Compensation Focus

Litigation is Causing Pressure on Director Pay: What You Need to Know

By Pamela Baker, Dentons US LLP, Dan Laddin and Matt Vnuk, Compensation Advisory Partners  |  April 2015

Figure 1:
Fortune 100 Market Data — Facts & Figures

Prevalence of Director
Pay Limits? 

23% of companies
95% apply limit to just equity based pay

Value of Pay Limit? 
Median of $800,000
Range of $250,000 to $2 million

Universal Pay Limits? 
10% of companies provide a separate limit for year of initial election to the board, to account for a potential initial at-election equity grant.

10% of companies include a separate limit for directors in a board leadership role, such as lead director or non-executive chair.

Total Pay of a Typical Director? 
25th Percentile = $240,000
Median = $260,000
75th Percentile = $288,000

During 2015, pay limits for non-employee directors will be a topic of discussion at nearly all large companies seeking to amend their outside director equity plans. We expect a majority of these companies to include a director compensation limit in their amended plan document put forth for shareholder approval.

Given litigation pressure, much of which is discussed in this article, there has been a steady increase in the prevalence of shareholder approved limits on director compensation (despite a trend toward simplified, conservative director pay programs). The goal has been for grants to directors to be protected by the business judgment rule.

Litigation is Increasing Momentum

In the 2012 court case, Seinfeld v. Slager, a shareholder claimed that because a company's directors were self-interested in their own equity awards under the company LTI plan, they acted unreasonably, and committed corporate waste. Therefore, the directors should not be presumed to have acted in the best interests of the company. This presumption is usually called the "business judgment rule," as shown below.

Under the plan in question, limits included to optimize tax deductibility for executive compensation also applied to director compensation (typical director pay is substantially lower). Each director could theoretically be granted over $21.6 million in shares each year; yet, actual awards ranged from $215,000 to $743,700. The Delaware Chancery Court declined to dismiss the case. The Court agreed the business judgment rule did not protect the directors' awards, and found the plan had "no effective limits" on director awards. Given this outcome, the directors would have to show their awards were "entirely fair," a higher legal standard.

Business judgment rule:  Entire fairness test:
The "business judgment rule" is judicial presumption that directors acted "on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." An action protected by the business judgment rule will not be second-guessed by the courts. When the business judgment rule does not protect directors' awards of compensation to themselves, the awards are subject to heightened scrutiny under the "entire fairness test" under which both the process and the amount of the compensation must be found to be entirely fair to the company.

Seinfeld v. Slager is not an isolated case. Mark Zuckerberg and the other Facebook directors were sued in June 2014 under a claim similar to the one in Seinfeld v Slager. Also in June 2014, the Delaware Chancery Court refused to dismiss a case challenging the cash compensation the directors of Unilife Corp. approved for themselves. They will now have to demonstrate that their cash compensation was "entirely fair." 

Current Market Practice and What Lies Ahead 

Compensation Advisory Partners (CAP) analyzed current incentive plans among Fortune 100 companies. CAP found that 23% of companies have adopted an annual limit on director compensation, with a median cap of $800,000. This represents approximately three times the typical total compensation paid to a non-employee director of $260,000. All but one company applied the limit to equity compensation only. (See Figure 1.)

Annual pay limits for directors will likely become majority practice among Fortune 100 companies over the next three to four years as companies seek shareholder approval for their plans in the normal course of business. Companies typically amend their equity plans every three to five years. 

As boards and management think through whether to implement an annual cap on director compensation, there are a number of questions to ask, including:

  • What is a sufficient cap to provide for flexibility to compensate directors while still being an "effective limit" from a legal perspective?
  • Should there be a carve-out/separate cap for the chairman role, even if it doesn't currently exist at the company? 
  • Should there be an exception for one-time special awards used either as an inducement grant or to compensate for extra service in special situations, such as an investigation?
  • Should the limit apply to total director compensation, not just equity-based compensation, to fully address this issue?

When considering adopting a pay limit for directors, companies take into account their own unique facts and circumstances, as well as the importance legal counsel places on this issue.

About the Authors

Pamela Baker is partner for Dentons US LLP and is based in Chicago. Dan Laddin is partner and Matt Vnuk is principal for Compensation Advisory Partners, and both are based in New York.

Read the April edition of Compensation Focus.

Contents © 2015 WorldatWork. No part of this article may be reproduced, excerpted or redistributed in any form without express written permission from WorldatWork.

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