Legal challenges to executive compensation in the US: have defendants won the war on ‘say-on-pay’ litigation?
July 2013 | SPOTLIGHT | CORPORATE GOVERNANCE
Financier Worldwide Magazine
Shareholders of public companies in the United Kingdom have had the right to an advisory vote on executive compensation for a little over a decade. But for shareholders in the United States, ‘say-on-pay’ is a much more recent development.
In 2010, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the ‘Dodd-Frank Act’), Congress enacted legislation requiring all public companies subject to the proxy rules to provide shareholders with an advisory vote on executive compensation at least once every three years. The Dodd-Frank Act makes it clear that say-on-pay votes are non-binding and do not overrule board decisions or affect directors’ fiduciary duties in any way.
Of the more than 3000 companies that held say-on-pay votes in 2011, the first year that these provisions took effect, approximately 40 companies did not receive majority shareholder support for their executive compensation plans. Plaintiffs quickly began filing shareholder derivative actions based on the negative votes. The complaints alleged that the directors and officers had breached their fiduciary duties in approving the executive compensation at issue, and that the compensation awarded constituted a waste of corporate assets, among other claims.
To date, only one court has denied a motion to dismiss; most courts have dismissed these suits for failure to plead demand futility, among other grounds. The question of demand futility has generally turned on the application of the business judgment presumption, which provides broad protection for board compensation decisions. Plaintiffs have contended that a negative say-on-pay vote, when viewed against the backdrop of a company’s poor financial performance, rebuts the presumption that the directors’ executive compensation decisions were the result of a valid exercise of their business judgment.
In September 2011, a Georgia state court issued one of the earliest decisions dismissing a say-on-pay derivative action. The court ruled that “an adverse say on pay vote” does not “alone suffice[ ] to rebut the presumption of business judgment protection applicable to directors’ compensation decisions”. Courts have since held that plaintiffs cannot defeat the business judgment presumption merely by pointing to the results of an advisory say-on-pay vote. In Gordon v. Goodyear (July 2012), an Illinois federal court explained that permitting plaintiffs to do so would “circumvent[ ] the protections” of the Dodd-Frank Act’s say-on-pay provisions.
In 2012, plaintiffs took a new approach to executive compensation litigation: filing direct (rather than derivative) actions to enjoin say-on-pay votes at annual shareholder meetings based on allegedly inadequate disclosures in proxy statements. Plaintiffs have also recently started bringing direct actions to enjoin votes to approve additional stock issuances for equity incentive plans on disclosure grounds. These suits appear to be modelled on high-stakes merger injunction litigation, in which plaintiffs have sought to leverage the time pressures involved to force defendants to agree to quick and lucrative ‘disclosure’ settlements.
Proxy statement disclosures concerning executive compensation are governed by Item 402 of Regulation S-K, which requires “clear, concise and understandable disclosure” of the compensation awarded to the company’s five most highly-compensated executives, and Item 407, which governs reporting obligations in connection with compensation consultants. Item 402 expressly notes that “the material information to be disclosed...will vary depending upon the facts and circumstances”.
Plaintiffs have pointed to these executive compensation disclosure requirements to claim that directors breached their fiduciary duties by failing to disclose arguably minor details, such as how the company chose its compensation consultant and compensation data for peer companies used as benchmarks in setting compensation.
To our knowledge, no court has thus far granted a motion to enjoin a say-on-pay vote on disclosure grounds. In Mancuso v. The Clorox Company (Nov. 2012), a California state court found the plaintiff’s showing of irreparable harm “non-existent” given that the case involved “an advisory vote on compensation”. The Clorox court explained that this was “not a merger or takeover case that would require the court after a trial on the merits to try to ‘unscramble the eggs’”. More recently, in Greenlight Capital, L.P. v. Apple, Inc. (Feb. 2013), a New York federal court found that the plaintiff had failed to establish a likelihood of success on the merits because “the depth and breadth” of executive compensation-related information disclosed in Apple’s proxy statement was “plainly sufficient under SEC rules”.
After denying preliminary injunctions, some courts have dismissed disclosure-based say-on-pay claims in their entirety. In Noble v. AAR Corp. (Apr. 2013), an Illinois federal court found that the complaint “fail[ed] to state a claim upon which relief can be granted because the information omitted from the Proxy was not required by law”. The court noted that the plaintiff did “not identify how the alleged omissions [were] even arguably covered under Item 402 or Item 407” of Regulation S-K. “Instead”, the plaintiff “attempt[ed] to create additional disclosure obligations for ‘say on pay’ votes without citing legal precedent”. The court found the plaintiff’s “bareboned arguments . . . without merit, especially in light of the business judgment deference accorded directors when setting executive compensation”.
The Noble court found that any remaining claims the plaintiff had were direct, rather than derivative. A California state court reached the same conclusion in Gordon v. Symantec Corporation (Feb. 2013), explaining that there was “no longer any direct disclosure claim available” because the say-on-pay vote had already occurred.
Plaintiffs have had a little more success with efforts to enjoin shareholder votes to approve additional stock issuances for equity incentive plans. In Knee v. Brocade Communications Systems (Apr. 2012), for example, a California state court found that “the balance of harms tilt[ed] in favor of the proposed injunction” because “[d]enial of the proposed injunction would forever preclude the Brocade shareholders from casting a fully-informed vote on a proposal that could have dilutive effects on their shares”. The parties subsequently settled on terms that included supplemental disclosures and attorneys’ fees and expenses of up to $625,000.
But the more recent court decisions have ruled against plaintiffs in these equity plan cases. In Wenz v. Globecomm Systems, Inc. (Nov. 2012), for instance, a New York state court declined to enjoin a vote to approve an additional stock issuance for an equity plan on the grounds that plaintiffs had “fail[ed] to show that any of the omitted information complained of significantly would have altered the ‘total mix’ of information available to shareholders”. Plaintiffs have also voluntarily dismissed several suits.
The case law suggests that disclosure-based executive compensation suits have at best a limited likelihood of success on the merits. However, a few defendants have opted to settle these actions, typically for additional proxy disclosures and attorneys’ fee payments.
Given these settlements, it is not surprising that plaintiffs have continued to bring disclosure-based executive compensation suits. More may be on the way, as plaintiffs have announced “investigations” of the adequacy of proxy disclosures at dozens of additional companies. The latest investigations focus on disclosures concerning additional stock issuances for equity incentive plans and votes to amend certificates of incorporation to increase the total number of authorised shares.
Finally, a third wave of executive compensation litigation is also well underway: actions concerning tax-deductible plans for executive compensation under Section 162(m) of the Internal Revenue Code. In Freedman v. Adams (Jan. 2013), the Delaware Supreme Court found allegations of a board’s failure to adopt a Section 162(m) plan insufficient to state a corporate waste claim. The court explained that a board’s “decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment”. However, a couple of courts have permitted Section 162(m) actions to proceed beyond the pleadings stage, emboldening plaintiffs to continue to bring these claims.
While defendants have been remarkably successful in defeating many executive compensation suits, plaintiffs continue to devise new strategies for challenging executive compensation decisions. Our expectation is that these suits – in one form or another – will continue to be a board concern for the foreseeable future.
Paul C. Gluckow and Jonathan K. Youngwood are partners at Simpson Thacher & Bartlett LLP. Mr Gluckow can be contacted on +1 (212) 455-2653 or by email: firstname.lastname@example.org. Mr Youngwood can be contacted on +1 (212) 455-3539 or by email: email@example.com.
© Financier Worldwide
Paul C. Gluckow and Jonathan K. Youngwood
Simpson Thacher & Bartlett LLP