Recent decisions in shareholder derivative lawsuits filed following a failed say-on-pay vote leave boards of public companies with more questions than answers.
In January 2011, the Securities and Exchange Commission adopted rules pursuant to Section 951 of the Dodd-Frank Wall Street Reform Act, which requires public companies to provide shareholders with an advisory "say-on-pay" vote on executive compensation. Section 951 of the Dodd-Frank Act makes clear that these shareholder votes are advisory in nature, are not binding on the board and do not create or imply a change or addition to the fiduciary duties of directors.
Shareholder Derivative Lawsuits Following Failed Say-On-Pay Votes
Notwithstanding the express language of Section 951, the directors of several companies that had failed say-on-pay votes in 2010 and 2011 have been named as defendants in shareholder derivative suits, pursuant to which the plaintiffs allege that the directors breached their fiduciary duties in approving executive compensation. The allegations in these shareholder derivative suits generally include: (i) that the directors breached their duty of loyalty (some suits also allege breach of the duty of candor and good faith and allege corporate waste); (ii) unjust enrichment with respect to executive officers; and (iii) aiding and abetting the breach of fiduciary duties and/or breach of contract with respect to independent compensation consultants. The complaints generally challenge the executive compensation decisions made by the board by alleging that these decisions were improper in light of the company’s poor or declining performance, and that the compensation decisions violate the company’s pay-for-performance policy. Generally, the complaints point to the board’s failure to take action to change the compensation decisions following a failed say-on-pay vote.
Cincinnati Bell Derivative Suit
On July 5, 2011, a shareholder derivative action was filed in the U.S. District Court for the Southern District of Ohio against the directors and executive officers of Cincinnati Bell Inc. (an Ohio corporation) and Towers Watson, the company’s compensation consultant. (NECA-IBEW Pension Fund v. Cox, case no. 1:11-cv-451). The complaint challenges the board’s executive compensation decisions in 2010, citing the "company’s severely impaired financial results," and the company’s failed say-on-pay vote. On May 3, 2011, the company’s say-on-pay vote failed, with 66 percent of the voting shareholders (representing just over 53 percent of the total shares outstanding) voting against the proposal. According to the complaint, the failed say-on-pay vote is evidence that the company’s shareholders, in their independent business judgment, concluded that the 2010 executive compensation was not in their best interests.
On September 20, 2011, Judge Timothy S. Black issued an order denying the defendants’ motion to dismiss the shareholder derivative suit. In the order, Judge Black posed the question raised by the complaint in this way: "…whether a shareholder of a public company may sue its directors for breach of the duty of loyalty when the directors grant $4 million dollars [sic] in bonuses, on top of $4.5 million dollars [sic] in salary and other compensation, to the chief executive officer in the same year the company incurs a $61.3 million dollar [sic] decline in net income, a drop in earnings per share from $0.37 to $0.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8% annual shareholder return."
In the order, Judge Black explained that, under Ohio law, in order to rebut the presumption provided by the business judgment rule, the plaintiff must show that the actions of the directors were undertaken with a deliberate intent to cause injury to the corporation or reckless disregard for the best interests of the corporation. He then stated that, at the motion to dismiss stage, the plaintiff need only state a plausible claim because the business judgment rule imposes a burden of proof, not a burden of pleading. The court then found: "These factual allegations [in the complaint] raise a plausible claim that the multi-million 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 Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith." The court adopted the position espoused in the complaint that the negative say-on-pay vote provides "direct and probative evidence that the 2010 executive compensation was not in the best interests of the Cincinnati Bell shareholders."
Judge Black also found that a pre-suit demand on the Board was futile because: (i) all of the directors were named as defendants in the suit; (ii) the directors devised the compensation; (iii) the directors approved the compensation; (iv) the directors recommended that the shareholders approve the compensation; and (v) the company suffered a negative shareholder vote on the compensation.
With this order, the case will proceed. Judge Black noted that the defendants may offer the business judgment rule as an affirmative defense at trial or at summary judgment.
The Beazer Homes Derivative Suit
A shareholder derivative suit was filed on March 15, 2011, against the directors, executive officers and compensation consultants of Beazer Homes USA, Inc. (a Delaware corporation) in the Superior Court of Fulton County, Georgia. (Teamsters Local 237 v. McCarthy, 2011 CV 197841). The allegations were similar to those in the Cincinnati Bell suit -- the plaintiffs challenged the "excessive" compensation decisions of the board as a breach of the duty of loyalty, pointing to the company’s net loss of $34 million and annual share price return of -7.23 percent, and cited the results of the failed say-on-pay vote in an effort to rebut the presumption provided by the business judgment rule.
In sharp contrast to the Cincinnati Bell outcome, the court in the Beazer suit ruled that a failed say-on-pay vote alone is not sufficient to rebut the presumption of the business judgment rule, and granted the defendants’ motion to dismiss in September 2011.
What Do These Cases Mean to Boards of Public Companies?
The similarities in the allegations and underlying factual situations presented in these two suits, and opposite results on the motions to dismiss, leave public company boards and their advisors with more questions than answers with respect to the prospects of litigation over executive compensation decisions in this new era of say-on-pay votes. Will courts addressing similar complaints reach the same conclusion with respect to the business judgment rule as the court in Beazer or the court in Cincinnati Bell? Has the say-on-pay legislation raised the de facto bar for directors’ fiduciary duties in the executive compensation context? Should a board or a company respond actively to a failed say-on-pay vote? Will the Cincinnati Bell decision result in an increasing number of such shareholder derivative suits?
It is at least clear that boards and compensation committees should examine closely their public statements regarding executive compensation objectives and policies and the reasons for their compensation decisions. Pay-for-performance disclosures should be drafted carefully to ensure that the disclosure adequately and accurately reflects the actual compensation decisions made with respect to each aspect of an executive’s compensation. If a company’s shareholders reject a say-on-pay proposal, the board and the compensation committee should consider whether changes should be made to the executive compensation program, and disclose publicly any actions taken in response to the failed say-on-pay vote in a timely fashion. Finally, public company boards and advisors should monitor the rulings in similar shareholder derivative suits for additional guidance that can be gleaned from courts interpreting a director’s fiduciary duties in this area.