New court ruling, new need for caution: in structuring director compensation, corporate boards face added scrutiny.

• Author: Raymond, Doug
• Position: LEGAL BRIEF

NAVIGATING potential conflicts of interest can be challenging for directors, particularly in the current environment, where many are skeptical of the loyalty of directors to the best interests of stockholders. Challenges to board actions often focus on claims that directors have compromised the interests of the stockholders for their own personal benefit. A recent Delaware case highlights the risks that boards face when taking action that may benefit themselves, even if the same action would not have raised eyebrows a few years ago.

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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 the decision is potentially influenced by a conflict of interest or the gross negligence of the board. However, the Delaware Court of Chancery recently denied business judgment deference to a board's decision to grant equity incentive awards to board members, even though the plan under which the awards were granted had been approved by stockholders.

The case, Seinfeld v. Slager, was brought by shareholder plaintiffs challenging executive compensation decisions made by the board of Republic Services Inc., a public company that provides waste management services. While the court dismissed most of the claims, it allowed one claim to proceed--that the directors had breached their fiduciary duties by giving themselves awards under the company's 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. This is a level of judicial scrutiny more challenging, and surely more expensive to defend in litigation, than the business judgment rule. The case illustrates the pitfalls of today's governance environment, particularly in the area of board compensation, where boards historically had significant latitude.

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, absent corporate waste or a total failure of consideration, which would be unlikely to exist except in the most egregious of circumstances. In reaching a different result...