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The Dodd-Frank Wall Street Reform and Consumer Protection Act created Section 14A of the Securities Exchange Act of 1934, which requires most public companies to conduct a shareholder advisory vote on executive compensation not less frequently than every three years; and to allow stockholders to vote once every six years on whether the “say-on-pay” vote should occur every one, two or three years. The compensation arrangements subject to vote include those paid to the chief executive officer, the chief financial officer and the three other highest-paid executive officers.
Section 14A specifically provides that these resolutions will not overrule the board’s compensation decisions or create or imply any change to or any additional fiduciary duties for the issuer or board.
Despite disclaimers by Congress, at least 10 companies are now facing one or more derivative lawsuits following negative stockholder votes. These complaints set forth similar allegations, including claims for breach of the fiduciary duty of loyalty against the company’s current directors, claims against the recipients of the pay raises for unjust enrichment, and claims against the company’s compensation consultant for aiding and abetting breaches of fiduciary duty.
Most interesting, the complaints also allege that the “no” vote constitutes “direct and probative evidence” that the pay decisions were not in the best interests of the company’s stockholders. This allegedly overcomes the business judgment rule and shifts the burden to the defendants to prove that the challenged compensation decisions were made in good faith and in the stockholders’ best interests.
It may seem difficult to understand how a nonbinding stockholder vote that, by its terms, was not to overrule the board’s compensation decisions or impose any new or enhanced fiduciary duties, could alone be sufficient to defeat the business judgment rule. One federal court, however, has found the argument persuasive, at least at the motion-to-dismiss stage. In NECA-IBEW Pension Fund v. Cox, Cincinnati Bell shareholders brought suit after the directors, inter alia, granted $4 million in bonuses, plus $4.5 million in salary to the CEO, in the same year that the company incurred a “$61.3 million decline in net income, a drop in earnings per share from $.37 to $.09, [and] a reduction in share price from $3.45 to $2.80.” Sixty-six percent of the voting shareholders voted against the plan. The court recognized that the negative vote was not binding nor should it alter the directors’ fiduciary duties, but nonetheless held that, under Ohio law, the business judgment rule did not apply because the factual allegations raised “a plausible claim that the multimillion dollar bonuses approved by the directors in a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of … [the] shareholders and therefore constituted an abuse of discretion and/or bad faith.”
As the business judgment rule “imposes a burden of proof, not a burden of pleading,” it may be that the plaintiffs are ultimately unable to prove the directors acted with “a deliberate intent to cause injury” or “reckless disregard for the best interests of the corporation” at trial, but their allegations were sufficient at the pleading stage.
The Georgia Superior Court reached the opposite conclusion in Teamsters Local 237 Additional Security Benefit Fund v. McCarthy et al. There, the directors of Beazer Homes recommended that the shareholders approve the 2010 compensation plan, which included raises for executives in a year in which the company suffered a $34 million net loss and a 17 percent decline in share price. The shareholders rejected the recommendation.
The complaint alleged, inter alia, that by approving the plan, recommending that the shareholders approve the plan and failing to rescind the plan after the negative vote, the directors breached their fiduciary duties to the company.
The court disagreed, holding under Delaware law that neither the negative vote nor the directors’ decision not to rescind the plan rebutted the business judgment rule. The directors could not have considered the results of the February 2011 vote when they approved and recommended the plan in 2010. As such, the vote failed to cast doubt that the directors acted on an informed basis, in good faith and in the company’s best interests a year earlier. “Hindsight second-guessing and Monday morning quarterbacking of the sort [the stockholders] urge are fundamentally inconsistent with the business judgment analysis,” the Georgia court wrote.
Even prior to this uncertainty, other suits had settled, encouraging more suits. In March 2011, KeyCorp, after being sued under a similar provision found in the Troubled Asset Relief Program (TARP), agreed to make changes to its compensation practices and to pay $1.75 million to the plaintiffs’ law firms. Recently, perhaps as a consequence of the unfavorable decision received in the Ohio federal court, Cincinnati Bell announced that it had reached a settlement in another lawsuit, pending in Ohio state court, involving its compensation plan.
In light of these varying outcomes, companies should recognize that they could be targets of similar litigation and take steps that may reduce the risk of such suits.
Know your constituents. Prior to any vote, consider: Have significant institutional investors previously indicated that they are unhappy with the company’s compensation practices or decisions? Have any of these same institutions voted “no” at other companies or filed suit, and if so, why? Are there aspects of the company’s recent performance that could be characterized (rightly or wrongly) as “disappointing”? Can the company take steps by way of additional communication, disclosure or the like, to address these risk factors proactively and render a positive vote more likely?
Be prepared. If there is genuine risk of a “no” vote, have a plan. Will the compensation committee revisit a rejected decision and adjust it, or will only prospective adjustments be considered? What are the ramifications (accounting and otherwise) of a retroactive adjustment? As a matter of good corporate housekeeping, the minutes of compensation committee and board meetings should capture and accurately convey the rationale for any action or nonaction that is taken in light of a negative vote.
Review your disclosures. Consider explaining what is meant by “pay for performance.” The plaintiffs’ bar often seeks to use the company’s Compensation Discussion & Analysis to support their claims, usually relying upon language that the company has a pay-for-performance policy. This argument is based on the latent ambiguity in terms that may not be defined or described in detail in the CD&A. Companies should consider explaining whether “pay for performance” means that pay is based solely upon total shareholder return, or whether it takes into account other considerations. Disclosing what goes into executive compensation decisions can provide defense counsel with more robust disclosures to rely upon, including in seeking to have claims dismissed at the outset.
Potential Impact on Compensation Advisors
The plaintiffs’ bar is also pursuing “aiding and abetting” claims against compensation advisors. As a result, companies should review whether, and to what extent, they have indemnification obligations, whether such obligations are insured, and what impact a lawsuit might have on their relationship with their advisor.
Roger A. Lane is a partner in law firm Foley & Lardner’s Securities Enforcement & Litigation Practice. He can be reached at rlane@foley.com. Courtney Worcester is senior counsel in the Boston office of Foley & Lardner. Her practice focuses on complex commercial litigation involving corporations, venture capital and private equity firms, financial institutions and their directors and officers. She can be reached at cworcester@foley.com.