In January 2011, the SEC adopted Final Rules on "say-on-pay" under Section 951 of the Dodd Frank Act. These rules provide, among other things, that public companies must provide shareholders with advisory votes on the compensation of named executive officers (NEOs).
A troubling development is that lawsuits are following in the wake of shareholder "no" votes on say-on-pay. In the past year, there have been at least six notable shareholder derivative lawsuits in which plaintiffs have argued that shareholders' "disapproval" of a company's executive compensation plan supports claims that the directors breached their fiduciary duties when they approved the plans, and that the directors are therefore personally liable for damages to the company resulting from allegedly excessive compensation payments to NEOs. Compensation consulting firms that provided advice to the directors have also been named as defendants in these lawsuits.
The companies sued in these cases include Occidental Petroleum Corporation (Gusinsky v. Irani, BC442658 (Cal. Super., filed July 29, 2010)); Keycorp (King v. Meyer, CV 10 730994 (Ohio Com. Pleas, filed July 6, 2010)); Beazer Homes USA (Teamsters Local 237 v. McCarthy, 2011CV 197841 (Ga. Super., filed March 15, 2011); Umpqua Holdings Corporation (Plumbers Local No. 137 Pension Fund v. Davis, CV 11 633 AC (D. Or., filed May 25, 2011); Jacobs Engineering Group (Witmer v. Martin, BC454543 (Cal. Super., filed February 4, 2011); and Hercules Offshore, Inc. (Matthews v. Rynd, 2011 34508 (Tex. Dist., filed June 8, 2011)).
Blueprint of the Complaints
With minor variations, all of these complaints follow the same "blueprint."
Fact Pattern and Allegations. The basic "fact pattern" targeted in these complaints is as follows: (1) the company advises shareholders that it maintains a "pay for performance" compensation philosophy; (2) the board relies in part on the advice of a compensation consultant to (3) approve an executive compensation plan pursuant to which NEOs receive an increase in compensation, despite (4) the company's arguably poor financial results; (5) directors who are also NEOs receive the compensation increases; (6) a majority of the shareholders vote "no" in the say-on-pay vote; and (7) the board fails to rescind the pay increases following the shareholder vote. Based on this combination of factors, the plaintiffs allege that the directors' approval of (and refusal to rescind) the compensation plan was irrational, unjustified, a profligate waste of corporate assets, and could not have been the product of a valid business judgment.
Causes of Action. The plaintiffs bring several causes of action against the defendants, including the following:
- Breach of fiduciary duty claims against the directors based on the theory that the directors' approval of the executive compensation plan violated their duties of care and loyalty to the shareholders.
- Misrepresentation claims against the directors based on the theory that the approval of the NEO pay hikes despite the company's poor financial performance contravenes the board's representation in SEC filings that the company has a "pay for performance" executive compensation philosophy.
- Corporate waste claims against the directors based on the theory that the executive compensation plans caused the company to squander corporate assets.
- Unjust enrichment claims against the directors who are also NEOs based on the theory that they have been unjustly enriched by the pay hikes. Notably, one complaint (involving Hercules Offshore) also sues the NEOs who were not directors on an unjust enrichment theory.
- Aiding and abetting claims against the company's compensation consulting firm based on the theory that the consultant, in giving its recommendations to the board, joined together with and aided the directors in their breaches of fiduciary duty.
- Breach of contract claims against the compensation consulting firm based on the theory that the consultant, in providing its recommendations, breached its consulting agreement with the company.
Relief Sought. The plaintiffs seek, among other things, unspecified damages resulting from the executive compensation plans, as well as costs and attorneys' fees. The plaintiffs also demand the implementation of internal controls to prohibit and prevent the payment of excessive executive compensation in the future.
Dodd Frank Act and the Business Judgment Rule
The plaintiffs in these complaints argue generally that the mere fact that the shareholders declined to endorse the executive compensation plans in their say-on-pay votes proves that the directors breached their fiduciary duties when they approved the compensation plans or when they failed to rescind them following the shareholder vote. Certain of the complaints also allege that the shareholders' "no" vote, characterized by the plaintiffs as an exercise of the shareholders' own "independent business judgment," rebuts the presumption that the board's approval of the executive pay hikes was a valid exercise of the board's business judgment. By arguing that the shareholders' negative vote rebuts the business judgment presumption, the plaintiffs seek to shift the burden to the directors to prove that they acted properly in approving the compensation packages.
Section 951 of the Dodd Frank Act, however, clearly establishes that the shareholder votes are advisory, and "shall not be binding" on a company's board. Further, the statute clearly provides that a shareholder vote "may not be construed" as "overruling" directors' executive compensation decisions, or as "creat[ing] or imply[ing]" "any changes" or "addition[s]" to directors' "fiduciary duties." Thus, in arguing that a negative shareholder vote requires the court to find that the directors breached their fiduciary duties by approving the executive compensation plan (or at least shifts the burden of proof to the directors to justify their decision), the plaintiffs are attempting to circumvent the statute by effectively converting an advisory vote into a binding vote, or at least a vote that "creates or implies" a change or addition to the directors' fiduciary duties.
In addition, under the business judgment rule, courts give great deference to directors' business decisions. Although the exact contours of the business judgment rule may vary from state to state, as a general matter, courts will not hold directors personally liable for errors in judgment regarding business matters, absent a clear showing that the directors acted in bad faith, with a conflict of interest, or in a fraudulent or grossly negligent manner when making the challenged decision. In analyzing whether the business judgment rule applies, the focus is on the manner in which the directors performed their duties and not the outcome of their performance. Recognizing that most lawsuits against directors are brought by shareholders, the business judgment rule was developed – and exists – precisely to protect directors from liability when shareholders disagree with the directors' decisions. Thus, the notion that directors, in a lawsuit brought by shareholders, are not entitled to the protections of the business judgment rule merely because the shareholders disagree with a director approved executive compensation plan is at odds with the policies behind the business judgment rule.
Impact of the Lawsuits
The impact of these lawsuits is yet to be determined. The dispositions of all six cases have not yet been publicly disclosed, and it appears that some are still pending. However, based on disclosures in SEC filings, it appears that at least two of the cases – Keycorp and Occidental Petroleum – have been settled. Under the Keycorp settlement, the company agreed to certain corporate governance enhancements with respect to executive compensation, the payment of $1.75 million in legal fees, and payment of $2,500 to each plaintiff ($5,000 in total). The terms of the Occidental Petroleum settlement have not been disclosed.
One of three law firms is named as plaintiffs' counsel in each of the six complaints, and, as discussed above, the lawsuits have been brought with respect to a fairly specific fact pattern. Thus, it is not clear whether these cases represent the beginning of a trend, or whether they reflect an effort by a small group of plaintiffs' law firms to capitalize on the new say-on-pay requirements under the Dodd Frank Act by targeting a specific plaintiff profile.
Because the risk of a negative shareholder vote may be higher in the current economic environment in which executive compensation is a hot topic (especially among institutional shareholders), there could be an increased risk of litigation in the wake of the "first round" of say-on-pay votes after the passage of the say-on-pay Final Rules in January. Indeed, as of late May 2011, approximately two dozen larger reporting companies have received "no" votes on say-on-pay proposals.
Even if lawsuits following negative say-on-pay votes lack merit, they are nonetheless expensive for companies to defend, and some may settle the cases merely to control or limit expenses, exposure and negative publicity.
If shareholder lawsuits following "no" votes on say-on-pay gain traction, it is unclear how insurance companies that provide director and officer (D&O) insurance to public companies will react with respect to the coverages they provide.
It is also unclear how these types of lawsuits will affect boards' decision processes with respect to executive compensation plans and/or governance policies and procedures concerning executive compensation.
Limiting Litigation Risk
As discussed above, in general, the Dodd Frank Act and the business judgment rule should protect directors from personal liability for their decisions concerning executive compensation, as long as the directors acted in good faith and without gross negligence, conflicts of interest or fraud.
To buttress the position that they are entitled to rely on these protections, particularly in the current environment where lawsuits may follow negative shareholder say-on-pay votes, directors should consider building the following items into their decision making process with respect to executive compensation plans:
- Engage in healthy discussions with compensation consultants and others involved in presenting the proposed compensation package. Ask detailed questions and probe the basis for the recommendations.
- Ensure that the board or committee meeting minutes document that there was a robust discussion in which questions were asked.
- Ensure that the supporting materials presented to the board provide solid empirical support for the recommendations, and not merely subjective assessments of the employees' value to the company (although such subjective assessments are also important and appropriate).
- Continue to vote for the compensation the directors believe in good faith will be needed to attract, retain and incentivize executives based on solid advice and recommendations (e.g., from compensation consulting firms, executives, HR department, etc.), but be prepared to explain the basis for that good faith belief if it is challenged in a lawsuit.