Delaware Court Decision Means Greater Scrutiny Of Directors Granting CEO Equity Awards

A recent decision by the Delaware Court of Chancery means that corporate boards may need to be more discerning in how they approve equity compensation awards—especially when the awards are challenged by shareholders. As a result, this decision could mean more legal challenges of equity compensation awards and higher scrutiny of board decisions to grant them.

In May, the Court heard the case of Garfield v. Allen and accepted, “with admitted trepidation,” the premise that corporate directors could be held liable for breaching their fiduciary duties to shareholders if they failed to reverse equity compensation awards made to the CEO after being made aware that the awards violated the company’s equity compensation plan via a plaintiff’s litigation demand letter.

A memorandum issued by the Fried, Frank, Harris, Shriver & Jacobson law firm details the court’s decision, stating that:

“The court accepted, at the pleading stage, the plaintiff’s “novel” theory that a board’s failure to act to address a problem it learns of through a litigation demand letter may constitute a breach of the directors’ fiduciary duties. The court declined to dismiss the plaintiff’s fiduciary claims (as well as certain contractual claims) against the directors who approved the awards; against the other directors (who did not approve the awards); and against the CEO who received the award.” 

While the court cautioned that this approach could be abused by plaintiffs in the future, it did allow that in certain situations breach of fiduciary duties claims against directors could be allowed to proceed. This increases the accountability of all corporate board members in the approval of CEO compensation and in failing to claw-back compensation when warranted.

As CEO compensation continues to rise, shareholder opposition to high CEO pay has been growing as well. With the added shareholder scrutiny of compensation plans and this new potential legal liability to corporate directors to correctly administer compensation plans, boards might consider the following:

• Prepare a defense of equity awards granted under the current executive pay plan.  Whether the board believes it has allocated equity awards correctly or not, it should prepare a defense of its compensation plan that can be communicated to investors if they have questions. Although the majority of pay plans are overwhelmingly approved by shareholders, there has been an increase in shareholders voting against compensation plans during “say-on-pay” voting in the last two years. Being open and transparent about how key executives are “earning” their compensation will build trust with investors that will make future votes on compensation plans less controversial.

• Review and clarify any ambiguous clauses/terms in the compensation plans. One of the key takeaways from the Delaware Chancery Court ruling was that directors could no longer use the fact that the compensation plan gave them sole discretion for interpreting and administering the plan as a reason they did not correct errors in granting equity awards that were clearly pointed out in a plaintiff’s legal action. A review of the terms of the current equity compensation plan to make sure it is in line with generally accepted “pay for performance” best practices and other appropriate metrics for the company’s size and industry might be in order. Making sure the plan clearly states how equity compensation is awarded and why the board has chosen that model will go a long way to reducing potential errors in how equity awards are granted.

• Seek advice on D&O insurance coverage.  With the current increase in litigation against corporations, it might also be a good idea to review the company’s directors’ and officers’ insurance coverage. The scrutiny on the actions of corporate directors has intensified in recent years and seeking advice on places where the board might be at increased risk would be prudent. Individual board members may also want to determine if the company’s D&O insurance policy limits are appropriate for the potential risks board members may be exposed to. In extreme cases, individual directors’ personal assets could be exposed (even if there is an indemnification provision) if D&O policy limits to cover the defense costs and judgements against directors are exhausted and the company is unable to absorb those costs and judgements.