By Robert Varian, Jonathan Ocker and Alex Talarides
In the first reported decision in a "say on pay" derivative suit,1 a federal court in Ohio delivered an unexpected blow to corporations, officers and directors who may be called upon to defend executive compensation lawsuits. The opinion, NECA-IBEW Pension Fund v. Cox, No. 1:11-cv-451 (S.D. Ohio Sept. 20, 2011), denied a motion to dismiss breach of fiduciary duty and unjust enrichment claims against the directors and officers of Cincinnati Bell, Inc.
The ruling is significant because it departs from settled legal principles, and gives short shrift to a seeming protection incorporated into the Dodd-Frank Act. It is likely to prompt more lawsuits—including claims that go beyond failed say on pay votes—while making such cases more difficult to defend.
As part of Section 951 of the Dodd-Frank 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 senior executive officers. Section 951 expressly provides, however, that a negative say-on-pay vote may not be construed to create or imply any change in directors' fiduciary duties.
Pursuant to Section 951, Cincinnati Bell's 2011 proxy included a resolution seeking shareholder approval of its 2010 executive compensation plan. On May 3, 2011, nearly two-thirds of the company's voting shareholders voted against the resolution.
Soon after the negative vote, a prominent shareholder class action firm filed a derivative lawsuit against the company's board of directors. The complaint alleged that the directors breached their fiduciary duty of loyalty by approving and recommending substantial pay raises in a year where the company's net income and stock price had declined from the year before. Plaintiff repeatedly referenced the negative say on pay vote as "evidence" that the directors breached their duty of loyalty, that pre-suit demand on the board was excused, and that the compensation at issue constituted unjust enrichment.
Typically, a board's decision on executive compensation is entitled to the protections of the business judgment rule, which is a judicial presumption that in making a decision the directors of a corporation "acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."2 As the Delaware Supreme Court said in 2000, "A board's decision on executive compensation is entitled to great deference. It is the essence of business judgment for a board to determine if a particular individual warrants large amounts of money, whether in the form of current salary or severance provisions."3
Accordingly, derivative lawsuits challenging a board's compensation decisions have met formidable obstacles under prior law, both on the merits and in connection with the requirement that the shareholder make a pre-suit demand before asserting claims that belong to the corporation. The enactment of Dodd-Frank's say on pay provisions and changes in the prevailing political environment appear to be changing that dynamic, in ways that elevate shareholder rights and create broader risks for companies and their officers and directors. The Cincinnati Bell decision may exacerbate that trend.
Following standard practice in defending derivative litigation, defendants filed a motion to dismiss based on the business judgment rule and plaintiff's failure to make the requisite pre-lawsuit demand on the board that it consider the claims asserted in the complaint. The court ruled against the directors on both grounds.
The decision framed the overarching issue in terms of "whether a shareholder of a public company may sue its directors for breach of the duty of loyalty" in granting substantial bonuses and other compensation to company executives in a year in which the company had experienced substantial declines in income, earnings and stock price. After discussing the duty of loyalty in terms of whether the board's actions were "not in the best interests of the company or its shareholders," the court held that plaintiff's allegations raised a plausible inference that the board had violated that duty. In reaching that conclusion, the court relied heavily on the negative say on pay vote, adopting the plaintiff's argument that it provided "direct and probative evidence" that the 2010 compensation was not in the shareholders' best interests.
Although it acknowledged the well-accepted rule that the mere fact that directors are being asked to sue themselves is insufficient to excuse demand, the court held that demand was excused because the allegations of the complaint created "a reasonable doubt that the challenged transaction is the result of a valid business judgment." In addition to citing the failed say on pay vote, the opinion emphasized that the directors were "the very same people who approved the pay hikes and bonuses," and then "recommended to the shareholders that the shareholders approve the compensation."
Finally, the court held that since the plaintiff sufficiently pled a breach of fiduciary duty claim, it was "axiomatic" that the plaintiff had also sufficiently pled a claim for unjust enrichment.
This decision is unsettling to say the least. The complaint's allegations were limited to the facts that (1) the company's financial performance and stock price had declined, (2) the company's compensation policy provided that a significant portion of total compensation be linked to financial performance and shareholder returns, (3) the board approved and recommended the pay increases, and (4) the shareholders voted against them. There were no compelling allegations that the directors acted in bad faith, had a conflict of interest, or were grossly negligent, which typically provide the backbone of any effort to overcome the presumptions of the business judgment rule.
Under an expansive reading of the court's rationale, the combination of declines in financial performance, increased executive compensation and an adverse shareholder vote may be sufficient to state claims for a breach of the duty of loyalty and unjust enrichment with respect to complex compensation decisions committed by law to the board of directors. That is contrary to well-established legal principles on fiduciary duty, and severely undercuts the policies and impact of the business judgment rule.
Moreover, the ruling's extensive reliance on the outcome of the say on pay vote fails to give appropriate deference to Section 951 of the Dodd-Frank Act which expressly provides that a negative say on pay vote may not be construed to create or imply any change in directors' fiduciary duties.
Executive compensation decisions will always be made and approved by the board, and under Dodd-Frank they must be recommended to the shareholders for an advisory vote. If that recurring pattern is viewed as sufficient to excuse demand whenever shareholders disagree with the board's recommendation in an advisory vote, derivative cases that would previously have been dismissed will proceed directly to discovery.
Under these circumstances, issuers who wish to avoid costly shareholder litigation should take all necessary steps to avoid a "no" on their say on pay vote. Steps to consider include:
Please see Orrick's Say On Pay Solutions Overview for more details.