Since the 1950s, it had been black letter law that where boards of Delaware corporations, pursuant to authority conferred by executive compensation plans approved by the shareholders, grant compensation awards, those awards, if challenged in court, are reviewed under the business judgment rule. Under that standard, the compensation award will be upheld unless it is shown to have amounted to corporate waste, i.e., that the corporation received in exchange no benefit or value from the services of the persons being compensated. That lenient form of judicial review was noncontroversial where the award recipients were executives or other employees, because the board had no conflicting interest and it was therefore presumed the grant of the award represented a disinterested, independent board judgment that the award served the corporation’s best interest.
The problem was that that presumption did not clearly fit compensation awards made by the board to its own non-employee directors, because in those cases, the board members would in effect be awarding compensation to themselves, thereby creating a financial conflict of interest. In those circumstances, settled Delaware corporate law principles would have required that the compensation award, if challenged in court, be reviewed under the entire fairness standard. In fact, however, director compensation awards continued to be reviewed under the same business judgment standard as awards to executives and other employees. The reason, the bar generally believed, was that because the shareholders had initially voted to authorize the board to make these awards, the approving shareholder vote operated as a “cleansing mechanism” that obviated any need for entire fairness review.
Because of this disparity in judicial review treatment, a tension has existed between the historic lenient business judgment review of non-employee director compensation awards and the inherent conflict of interest that, under traditional fiduciary principles, called for more stringent entire fairness scrutiny. It was predictable that at some point the Delaware courts would be asked to resolve that tension by addressing the inconsistent treatment of non-employee director compensation cases, unlike other forms of director conflict transactions that typically received entire fairness review. That inconsistency was first addressed in Seinfeld v. Slager, 2012 WL 2501105 (Del. Ch. June 29, 2012), and most recently was addressed in Calma v. Templeton, 2015 WL 1951930 (Del. Ch. April 30, 2015) (Citrix), decided by Chancellor Andre Bouchard on April 30, 2015. Citrix confirms that it should no longer be assumed that advance shareholder approval of an executive compensation plan, without more, will suffice to insulate non-employee director compensation awards from entire fairness review. What is required is that the shareholders specifically approve in advance either limits on the size of future director compensation awards or the magnitude of any such future awards.
Citrix was a shareholders derivative action for damages against the board of Citrix Systems, Inc. challenging awards of restricted stock units (RSUs) granted to eight non-employee directors in 2011, 2012 and 2013, under a 2005 Equity Incentive Plan. The directors were charged with breach of fiduciary duty, waste of corporate assets and unjust enrichment for having awarded and received the RSUs for those years. Denying a motion to dismiss the complaint for failure to make a pre-suit demand under Court of Chancery Rule 23.1, Chancellor Bouchard held that: (i) a demand would be futile because a majority of the directors in office when the suit was filed were interested by virtue of receiving the RSU awards, (ii) as a consequence, the legality of the awards would be reviewed for entire fairness, (iii) the complaint alleged facts that, if true, permitted an inference that, measured by the amount of awards granted to directors of selected peer group companies, the RSU awards granted to the Citrix directors were unfair, and (iv) the defendant directors were not entitled to a “shareholder ratification” defense under which the awards would receive business judgment review, because the shareholders had voted only to approve the Plan, which did not prescribe any specific award amount to directors or any director-specific upper limit on future awards made to directors. Therefore, under Delaware law, the shareholder vote did not operate as a “ratification” of the awards at issue.
The pertinent facts were as follows: The Plan, and later amendments, had been approved by a fully informed vote of a majority of Citrix’s disinterested shareholders, but the shareholders never approved any specific award to directors thereafter. The Plan gave the Compensation Committee “complete authority, in its discretion, to make or to select the manner of making all determinations with respect to each Award to be granted [to the beneficiaries] under the Plan,” which included Citrix directors, officers, employees, consultants and advisors. The only limitation imposed by the Plan—without regard to any beneficiary’s status or position at Citrix—was that no beneficiary could receive more than one million shares (or RSUs) per calendar year. There were no director-specific ceilings on the amount that could be awarded. At the time the lawsuit was filed, one million RSUs (based on Citrix’s stock price) were worth over $55 million.
The defendant directors, relying on several cases decided in 1952,1 argued that where shareholders have approved a plan that authorizes a corporate board to award stock options in their discretion as executive compensation, the earlier-in-time shareholder approval must be upheld unless the action by the directors “constituted a gift of corporate assets to themselves or was ultra vires, illegal or fraudulent.”2 After intensively analyzing those earlier cases, Chancellor Bouchard concluded that they do not support a global rule that in every circumstance, advance shareholder approval of a compensation plan will constitute a ratification of any award authorized by the plan. Rather (the Chancellor observed) the courts in those cases employed business judgment review either because (i) the plan that the shareholders had approved, in advance, identified the specific options and/or amounts the directors were authorized to award to themselves, and also the recipients or recipient categories; or (ii) the directors had granted awards to others and not to themselves, and therefore were not conflicted. After next surveying the more recent body of Delaware compensation case law, the Chancellor determined that “the modern” Delaware shareholder ratification doctrine applicable to director compensation requires that the shareholders must vote in favor of “board action bearing specifically on the magnitude of compensation for the Company’s non-employee directors.” Where the ratification defense is based on shareholder approval of the plan in advance of any award, the plan must set forth either the specific compensation to be granted to non-employee directors or director-specific “ceilings” on the compensation potentially awardable to the directors. Relying most particularly on Seinfeld v. Slager,3 the court concluded that the non-employee director awards under the Citrix Plan must be reviewed for entire fairness, because that Plan did not prescribe either form of director compensation limitation.
Citrix, together with its predecessor, Seinfeld, make it abundantly clear that a seismic change has occurred regarding how non-employee director compensation awards will be judicially reviewed under Delaware law. Because director compensation has become an increasingly fertile ground for litigation, boards are well advised to be mindful that an appropriate, well-considered process is essential in determining and making changes to director compensation. Boards should also be aware of the litigation benefit—business judgment review—that can be had from having shareholders approve a meaningful limit on director compensation in their equity compensation plans, and the litigation risk—entire fairness review—that can result from not incorporating such compensation limits. This litigation benefit needs to be weighed against the loss of flexibility that results from including a limit on individual director compensation. Many companies incorporated such limits in their compensation plans after Seinfeld. We expect that Citrix will even more markedly reinforce that trend.
From a litigation standpoint, even where meaningful limits are approved by shareholders and a ratification defense is available in a lawsuit attacking director compensation awards, it will be difficult to obtain a dismissal of the case at the pleading stage. The reason is that the complaint will rarely allege all the facts that are essential to state a ratification. Defense counsel, therefore, are advised to consider alleging those facts in a verified answer and moving for judgment on the pleadings or, alternatively, for partial summary judgment limited to the applicability of the shareholder ratification defense.
1 Kerbs v. California Eastern Airways, Inc., 90 A.2d 652 (Del. 1952); Gottlieb v. Heyden Chemical Corp., 90 A.2d 660 (Del. 1952); and Kaufman v. Schoenberg, 91 A.2d 786 (Del. Ch. 1952).
2 Kerbs, 90 A.2d at 655 (italics in original).
3 2012 WL 2501105 (Del. Ch. June 29, 2012). In Seinfeld, the executive compensation plan was highly similar, if not functionally identical, to the Citrix plan. The Court of Chancery found that the plan in Seinfeld had “no effective limits on the total amount…that can be awarded through time-vesting [RSUs],” as a result of which the directors had “the theoretical ability to award themselves as much as tens of millions of dollars per year, with few limitations.” “[B]ecause the stockholders had not voted in favor of the specific RSU grants at issue or to impose a limit applicable to directors specifically—as opposed to a generic limit applicable to a range of beneficiaries with differing roles,” the Seinfeld court held that there was no ratification defense and that the amounts the directors awarded themselves would be reviewed for entire fairness.
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Matthew E. Johnson
John P. Kelsh
Sidley Corporate Governance and Executive Compensation Practice
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