Among its myriad provisions, the Dodd-Frank Wall Street Reform and Consumer Protection Act created Section 14A of the Securities Exchange Act of 1934. This new section requires most public companies to conduct a shareholder advisory vote on executive compensation not less frequently than every three years. Section 14A also requires issuers to allow stockholders to vote once every six years on the frequency of the “say-on-pay” vote — that is, whether it should occur every one, two, or three years. The compensation arrangements subject to the stockholder vote are those set out in Item 402 of Regulation S-K, and include all compensation paid to the chief executive officer, the chief financial officer, and the three other highest-paid executive officers. The first stockholders' meeting occurring on or after January 21, 2011 must include both a say-on-pay resolution and a timing resolution. In addition, a shareholder advisory vote is required on golden parachute arrangements. What risks accompany these advisory votes? The outcome of these resolutions is expressly not binding on the issuer. Section 14A specifically provides that these resolutions will not be construed to: (i) overrule the board's compensation decisions, (ii) create or imply any change to the issuer or board's fiduciary duties, (iii) create or imply any additional fiduciary duties for issuers or boards, or (iv) limit stockholders' ability to make other compensation-related proposals.
Despite Congress' disclaimer of new or enhanced fiduciary duties arising from these “advisory” votes, several companies are now facing derivative lawsuits following stockholder rejection of board-approved compensation plans. At least six companies are facing derivative suits (and in many instances, more than one such suit), and plaintiffs' class action/derivative firms have announced investigations of additional companies. Many of these suits are still in their infancy, and, as a result, it is unclear how much traction the suits will ultimately have. At least one such suit, however, has already resulted in a monetary settlement. 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 procedures and to pay $1.75 million to the plaintiffs' law firms. The potential of achieving similar settlements will likely encourage the plaintiff's bar to continue to pursue such suits — at least until some of the cases are dismissed, or otherwise work their way through the courts.
The recently filed derivative lawsuit against the board of directors of Helix Energy Solutions Group, Inc. (Helix) and its compensation consultant illustrates the types of allegations made in these lawsuits. As a consequence, the Helix lawsuit can be used to provide guidance on how companies might avoid drawing similar litigation, or at least better position themselves to defend against such claims.
In its 2011 proxy statement, Helix's board unanimously recommended that its stockholders approve its 2010 executive compensation. The complaint alleges that despite the assertion in Helix's proxy statement that “[w]e have a pay-for-performance culture,” Helix instituted pay raises for executives (primarily by increasing stock awards), despite the company's poor financial performance in 2010. The complaint alleges that in 2010, net revenue declined 17.9 percent, gross profits fell 86.2 percent, and earnings per share swung from a positive $1.01 in the prior year to a negative $1.22. A substantial majority of Helix's voting stockholders — more than 66 percent — rejected the board's recommendation and voted against Helix's 2010 executive compensation. Following that vote, Helix's board adopted performance metrics for 2011 cash incentive bonuses, but did not change the 2010 executive compensation.
Less than a month later, a stockholder derivative suit was filed against Helix's current and former directors, certain executives, and Helix's compensation consultant. The Helix complaint includes a claim for breach of the fiduciary duty of loyalty against the company's current directors, a claim against the recipients of the pay raises for unjust enrichment, and a claim against Helix's compensation consultant for aiding and abetting breaches of fiduciary duty.
Most interesting, the Helix complaint contends that the negative stockholder vote is sufficient, in and of itself, to rebut the presumption of the business judgment rule and put the burden on the defendants to prove that their actions were appropriate. As most directors and their advisors are aware, the business decisions of corporate directors are generally entitled to the protection of the business judgment rule, which precludes courts and stockholders from second-guessing such decisions. According to the plaintiffs, however, the stockholder “no” vote constitutes “direct and probative evidence” that the directors' 2010 executive pay decisions were not in the best interests of Helix's stockholders. The plaintiffs claim that this alone 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 is, to put it mildly, unclear how a nonbinding stockholder vote that, by its terms, was not to be construed to overrule the board's compensation decisions, or to impose any new or enhanced fiduciary duties on the board, can be sufficient in and of itself to defeat the business judgment rule. However, in light of the KeyCorp settlement, companies who face a potential “no” vote on executive compensation should recognize that they could be targets of similar litigation — an experience that is inherently costly and distracting, regardless of the merit or lack of merit of the claims. While one cannot categorically prevent a lawsuit from being filed, companies can take steps that may reduce the risk of such suits.
Know Your Constituents
Does the board have a sense of whether the company's principal stockholders will approve or reject the company's executive compensation? Long before any vote takes place, the board may wish to consider factors such as the following to assess the risk of a stockholder “no” vote: Have significant institutional investors — the parties who drive these votes — indicated in the past that they are unhappy with the company's compensation practices or decisions? Have any of these same institutions “no” voted other companies or filed suit, and if so, do we know why? Are there aspects of the company's recent performance that a stockholder could seek to characterize (rightly or wrongly) as “disappointing”? If so, how do those aspects factor into the company's compensation philosophy and decisions? Are there steps that the company can take, by way of additional communication, disclosure, or the like, to address these risk factors proactively and render it more likely that the plan will obtain a positive vote?
If there is genuine risk of a stockholder “no” vote, companies may wish to consider having a plan in place to address the issue. Will the compensation committee revisit a rejected compensation decision and consider adjustments to it, or will adjustments be considered on a prospective basis only? What are the tax, accounting, and other ramifications of a retroactive adjustment, and are they problematic? Does a decision to make adjustments depend on the percentage of stockholders that vote against the plan (e.g., 51 percent versus a supermajority) or other factors? If no adjustments will be made, will the company provide an explanation of why it is maintaining a decision that the stockholders have rejected? As a matter of good corporate housekeeping, the minutes of compensation committee and board meetings should, of course, capture and accurately convey the rationale for any action or non-action that the compensation committee and board decide to take in light of a negative stockholder vote.
Helix provides a cautionary example. Two days after receiving a negative stockholder vote on its 2010 executive compensation, Helix stated in a May 2011 8-K that, “the Compensation Committee of the Board of Directors values the opinion of our shareholders and as a result has determined to take the following actions: (i) implement defined performance metrics for the 2011 Cash Bonus Program for executive officers with the Committee, however, retaining overall discretion with respect to the grant of individual awards made under the program, and (ii) modify the long-term incentive compensation awarded to executive officers to include additional pay for performance elements in future grants.” One month later, in a June 2011 8-K, Helix announced the performance metrics it had adopted for 2011 cash bonuses. Apparently not satisfied with such prospective measures, the stockholders proceeded to file suit.
Review Your Disclosures
Consider explaining what the company means by terms such as “pay for performance.” In lawsuits challenging decisions to proceed with stockholder-rejected compensation plans, the plaintiffs' bar often seeks to use the Compensation Discussion & Analysis (CD&A) section of the proxy statement to support their claims. The Helix complaint again provides a useful illustration. There, the plaintiffs point to language in the CD&A stating that executive pay is based on performance. Then, the plaintiffs point to a decline in the company's performance and allege that despite the decline, the company increased the compensation of its executives, and did so notwithstanding the “no” vote of its stockholders. On this basis, the plaintiffs assert that the company is not, in fact, paying executives based on the company's performance, and the plaintiffs charge the directors with ignoring the company's compensation policy.
This type of argument, and its superficial appeal, are based on the latent ambiguity in common, everyday terms that may not be defined or described in detail in the CD&A. As a result, companies should consider explaining in the CD&A whether “pay for performance” means that pay is based solely upon total shareholder return, or whether “pay for performance” takes into account other considerations or metrics. Disclosing what goes into executive compensation decisions may not convince stockholders and their lawyers not to sue, but it can reduce the “field of play” on this issue and provide defense counsel with more robust disclosures to use in defending against these claims, including in seeking to have the claims dismissed at the outset.
A Postscript: Potential Impact on Compensation Advisors
As the complaint against Helix and other, similar complaints show, the plaintiffs' bar is pursuing claims not only against corporate directors and officers, but also “aiding and abetting” claims against compensation advisors. As a result, companies should review whether, and to what extent, they have indemnification obligations to their compensation advisors; whether such obligations are insured; and what impact a lawsuit might have on the relationship between the advisor and the company. In addition, if compensation advisors perceive a genuine risk of regularly becoming defendants in lawsuits, they may well seek additional indemnification or an increase in their fees, and they also may charge higher fees to companies that have received negative stockholder votes.
It should be noted that “aiding and abetting” claims are not, generally speaking, a favored type of claim. Thus, whether these issues ultimately prove to be significant or not depends in large part on how the courts treat these claims in the current raft of “say-on-pay” lawsuits.