2015-Issue 24—A recent decision by the Delaware Court of Chancery should cause many employers to at least consider amending incentive plans that cover their directors and to review their peer groups. The basis of the court’s holding in Calma v. Templeton, No. 9579-CB (Del Ch. Apr. 30, 2015) was that equity grants by directors to themselves were self-interested transactions that, unlike most director actions, are not protected by the more lenient business judgment rule, but instead must satisfy the significantly more stringent “entire fairness” standard. The court also refused to find that the company’s peer group, which included several companies that were significantly larger than the company in several key measures, was appropriate for determining fairness, and remanded that determination to the trial court.
Citrix, Inc. maintained an “omnibus” incentive plan under which the compensation committee of the board was delegated authority to grant multiple forms of equity (and equity equivalents) to non-employee directors and others. The sole limit placed on the committee’s authority was that no participant could be granted more than one million shares (or share equivalents) in a year. The plan was approved by shareholders in 2005, and in each of 2011, 2012 and 2013, the committee awarded non-employee directors substantial restricted stock units. In a derivative suit, a shareholder alleged that these awards breached the directors’ fiduciary duty and constituted corporate waste and unjust enrichment because, combined with the directors’ cash compensation, the amounts were excessive when compared to that paid by Citrix’s peer group (as reflected in the company’s proxy statement). The defendants moved to dismiss the action, primarily on the ground that the shareholder approval constituted ratification of the awards. The court disagreed.
The Court’s Reasoning
Under Delaware law, a claim of breach of fiduciary duty by directors is generally considered under the standard of the business judgment rule, which is relatively easy to satisfy. However, where, as here, the directors stood to gain by their actions, the court held those actions must satisfy the “entire fairness” test (i.e., they were the “product of fair dealing and fair price”). The court rejected the ratification defense, holding that the defense applies only when the shareholder vote was “in favor of a specific decision of the board of directors” [emphasis in original] and finding that the defense did not apply because the shareholders were not presented with any action “bearing specifically on the magnitude of compensation for the Company’s non-employee directors.” The court found that the one million share limit (a variant of which is used in many plans) was not sufficiently specific, noting that a grant of that number of share-based awards would have had a value of more than $50 million when the suit was instituted.
The parties agreed that the compensation paid to the directors of Citrix’s peers was an appropriate measure of fairness. The court agreed, but found that the defendant had raised significant questions about Citrix’s peer group, which included several companies with significantly higher market capitalization, revenue and net income. This raised factual questions of the appropriateness of the group, which could not be decided on a motion to dismiss.
Alvarez & Marsal Taxand Says:
While the Calma decision is only procedural in nature (i.e., it did not reach the merits of the plaintiffs’ claims), its impact may be broad, both for companies subject to Delaware law and those incorporated in states that generally follow Delaware corporate law. At a minimum, any company that maintains an incentive plan that permit awards to directors should review the plan’s terms to determine whether it contains a limit on director grants that would satisfy the Calma standard. If not, the company should consider amending the plan as to future grants.
Regarding previously made grants under a non-complying plan, the company would be prudent to consult with counsel and other consultants as to whether shareholder approval of such grants would have been sufficiently specific as to constitute ratification. If seeking such approval is not feasible for cost or other reasons, the company should have a consultant carefully review its director compensation program (including the cash compensation elements thereof) to ensure, to the maximum possible extent, that it would withstand a challenge to its fairness. This should include a vigorous review of the company’s benchmarking process, including the peer group used to date, as well as that to be used in the future. In this regard, Alvarez & Marsal Executive Benefits & Compensation uses a proprietary method for analyzing peer groups that it believes will accurately determine whether a peer group challenge might be successful.
Of course, before taking any action, public companies should consider the possible reaction of the proxy advisory services to any changes, as well as that of any shareholder activists who might challenge the action.
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