While the “say-on-pay” provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) is not even a year old, it has already spawned several derivative suits against corporate officers and directors. Litigation stemming from “say-on-pay” votes has been costly to companies, with one company paying nearly $2 million to settle its suit.1
In one respect, the commencement of such litigation is surprising given that the shareholder “say-on-pay” vote is nonbinding on a company, expressly does not expand the scope of an officer’s or director’s fiduciary obligations, and does not expressly provide for any remedy for shareholders if a company declines to change its executive compensation practices following a “no” vote by shareholders.
The initial wave of derivative litigation raises several issues that boards should consider in connection with their future decisions on executive compensation, and provides insight into several common allegations running throughout the “say-on-pay” litigation.
As part of Section 951 of the Act, public companies are required to conduct a nonbinding shareholder advisory vote at least once every three years to approve the compensation of a company’s named executive officers disclosed pursuant to Item 402 of Regulation S-K under the Securities Act of 1933, as amended.2 This section of the Act also mandates that every six years, companies ask shareholders in a nonbinding vote whether the “say-on-pay” vote should be held every one, two, or three years.3
So far, at least 41 companies have seen their “say-on-pay” proposals rejected by more than a majority of their shareholders who had authority to vote (a “no” vote).4 In fact, in a majority of these votes, less than 45% of the shareholders who voted at the meeting voted in favor of the company’s executive pay.5 In other words, many of the votes that have occurred were not even that close.
Of the 41 companies that experienced a “no” vote, at least eight have become involved in derivative litigation in which, following a failed vote, the plaintiffs allege that the companies have excessive executive compensation practices. These companies are Occidental Petroleum Corporation (NYSE: OXY), Umpqua Holdings Corporation (NASDAQ: UMPQ), KeyCorp (NYSE: KEY), Jacobs Engineering Group (NYSE: JEC), Beazer Homes USA (NYSE: BZH), Hercules Offshore, Inc. (NASDAQ: HERO), Janus Capital Group (NASDAQ: JANSX), and Cincinnati Bell (NYSE: CBB). The shareholder suits name every company director and most—if not all—of the company’s officers as defendants.
The allegations of several of the complaints generally claim that the directors breached their fiduciary duties in three different ways. The first alleged breach arises from allegations that the directors diverted corporate assets to the executives in a manner that put the executives’ interests ahead of those of the shareholders. The second alleged breach arises from allegations that the companies that have adopted “pay-for-performance” compensation policies failed to disclose in their proxy statements that the compensation awards were made notwithstanding or in contravention to the policies. Finally, the complaints also bring claims for corporate waste against the directors based on the alleged excessive size of the executive compensation awards.
Maintaining the Status Quo with Respect to Compensation Practices Will Do Little to Discourage a Suit
Boards of directors—or, more typically, committees of these boards—are required to approve executive pay. Often, they rely upon a company’s finance and human resource professionals and outside compensation consultants to provide them with information in order to make these decisions.
While it would seem that directors using compensation professionals to determine executive pay are acting consistently with their fiduciary obligations, the plaintiffs in these derivative suits have taken a different perspective. For example, directors that have been sued for awarding excessive compensation all engaged reputable compensation consultants to assist with the determination of reasonable executive compensation. Not only did this step fail to shield the directors from suit, but the compensation consultants were actually named as co-defendants in the suits. The compensation consultants were alleged to have breached their contract with the company to provide “competent and sound” advice with respect to executive compensation. In addition, companies at which directors have been sued all had relatively comprehensive compensation policies approved by the directors that, as discussed in their proxies, the companies had concluded were reasonable and based on numerous, valid factors with respect to the ultimate compensation decisions.
Last Second Changes Potentially Can Help
In some instances, companies have revised some aspects of their executive compensation programs after filing their proxy statements in response to criticism by institutional investors or shareholder proxy advisers, and these changes, at least in some cases, have seemed to help avoid a “no” vote from shareholders. For example, in response to criticism by Institutional Shareholder Services, Alcoa made several changes to its 2011 stock awards,6 and ended up avoiding a “no” vote. 7 Likewise, Walt Disney Company made changes in executive pay in the days leading up to its annual shareholders’ meeting.8 What is surprising about these changes is that they required approval of the executives receiving the compensation because the changes required amending contracts already in place with the executives, and show that the executives were willing to give up compensation without receiving any consideration in return in order to appease shareholders.
Overall, more time, energy, and resources are being expended with respect to avoiding a “no” vote, which is not surprising given that the alternative includes potentially negative public criticism, alienation of powerful institutional investors, and, as set forth above, a significant increase in the risk of derivative litigation.
“Pay-for-Performance” Language Is an Attractive Target
It is not surprising that almost every company’s executive compensation philosophy as disclosed to shareholders contains a commitment to tie compensation to performance. But it is this policy, which is intended to benefit shareholders, that has served as the critical hook for plaintiffs in the initial “say-on-pay” derivative litigation. The derivative cases referred to above are based primarily on allegations that the directors breached their fiduciary duties by approving executive compensation that was inconsistent with the company’s stated pay-for-performance policy described in its proxy statement.
Given this fact, it is critical to reevaluate and, if necessary, revise the language describing the company’s executive compensation pay-for-performance philosophy in its proxy statement and other public disclosures. In the current climate, it is clear that many companies have compensation policy language that is vulnerable to being exploited by derivative plaintiffs, and which is not necessary to provide an accurate and reasonable basis for the company’s compensation decisions. In general terms, the following guidelines can be used to improve disclosure in the proxy statement regarding executive compensation practices and policies:
- Consistency: Some derivative plaintiffs have been able to exploit language from a company’s compensation policy that seems internally inconsistent. For example, some policies, at certain points, seem to suggest that pay-for-performance is the core of the policy, while at other points, articulate that other considerations may predominate. These types of inconsistencies can be easily fixed.
- Integration: It is important to ensure that any “pay-for-performance” language is sufficiently integrated into the overall description of how compensation is determined, and that it is not isolated or unnecessarily highlighted. Unless this language is properly integrated to make clear it is one among several valid factors that a company considers when making compensation decisions, there is an increased risk that plaintiffs will be able to take the language out of context and use it to bolster the allegations in their complaints.
- Conciseness, Preciseness: Some descriptions of compensation policies take a “kitchen sink” approach by incorporating just about every single piece of boilerplate language that a company believes is considered to be shareholder-friendly. This approach allows derivative plaintiffs to cherry-pick language that is advantageous to them while ignoring language that may undercut their allegations. Given the new risk of executive compensation litigation, it makes sense to abandon the kitchen-sink approach and develop customized and more precise language that does not unnecessarily provide fodder for derivative allegations, and more accurately describes a company’s executive compensation practices.
As discussed above, making such changes will not necessarily provide insulation from derivative litigation in instances of a “no” vote, but, at the very least, it will weaken the allegations that plaintiffs may be able to make, and should provide a better foundation for a motion to dismiss.
Likewise, documenting the specific reasoning behind the board’s compensation decisions in the proxy statement will also put directors in a relatively better position in case of a derivative suit. For example, both Beazer9 and Jacobs10 provided a detailed analysis of why the executive compensation was reasonable and consistent with the company’s compensation policy. Again, while this type of reasoning was insufficient to prevent a “no” vote or a derivative suit, it can place the directors in a better position to rebut the allegations that they breached their fiduciary duties to the shareholders.
Demand Futility Allegations
Many of the companies that have received a “no” vote are incorporated in Delaware, and so Delaware law will be influential in deciding the future course of derivative suits based on a “no” vote. The principal barrier to maintaining a successful derivative suit in Delaware (and in most other states) is being able to adequately plead “demand futility.”11
It does not appear that the Dodd-Frank Act changes what is currently required under Delaware law for pleading demand futility, because the Act makes it clear that the “say-on-pay” requirement does not:
- Create or imply any change to the fiduciary duties for a company or its board of directors12; [or]
- Create or imply any additional fiduciary duties for a company or its board of directors.13
Even though these provisions do not expressly state that “say-on-pay” is not intended to change any pleading standards, it is clear that the intention of the “say-on-pay” legislation was not to change corporate law principles of fiduciary duty. So, it would seem to be difficult to argue that the Act somehow changes what shareholders are required to plead in order to establish demand futility.
Under Delaware law, a shareholder establishes demand futility by casting “. . . reasonable doubt as to (i) director disinterest or independence, or (ii) whether the directors exercised proper business judgment in approving the challenged transaction.”14 These two considerations are commonly known as the Aronson prongs, and a plaintiff must allege facts concerning these prongs with particularity.15 The Delaware Supreme Court has specifically applied these Aronson prongs in the executive compensation context by noting:
If an independent and informed board, acting in good faith, determines that the services of a particular individual warrant large amounts of money, whether in the form of current salary or severance provisions, the board has made a business judgment. That judgment normally will receive the protection of the business judgment rule unless the facts show that such amounts, compared with the services to be received in exchange, constitute waste or could not otherwise be the product of a valid exercise of business judgment.16
In the “say-on-pay” complaints filed against Delaware corporations, shareholders take aim at the first Aronson prong by contending that all the directors were interested because they (a) approved the executive compensation to be voted upon by shareholders, and (b) encouraged shareholders to vote in favor of their decisions. However, these allegations appear to be relatively thin. Delaware courts have stated that “[i]t is no answer to say that demand is necessarily futile because (a) the directors ‘would have to sue themselves, thereby placing the conduct of the litigation in hostile hands,’ or (b) that they approved the underlying transaction.”17
As for the second Aronson prong, plaintiffs have taken a couple of different approaches. Some complaints have alleged that the shareholder “no” vote was sufficient to rebut any presumption that the directors’ determination of executive compensation was a valid exercise of the business judgment rule. Other complaints allege that the board’s failure to adjust executive compensation in light of the “no” vote demonstrates demand futility. In all cases, however, the “no” vote plays a prominent place in plaintiffs’ allegations that demand is futile. But do allegations of excessive compensation and reference to a “no” vote constitute sufficient factual allegations to raise a strong doubt that the compensation decision was the result of legitimate business judgment? There is another key aspect of Delaware law that could help answer this question.
In Brehm v. Eisner, the Delaware Supreme Court explored the impact of Section 141(e) of the Delaware General Corporation Law on allegations that the board breached its fiduciary duty by approving excessive executive compensation. Section 141(e) provides that:
A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member’s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.18
Because the directors in Brehm had relied upon a compensation consultant in connection with their compensation decision, the court held that Section 141(e) would bar an action against them based on that decision unless the plaintiff alleged:
(a) the directors did not in fact rely on the expert; (b) their reliance was not in good faith; (c) they did not reasonably believe that the expert’s advice was within the expert’s professional competence; (d) the expert was not selected with reasonable care by or on behalf of the corporation, and the faulty selection process was attributable to the directors; (e) the subject matter (in this case the cost of calculation) that was material and reasonably available was so obvious that the board’s failure to consider it was grossly negligent regardless of the expert’s advice or lack of advice; or (f) that the decision of the Board was so unconscionable as to constitute waste or fraud.
This sets a relatively high bar when an expert is involved in executive compensation decisions as is generally the case.
Finally, it is interesting to note that the plaintiffs in the Beazer, Jacobs, Hercules, and Occidental cases chose not to bring suit in Delaware, despite the fact that the companies are incorporated there. While there could be several valid reasons for not suing in Delaware, it is possible that this was a strategic choice by the plaintiffs’ counsel who may have believed that the Chancery Court would be more likely to hold that allegations relying primarily on a “no” vote are not enough to plead demand futility, and that, perhaps, it was better taking this question to another state court with the hopes that the court does not apply Delaware law, or, that if it applies Delaware law, it does not construe Aronson as strictly as the Chancery Court would.
New derivative actions resulting from failed “say-on-pay” votes under the Dodd-Frank Act are being filed with increasing frequency, providing an additional reason why directors should focus additional time and resources on preparing, effecting, and disclosing their executive compensation programs and practices.