First, there was say-on-pay; now there is sue-on-pay.
Companies that lost say-on-pay votes last proxy season are now becoming targets for shareholder derivative lawsuits that accuse the boards of those companies of violating their duties by approving pay packages for top executives that were not in the best interest of the company.
Shareholders filed lawsuits against nine companies so far, including Cincinnati Bell, Beazer Homes, and Johnson & Johnson. Early speculation was that the judges would consider the cases frivolous and dismiss them, but when a federal judge declined to dismiss the case against Cincinnati Bell, defendants in similar lawsuits and others that lost say-on-pay votes last proxy season grew worried that the cases could present a real threat.
If derivative lawsuits on say-on-pay are allowed to proceed, it would open a new front in the battle between shareholders and boards over executive compensation plans. It also gives companies another reason to examine their compensation practices. Already some lawyers predict that say-on-pay litigation will be an even bigger issue and affect more companies next proxy season. “We will continue to see more negative vote recommendations,” says Kevin Kinross, an associate at law firm Bricker & Eckler.
The say-on-pay lawsuits got an early test of their validity last month, when a motion to dismiss by Cincinnati Bell came up in the Southern Ohio District Court. Judge Timothy Black, however, nixed the wireless provider's motion giving shareholders hope that say-on-pay litigation would move forward.
Plaintiffs in that case seek to revoke what they consider an exorbitant pay raise for the company's top three executives after a period of poor financial performance. During the annual meeting in May, shareholders voted against the compensation plan with 66 percent negative votes. This is the first shareholder say-on-pay lawsuit to survive a motion to dismiss and also the first time that a judge cited a say-on-pay vote result as one of the determining factors in his decision.
Cincinnati Bell had argued that the case should be dismissed based on the idea that the business judgment rule provided the company's board sufficient protection, since it believed the board acted in good faith, and with loyalty and due care—the three tenants of the business judgment rule.
To claim protection under the rule, companies must demonstrate that their business decisions were not guided by personal conflict of interest, egregious, or disloyal, and that they considered their options carefully. (Although the burden of proof is on plaintiffs to prove the board's actions didn't meet these standards.) “If all the criteria are satisfied, the rule will offer protection for directors against liability claims,” says J. Mark Poerio, a partner at law firm Paul Hastings.
In denying the company's motion to dismiss, Judge Black wrote that the firm's claim for protection under the business judgment rule is subject for debate at trial. He noted that shareholders in this case have provided sufficient factual allegations against the company. The evidence raised by shareholders was the company's action in awarding the multi-million dollar bonuses to directors, despite declining financial performance—Cincinnati Bell's net income declined from $89.6 million in 2009 to only $28.3 million in 2010—and the negative say-on-pay vote. He also said in his ruling that allegations “raise a plausible claim” that the multi-million dollar bonuses approved by the directors violated Cincinnati Bell's own pay-for-performance compensation policy and “constituted an abuse of discretion and/or bad faith.”
Companies that lost say-on-pay votes last proxy season or those that are concerned that proxy advisory firms such as ISS may advise investors to vote no on their compensation plans in 2012 may be troubled by the court's reliance on the negative say-on-pay vote result, even though the rule is non-binding. “The court without doubt gives significant consideration on the say-on-pay vote,” Poerio says. He adds that the ruling certainly sends a message to corporations that they cannot rely solely on the business judgment rule protection when approving compensation plans for top executives.
“All the [Cincinnati Bell] case represents is a procedural issue. One must remember that say-on-pay is a non-binding vote, and the state law on corporations will still be used to decide the outcome of the case.”
—Kevin Kinross,
Associate,
Bricker & Eckler.\
“Based on the results In this case—which seem aberrant— if shareholders vote down a proposal, the rule is not going to protect directors' actions. The judge is saying the business judgment rule has its limitations,” he says. Poerio adds companies should heed the case as the signal for directors to be more responsive toward shareholder demands. In addition, he says the economic climate may have influenced the case. “There is not much sympathy for excessive executive pay,” says Poerio.
Keir Gumbs, a partner at Covington & Burling says companies should view the case as a cautionary tale of what may happened to them as well should they choose to ignore majority shareholder opinions. He says the case sets the precedent for other cases to follow if plaintiffs can provide sufficient factual support to enable it to go to trial.
One lawyer, however, cautioned shareholder activists from celebrating the news too soon. “All the [Cincinnati Bell] case represents is a procedural issue. One must remember that say-on-pay is a non-binding vote, and the state law on corporations will still be used to decide the outcome of the case,” says Bricker & Eckler's Kinross.
He says at the heart of the argument is the fiduciary duty of Cincinnati Bell's directors. If the board members can prove that they are performing their responsibilities according to the Ohio state law, the business judgment rule will provide the protections they sought on their executive compensation decisions, he says.
In fact, just days after the Ohio court refused to dismiss the claim against Cincinnati Bell, a state court judge in Georgia dismissed a shareholder derivative suit against the board members of Beazer Homes that was also based on a negative say-on-pay vote.
Shareholder Communication
The threat of litigation will likely raise the stakes next proxy season, prompting companies to work harder to avoid negative say-on-pay votes. According to Poerio, it's more important than ever for companies to communicate to shareholders the steps they are taking to address compensation issues. “Be prepared to explain to your shareholders, here are these red flags, the causes of these issues and what the board is doing to mitigate them,” he says.
PREPPING FOR SOP
In the chart below, respondents to a Towers Watson survey were asked to identify what steps they've taken to prepare for new say-on-pay legislation:
Source: Data Supplied by Towers Watson Say-on-Pay Legislation Survey.
In the past proxy season, he said many companies failed to address perceived compensation problems in the compensation, discussion & analysis (CD&A) portion of the proxy statement. “Their (compensation) summary tables showed red flags, yet the CD&A did not explain why they exist.” He says companies must demonstrate the boards are acting in the best interest of shareholders.
“You can make your arguments to increase pay for long-term performance, but be prepared to argue it convincingly,” he says.
Meanwhile, Gumbs says companies should try to avoid costly litigation by having good compliance programs in place to ensure they practice what they preach. He says discrepancies between management policies and practices were the reason litigation arose in sue-on-pay cases. “You better be prepared to do what you say,” he said.
No comments yet