015, Delaware's Chancery Court comprehensively reviewed past shareholder derivative litigation alleging excessive compensation for directors. That decision, Calma v Templeton (4/30/2015), focused on the circumstances under which shareholder approval would either secure highly deferential court review under the business judgement rule, or result in review under an "entire fairness" standard that generally enables such litigation to survive a motion to dismiss. In the wake of the Citrix decision, it has become common for public companies to consider receiving shareholder approval of some director compensation limit when they seek approval for new or amended stock plans. Should approval relate to total compensation, or focus on equity awards. 
The safest course involves seeking shareholder approval of a reasonable limit on total compensation - cash plus equity.  Any such provision needs careful drafting to avoid precluding a board member from, for example, later collecting special compensation for extraordinary services. A reasonable shareholder-approved limit imposed solely on equity compensation has one notable drawback: any cash compensation could arguably be contested a having made overall compensation excessive. Although the caselaw is nuanced, the message is clear: seek shareholder approval of reasonable limits on director compensation because there is case law momentum that is sure to fuel more shareholder derivative actions. Note we suggested this defensive action almost three years ago, in our Cannons Article reviewing U.S. executive compensation litigation risks.

2014.Jun.26   Delaware Chancery Again Requires "Entire Fairness" . . .  in order to justify director compensation.  See Cambridge Ret. Sys. v. Bosnjak, 2014 Del. Ch. LEXIS 107 (Del. Ch. June 26, 2014). Law360 reported as follows:

  • "A Delaware Court of Chancery judge agreed with Unilife's contention that Massachusetts-based Cambridge Retirement System, which holds stock in the company, could not pursue damages for equity awards provided to a number of nonexecutive directors because the awards were approved by a majority of the company's stockholders."


2014.June.9   Director Compensation - FaceBook Struck with Shareholder Litigation.
A Facebook shareholder has launched derivative litigation in Delaware Chancery Court, seeking to recover "unfair excessive compensation" being paid to directors (quoting from this Bloomberg article).  The lawsuit alleges corporate waste, breach of fiduciary duties, and unjust enrichment.

2013.Nov.13  Mere Eligibility for Future Stock Awards does not Make Directors "Interested"
An amended complaint in a shareholder derivative action was dismissed with prejudice after revised allegations failed to excuse demand on the board. The court explained in Abrams v Wainscott (D.DE, 11/13/13):

  • "While the pool of shares increased, this fact alone is not sufficient to raise a reasonable doubt that the outside directors (i.e., a majority of the board) were disinterested in the proposals. As demand futility analysis proceeds transaction-by-transaction, the transaction here - the proxy proposals - split the Director Defendants' interest in determining their own pay from both the increase in the time period during which the Directors receive compensation and the increase in the options pool.  In other words, the Directors' ability to grant themselves stock remains unaffected by the proxy vote and exists regardless of the proxy proposals. . . . Therefore, for the reasons stated above, the Plaintiff has failed to plead sufficient facts to raise a reasonable doubt concerning the Directors' disinterest.

2013.Oct.11  "Spring-loading" of Director Compensation, alleged by Shareholders
The appearance of grant-making based on inside information has fueled past shareholder derivative lawsuits, as well as the adoption of corporate guidelines for the timing of stock option and other awards (and SEC rules requiring their disclosure).  Boards should not let their guard down however. Law360 reports that Peregrine Pharma's directors have been sued in a shareholder derivative suit asserting claims that they awarded themselves excessive compensation, quoting from the article:

  • “The suspicious purpose, timing and size of the grants strongly indicate that these grants were made to take advantage of the positive findings that were just days away from being announced,” the suit claims.


2012.Jul.09  Delaware Court Permits Claims to Proceed re Director Equity Awards 
The typical omnibus stock plan includes non-employee directors among the list of those eligible to receive discretionary stock awards. Shareholder approval of those plans will not alone insulate directors from claims that they have awarded themselves excessive compensation, based on refusal to dismiss such a claim in Seinfeld v. Slager, DE Ch, 6/29/2012.