On Governance is a series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.

Last week Agenda published my very short Opinion encouraging corporate boards to seriously consider amending compensation plans for non-employee directors (hereinafter referred to as “directors”) before their 2019 annual shareholder meetings to limit director discretion in ways that as a matter of law or as applied in practice would not subject their compensation to review under the entire fairness standard under Delaware, New York and other similar state corporate laws.  My opinion is based on my reading of the Delaware’s Supreme Court’s decision in December of last year In Re Investors Bancorp Inc. Stockholder Litigation, recent settlements in two director compensation lawsuits and the feasibility of designing plans that would substantially reduce the risk that companies might lose control over their director compensation plans and processes to the courts and the plaintiffs’ bar. All of this deserves a more detailed elaboration of the facts and my reasoning, as follows. 

The Investors Bancorp decision

In Investors Bancorp, the Delaware Supreme Court reversed the Court of Chancery’s April 2017 decision, which had held that shareholder approval of Investors Bancorp’s equity plan, which limited director awards to up to 30 percent of the plan’s authorized shares, constituted shareholder ratification of the directors’ generous compensation that supported a motion to dismiss the suit under the deferential business judgment rule.  In reversing, the Supreme Court held that when shareholders properly allege that directors have breached their fiduciary duties when exercising discretion over their compensation after shareholders have approved the general parameters of a compensation plan, the directors have the burden of proving that their self-interested actions were entirely fair to the company, both in the amounts paid and the process used to determine the amounts.

This “entire fairness” standard of review imposes a very heavy burden on directors and is not one that can support a motion to dismiss or likely even a motion for summary judgment.  Therefore, in practice, if the entire fairness standard applies in a director compensation case, the company is forced to settle unless it is prepared to engage in expensive, time consuming, highly distracting and potentially embarrassing litigation and a trial on the merits, which most companies are not.   

Investors Bancorp has unsettled many companies that had relied on Seinfeld v. Slager and Calma v. Templeton earlier Chancery Court decisions, which had held that shareholder approval of “meaningful limits” (less than the very large maximum limits based on IRC Section 162(m) that applied to all participants, as were involved in those plans) could constitute shareholder ratification that would support a business judgment standard of review to exercises of discretion within those limits.

The “meaningful limits” adopted by many companies to come within Seinfeld and Calma generally range from two to three times the directors’ compensation as of the date of the amendment, have been discussed and recommended by many advisors (including me) and have been adopted by many companies, even in 2018 after Investors Bancorp.     

Many fine lawyers and compensation advisors have written many detailed and thoughtful commentaries on Investors Bancorp, examining its unusual and bad facts and its possible implications, which are worth reviewing.  Some of these are more bullish on the defensibility of discretion than others.  Suffice it to say that I have never been in the bullish pen, because to me the Supreme Court’s holding as paraphrased above is simple and clear and the Court appeared to go out of its way not to give any hope that shareholder-approved plans with more meaningful limits than those of Investors Bancorp might be saved by the business judgment rule. Nothing that I have seen or heard this year makes me more bullish.

(See related February 7, 2018, Governance Center Blog post.)

On remand to the Chancery Court, the litigation in the Investors Bancorp case grinds along in discovery and motion proceedings that could lead to a trial subjecting the directors’ compensation decisions to the entire fairness standard of review, or more likely, a more expensive and restrictive settlement than those negotiated by companies after Seinfeld and before Investors Bancorp.  Only time will tell the final outcome for Investors Bancorp. In the meantime, recent settlements in two other cases appear to have been heavily influenced by the Supreme Court’s decision in ways that do not bode well for directors who determine their own compensation under shareholder-approved plans that do not limit their discretion to amounts that either would not make it worthwhile to the plaintiff lawyers to sue or could be protected by the business judgment rule. 

The recent Clovis Oncology and OvaScience settlements

On May 30, Clovis Oncology and its directors settled their director compensation lawsuit (Solak v. Barrett), which had been filed in May 2017 after the Chancery Court’s decision in Investors Bancorp but prior to its reversal by the Supreme Court.  In approving that settlement, Vice Chancellor Slights (who had decided Investors Bancorp in the Chancery Court) noted with approval that the parties’ negotiations, which initially had focused on crafting discretion subject to limits, were “informed by” and “reset” after the Supreme Court’s decision in Investors Bancorp.

The “reset” settlement requires Clovis Oncology to submit a binding proposal at its 2018 shareholder meeting to approve a new director compensation plan that prescribed dollar amounts of annual total compensation (cash and equity) determined by the board and to be specified in the proposal. 

The company also agreed that if approved by shareholders these amounts would remain in effect for two to five years unless amended and approved by shareholders. In addition, the company agreed to

(i)            provide fulsome proxy disclosure of its process for determining the compensation and identifying members of the company’s peer group;

(ii)           adopt mandatory stock ownership guidelines for directors;

(iii)          adopt certain practices, including being guided by peer group compensation and “best practices,” and

(iv)          pay the plaintiffs’ lawyers $395,000 in legal fees.

Accordingly, the company submitted a standalone director compensation policy with prescribed retainers to its shareholders for approval at its June 7 meeting, which failed with 42 percent support.  It will be interesting to see how this very unusual development will be handled by the company as it determines what to pay its directors, likely subject to even closer scrutiny under the entire fairness standard.    

On June 4, OvaScience, its directors and a shareholder plaintiff filed a proposed settlement of their director compensation lawsuit (Fulton v. Dipp) in the Delaware U.S. District Court.  Very much like the Clovis Oncology settlement, OvaScience’s proposed settlement would require the company to present a binding proposal at its next shareholder meeting to approve a new director compensation plan with prescribed dollar amounts of annual total compensation (cash and equity), but also inclusive of any fees for board or committee service.

Following the Clovis pattern, the company also agreed that if approved by shareholders these amounts would remain in effect for no less than three years unless amended and approved by shareholders and to

(i)            provide fulsome proxy disclosure of the its process for determining the compensation and identifying members of the company’s peer group;

(ii)           adopt mandatory stock ownership guidelines for directors;

(iii)          adopt certain practices, including being guided by peer group compensation and “best practices,” and

(iv)          pay the plaintiffs’ lawyers up to $300,000 in legal fees, to be determined by the court.

In addition, going beyond the Clovis settlement and breaking new ground, the company agreed to hold shareholder votes on its director compensation every three years unless earlier required by a proposed change (essentially birthing “mandatory (not advisory) say-on-director-pay” votes).  Pursuant to the proposed settlement, the company submitted a new free-standing director compensation plan for shareholder approval, which passed with 95 percent support at its June 26 annual meeting.

The current environment and mitigating the risks

Investors Bancorp was decided so late in 2017 that most companies were not able to fundamentally restructure their director plans to substantially reduce director discretion in time to submit the plans to shareholders for approval at their 2018 meetings.  So, this proxy season most companies adopted a wait-and-see approach to amending their director compensation plans, unless they were otherwise submitting their plans for shareholder approval to increase the number of authorized shares or for other reasons. In this case, most (but strangely not all) made the quick fix of adding “meaningful limits” of the post-Seinfeld type. 

Given the slow pace at which lawsuits are resolved and law develops, we are still early in the post-Investors Bancorp era, as we wait to see what happens in the case on remand, how the Supreme Court’s decision and recent settlements impact settlements in pending cases, future lawsuits and the development of director compensation “best practices.”

However, things are not looking better for companies. The plaintiffs’ lawyers are not sitting on their hands, and the prescriptive and far-ranging terms of the settlements in the Clovis Oncology and OvaScience cases and how they were achieved are troublesome.  Bottomline, there are clear risks that if companies are sued over their director compensation they could be forced at the point of a lawsuit to do things they could avoid having to do, or could do better, if they were to now take the initiative, consult with their lawyers and other advisors, monitor ongoing developments and consider changing their plans and practices to reduce their exposure.  While companies’ exposure to litigation and relevant facts differ greatly, in general, director retainer compensation is formulaic, predictable and capable of being committed to for a period of years and submitted to shareholder approval, and extraordinary compensation if ever necessary can be designed and administered to qualify for the business judgment rule.  

One thoughtful approach for companies to consider is that taken by JP Morgan Chase in amending its Long-Term Incentive Plan in March of this year, contingent on shareholder approval, and as approved by its shareholders with more than 95 percent support at its May meeting.  In its 2018 amendment and restatement of its 2015 amended and restated plan, the company extended the term of the plan to May 31, 2022, increased the authorized number of shares and incorporated the terms of its director compensation program into the plan. This previously had given the board complete discretion to determine director compensation, subject only to the plan’s IRC Section 162(m)-driven limit of 7.5 million shares per participant during the plan’s term. 

In the 2018 amendment, the company retained the 7.5 million share limit but added new provisions applying to director compensation, which specified

(i)            an annual base retainer per director of $350,000 per year, with discretion to increase it by up to $25,000 but not until January 2020; and

(ii)           additional retainers for special service of $30,000 for the Lead Independent Director, $25,000 for chairing the Audit Committee, the Directors’ Risk Policy Committee or the company’s bank board, and $15,000 for chairing any other principal standing committee or serving on the bank board, the Audit Committee or the Directors’ Risk Policy Committee, with discretion to increase any of these special retainers by $5,000, but also not until January 2020.

In addition to specified retainers, with bands of limited discretion to increase them after 2019, the plan also provides the board with safety-valve discretion to pay any director an additional retainer or other fee, including for service on any specific service committee or for any other special service, in its discretion, subject to the plan’s 7.5 million share limit.  Under the amended plan, any director’s compensation may be paid in cash, in stock or in a combination of both, in the discretion of the board. The board has delegated its discretion under these provisions to its Corporate Governance and Nominating Committee, subject to the board’s discretion to later determine otherwise.   

JP Morgan Chase’s director compensation program, which is now locked into its shareholder-approved omnibus plan, was adopted one year in advance of the expiration of the 2015 plan and appears to have been informed by Investors Bancorp, provides companies with a good roadmap of the plan design issues and possible solutions that should be considered by companies that would like to reduce their exposure to Investors Bancorp and its progeny.

The key features worth consideration are that

(i)            it specifies the dollar amounts of the directors’ basic and special service retainers, thereby protecting these amounts under the business judgment rule because they have been ratified by shareholders;

(ii)           even if the board exercises its discretion to increase any of the retainers after 2019 within the prescribed bands and even if such an exercise of this discretion would be subject to the entire fairness standard of review, the dollar amounts subject to this limited discretion are so small as not to make them attractive targets for plaintiffs’ lawyers, whose fees are largely based on the amounts that directors were paid using their discretion;

(iii)          if the board ever determines to pay special fees to any directors under the plan’s safety-valve provision, it is highly likely that this compensation could be protected by the business judgment rule by having it approved by the board or a committee with a majority of members who are disinterested with respect to the compensation; and

(iv)          these provisions apply to total stock and cash compensation and give the board discretion to determine the mix.

Finally, the terms of the director compensation program are included in an omnibus equity plan that also covers employees and could be resubmitted periodically to shareholders for approval when a company requests more authorized shares. Including these provisions in an omnibus plan and submitting them for approval with other plan changes every several years likely would not expose the directors program to as much risk of shareholders venting their possible unrelated grievances with the company or its board on director compensation as could be the case if the program were submitted in a free-standing director plan, as taught by the Clovis Oncology case.   

 The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.