Staying in Front of Shareholder Litigation Challenges to Executive Compensation: The Corporate Governance Advisor
Executive compensation has long been within the purview of the board of directors business judgment. However, the advent of the proxy rules requiring advisory votes on executive compensation stemming from congressional legislation has spurred many shareholders to push forward derivative suits challenging executive compensation packages and the board of directors business judgment in recommending and approving executives compensation. While most shareholder challenges have been disposed of at the motion to dismiss stage for (1) failing to properly assert demand futility and/or (2) failing to state a claim, shareholder strategies have shifted and companies can expect derivative litigation related to executive compensation to continue. Discussed below are the general impediments to shareholder derivative litigation of this kind, instances where shareholders have avoided dismissal of their claims, and actions that Board should consider in order to reduce their litigation risks.
(a) Dodd-Frank and Say-On-Pay
Perhaps unsurprisingly in the wake of corporate financial turmoil, in January 2011, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Section 951 of the Dodd-Frank Act enacted say-on-pay requirements. The SEC issued final rules implementing say-on-pay and shareholders were given the opportunity to vote, on an entirely advisory basis, on corporate executives compensation. In the two years since say-on-pay rules have been enacted, nearly 80 companies have failed to receive majority support and several faced shareholder derivative challenges soon thereafter.
(b) IRS Code Section 162(m)
Section 162(m) of the Internal Revenue Service Code limits the tax deduction that a publicly held corporation may take with respect to annual compensation paid to its chief executive officer and the three other most highly compensated executive officers, other than the chief financial officer. An exemption from Section 162(m)s deduction limit is available for certain performance-based compensation that is paid pursuant to a plan that has received shareholder approval with respect to the material terms of the applicable performance goals. Plaintiffs have seized upon this regulatory provision and pursued derivative actions upon theories of corporate waste for implementing bonus awards that produce tax liabilities for the corporation. Alternatively, plaintiffs have sought to hold corporate directors liable for misleading statements in public filings related to the increased tax burden and the performance-based nature of the compensation.
2. Procedural Obstacles and the Board of Directors Business Judgment
Shareholders seeking to challenge executive compensation recommendations based upon a non-favorable say-on-pay vote face significant hurdles. The overwhelming majority of courts have dismissed executive compensation derivative actions on procedural grounds. Because of the longstanding preeminence of Delaware corporate law, its judicial structure for shareholder derivative litigation presents a threshold, and formidable, challenge to shareholders who want to contest executive compensation through derivative lawsuits against corporate directors. Delaware, like every state, vests management of a corporations business and affairs with its board of directors, and therefore the board generally determines whether to bring a lawsuit on the corporations behalf. A boards decision i.e., business judgment not to pursue a particular action as detrimental to the company is generally respected by the courts, absent a showing that the boards action was wrongful.
A shareholder, therefore, before initiating a derivative action must allege that she made a presuit demand (requesting the board to take action) that was wrongfully rejected by the company or establish, with heightened scrutiny, demand futility (by alleging with particularized facts that a reasonable doubt exists that either, (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment). When challenging a board decisions relating to executive compensation, shareholders, where permitted, plead demand futility in order to speed their cases into litigation. Generally, corporations have successfully defeated demand futility arguments in executive compensation derivative actions due to (a) plaintiffs inability to sufficiently allege directors are interested and (b) the strong business judgment presumption. (a) Demand Futility from Interested Directors
A showing of futility due to the absence of board independence generally involves a careful director-by-director examination into whether a majority of the corporations board qualifies as being disinterested. A director's interest may be shown by demonstrating a potential personal benefit or detriment to the director as a result of the decision. Although shareholders have argued that a personal detriment inheres in director liability for approving the excessive compensation at issue, Delaware law has weighed against that finding. A New York court reflected a common analysis on this point in a challenge to Morgan Stanleys directors dismissing alleging excessive bonus award claims. As to their independence regarding pursuit of claims, the court applied Delaware law and held:
[T]he complaint must allege particularized facts that would show that the directors acted with scienter, i.e., that they had actual or constructive knowledge' that their conduct was legally improper (see Wood, 953 A2d at 141; Citigroup, 964 A2d at 132). The complaint does not allege such facts.
Courts across the country have reached similar conclusions: mere involvement of directors in the challenged transaction is insufficient to properly assert that a director is interested and/or not independent to support demand futility. Applying these demand futility principles to say-on-pay derivative actions, only one case has held that a plaintiff sufficiently alleged demand futility because the company directors were not independent. In NECA-IBEW Pension Fund v. Cox (Cincinnati Bell), an Ohio federal district court found that a presuit demand on a corporation was presumptively futile where the complaint alleged the directors were involved in the transaction. The Ohio federal court opinion is based on Ohio state appellate law that a derivative action may establish demand futility when it names every company director. The Cincinnati Bell decision is very likely an aberration. The decision cut against the weight of authority in Delaware and other demand futile states; however it emboldened plaintiff attorneys to continue to pursue similar cases. (b) The Business Judgment Presumption
Turning to the second prong of Aronson, shareholders may successfully plead demand futility by alleging particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision. Essentially, this requires casting doubt on whether the challenged decision qualifies for deference under business judgment rule principles.
Executive compensation is generally a matter of business judgment. Applied to Aronsons second prong, a shareholder must plead particular facts creating a reasonable doubt that the action was taken honestly and in good faith or . . . that the board was adequately informed in making the decision. Failure to carry this pleading requirement enables board members to dismiss shareholder derivative litigation by showing that their challenged decision had a rational business purpose. As with director independence, this standard has proven to be a major obstacle for shareholders seeking to hold boards accountable through derivative litigation for their executive compensation decisions.
In Beazer Homes USA, Inc., a Georgia state court, applying Delaware corporate law, found that the plaintiff failed to allege particularized facts that would rebut the strong legal presumption of the business judgment rule. Importantly, the court emphasized that the Dodd Frank Act:
expressly and unambiguously states that shareholder say on pay votes are advisory and shall not be binding on the issuer or the board of directors of an issuer and may not be construed (1) as overruling a decision by such issuer or board of directors; to create or imply any change to the fiduciary duties of such issuer or board of directors; [or] (3) to create or imply any additional fiduciary duties for such issuer or board of directors. See Dodd-Frank Act, 124 Stat. 1376 (1900) (emphasis added); 15 U.S.C. § 78n-1(c).
(emphasis in original).
Likewise, in PICO Holdings, Inc. Shareholder Derivative Litig., the Southern District of California dismissed plaintiffs request for declaratory relief that the non-binding advisory vote rebutted the business judgment presumption of the board of directors. The federal district court cited the express language of the Dodd-Frank Act and granted PICO Holdings, Inc.s motion to dismiss stating the Dodd-Frank Wall Street Reform Act did not change state law regarding fiduciary duty or the business judgment presumption.
The business judgment presumption so heavily favors dismissal in derivative actions premised upon non-favorable say-on-pay votes, plaintiffs have begun to explore new avenues to attack. In similar say-on-pay cases, plaintiffs have asserted that the board of directors issued a materially false and misleading proxy statement regarding the companys executive compensation. Courts should similarly dismiss these claims, as the mere issuance and signing of a proxy statement cannot support rebutting the strong business judgment presumption. Given the success defendants have had in defeating derivative actions on demand futility grounds, it is likely plaintiffs will continue to seek new avenues to attack.
3. Shareholder Successes
As noted above, Ohios Cincinnati Bell decision may be aberrant but it enabled failed say-on-pay litigation to proceed, and thereby resulted in settlement: prospective governance changes coupled with the corporations payment of attorneys fees for the plaintiff-shareholders. Failed say-on-pay votes have been quick to spur copy-cat litigation, with Citigroup being struck within a week after its failed vote on April 20, 2012. Meanwhile, shareholders of Helix Energy filed their derivative litigation on May 4, 2012, alleging that the corporations board ignored the presuit demand they made in October 2011 based on a failed say-on-pay vote earlier that year.
So-called 162(m) claims have provided another avenue by which shareholders have avoided dismissal of their claims alleging that fiduciary breaches occurred through board decisions awarding excessive executive compensation. These cases have involved a two-step route to shareholder success. First, a Delaware court dismissed claims that the corporations stock plan proposal was materially misleading in that it promised all compensation would be deductible under Code §162(m). The courts decision provided the following heads up for the plaintiffs bar:
An immediate problem with this theory is, again, that the proxy statement does not state that the EIP [plan] will be deductible. Moreover, as the Court has already explained, Republic's expressed belief that the EIP would be deductible was a reasonable belief.
Activist shareholders followed up soon afterward with a similar lawsuit, derived from a proxy statement that was allegedly more definitive in promising that shareholder approval of a stock plan would result in tax deductibility for the income from plan awards. As a result, their derivative claim avoided dismissal, with the court holding that Athough it is a close question as to whether Hoch has properly interpreted the proxy statement, this Court cannot conclude at this stage of the proceedings that his Complaint fails to state a claim. Encouraged, shareholders sued Conoco Phillips hardly a month later for allegedly misstating the Code §162(m) consequences of the stock plan it proposed for shareholder approval.
Just to complete the picture, shareholders have tried an off-shoot variety of Code §162(m) litigation. It is waste, derivative plaintiffs argue, for boards to lose corporate tax deductions by failing to structure executive compensation in a manner that qualifies for a Code §162(m) exemption. In Freedman v. Adams, the claim involved $40 million of lost deductions, but fell on deaf Delaware ears, with the court explaining that:
• decisions regarding a company's tax policy are not well-suited to after-the-fact review by courts and typify an area of corporate decision-making best left to management's business judgment, so long as it is exercised in an appropriate fashion. This Court rejects the notion that there is a broadly applicable fiduciary duty to minimize taxes, and, therefore the Plaintiff's argument that the board failed to act despite a duty to minimize taxes is unavailing.
• the Board's decision falls within the line of cases dismissing executive compensation-related waste claims and concluding that "the size and structure of executive compensation are inherently matters of judgment.
Conclusion - Board Precautions
Executive compensation has been in the public crosshairs for nearly a decade. Most corporate boards have responded with improved systems and better decisions. Meanwhile, the risk spectrum has focused on identifying the outliers. For instance, Institutional Shareholder Services aimed its 2012 pay-for-performance policies at the identification of outliers who, in varying degrees, deserve medium to high concern.
Likewise, the UK government is pursuing binding say on pay legislation because of the small but significant number of cases where a large proportion of shareholders withhold support for remuneration proposals.
Unfortunately for corporate boards, executive compensation is poised to escalate from being a risk to outliers to being a broad risk to all directors. The April headline Occupy Boardroom warned about shareholders fighting back against executive pay packages. The fight has broadened through regular rounds of enhanced disclosure that foments public outrage, governmental initiatives, and shareholder derivative litigation. This vicious circle challenges board members to stay abreast of best practices and worst risks, with the following action items being worth consideration (at a minimum):
• Revise the compensation committees charter, especially (i) to conform its provisions to actual practices, and (ii) to make changes that better reduce litigation risks.
• Assure regular briefings for directors regarding new developments in executive compensation - from design alternatives, to survey data, to governmental initiatives, to recent litigation.
• Consider adopting new corporate best practices by engaging separate, independent compensation consultants for both the compensation committee and the board of directors to strengthen reliance upon the advice of independent, outside consultants.
• Consider independent legal counsel for the compensation committee (in order to have dedicated counsel watching for legal compliance, proper procedures and records, and emergent litigation risks).
• In instances where a demand is properly made upon the company, consider appointing a special committee to inquire into the demand allegations and properly address the shareholder concerns, while limiting risk of future costly litigation.
The article above appeared in
The Corporate Governance Advisor.