An important corporate governance topic – but a subject that I frankly have not addressed frequently this site – is the topic of executive compensation. In the following guest post, Sarah Abrams, Director, Management Liability Claims at Markel, examines the recent rise in D&O litigation involving executive compensation. I would like to thank Sarah for allowing me to publish her article on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah’s article.
As of May 2021, heady conditions in the equity markets, combined with a shift toward stocks as the basis for director and officer compensation, are highlighting an area of growing litigation-related risk for both providers of D&O coverage and their insureds.
Over the past couple of years, shareholder derivative lawsuits alleging excessive and unfair compensation awarded by directors and officers to themselves have been on the rise. Especially prolific are filings in Delaware, where In Re: Investors Bancorp[i] has set the stage for application of the “entire fairness standard” to pending litigation. The entire fairness standard requires the court to examine two aspects of the board’s dealings with the corporation: whether the board dealt fairly with the corporation, and whether the challenged transaction was at a fair price to the corporation.
The In Re: Investors Bancorp litigation was filed by stockholders challenging equity awards valued at more than $51 million granted to company directors shortly after stockholder approval of a new equity incentive plan.[ii] The plaintiffs claimed that the awards were excessive in light of peer and prior company compensation and, contrary to proxy statement disclosures regarding the company’s incentive plan, rewarded prior (not future) performance.[iii] The Chancery Court granted the directors’ motion to dismiss the complaint; however, this ruling was subsequently overturned by the Delaware Supreme Court, which thereby created the precedent of applying the entire fairness standard to shareholder derivative lawsuits targeting executive compensation.[iv]
In the wake of In Re: Investors Bancorp, a number of shareholder derivative lawsuits have survived the motion-to-dismiss stage. In Stein v. Blankfein, plaintiff shareholders claimed that the compensation paid to the non-employee directors of Goldman Sachs was grossly excessive – $600,000/year, compared to an average of $350,000 at the company’s peers. The plaintiffs also claimed that this compensation was in breach of the board’s fiduciary duty of loyalty, based on the assertion that the company had a lower net income than its peers, and that its directors attended fewer board meetings than their peers.[v] In this context, relying on the entire fairness standard, the Delaware Chancery Court questioned whether stockholders could ever release directors in advance for unknown breaches of the duty of self-dealing.[vi] In its decision, the court further postured that any such release would not be possible, at minimum, without expressly calling out that a vote on an equity incentive plan included approval of director absolution for any future breaches of duty.[vii]
When the Delaware Chancery Court has ruled such lawsuits are able to proceed, quick settlements are the typical outcome. In Feuer v. Redstone, CBS Corporation directors agreed to quickly settle litigation brought by investors claiming that over a period of three years, CBS’s former CEO was paid large salaries and bonuses, in line with historical pay practices but in spite of his increasing incapacity.[viii] The plaintiffs in Feuer alleged that multiple directors knew of the CEO’s declining health but failed to alert others on the board or to consider the appropriateness of his compensation in light of his decreasing role at the company. On initial review, the Delaware Court of Chancery found, among other items, that the contribution of the CEO compared to his salary was “beyond the range of what any reasonable person might be willing to trade for such ‘services,’” and allowed the case to proceed in part.
Another high-profile shareholder lawsuit, Tornetta v. Musk, challenged Tesla’s awarding stock options with a value of up to $55.8 billion to controlling stockholder and CEO Elon Musk, claiming breach of the CEO and board’s fiduciary duties, unjust enrichment and corporate waste.[ix] Upon a motion to dismiss, the court dismissed the corporate waste claim, but let the other claims survive.[x] On the breach of fiduciary duty claim, the court applied the entire fairness standard of review because (1) the CEO was a controlling stockholder and (2) it found that the plaintiff adequately alleged that the board and minority stockholders were unduly influenced by the CEO in approving the award. In applying the entire fairness standard of review, the court considered the extent to which an independent board committee acted, and whether a majority of the minority stockholders had approved an action involving a controlling stockholder.[xi] The court indicated that the company met the majority-of-the-minority-stockholders vote requirement, but failed to satisfy the independent, special committee condition.[xii]
The COVID-19 pandemic has created another set of issues, particularly after the shutdown of many companies starting in March 2020 caused governance committees to shift the focus of director and officer compensation away from cash payouts and toward company shares. With the stock market’s bounce back and continued rise, retail and intuitional investors felt confident enough to continue to invest in the market. The resulting higher share prices translated to the appearance of a bigger payout to corporate directors and officers who accepted compensation in stocks versus cash.
A recently filed lawsuit, Zalvin v. Aguiar, demonstrates the optics of stock option value awarded to company directors and officers.[xiii] The Zalvin derivative suit alleges the BridgeBio board breached its fiduciary duty by setting its own excessive compensation, which amounted to $20M in stock awarded beginning in 2019; including $12M this year.[xiv] Much of this dollar value was in stock.[xv] Plaintiffs assert the board did not look to peer boards, which they claim receive much lower compensation, and did not seek shareholder approval.[xvi] The anticipation is that any motion to dismiss will be denied, given that the entire fairness standard is likely to be applied by the judiciary in determining whether there was fair dealing by the BridgeBio board.
To sum up, director and officer liability insurance underwriters should be considering this rapidly evolving area of liability, particularly honing in on corporate self-executing plans. Requiring stockholder approval of specific director compensation appears to blunt findings of liability. Similarly, corporate governance committees that have adopted meaningful limits on director compensation, particularly requirements for stockholder approval, may be a much better insurance risk. Corporate governance practices should be scrutinized for, among other things, (1) establishing a process for annual or other periodic reviews of compensation; (2) benchmarking against peer group compensation; (3) utilizing compensation consultants; and (4) providing detailed disclosures of director compensation to stockholders.
[i] In Re: Investors Bancorp, 177 A.3d 1208 (Del. 2017).
[v] Stein v. Blankfein, C.A. No. 2017-0354 (Del. 2017)
[viii] Feuer v. Redstone, C.A. No. 12579-CB (Del. 2017)
[ix] Tornetta v. Musk, C.A. No 2018-0408-JRS (Del. 2018)
[xiii] Zalvin v. Aguiar C.A. No. 2021-0395 (Del. 2021)
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