In the current environment and in the wake of Dodd-Frank (and, before that, TARP) mandated rules requiring shareholder advisory votes on executive compensation, shareholder-plaintiffs have more aggressively challenged executive compensation decisions. In recent months, an active plaintiffs’ bar has filed a series of cases, which generally fall into three broad categories:
- “say-on-pay” litigation;
- litigation relating to annual proxy disclosure, particularly with respect to equity compensation plans and say-on-pay proposals; and
- litigation relating to Section 162(m) of the Internal Revenue Code.
While most of these challenges have failed on substantive or procedural grounds or both, some have been more successful, and the plaintiffs’ strategies continue to evolve. Notably, even unsuccessful claims can result in costly disruptions and/or reputational harm, especially where injunctions against annual shareholder meetings are threatened.
In this memorandum, we:
- present a brief review of the procedural and substantive standards generally applicable to executive compensation litigation;
- describe select recent cases; and
- offer a few tips to possibly minimize the risk of being subject to these claims or improve the chances of more efficiently rebuffing such claims.
II. Review of Procedural and Substantive Standards
A. Procedural Hurdles—Derivative Suits Require “Demand Futility”
Executive compensation-related lawsuits are often brought as derivative actions—i.e., suits brought by a shareholder on behalf of the company, purporting to assert claims on behalf of the company. Generally under state law, including in Delaware, in order for a shareholder to bring a derivative suit, a shareholder must first either demand that the board of directors take action to initiate the suit or otherwise establish “demand futility.” In Delaware, to establish so-called demand futility, a shareholder must allege particularized facts that create a reasonable doubt as to whether:
- the directors are disinterested and independent; or
- the challenged transaction was otherwise the product of a valid exercise of “business judgment.”
Because shareholders bringing executive compensation-related derivative claims frequently cannot establish director interestedness, and because of the strong presumption in favor of the board’s business judgment, many executive compensation lawsuits do not advance beyond the demand futility stage. And, while the relatively new wave of proxy-related disclosure cases features direct (not derivative) suits and therefore is not subject to these demand requirements, these cases have faced other challenges relating to the requirements for granting injunctive relief (e.g, establishing irreparable harm), as discussed generally in Section III.B below. In addition to derivative lawsuits, plaintiffs frequently file putative class action lawsuits on behalf of a class of all shareholders of the corporation that is named as a defendant in the litigation.
B. Legal Bases—Same Name, Potentially New Game
The recent cases generally include claims that have served as the bases for plaintiffs’ challenges for years:
- Breach of Fiduciary Duty—Many states’ laws impose fiduciary duties of loyalty, good faith and care on directors and executive officers. The alleged breaches asserted in recent compensation litigation come in all shapes and sizes—from awarding particular types of equity compensation to failing to respond to a say-on-pay vote to making or not making certain disclosures in annual proxy statements.
- Waste of Corporate Assets—Many states’ laws require that, when dealing with the assets of a corporation, directors engage in fair exchanges. Reflecting the strong presumption of the board’s business judgment, however, the standard tends to protect directors even in circumstances where, with the benefit of hindsight, the transaction may have been imprudent, as long as the decision was made in good faith and the corporation received any substantial consideration in the exchange.
- Unjust Enrichment—Many states’ laws prohibit directors from unjustly retaining some sort of benefit which results in a loss to shareholders. In the context of recent compensation litigation, this allegation is often based on the receipt of compensation obtained through a proxy statement containing inadequate disclosure.
- False or Misleading Disclosure—Section 14(a) of the Exchange Act and SEC Rule 14a-9 prohibit proxy statements which contain false or misleading statements with regard to any material facts, or which omit material facts necessary in order to make the proxy statement not false or misleading. Many states’ laws can provide a corresponding cause of action via directors’ fiduciary duties.
The first three claims (like the demand requirement) are often brought under the common law of the state in which a company is incorporated (which, in the majority of cases, is Delaware). Disclosure-based claims can be brought under the federal securities laws or state common law.
C. Jurisdiction—Learning the Geography
While compensation-related lawsuits generally are filed in the Delaware Court of Chancery and/or federal courts, the new say-on-pay lawsuits in which plaintiffs seek to enjoin annual shareholder meetings largely have been brought in state courts outside of Delaware (typically, in the state where the corporation- defendant is headquartered). Many of these courts are relatively inexperienced in litigation concerning executive compensation and corporate governance.
III. Select Recent Cases
A. Say-on-Pay Litigation
Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires issuers with a class of equity securities registered under Section 12 of the Securities Exchange Act of 1934 to include a separate shareholder resolution to approve executive compensation in their annual proxy statements at least once every three years. This say-on-pay vote is only advisory in nature, but, notwithstanding clear statutory language that the results of the vote may not be construed to create or imply any change to the fiduciary duties of boards or impose any additional fiduciary duties, a number of companies with low say- on-pay approval votes have been the subject of lawsuits alleging that the directors breached their fiduciary duties. For these derivative lawsuits, to establish demand futility, plaintiffs typically allege that the result of the say-on-pay vote is evidence that the shareholders did not approve of the compensation decisions and that, combined with the company’s poor performance, there are sufficient particularized facts to raise a reason to doubt that the board’s compensation decisions were the product of valid exercises of business judgment. However, most of these claims have not advanced past the demand futility stage.
1. Low Say-on-Pay Approval Vote Likely Won’t Excuse Demand
While plaintiffs have been creative in their arguments, the bottom line is that a low say-on-pay approval vote, whether alone or in combination with other factors, likely will not excuse demand.
The plaintiff in Gordon v. Goodyear argued that certain pay increases and cash bonus awards, which were made while Navigant Consulting was experiencing declining financial performance, were evidence of the directors’ breach of fiduciary duties. A federal district court in Illinois applied Delaware law and dismissed the claim for failure to establish demand futility, finding that a say-on-pay approval vote of 45%, combined with the company’s poor performance, was not sufficient to raise reasonable doubt that the transaction approving the compensation was the product of a valid business judgment. It further reasoned that the plain language of Section 951 makes clear that the say-on-pay vote does not change or impose additional fiduciary duties.
Echoing the Goodyear decision, in Swanson v. Weil, a federal district court in Colorado applied Delaware law and concluded that a company’s poor performance, taken with a failed say-on-pay vote, is insufficient on its own to establish demand futility. The plaintiff claimed that the board’s approval of Janus Capital’s 2010 executive compensation program, which allegedly raised its top executives’ pay by 41%, coupled with a say-on-pay approval of 42% and a stock price decline of 7%, was a violation of the board’s fiduciary duty to act in good faith. In rejecting the plaintiff’s argument that the low say-on-pay approval was powerful evidence of a breach, the court reasoned that Section 951 explicitly declined to alter existing fiduciary duties and noted that most of the approved compensation related to a one-time executive signing bonus. Excluding this payment, the total compensation paid to the other four highest paid executives increased by less than 1%.
In Haberland v. Bulkeley, the plaintiff alleged that Dex One’s directors breached their fiduciary duties when they failed to alter or amend the company’s 2010 executive compensation plan, or to recoup any compensation paid pursuant to it, in response to a say-on-pay approval of 48%. A federal district court in North Carolina applied Delaware law and dismissed the case for failure to state a claim, again affirming that the board has no legal duty to respond to a negative say-on-pay vote. The court noted, however, that a board would be bound to take some action in response to a negative say-on-pay vote if it promised to do so in the proxy statement. In this case, however, the board only explicitly agreed to “consider” a negative say-on-pay vote.
2. Board’s Interpretation of Pay-for-Performance Policy Trumps
Many of the say-on-pay lawsuits also allege that, when making a particular executive compensation decision, a board breached its state-law fiduciary duties by not adhering to the company’s pay-for- performance compensation plans or policies, as previously disclosed in the company’s proxy statement. To establish demand futility under this claim, the plaintiff must plead facts that create a reasonable doubt as to whether or not the board violated its own policies and metrics in awarding performance or as to whether or not the board applied the metrics in bad faith. Courts generally have held that disagreement over the interpretation of compensation plans’ provisions governing performance requirements is not sufficient to establish demand futility. In addition, the mere fact that a company granted incentive compensation outside of a shareholder-approved compensation plan should not excuse demand.
In Gordon v. Goodyear, where the plaintiff alleged that the directors violated Navigant Consulting’s policy of carefully linking executive pay to company performance, the court held that the plaintiff did not establish demand futility. The court reasoned that, in addition to focusing on the company’s performance and shareholder return, the compensation committee’s charter directed the compensation committee to consider a number of other factors when assessing the incentive component of executive compensation, including the value of similar incentive awards to CEOs at comparable companies and the awards given to the company’s CEO in past years. Furthermore, the court noted that the plaintiff only focused on certain financial metrics (the company’s negative 38.1% shareholder return and underperformance according to the S&P 500 index) and did not consider the additional factors disclosed in the company’s proxy statement.
Plaintiffs have brought similar allegations against companies for failing to follow pay-for-performance policies even where their say-on-pay vote results were positive. Such a claim was brought in Freedman v. Bruch against The Bank of New York Mellon, despite a say-on-pay approval of 79%, where the plaintiff alleged that the board violated the terms of its incentive plan by granting certain executive bonuses. The defendants countered that the bonuses in dispute were given to two executives for their roles in helping the company to achieve certain company priorities and for other accomplishments specific to each executive. A New York state court applied Delaware law, accepted the company’s statement that the awards were made outside the context of the incentive plan and affirmed the discretion of the board to grant bonuses designed to incentivize and retain the company’s talent.
In Haberland v. Bulkeley, the court dismissed the plaintiff’s claim that the Dex One directors breached their fiduciary duties by making materially false and misleading statements in the company’s 2011 proxy statement by describing the executive compensation plan as a strict pay-for-performance system. The court reasoned that the plan was not described as a strict pay-for-performance plan. Instead, the proxy statement referred to a number of plan objectives, including to enable the company to attract and retain the key leadership talent required to successfully execute its business strategy. Even assuming the plan was a strict pay-for-performance plan, the court explained, the plaintiff ignored the performance-based metrics disclosed in the proxy statement (ad sales grown, EBITDA and free cash flow, among others) and used his own criteria (i.e., share price, the company’s predecessor’s Chapter 11 status and the fact that the New York Stock Exchange had suspended trading of the predecessor’s stock) for determining annual incentive compensation.
B. New Wave of Cases Based on Allegedly Inadequate Disclosures
Until recently, conventional litigation alleging inadequate disclosures in proxy statements stemmed from requests to shareholders to approve a proposed merger or acquisition of a public company. In such cases, shareholders typically allege that the disclosure regarding the proposed transaction provided to the target’s shareholders in the SEC filings (e.g., a proxy statement, a Form S-4 or a Schedule 14D-9) omit material information. Such shareholders seek to preliminarily enjoin the shareholder vote pending the issuance of supplemental or corrective disclosure. These cases frequently settle on the basis of supplemental disclosure.
Now, such lawsuits are no longer limited to merger proxy statements. Instead, the plaintiffs’ bar is also focused on certain proposals included in annual meeting proxy statements, in particular:
- proposals to increase the number of shares available for issuance under equity plans; and
- say-on-pay proposals.
Many cases have been filed to date, generally in state court (though some defendants have attempted to remove these lawsuits to federal court). These new lawsuits typically allege that the companies’ boards breached their fiduciary duties by approving purportedly deficient disclosure relating to such proposals. Generally, the plaintiffs request that the vote on the contested proposal be enjoined pending the issuance of supplemental or corrective disclosure. The costs associated with postponing the annual shareholders’ meeting (or a vote on any particular proposal) can create incentives for defendants to settle quickly. These lawsuits have so far produced mixed results, and, at least with respect to say-on-pay proposals, the advisory nature of the say-on-pay vote and courts’ focus on customary industry practices have created obstacles for plaintiffs.
1. Brocade Communications—the Seminal Precedent?
In one of the early lawsuits of its kind, Knee v. Brocade Communications Systems Inc., the plaintiff alleged that Brocade’s annual proxy statement did not include sufficient disclosure regarding a proposed increase to the number of authorized shares available for grant under the company’s equity plan and requested that the Superior Court of California, County of Santa Clara, enjoin the vote on the proposal until the defendants remedied the defective disclosure. Specifically, the plaintiff claimed that the additional disclosure, among other things, should include the following information:
- the number of shares currently available for future issuance under the current equity plan;
- any projections considered by the company’s board of directors concerning shares to be granted
under equity plans in the future;
- reasons that the company determined the number of additional shares requested to be approved for issuance;
- the potential dilutive impact of the issuance of additional shares; and
- a “fair summary” of any management and compensation consultant analyses provided to the
company’s board of directors.
Two days prior to the scheduled annual meeting, the court issued a preliminary injunction enjoining a vote on the proposal, reasoning that the projections and estimates considered by Brocade’s board in determining the number of additional shares to authorize would be material to a shareholder. The day before the annual meeting, Brocade entered into a settlement order, pursuant to which:
- Brocade proceeded to hold its annual meeting on April 12, 2012 as scheduled with respect to all proposals, except for the equity plan proposal.
- The vote on the equity plan proposal was adjourned until April 20, 2012 and on April 12, 2012 Brocade filed revised additional soliciting materials disclosing the forecasted utilization rates with respect to Brocade’s proposal to increase the number of shares available for grant under the plan.
- Plaintiff’s counsel received an award of attorneys’ fees and expenses of up to $625,000.
Following the court’s grant of the preliminary injunction, some commentators wondered whether this left companies with little choice but to settle in order to avoid the significant costs associated with postponing annual meetings or votes on discrete proposals.
2. Enter Symantec—A “Loser” for the Plaintiff’s Bar or Difference in Principle?
Brocade put pressure on companies to settle these types of litigations in order to avoid the risk of having a court preliminarily enjoin a shareholder vote. For example, Martha Stewart Living Omnimedia and WebMd, among others, agreed to issue supplemental disclosures regarding their proposals to approve amendments to their equity plans in advance of pending motions seeking injunctive relief. H&R Block similarly did so in respect of its proposal to increase the number of shares available under its equity plan and its say-on-pay proposal, thereby seemingly extending the impact of Brocade beyond equity plan proposals.
However, in Gordon v. Symantec Corp., which was filed in Santa Clara County before the same judge who granted the preliminary injunction in Brocade, the plaintiffs sought—but ultimately failed—to enjoin Symantec’s say-on-pay vote. The plaintiffs claimed that Symantec’s proxy statement failed to disclose essential information, including the following:
- the reasons that the company selected and/or changed its compensation consultant;
- a “fair summary” of the compensation consultant’s analysis or details of “unrelated consulting and
business” services provided to the company’s board of directors;
- the reasons that the company selected particular companies as peers for purposes of benchmarking compensation;
- a “fair summary” of peer group analysis; and
- certain other benchmarking data.
Symantec retained Cornerstone Research and Professor Robert Daines of Stanford Law School, who submitted a declaration in support of the defendant’s motion in opposition to the preliminary injunction, concluding that Symantec’s disclosures were consistent with customary industry standards and complied with regulatory requirements. On October 17, 2012, the court, citing Professor Daines’ analysis and relying on information contained in the defendants’ opposition brief, denied the plaintiff’s motion for a preliminary injunction, finding no precedent for enjoining an advisory say-on-pay vote or imposing additional disclosure requirements that neither Congress nor the SEC had adopted. The court distinguished the non-binding nature of the say-on-pay vote from the amendment of an equity plan (as in Brocade) or the vote to approve a merger.
The Symantec result was subsequently replicated in several other cases and jurisdictions. In Noble v. AAR Corp., for instance, the plaintiff alleged, among other things, that AAR’s proxy statement omitted material information regarding peer companies and fees paid to the compensation committee’s compensation consultant. On October 9, 2012, the federal district court for the Northern District of Illinois denied the plaintiff’s motion for an injunction on the ground that the say-on-pay vote was merely advisory and, therefore, did not generate the level of irreparable harm necessary to issue a preliminary injunction.
3. Life After Symantec—What Now?
What remains to be seen after Symantec is whether Brocade will govern the analysis of equity plan proposals or whether Symantec’s “customary industry standard” analysis will be extended even to binding proposals, such as proposals to amend equity plans.
For example, when Clorox was sued in Mancuso v. The Clorox Company on October 10, 2012, in the Supreme Court of California, County of Alameda, the plaintiff combined the two theories and sought to enjoin the company’s say-on-pay vote and the vote on amending the company’s equity plan due to what were alleged to be severe and material disclosure violations. Professor Daines was retained by the defendants, and he again concluded that the additional disclosures requested by the plaintiff were unlikely to be important to economically rational shareholders and that the company’s existing disclosures regarding say-on-pay and the equity plan were consistent with industry custom and practice (based on Professor Daines’ review of a “significant number” of proxy statements for similar companies).
On November 13, 2012, the Clorox court denied the plaintiff’s motion for a preliminary injunction citing the plaintiff’s “meager evidentiary presentation,” versus the defendants’ “substantial evidence” that the information the plaintiff claimed should have been disclosed was immaterial. More importantly, the court found that there was no threat of irreparable harm, because, unlike a merger or takeover situation which “would require the court after a trial on the merits to try to ‘unscramble the eggs’ if the plaintiff were to prevail,” both shareholder actions could be voided by court order and new votes could be held.
Similar allegations were set forth in the Wenz v. Globecomm Systems Inc. complaint filed on October 11, 2012. On November 14, 2012 (the day before Globecomm’s annual shareholders’ meeting), the state court in Suffolk County, New York, denied the plaintiff’s motion for a preliminary injunction with respect to Globecomm’s equity plan and say-on-pay proposals, because, among other grounds, the disclosures requested by the plaintiff (e.g., a fair summary of the compensation consultant’s analysis, projected stock grants, dilutive impact and certain peer group data) were not material.
(i) Equity plans that are broad-based might be easier to defend.
In Gordon v. Microsoft Corp., filed on October 11, 2012, the plaintiff alleged that Microsoft’s proxy statement failed to provide adequate disclosure concerning the information the board of directors considered in making its say-on-pay recommendation, as well as the reasons for, and effects of, the company’s proposal to reserve additional shares for issuance under its 2003 Employee Stock Purchase Plan (“ESPP”). In its opposition to plaintiff’s motion for a preliminary injunction, the company emphasized that the three leading proxy advisory services (Glass, Lewis & Co., Institutional Shareholder Services and Egan-Jones) had recommended for approval by the shareholders the two proposals in question and that one of its largest shareholders (the California State Teachers Retirement System) confirmed that Microsoft’s proxy disclosures were “sufficient . . . to understand [the proposals].” In addition, Microsoft (like Symantec and Clorox) retained Professor Daines, who concluded that there was no basis for the additional disclosures that the plaintiff demanded, finding that Microsoft’s disclosure was consistent with that of its peers.
Microsoft argued that:
- a non-binding say-on-pay vote could not possibly cause the plaintiff to suffer a substantial injury; and
- “[r]eplenishing a stock purchase plan in existence for twenty years, which allows employees to buy stock at a 10% discount, could not conceivably cause irreparable harm to shareholders of one of the world’s most valuable companies, with 8.4 billion shares outstanding.”
Microsoft further noted that, if necessary, the court could unwind the ESPP decision in due course, require new disclosures and mandate a new vote, and that it did not need to issue an injunction to enjoin the vote in progress. The company argued that the facts in Brocade were distinguishable because Brocade “involved a stock plan that provided for outright awards of large amounts of stock to executives at no cost—not a standard ESPP,” and the plaintiff in Brocade did not attack a similar ESPP proposal. On November 20, 2012, the lawsuit was dismissed with prejudice. No details regarding the basis for dismissal were included in the order (although Microsoft’s deputy general counsel recently shared that the plaintiff offered to voluntarily dismiss the lawsuit after Microsoft indicated that it was not willing to settle).
(ii) Say-on-pay v. equity plan proposals.
What the above cases appear to indicate is that, while defendants are more likely to defeat a motion for a preliminary injunction seeking to enjoin a say-on-pay vote, they may have more difficulty doing so with respect to proposals to amend equity plans. Given that the amendment of an equity plan requires a binding shareholder vote, a shareholder-plaintiff may have a stronger argument as to the potential for irreparable harm if the vote is taken without full disclosure of all material information.
As a general matter, it appears that the more a company’s disclosure is in line with customary industry practice (and, perhaps, the less executive-friendly the equity plan amendment is or where dilution is not an issue), the less likely a plaintiff will be able to succeed in obtaining a preliminary injunction. For instance, in St. Louis Police Retirement System v. Severson, the plaintiff sought, among other things, to enjoin Abaxis Inc.’s vote on an amendment to its equity plan. This amendment sought to eliminate the restricted stock limit under the company’s equity plan as the company granted and ultimately issued common stock in settlement of restricted stock units in excess of the restricted stock limit. The plaintiff claimed that the proxy disclosure was misleading as to, among other things:
- the bases for the compensation committee’s decision to eliminate the restricted stock limit (e.g., that the company had already violated the equity plan by dramatically exceeding the restricted stock limit);
- the company’s admission that it violated the equity plan by exceeding the restricted stock limit; and
- the number of restricted stock units that the company has granted beyond those that could be settled in accordance with the restricted stock limit and the effect of the proposed amendment on those excess restricted stock units (notably, many of the excess equity grants were made to executives of the company).
The district court in the Northern District of California granted in part the plaintiff’s motion for a preliminary injunction because the company’s annual proxy statement did not explain the consequences of failure to approve the proposed amendment (e.g., state that the proposed amendment is necessary to re-achieve compliance with Listing Rule 5635(c) of NASDAQ). Even though this had previously been disclosed on a Form 8-K, the Form 8-K was not incorporated by reference into the proxy statement. The court found that this information was material to shareholders and enjoined the shareholder vote on the amendment until additional disclosure could be provided. The company filed the disclosure on October 26, 2012, and the proposal passed on November 8, 2012. The motion to dismiss this case is currently pending. While this case came after Symantec, it is distinguishable given its unique facts (i.e., eliminating a very specific provision in the plan was disproportionately beneficial to the company’s executives who held significant awards under the plan in excess of the restricted stock limit).
(iii) Not-so-certain future.
At the time of this writing, several other cases are still pending in state and federal courts. And, while it is not possible to predict the outcome of these cases, barring unique facts, it appears that the plaintiff’s bar might not be as successful in this “new wave” of compensation-related litigation as the Brocade case first led some to believe.
C. Section 162(m) Litigation
Section 162(m) generally limits the tax deduction a publicly held corporation may take for compensation paid to covered executives that is in excess of $1 million per year. However, an exception to the rule provides that the limit does not apply to performance-based compensation pursuant to a shareholder- approved plan that has one or more performance goals and meets certain additional criteria.
While Section 162(m)-related claims are not new, they have proliferated in recent months. In Delaware alone, we are aware of at least seven cases filed during 2011 and 2012, several of which are discussed in more detail below.
Plaintiffs have pursued both derivative and direct theories, claiming, for example, breach of fiduciary duties, waste and unjust enrichment where corporations have failed to take advantage of the exception to non-deductibility under Section 162(m) or false or misleading disclosure in connection with statements made in public filings in respect of compliance with Section 162(m). Notably, such claims are brought without the Internal Revenue Service having challenged the deductibility of the awards. Recent claims include the following allegations, among others:
- the directors failed to structure or operate a plan in compliance with Section 162(m);
- the compensation committee’s use of discretion to determine awards under an incentive plan
violated the terms of the plan and/or relevant regulations;
- the proxy statement indicated that the plan was designed to comply with Section 162(m) when the plan was somehow non-compliant;
- the proxy statement indicated that the compensation would be paid regardless of shareholder approval, in violation of the regulations implementing Section 162(m); and
- the proxy statement failed to disclose, with meaningful specificity, the material terms and provisions under which the incentive compensation would be paid.
With several exceptions, these claims generally have not advanced past the motion to dismiss stage due to failure to establish demand futility. The few claims that have been permitted to move forward do not differ significantly in terms of legal theory or factual background from those that have been dismissed and therefore introduce some uncertainty as to the future of these types of suits.
1. Hitting the Demand Futility Wall
A representative recent case is Freedman v. Adams, a derivative suit on behalf of XTO Energy, which alleged waste and breach of fiduciary duties, as well as misleading disclosure, in connection with bonus payments that were allegedly not deductible under Section 162(m). To establish demand futility, the plaintiff proffered a number of theories as to why the directors were interested or acted in bad faith, each of which the Delaware Court of Chancery rejected. In response to the plaintiff’s argument that the failure to minimize taxes itself constituted bad faith, the court held that there was no general fiduciary duty to minimize taxes. The court also noted that if the board believed in good faith that implementing a Section 162(m) plan would constrain its discretion to make compensation decisions, sufficient consideration existed for its determination to forgo the deductions (and therefore, the plaintiff’s waste claim failed). The court emphasized that its “deference to directors’ business judgment [was] particularly broad in matters of executive compensation.”
The plaintiff also claimed that the company’s proxy statement had materially misstated that the company intended to monitor the compensation paid to its executive officers in light of the provisions of Section 162(m), when, in fact, the company had no Section 162(m) plan at the time. In the context of other statements in the proxy, the court found that a reasonable investor would not have interpreted such disclosure to mean that the company had a Section 162(m) plan in place and dismissed the claim.
Seinfeld v. Slager, a case involving five distinct waste claims based on compensation actions taken by the board of Republic Services, hit a similar procedural impasse this year. The Delaware Court of Chancery dismissed all of the Section 162(m)-related claims due to the failure to establish demand futility. In affirming that the decision to “pursue or forgo tax savings” was generally a business decision for the board and that there was “no general fiduciary duty to minimize taxes,” the court observed that there were a variety of reasons why a corporation might choose or not choose to pursue tax savings.
In a third case decided in late August 2012, the federal district court in Delaware refused to excuse the demand requirement in a derivative suit on behalf of AK Steel. The complaint alleged that the company’s compensation plans were defective:
- first, in giving the compensation committee discretion to increase the amount of compensation payable after one quarter of the performance period had elapsed, in violation of Section 162(m); and
- second, because shareholders were threatened in the proxy statement that if they did not vote to approve the performance goals under the plans, the compensation would nevertheless be paid.
With respect to the latter, the court noted that, while disclosure-based claims were generally not subject to the demand requirement because they are typically brought as direct claims, a derivative claim based on a proxy statement nondisclosure required particularized facts to establish demand futility that the plaintiff had failed to produce. The court further observed that the board’s failure to follow the terms of an approved compensation plan was insufficient on its own to excuse demand without additional facts pointing to directors’ knowledge and intent.
2. Resnik and Hoch—An Interesting Wrinkle
However, in a minority of cases, Section 162(m)-related claims have survived a motion to dismiss. In Resnik v. Woertz, the federal district court in Delaware refused to dismiss the plaintiff’s derivative claims for waste, breach of fiduciary duty, unjust enrichment and inadequate disclosure. Archer-Daniels- Midland’s plan permitted awards of up to $90,250,000 per director and the aggregate payments to directors and executive officers could have reached up to $1,263,500,000 (which indicated, in the Freedman v. Adams court’s view, that the forgone tax deductions in Resnik were of “a completely different magnitude” and that there were “elements of excessive compensation, director interestedness, and a lack of candor” not present in Freedman).
Furthermore, the plaintiff asserted a myriad of inadequate disclosure claims, some of which the Delaware district court found lacked materiality, but many of which survived the motion to dismiss. Of note are the following allegations relating to the company’s Section 162(m) compliance:
- the proxy statement had been misleading in representing that the plan was designed to be performance-based and comply with Section 162(m) when the tax deductibility of the awards under the plan had previously expired; and
- the proxy statement had been misleading in failing to disclose with specificity the performance goals under which the compensation would be paid, where the plan and the proxy statement listed a series of performance goals but the ultimate awards were made in the discretion of the compensation committee.
The court specifically noted that such omissions were material in that they could “very likely preclude” the deductibility of the awards under Section 162(m). Finding that the substantial financial interest the directors had in the outcome of the shareholder vote was sufficient to create a reasonable doubt as to their independence and disinterestedness, the court held that the demand futility requirement had been met.
Hoch v. Alexander is another somewhat recent example in which derivative claims on behalf of Qualcomm relating to Section 162(m) survived a motion to dismiss. Qualcomm’s proxy statement, through which the company sought approval for an amendment of an equity plan, stated that certain types of equity granted by the compensation committee qualified as performance-based compensation, and that other awards subject to performance goals might also qualify. The proxy statement also disclosed that, if shareholders did not approve the plan, the amended plan would not be implemented and the prior plan would remain in effect. Therefore, the plaintiff argued, because the performance-based compensation would be paid under the existing plan regardless of whether the amended plan received shareholder approval, no shareholder vote would make the payments tax-deductible and the directors had breached their fiduciary duties and committed waste as a result. Though it dismissed the plaintiff’s direct claim due to the failure to establish a link between the alleged misstatements and any actual economic harm, the Delaware district court found that the plaintiff had met its burden of establishing demand futility because of the directors’ interests in the payments under the equity plan.
In both Resnik v. Woertz and Hoch v. Alexander, the fact that at least a majority of directors was eligible to participate in the compensation plans led the Delaware district court to conclude that demand was excused. However, more recent cases have analyzed the issue in a more nuanced fashion. For example, both Seinfeld v. Slager and Abrams v. Wainscott addressed the demand futility requirement separately for each transaction and concluded that, while the directors were entitled to payments under the compensation plans at issue, they were not interested in the challenged transaction itself (other than, in the case of Seinfeld v. Slager, the awards to directors).
3. The Suits Keep Coming—The Viacom Complaint
Though most Section 162(m) claims have met with limited success, plaintiffs’ firms continue to bring suits against new defendants—Allergan, ConocoPhillips and, most recently, Caterpillar have all been engaged in Section 162(m)-related litigation over the past year. In addition, a complaint filed in August 2012 alleges that the directors of Viacom breached their fiduciary duties and committed waste by using subjective qualitative factors to determine a portion of bonus payments and positive discretion to increase payments, each of which would be in violation of Section 162(m), under a short-term incentive plan purportedly designed to qualify for the performance-based exception to non-deductibility. The defendants filed a motion to dismiss in late October 2012, arguing that the plaintiff failed to adequately establish that demand was excused and that the directors had no general duty to minimize taxes under Delaware law. The defendants maintain that the discretion exercised by the compensation committee was used only to reduce the maximum earned award authorized under the plan, which they noted would be consistent with the terms of Section 162(m) and the plan itself. At this time, no hearing has been scheduled on the motion to dismiss.
IV. Steps to Potentially Minimize Your Litigation Exposure
Despite the fact that many executive compensation-related lawsuits have been frustrated by the significant hurdles that accompany these types of claims, there are considerable costs associated with discovery and protracted litigation (even where defendants succeed) or having to postpone or hold a separate shareholder vote (where plaintiffs succeed on some or all of their claims). Moreover, the plaintiffs’ bar does not appear to be slowing down in their efforts to pursue these claims. While there is no combination of steps that a company can take to fully insulate itself from litigation risk, there are a number of precautionary measures that can be taken to limit the likelihood of being sued, to increase the likelihood of success in defending against such lawsuits and/or to manage the risks of plaintiff activity. These steps include:
- Keep the compensation committee informed about developments with respect to these types of lawsuits so that the committee may incorporate relevant considerations stemming from such developments into its decision-making process.
- Be wary of making statements promising that any sort of definitive action will be taken depending on the results of a say-on-pay advisory vote.
- When describing a program as a “pay-for-performance” program, ensure that the program is actually implemented and that the metrics and other factors used to evaluate “performance” are properly described.
- Consider obtaining equity compensation plan approval a year before you need it.
- When proposing to amend an equity compensation plan, consider describing the methodology used to determine the requested number of additional shares, dilutive impact and expected and/or historical usage rates, as well as the number of shares available under the plan as of a recent date (especially if the company has just made its annual equity compensation grants). The relatively boilerplate disclosure of years past may not be sufficient to withstand a claim.
- The description of a Section 162(m) plan in the annual proxy statement should accurately reflect its operation in practice, and companies should take steps to ensure that those responsible for implementing Section 162(m) plans operate such plans in accordance with their terms.
- Even if a plan is designed to comply with Section 162(m), avoid making statements in an annual proxy statement that could be interpreted to guarantee that payments under the plan will be tax-deductible in all circumstances.
- Consider whether incentive compensation plans for directors should be separate from those for executives, in order to reduce the likelihood of a finding of director interestedness or non- independence.
- Avoid being an outlier—minimize the risk of becoming a target by making sure you know what your peers are doing and ensuring that your compensation and disclosure practices are in line with customary industry standards.