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Business Judgment Rule Protects Equity Incentive Plan for Directors from Shareholder Challenge

By Jim Hamilton

The business judgment rule protected a banking company?s equity incentive plan for directors since the plan was properly approved by the company?s shareholders after consultation with outside advisers and was consistent with equity awards for similarly situated financial institutions, ruled a New Jersey appeals court. Similarly protected was the compensation package for the company?s board chairman since the shareholders challenging the compensation in a derivatives action failed to establish that the setting of the pay package involved self-interest or self-dealing on the part of the directors.

The court also said that the shareholder failed to show that the equity incentive plan and the chair?s compensation constituted corporate waste. However, payments to a former board chair in his capacity as a consultant for the company did constitute waste. The court noted that it followed Delaware's pronouncements on corporate law. The case is on appeal to the NJ Supreme Court and oral argument took place January 5, 2011. Seidman v. Clifton Savings Bank, NJ Superior Court, Appellate Division, No. A-4033-07T2, Aug., 19, 2009.

Under the business judgment rule, there is a rebuttable presumption that good faith decisions based on reasonable business knowledge by a board of directors are not actionable by those who have an interest in the business entity. The rule protects a board of directors from being questioned or second-guessed on conduct of corporate affairs, except in instances of fraud, self-dealing, or unconscionable conduct

The rule places the initial burden on the person challenging a corporate decision to demonstrate self-dealing on the part of the decision-makers, or any other disabling factor. If the challenger sustains that initial burden, then the presumption of the rule is rebutted, and the burden of proof shifts to the directors to show that the transaction was, in fact, fair to the corporation.

The chair?s cash compensation was set by the board of directors and that decision was protected by the business judgment rule and the shareholders did not rebut the presumption of validity. The shareholders failed to establish that the setting of cash compensation involved self-interest or self-dealing on the part of the directors. In addition, there was no evidence that any of the directors on the compensation committee received any financial gain in setting the cash compensation for the board chair.

The shareholders also failed to demonstrate that the directors breached their duty of care. To rebut the business judgment rule based on a breach of the duty of care, the challengers must establish gross negligence on the part of the board. Here, the board members had the assistance of outside advisors and reviewed substantial data regarding the compensation paid to senior executives by other New Jersey institutions in setting the cash compensation. There was no evidence that the directors were grossly negligent in setting the chair?s cash compensation.

Regarding the equity incentive plan, the court found that the awards under the shareholder approved plan were consistent with other incentive plans of financial institutions of similar size and that the board obtained the advice of outside counsel and advisors. Because the directors awarded themselves stock and stock options, they were clearly interested in the transaction. But because the awards were made pursuant to a shareholder approved plan, the burden shifted to the shareholder plaintiffs, which they failed to meet.

Citing Delaware case law, the court said that corporate waste is an extreme test very rarely satisfied by a shareholder plaintiff. Directors are guilty of corporate waste only when they authorize an exchange that is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration. Here, the directors acted in good faith and the corporation received a benefit from the executives? services. Moreover, the directors' actions were not tainted by self-interest, and the plan was properly ratified by the shareholder

The shareholders did prevail with respect to their claim for waste relating to the payments to the former director under the consulting agreements. Recovery was limited to payments made to the consultant after the plaintiff-shareholders obtained the stock which conferred the requisite standing to bring this action.

Full post as published by Jim Hamilton's World of Securities Regulation on January 11, 2011 (boomark / email).