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E-MailEd Batts is partner and co-head of the M&A and Private Equity groups at Orrick, Herrington & Sutcliffe LLP. This post is based on an Orrick publication and is part of the Delaware law series; links to other posts in the series are available here.
Compensation committees composed of independent outside directors were created as the check-and-balance guardians against management compensation engorgement. But as the Roman philosopher Cicero famously posed, “Who guards the guards?”
A few, relatively recent cases stemming from director compensation—most prominently involving outside directors at Citrix and Facebook—have opened up a new front for the Delaware plaintiff’s bar to seek fees in return for easily-implemented and relatively small governance changes.
When there is no inherent conflict of interest in a given corporate decision, directors are afforded the business judgment rule—or essentially wide ranging latitude to direct the business as they see fit. However, Delaware courts have held it is an inherent conflict to have independent outside directors approve their own compensation. This throws such determinations under the scrutiny of the harsh light of the entire fairness rule—where directors (and not plaintiff stockholders) bear the burden of proving that their compensation is fair in terms of both price and process.
As a practical matter, the shifting of the burden of proof makes it much more difficult for a corporate defendant and board to succeed in throwing out a suit on a motion to dismiss early on, prior to discovery or trial. This thereby leads to the specter of litigation cost both in terms of opportunity cost, through time and distraction, and out of pocket costs, through outside defense counsel, discovery and the bells and whistles of full blown litigation. The potential for a lengthy and costly battle thus encourages public companies to hash out a quick-and-easy settlement that makes changes that may have little practical difference to the company or its stockholders, but nonetheless close an optics-based loophole while flicking some gold coins in the pockets of the plaintiff’s firms.
Public companies have been quick to point out that director compensation—particularly equity compensation—is fully disclosed in proxy statements annually and has customarily been awarded under plans that are subject to stockholder approval. Moreover, proxy advisory firms were entirely free to (and do) take director compensation amounts into consideration when making recommendations as whether to re-elect directors. The Delaware judiciary has retorted, however, that because omnibus plans historically were effectively free from limits, any stockholder approval was essentially illusory. Never mind that directors are subject usually to annual election. Never mind that shareholders are in fact free to reject adoption of omnibus stock plans.
Accordingly, public company boards should now consider:
- Setting realistic, benchmarked limits on director compensation, whether in cash or equity—and preferably submit these limits to affirmative stockholder approval at an annual meeting of stockholders.
- Being extra proactive in disclosures surrounding director compensation, including benchmarking procedures, whether outside compensation consultants were engaged and general director compensation philosophies. In other words, create a “mini-CD&A” (Compensation Disclosure & Analysis) section in the proxy statement for outside directors that in many respects mirrors disclosure for management.
The upside of these changes is likely to be modest, at most. For example, in the Facebook case, the Delaware court ruled that Mark Zuckerberg’s relatively informal endorsement of the compensation policy after the fact was insufficient—and that a formal consent or meeting was required. While the overlooking of corporate formalities may allow for a plaintiff firm to greenmail a juicy settlement from an issuer—it is a fleeting opportunity as the simple adoption of such formalities stymies a case when a controlling stockholder resoundingly sides with directors. Nothing substantively changes. And, in the more customary context of shares that are widely held, public companies generally were already attuned to director compensation issues given scrutiny from proxy advisory firms and activist investors who may seek to highlight any corporate warts.
Indeed, this genre of lawsuit is almost certainly a “business line” for the Delaware plaintiff firms that will inevitably fade out quickly over time. For the next couple of proxy seasons, it would be unsurprising if such plaintiff’s firms scour the proxy statements and equity plans of issuer after issuer, and upon striking “Eureka!” with a non-compliant issuer, filing a formulaic suit. But as issuers are sure to heed the alarmist cries of their outside advisors (yours truly included) and adopt such explicit limits over time while enhancing proxy statement disclosure, the vulnerability will become closed and such plaintiff’s firms will be forced to search out more meaty issues. No doubt, given the dramatic judicially-driven and long overdue curtailment of M&A disclosure-only litigation in the past year through the rejection of generous settlement fees to plaintiff’s counsel, more than one plaintiff’s firm will be eager to find similar new lines of argument and business.
More broadly, these cases and the underlying issues illustrate the ongoing tension between the level of direct democracy, versus representative democracy, that stockholders are afforded. With the advent of the federally-mandated “advisory” vote on executive compensation (“say-on-pay”) and now continued ratcheting down on areas such as director compensation where there are still checks and balances (before these cases, there was already plenty of required disclosure—and an option to simply throw the directors out of office), will we continue to see either federal government or state judiciary mandated direct approval of specific business items by stockholders? And, if so, does the investment of time and energy in such individualized direct-democracy pursuits truly benefit the corporation and its stockholders in efficiently maximizing stockholder return?
