Boards of directors have long set their own compensation, creating an inevitable conflict of interest, but change is on the horizon thanks to a recent Delaware Supreme Court ruling.
Based on past court decisions, if shareholders voted to give directors the authority to use their discretion to make compensation awards to themselves, boards had significant protection against litigation challenging those decisions. This is known as the ratification defense.
Last December, however, the Delaware Supreme Court significantly narrowed this ratification defense in In re Investors Bancorp, Inc. and shifted the focus away from stockholder ratification of "meaningful limits," i.e. general parameters that confine the directors' compensation awards.
In Investors Bancorp, a derivative suit was filed against the company's board for a breach of the directors' duty of loyalty, alleging that the directors awarded themselves excessive stock-based compensation. Looking to the existing Chancery Court cases, the directors relied on the stockholder ratification defense. They argued that the stockholders had both approved the equity plan and ratified the "meaningful limits" applicable to director compensation.
These limits, however, were not very restrictive--the directors could allocate up to 30% of all option or restricted stock available under the entire plan to themselves. According to the stockholders' complaint, the total value of the award was almost $52 million, and certain directors' individual awards were over 2,500% higher than average awards at peer companies.
Nonetheless, the Chancery Court agreed with the directors and dismissed the suit on ratification grounds because the awards were within the limits set out in the stockholder-approved plan.
On appeal, the Delaware Supreme Court reversed the Chancery Court decision.
The court reviewed stockholder ratification of director compensation in the earlier cases and held that stockholder ratification applies where the stockholders have specifically approved the board action. The court held that it is not sufficient for the stockholders merely to authorize the directors to use their discretion to determine their own compensation under an overarching compensation plan. The ratification defense is available only if stockholders approve the specific amount of director compensation or the formula for determining compensation, leaving no discretion to the board as to the amount.
The court made clear that if the...