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Less Is More? Not when it comes to director compensation plans and effective shareholder ratification

Less Is More? Not when it comes to director compensation plans and effective shareholder ratification.

Companies cannot merely rely upon shareholder approval to obtain protection under the business judgment rule. While the courts in Delaware do frequently apply the standard of waste to claims of breach of fiduciary duty and grant boards broad discretion to make business decisions, the courts apply the stricter standard of entire fairness when shareholder ratification of interested directors’ actions was ineffective. The affirmative defense of ratification is not available if shareholders approve a director compensation plan that grants unbridled discretion to the board to determine the amounts of specific awards. Rather, for shareholder ratification of a director compensation plan to be effective as an affirmative defense to a claim of breach of fiduciary duty, the plan should detail the amounts of or reasonable limits on the awards to be granted, or the shareholders should approve the actual awards granted pursuant to the plan.

As is taught early in law school, the standard of review that the court applies can make or break your case. In Delaware, whether the court applies the standard of entire fairness (can one reasonably conceive that the decision was not entirely fair to the company) or waste (can no rational business purpose be attributed to the decision) to a claim for breach of fiduciary duty is often pivotal. Effective shareholder ratification will often determine which standard applies.

In Calma v. Templeton, the company, like many others, sought to attract and retain knowledgeable directors by providing generous compensation. The stock to be awarded to the directors was governed by an equity incentive plan approved by the shareholders. Despite shareholder approval, one shareholder sued the company over the directors’ compensation alleging breach of fiduciary duty, waste of corporate assets and unjust enrichment. The company argued that the breach of fiduciary duty claim should be reviewed under the waste standard because the shareholders had ratified the equity incentive plan. While the plaintiff did not dispute that the shareholders had approved and were informed of the details of the plan or that the awards were granted in accordance with the terms of the plan, the plaintiff argued that the shareholders had not effectively ratified the plan. The court agreed and applied the higher standard of entire fairness.

The company’s plan in Calma did not specify amounts to be awarded to directors; rather, the only limit imposed was that no beneficiary could receive more than one million shares per year, which had an approximate value of $55 million dollars. The plan, which had been approved by the shareholders, was not effectively ratified by the shareholders because it lacked sufficient definition, and, therefore, the shareholder approval failed to protect the directors under the business judgment rule and shift the burden to the plaintiff. Based on the court’s analysis of several Delaware cases involving shareholder approval of self-interested director transactions, to have effective shareholder ratification of an equity incentive plan, the plan should not grant unlimited discretion to the board; it should either specify the amounts of awards or set reasonable limits on the awards that can be granted.

While directors may be inclined to include less detail in incentive plans to enable the board to have more discretion, the lack of specifics may make shareholder approval ineffective. So, less is not always more.

— Natalie F. Malone

Natalie Malone