A version of this article will appear in the winter 2011 Informer magazine, published by Thomson Reuters.

Focus on corporate executive compensation levels and practices is at an all-time high, thanks in large part to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) enacted in 2010.1 The Dodd-Frank Act mandated that public companies give their shareholders some say on executive pay, by allowing the shareholders to vote on non-binding resolutions regarding executive compensation. And perhaps not surprisingly, when the shareholders' voices have been ignored, lawsuits have followed. To date, shareholders have sued the boards of directors of at least nine companies that did not receive majority approval on say-on-pay proposals. These derivative suits have been filed in various state and federal courts across the United States. Two cases have already been settled, with the settling companies paying significant sums toward plaintiffs' attorney's fees and expenses. The potential for expensive and intrusive shareholder litigation is yet another reason for companies to take great care in crafting compensation policies and communicating with shareholders on compensation-related topics.

What Are Say-on-Pay Votes?

Section 951 of the Dodd-Frank Act provides that, no less frequently than every three years, public companies must provide their shareholders with an opportunity to vote on a resolution to approve or reject the compensation of certain of the company's executives. Section 951(c) specifically states that the shareholder voting results on these resolutions "shall be non-binding" on companies or their boards of directors and may not be construed:

  1. As overruling a decision by the issuer or board of directors;
  2. To create or imply any change to the fiduciary duties of the issuer or board of directors;
  3. To create or imply any additional fiduciary duties for the issuer or board of directors; or
  4. To restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.

Legislative history of the Dodd-Frank Act confirms that the voting results on these "say-on-pay" resolutions are to be non-binding.2

The Securities and Exchange Commission adopted rules implementing the requirements of Section 951 that became effective on April 4, 2011. The rules state that starting on January 21, 2011,3 and not less frequently than once every three years thereafter, all public companies that are subject to the proxy rules are required at shareholder meetings to hold non-binding votes of the shareholders on the compensation of the CEO, CFO, and at least three other of the most highly compensated executives (i.e., "say-on-pay votes").

How Have Shareholders Voted?

Approximately 290 say-on-pay votes were taken in 2010, and a majority of votes were cast against the company's compensation of named executive officers in only three instances — approximately 1 percent of the votes. So far in 2011, of the more than 2,800 companies that have reported say-on-pay voting results, more than 40 companies — or approximately 1.5 percent — did not receive majority shareholder support for their say-on-pay proposals.

What Is the Impact of a Negative Say-on-Pay Vote?

The fact that the majority of a company's shareholders disapprove of the company's executive compensation plan is clearly embarrassing and may create bad publicity. But the impact of a negative say-on-pay vote does not end there. In many cases, the next step after the negative vote — assuming the compensation packages are still paid despite the shareholder disapproval — is a shareholder derivative lawsuit against the company's directors, officers, and/or compensation consultants. These lawsuits generally allege that the officers and directors breached their fiduciary duties to the company and engaged in corporate waste. This trend was almost immediate; shareholder derivative lawsuits were filed against two of the three companies receiving negative say-on-pay votes in 2010 and, thus far, derivative lawsuits have been filed against seven of the companies that received negative say-on-pay votes in 2011. And of course, these lawsuits are expensive to defend.

In addition, a company receiving a negative say-on-pay vote may also incur substantial expense investigating whether the putative claims have merit and should be pursued by the company itself. That is, because these are shareholder derivative lawsuits seeking to bring claims on behalf of the company, the company may choose to create a special litigation committee. Such a committee would be tasked with conducting an investigation into whether any potential breaches of fiduciary duty were committed relating to historical and/or potential executive compensation, and determining whether it is in the best interests of the company to pursue the claims. These investigations are certainly intrusive and are also expensive.

Say-on-Pay Lawsuits — What Are the Claims?

Plaintiffs in these cases typically sue company directors and officers for corporate waste, unjust enrichment, breach of the duty of good faith and loyalty, breach of the duty of candor and full disclosure, false and misleading proxy statements, and breach of contract. Some plaintiffs have also sued the company's compensation consultants for breach of the consulting agreement and/or for aiding and abetting the directors' breaches of fiduciary duty. Shareholders generally seek unspecified monetary damages (which would benefit the company); equitable accounting against all recipients of challenged compensation; extraordinary or injunctive relief (including disgorgement, attachment, constructive trust, and/or impoundment of the compensation); an order requiring the implementation of internal controls to prohibit excessive compensation in the future; and attorneys' fees.4

These suits also generally argue that the award of the challenged compensation or the approval of a challenged compensation-related plan — despite the negative say-on-pay voting results and/or the company's unfavorable financial results/performance — was disloyal, irrational, unreasonable, and not in the shareholders' best interest.

Thus, plaintiffs in these suits assert that the decision was not the product of the valid exercise of the directors' business judgment.5

A sub-set of these suits also assert that compensation paid by the company was not only excessive, but also violated the company's own executive compensation "pay-for-performance" policies (e.g., that executive compensation will be based on, and aligned with, the company's earnings, revenues, shareholder returns, and/or other performance factors) and, in some cases, rendered certain of the company's prior representations that the company adheres to this "pay-for-performance" policy false and misleading.6

What Are the Available Defenses?

The claims are, at their core, typical derivative claims and thus are subject to the typical derivative claim defenses. This includes arguing that the plaintiff lacks standing due to a failure to make a demand on the board of directors.7 But beyond the arguments that are typically made in derivative cases, there are also a number of arguments specific to say-on-pay votes that are available to defendants.

First, as noted above, the Dodd-Frank Act and its legislative history are clear — the results of shareholder voting on say-on-pay proposals "shall be non-binding" on companies or their boards of directors and may not be construed to create or imply any change to a director's fiduciary duties or to impose any additional fiduciary duties.

Second, U.S. courts — most notably those in Delaware — have often seemed reluctant to intervene in matters relating to executive compensation. Delaware courts generally consider decisions about executive compensation to be matters of business judgment and entitled to deference by the courts. See, e.g., In re InfoUSA, Inc. S'holders Litig'n, 953 A.2d 963, 985 (Del. Ch. 2007). Thus, company directors are given wide latitude under the business judgment rule to set corporate compensation policy and structure executive compensation agreements that they believe are in the corporation's best interest.

Third, a negative say-on-pay vote, without more, will likely not constitute sufficient evidence of bad faith, lack of due care, or waste by a corporate board of directors to overcome the business judgment rule on a motion for summary judgment or at trial. The Delaware Supreme Court has recognized the following three types of acts by corporate fiduciaries as examples of bad faith: (1) intentionally acting with a purpose other than that of advancing the best interests of the corporation; (2) acting with an intent to violate applicable positive law; and (3) intentionally failing to act in the face of a known duty to act, demonstrating a conscious disregard for the corporate fiduciary's duties. In re Walt Disney Co. Deriv. Litig'n, 906 A.2d 27, 64-67 (Del. 2006). The third of these examples requires "a sustained or systematic failure of the board to exercise oversight — such as an utter failure to attempt to assure a reasonable information and reporting system exists." Stone v. Ritter, 911 A.2d 362, 369 (Del. 2006). A violation of the duty of good faith requires a showing that the directors knew that they were not discharging their fiduciary obligations. Id. at 369-70. In other words, mere procedural defects or directorial inattention are not sufficient.

With regard to the duty of care, the analysis is a process inquiry, not a substantive one, which requires only that the decision-makers be informed of all reasonably available material information and exercise the level of care of a reasonably prudent person in similar circumstances. Brehm v. Eisner, 746 A.2d 244, 259 (Del. 2000). Further, except for situations in which the directors' actions were grossly negligent or their decision was so unconscionable as to constitute waste or fraud, under Delaware General Corporation Law,8 directors are protected from liability if they rely in good faith on an outside compensation consultant as to matters the director reasonably believes are within the consultant's professional or expert competence if that consultant was selected with reasonable care by or on behalf of the corporation. Id. at 262.

Finally, to prevail on a waste claim, under well-settled Delaware law, a derivative plaintiff would need to demonstrate that the company directors "authorize[d] an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." In re Walt Disney Co. Deriv. Litig'n, 731 A.2d 342, 362-63 (Del. Ch. 1998). Thus, successful waste claims are "confined to unconscionable cases where directors irrationally squander or give away corporate assets." Brehm, 746 A.2d at 263.

Thus, under currently prevailing law, so long as a corporate board's decisions related to executive compensation were made with a belief that such decisions would be in the corporation's best interest (e.g., to retain executives or to reward them for achieving certain preselected performance objectives) and the directors (1) reasonably informed themselves, (2) employed appropriate procedures in making compensation-related decisions (including some meaningful discussion or deliberation over such decisions), and (3) reasonably relied on compensation experts (if any) that were selected with reasonable care, then a negative say-on-pay vote — or any manifestation of shareholder disagreement with the board's ultimate decisions on executive compensation, for that matter — is not likely to be sufficient, in and of itself, to overcome the presumptions of the business judgment rule on bad faith, lack of due care, or waste grounds.

How Are These Claims Faring in Court?

The two companies that were named in say-on-pay derivative suits in 2010 have settled those lawsuits. In connection with these settlements, both companies agreed to implement certain corporate governance enhancements and pay significant sums towards plaintiffs' attorney's fees and expenses. KeyCorp, in particular, agreed to pay $1.75 million in attorneys' fees and expenses.9 KeyCorp also agreed to shorten the exercise period for options previously granted to the company's CEO.10

Motions to dismiss have also been filed in several other derivative suits, but so far only two such motions to dismiss have been decided. In Beazer Homes, on September 16, 2001, Judge Melvin Westmoreland of the Superior Court of Fulton County, Georgia rejected "as wholly unpersuasive both factually and legally" plaintiffs' argument that adverse say-on-pay voting results, without more, constitute evidence that rebuts the presumption that the Beazer directors' prior compensation decisions reflected valid business judgment.11 The court further held that the Dodd-Frank Act expressly preserved, and did not alter, the preexisting fiduciary framework regarding directors' executive compensation decisions.12 In Cincinnati Bell, however, on September 20, 2011, Judge Timothy Black of the United States District Court for the Southern District of Ohio denied defendants' motion to dismiss.13 Judge Black ruled that plaintiff had pleaded sufficient factual allegations to "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."14 Cincinnati Bell, therefore, is a case to watch.

Conclusion

While say-on-pay proposals under the Dodd-Frank Act are non-binding on company directors, a negative say-on-pay vote can trigger a number of possibly adverse effects on a company, not the least of which is the filing of a shareholder derivative suit. While such derivative suits may ultimately lack merit, defending such suits can be expensive, distracting, and intrusive. And at least one case has survived a motion to dismiss and is proceeding into the discovery phase. Thus, an ounce of preventative attention paid to executive compensation best practices up-front may prevent the expensive headache of shareholder litigation later.

Footnotes

1 Dodd-Frank Wall Street Reform and Consumer Protection Act, §14A(c), 15 U.S.C. § 78n (2010).

2 S. Rep. No. 111-176, at 133-34 (2010) (Report of the Committee on Banking, Housing, and Urban Affairs) stating that say-on-pay voting results "must be tabulated and reported, but the result is not binding on the board or management" of the company.

3 These requirements were delayed for two years (until January 21, 2013) for "smaller reporting companies" (companies with public float of less than $75 million).

4 See, e.g., Plumbers Local No. 137 Pension Fund v. Davis, 3:11-cv- 00633 (D. Or. May 25, 2011) (derivatively, on behalf of Umpqua Holdings Corporation); see also infra notes 5 and 6.

5 See, e.g., Witmer v. Martin, BC-454543 (Ca. Super. Ct. Feb. 4, 2011) (derivatively, on behalf of Jacobs Engineering Group Inc.); King v. Meyer., CV 10-730994 (C.P. Cuyahoga County, Ohio July 6, 2010) (one of two suits filed derivatively, on behalf of KeyCorp, which were ultimately consolidated and removed to the U.S. District Court for the Northern District of Ohio).

6 See, e.g., Swanson v. Weil, 1:11-cv-02142-CMA (D. Colo. Aug. 16, 2011) (derivatively, on behalf of Janus Capital Group Inc.); Haberland v. Bulkeley, (E.D.N.C. Sept. 1, 2011) (derivatively on behalf of Dex One Corporation).

7 In Delaware and other U.S. jurisdictions, derivative plaintiffs must either make pre-suit demand on the board of directors of the corporation to take action to correct the wrongdoing or plead particularized facts sufficient to establish that such a demand would be futile. See Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984); Del. Ch. Ct. R. 23.1(a).

8 Del. Code. Ann. Tit. 8 § 141(e) (2011).

9 KeyCorp, Current Report (Form 8-K) Exhibit 99.2, at 16-17 (Mar. 25, 2011).

10 KeyCorp, Current Report (Form 8-K), at 2 (Mar. 25, 2011).

11 Teamsters Local 237 Additional Sec. Benefit Fund v. McCarthy, 2001-CV-197841 at 10 (Super. Ct. GA Sept. 16, 2011) (order granting motion to dismiss).

12 Id. at 11-12.

13 NECA-IBEW Pension Fund v. Cox, 1:11-cv-00451-TSB (S.D. Oh. Sept. 20, 2011) (order denying motion to dismiss).

14 Id. at 6.

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