A recent federal district court decision represents a growing trend by courts to limit the enforceability of a shareholder oversight provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010 as a response to the financial crisis. Section 951 of the Dodd-Frank Act requires public companies to conduct a non-binding shareholder vote on executive compensation at least once every three years. 15 U.S.C. § 78n-1. Congress intended the “say-on-pay” provision to give shareholders “the ability to hold executives accountable, and to disapprove of misguided incentive schemes.” 156 Cong. Rec. S5902–01, S5916 (2010) (statement of Sen. Jack Reed).
The provision provokes no controversy when a board of directors follows the shareholder vote in authorizing executive compensation. But what happens when a majority of shareholders disapprove of executive compensation and the board disregards the shareholder vote? Section 951, by its terms, does not create a new cause of action: it expressly states that the shareholder vote is not binding and “may not be construed . . . to create or imply any change to the fiduciary duties” or “to create or imply any additional fiduciary duties.” 15 U.S.C. § 78n-1(c). Shareholders have therefore attempted to enforce the provision by filing derivative actions on behalf of the corporation asserting traditional claims for breach of fiduciary duty against a board of directors that disregards the say-on-pay vote.
In Laborers’ Local v. Intersil, No. 5:11-cv-04093, 2012 WL 762319 (N.D. Cal. Mar. 7, 2012), the Northern District of California dismissed claims arising from disregard of a say-on-pay vote at the pleading stage for failure to make a demand on the board or plead demand futility, a requirement for maintaining a shareholder derivative action. In Laborers’ Local, the board of directors of Intersil, a Delaware corporation headquartered in California, approved increases in compensation for the chief executive officer, the chief financial officer, and three senior vice presidents by an average of 41.7 percent and submitted the increases to a shareholder vote pursuant to Section 951 of the Dodd-Frank Act. Id. at *1 & n.1. Fifty-six percent of voting shareholders rejected the increases. Id. at *1. After the board disregarded the say-on-pay vote and allowed the compensation increases, the shareholder plaintiff filed a derivative action asserting claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and unjust enrichment against the board, several executives, and the board’s compensation advisory firm. Id. at *2.
The court analyzed the threshold question of whether the plaintiff had satisfied the demand requirements for bringing a derivative suit, which are determined by the law of the state of incorporation (in Intersil’s case, Delaware). Id. at *4. Because the plaintiff admittedly had not made a demand on the board, the court considered whether the plaintiff had sufficiently pleaded demand futility under Delaware law. Id. Failure to make a demand under that law may be excused if a plaintiff can plead particularized facts demonstrating either that a majority of the board is interested or not independent, or that the challenged act was not a product of the board’s valid exercise of business judgment. Id.
The court first held that the plaintiff had failed to plead facts demonstrating that a majority of the board was interested. Id. at *5. Directorial interest exists under Delaware law whenever divided loyalties are present, when the director will receive a personal financial benefit from a transaction that is not equally shared by the shareholders, or when a corporate decision will have a “materially detrimental impact” on a director but not on the corporation or its shareholders. Id. The court held that the plaintiff had failed to meet this test because only one director (the chief executive officer) had received any financial benefit from the challenged compensation increases, and there were no facts alleged that this one director so dominated the board as to make a majority of the board not independent. Id.
The court next held that the plaintiff had failed to plead facts demonstrating that the board’s allowance of the executive compensation increases after the negative say-on-pay vote was not a product of its valid exercise of business judgment. Id. at *6-*8. Under Delaware’s version of the business judgment rule, a corporate action is presumed to be a valid exercise of the board’s business judgment unless a plaintiff can rebut the presumption by pleading particularized facts raising a reasonable doubt whether the board was adequately informed before taking the action or whether the action was taken honestly and in good faith. Id. at *6. Because the plaintiff had failed to plead any facts suggesting that the board was not adequately informed, the question turned on whether the board’s allowance of the compensations increases after a majority of shareholders rejected them was taken honestly and in good faith. Id. The court rejected the plaintiff’s argument that the negative say-on-pay shareholder vote was always sufficient to rebut the business judgment rule presumption. Id. at *7-*8. Instead, the court held that a say-on-pay vote under the Dodd-Frank Act “has substantial evidentiary weight” and “may” be used by a court in determining whether a plaintiff has rebutted the business judgment rule presumption. Id. at *8 (emphasis in original).
The court applied its holding to the facts alleged in Laborers’ Local, in which only one director stood to benefit from the compensation increases and 56 percent of voting shareholders disapproved of the increases, and concluded that the shareholder vote alone was not enough to rebut the presumption of the business judgment rule. Id. The court did not indicate whether a more resounding disapproval (by 85 percent of voting shareholders, for example) would be sufficient to rebut the presumption.
The opinion in Laborers’ Local represents a growing trend by courts to dismiss derivative claims based on negative say-on-pay shareholder votes at the pleading stage for failure to plead demand futility. Courts in at least three recent cases have done so. In Weinberg v. Gold, -- F. Supp. 2d --, 2012 WL 812348 (D. Md. Mar. 12, 2012), the District of Maryland dismissed derivative claims on behalf of a Maryland corporation for failure to plead demand futility under Maryland law. In Plumbers Local No. 137 Pension Fund v. Davis, No. 03:11-633-AC, 2012 WL 104776 (D. Or. Jan. 11, 2012), the District of Oregon dismissed claims on behalf of an Oregon corporation for failure to plead demand futility under Delaware and Oregon law. And in Teamsters Local 237 Additional Security Benefit Fund v. McCarthy, No. 2011-cv-197841 (Fulton County, Ga. Superior Court Sept. 16, 2011), the Georgia Superior Court dismissed claims on behalf of a Delaware corporation for failure to plead demand futility under Delaware law.
The only court that has reportedly allowed such claims to proceed is the Southern District of Ohio in NECA–IBEW Pension Fund v. Cox, No. 11-cv-4512011, WL 4383368 (S.D. Ohio Sept. 20, 2011), which applied Ohio law and held, contrary to well-established Delaware law, that the threat of personal liability faced by the directors for their involvement in approving and recommending the compensation increases was sufficient to plead demand futility. Id. at *4. Courts are consistently refusing to follow this decision. See Plumbers Local No. 137, 2012 WL 104776, at *5 (criticizing the decision for the court’s apparent lack of subject matter jurisdiction, the plaintiff’s failure to disclose contrary authority, and circular logic of the argument); Laborers’ Local, 2012 WL 762319, at *6 n.5 (same).