What is the True Impact of The Dodd-Frank s Say-on-Pay Rule?

What is the True Impact of The Dodd-Frank s Say-on-Pay Rule? Introduction By Richard Moon & Matthew Bahl 1 The Dodd Frank Wall Street Reform and Consumer Protection Act ( Dodd Frank ) took aim at executive compensation. To address the perception (and, frankly, reality) that executive compensation was, in many cases, a runaway juggernaut consuming shareholder profits even when none existed, Dodd Frank now requires a shareholder say-on-pay vote at least once every three years on executive compensation. Indeed, the recent derivative lawsuit shareholders filed against CitiGroup and its CEO, Vikram Pandit, is a prime example of how shareholder outrage over executive compensation can result in litigation. The shareholders in CitiGroup allege, among other things, that CitiGroup directors and executives awarded excessive and unwarranted pay to its senior officers in 2011, despite a disappointing year financially. 2 Shareholders filed the lawsuit two days after rejecting a $54 million pay package. The shareholders noted in their complaint that the $54 million figure includes a $15 million payout to Pandit a 1,499,999,990% raise. 3 According to the shareholders, such compensation is inappropriate, especially in light of extremely disappointing Company performance in 2011. 4 The CitiGroup litigation is just the most recent example of the type of say-on-pay lawsuit that has sprung up all over the country following Dodd-Frank s implementation. A central 1 Richard G. Moon is counsel at Verrill Dana, LLP. Matt Bahl is an associate at Verrill Dana, LLP 2 Moskal v. Pandit, S.D.N.Y., No. 12-03114 (April 19, 2012). 3 Id. 4 Id. 1

question is whether these lawsuits mean anything other than giving lawyers an excuse to quibble over the finer points of the business judgment rule and presuit demand requirements. The say-on-pay vote is only advisory and, with the exception of one court in Ohio, courts have generally dismissed say-on-pay lawsuits. So why do shareholders continue to file these claims? The answer, which may have nothing to do with the law, seems to implicate intra-corporate warfare. That is, shareholders are using say-on-pay votes to influence changes to company s executive compensation. In addition, the political and economic climate is such that the court of public opinion is perhaps the best venue to vilify executive pay, even if the legal system says say-on-pay claims have little merit. Understanding Say on Pay The Vote s Impact and Frequency Adopted as Section 14A of the Securities Exchange Act of 1934 (15 U.S.C. 78-n), sayon-pay voting is not binding on the company, cannot overrule board or company decisions, cannot create new fiduciary duties or change existing fiduciary duties for the company or board, and cannot restrict stockholders ability to issue other proposals regarding executive compensation. 5 The say-on-pay rules require shareholders to vote on executive compensation, and also to vote on the frequency of that vote. 6 The say-on-pay rules require that a say-on-pay vote occur not less frequently than once every three years. 7 Additionally, once every six years shareholders will vote on the frequency of the approval selecting either one year, two year, or three year 5 15 U.S.C.A. 78n-1(a)(1)-(3), (c)(1)-(4) 6 Id at (a)(1). 7 Id. 2

voting cycles. 8 The final SEC rules (issued January 25, 2011) required companies to provide a fourth choice for voting: abstain from voting. 9 Many company shareholders, during the first proxy vote on the duration of the voting cycle, selected the one year period which means those companies have to hold a say-on-pay vote every year. 10 Say on Pay Litigation A Summary As noted above, Dodd Frank requires a shareholder say-on-pay vote at least once every three years to approve a company s senior executive compensation. However, the say-on-pay vote is only advisory and companies are not required to adhere to the shareholder votes. In fact, Dodd Frank specifically states that the vote is non-binding on the issuer or the board of directors and may not be construed as: (1) overruling a decision by an issuer or board of directors, (2) creating or changing fiduciary duties, or (3) restricting or limiting shareholder proxy access to make proposals on executive compensation. 11 In 2011, roughly 45 companies failed the say-on-pay vote because fewer than half of the shareholders voted in favor of the proposed executive compensation. 12 As of May 24, 2012, approximately 33 companies failed the say-on-pay vote. 13 And despite Dodd Frank s recognition that the say on pay vote is advisory, close to one-third of the 2011 failed votes resulted in shareholder derivative actions. While some of these actions were certainly filed to 8 Id at (a)(2). 9 17 C.F.R. 240.14(a)(2). 10 15 U.S.C.A. 78n-1, at (a)(3). 11 Id at (c)(1)-(3). 12 See http://say-on-pay.com/wp-content/uploads/2012/04/sop_lessthan50prctsuprt_20111114.png 13 See http://say-on-pay.com/wp-content/uploads/2012/05/2012failedsop_2012-05-24.png 3

test the waters, as is explained below, the courts have almost uniformly dismissed say-on-pay lawsuits. Yet, despite the dismissals, the lawsuits keep coming. Following implementation of the say-on-pay voting requirement in 2011, the plaintiff s bar began using failed say-on-pay votes as a basis for shareholder derivative actions, alleging that company s board of directors breached their fiduciary duties to the shareholders by approving excessive executive pay. Shareholders have attempted to use the failed say-on-pay votes to avoid legal obstacles that have long prevented derivative suits based on excessive executive compensation; namely, overcoming pre-suit demand futility and the presumption of the business judgment rule on the board s decision to increase compensation. A number of courts have issued orders or opinions in say-on-pay actions. The following is a brief summary of these cases: 1. Teamsters Local 237 Additional Security Benefit Fund, derivatively and on behalf of Beazer Homes USA, Inc. v. McCarthy, et al, 2011 WL 4836230 (Ga. Sup. Ct., Sept. 16, 2011): On September 16, 2011, the Georgia Superior court became the first court to issue an order on the say-on-pay question. The court dismissed the suit for failure to plead demand futility and for failure to state a claim. 14 With respect to demand futility, the court began by summarizing Delaware s prederivative suit demand requirement and the business judgment rule as outlined in Aronson v. Lewis, 473 A.2d 805 (Del. 1984): Delaware law requires would-be derivative plaintiffs to make a pre-suit demand on the company s board that it investigate and evaluate whether to bring claims or to plead particularized facts demonstrating legal excuse from the demand requirement. These requirements follow from the well-settled corporate governance principle that decisions concerning whether a company should 14 2011 WL 4836230 4

initiate litigation to pursue legal claims, like the management of other matters of internal corporate affairs, should ordinarily be left to the judgment and discretion of the company s board. Derivative lawsuits, in which shareholder plaintiffs seek to compel the litigation of claims that legally belong not to them but to the company on whose behalf they are asserted, inherently impinge on this managerial prerogative of the board. Hence, Delaware law requires a pre-suit demand or allegations of particularized facts sufficient to show legal excuse from the demand requirement. 15 The Beazer court ultimately rejected plaintiff s say-on-pay contentions for two main reasons. First, the failed say-on-pay vote occurred after the board voted to increase executive compensation and after the board had recommended to shareholders that they approve the compensation. According to the court, the failed vote did not indicate that the board failed to act on an informed basis, in good faith, and in the honest belief that the [compensation] decisions were in Beazer Home s best interest to establish demand futility or rebut the business judgment rule. 16 Second, the plaintiff s assertion that the independent business judgment of Beazer Home s shareholders was sufficient to rebut the business judgment rule presumption was not supported by Delaware law or Dodd-Frank. In fact, the court emphasized that Dodd-Frank expressly preserved the pre-existing fiduciary duty framework concerning the directors executive compensation decisions. 2. NECA-IBEW Pension Fund, derivatively on behalf of Cincinnati Bell, Inc. v. Cox, et al., 2011 WL 4383368 (S.D. Ohio, Sept. 20, 2011): Following a say-on-pay vote, Cincinnati Bell s directors approved multi-million dollar bonuses to executives (which the majority of the shareholders voted against). Shortly thereafter, shareholders brought a derivative lawsuit claiming Cincinnati Bell s board of directors acted in bad faith and violated the 15 Id. 16 Id. 5

company s pay for performance compensation policy, as evidenced by the failed say-on-pay vote. In September of 2011, the Southern District of Ohio ruled contrary to Beazer Homes. Critically, the Cincinnati Bell court applied Ohio law (not Delaware law) in concluding that the plaintiff s factual allegations raise a plausible claim that the multi-million dollar bonuses approved by the directors while the company experienced 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. 17 Central to the court s decision was a nuance to the business judgment rule that exists under Ohio (but not Delaware) law. Specifically, under Ohio law the business judgment rule imposes a burden of proof, not a burden of pleading and the plaintiff s allegation that the failed say-on-pay rebuts the business judgment rule was therefore sufficient. 18 The Cincinnati Bell court also held that the pre-suit demand on the board would have been futile. 19 According to the court, under Ohio law a plaintiff need only point to facts establishing that a corporate board was incapable of making unbiased, independent business judgments about whether to sue on behalf of the company. 20 The plaintiffs in Cincinnati Bell established demand futility as far as the court was concerned because the same people who approved the executive compensation would be deciding whether to press a derivative suit. 21 17 2011 WL 4383368, at *3. 18 Id at * 2-3. 19 Id at * 3-4. 20 Id. 21 Id. 6

Therefore, the court found that there was reason to doubt that the board of directors could exercise independent business judgment over whether to sue themselves. 22 3. Jacobs Engineering Group, Inc. Consolidated Shareholder Derivative Litigation, No. BC454543 (Los Angeles County Superior Court, Nov. 10, 2011): Following up the Beazer Homes and Cincinnati Bell decisions the Los Angeles county superior court dismissed a breach of fiduciary duty claim against the company s directors and a compensation consultant. 23 Although the minute order did not discuss the competing holdings in Beazer Homes and Cincinnati Bell, it did note that it was dismissing the fiduciary duty claim based on deficiencies in the underlying claims against the individual defendants. 24 4. Dennis v. Hart, 2012 WL 33199 (S.D. Cal., Jan 6, 2012): On January 6, 2012, the Southern District of California denied a group of shareholder s request for a declaratory judgment that Pico Holdings, Inc s shareholder failed say-on-pay rule rebutted the business judgment regarding the board s decision to increase executive compensation. 25 In reaching its decision, the Southern District of California relied principally on Dodd-Frank s express prohibition that the say-on-pay rules do not create new or change existing fiduciary duties. 26 As such, the court held that the shareholder plaintiff s failed to state a claim for declaratory judgment. 22 Id. 23 No. BC454543 (Los Angeles County Superior Court, Nov. 10, 2011). 24 Id. 25 2012 WL 33199, at *1-2. 26 Id. at 3 ( The language of the statute expressly states that it may not be construed... to create or imply any additional fiduciary duties. The Dodd-Frank Wall Street Reform Act did not change state law regarding fiduciary duty or the business judgment presumption. ). 7

5. Plumbers Local No. 173 v. Davis, 2012 WL 104776 (D. Or., Jan 11, 2012): The District Court of Oregon was the first court to address the competing holdings in Beazer Homes and Cincinnati Bell. The court relied on Delaware s Aronson v. Lewis decision for guidance and expressly agreed with Beazer Homes, although the court limited the holding to finding that the shareholder plaintiffs failed to plead that a demand on the Umpqua Holdings Corp. board would have been futile. 27 The court also called into question Cincinnati Bell s futility analysis: Cincinnati Bell s holding was recently called into question in light of the court s apparent lack of subject matter jurisdiction and, as the court found particularly troubling, the plaintiff s failure to disclose contrary authority in response to the court s specific inquiry. Notwithstanding any continued life Cincinnati Bell might retain, the court declines to embrace Plaintiff s [futility] argument because its logic is circular and thus unpersuasive. The implicit premise of Plaintiffs argument is that the self-interest sufficient to trigger demand futility is present whenever board members face the possibility of a lawsuit filed against them in response to a decision or other board action. Under Plaintiffs reasoning, the fact that the presuit demand is itself suggestive of impending liability is sufficient to create the type of self-interest that triggers the demand futility exception. This would permit every derivative action plaintiff to argue that demand is futile and need not be made because no board would be able to act objectively in evaluating a presuit demand. Such a result would effectively erase the demand requirement and negate its purpose. 28 The court then went on to find that the plaintiffs reliance on Cincinnati Bell s business judgment analysis was equally misplaced, and that Beazer Homes business judgment analysis is consistent with Oregon law: Plaintiffs reliance on Cincinnati Bell is misplaced for two reasons. As already discussed, it is unlikely that the case remains viable 27 2012 WL 104776, at * 3-5 28 Id at *5. 8

legal authority. Further, the court relied upon Ohio law in reaching its decision, which is different than Delaware law, the body of law to which Oregon looks for guidance. To contrast the legal frameworks, Defendants cite [Beazer Homes], a decision that applies Delaware law in a situation similar to this case, reached the conclusion Defendants urge here. In Beazer, the court concluded that the pleading did not meet the standard for presuit demand with respect to the business judgment rule... Cincinnati Bell applied a legal framework different from that which controls the court s decision here. In contrast, Beazer [Homes] hews directly to the law of Delaware, which Oregon follows, and its reasoning is clear and well-taken[.] 29 6. Weinberg, derivatively on behalf of Biomed Realty Trust, Inc. v. Gold, et. al, 2012 WL 812348 (D. Md., March 12, 2012): In the most recent say-on-pay derivative lawsuit, the District Court of Maryland dismissed the shareholder action because the plaintiff failed to make a presuit demand, and failed to allege facts showing such a demand would be futile. 30 In Weinberg, the plaintiff alleged that the company s compensation committee and board of directors breached their fiduciary duties to the company and its shareholders by approving excessive executive compensation packages. 31 The court roundly rejected the plaintiff s arguments applying Maryland law, which is analogous to Delaware law. In so doing the court held that: In ruling on whether a shareholder s derivative complaint adequately alleges futility, a court s focus is limited to whether a majority of the directors are so personally and directly conflicted that they cannot possibly be expected to respond in good faith to a presuit demand. 32 29 Id at *8. 30 2012 WL 812348, at *6-7. 31 Id at *1 32 Id at *5. 9

A say-on-pay advisory vote is not a substitute for a formal presuit shareholder demand. And while a say-on-pay vote may be reasonably considered as a factor in the demand futility analysis, it does not constitute a presuit demand nor does it, in and of itself, demonstrate futility. 33 An officer s or director s participation in approving the compensation (or their status as a defendant in a derivative lawsuit) does not disqualify them from considering a presuit demand. 34 Legal and Practical Impact of Say-on-Pay Litigation Outside of Cincinnati Bell, courts have rejected shareholder plaintiff arguments that failed say-on-pay votes rebut the business judgment presumption or demonstrate futility for purposes of making presuit demand. Courts have distinguished Cincinnati Bell because of its reliance on Ohio law, which appears to employ a different version of the business judgment rule than Delaware, Maryland, and Oregon. Indeed, the Ohio business judgment rule as applied in Cincinnati Bell does not appear to require a plaintiff to plead operative facts in a complaint that would rebut the presumption afforded by the business judgment rule. Rather, the business judgment rule imposes a burden of proof, not a burden of pleading. By contrast, Delaware s business judgment rule (which serves as the model for many other states business judgment rules) will not allow a suit to survive a motion to dismiss unless it contains particularized facts sufficient to create a reasonable doubt that either (1) the directors were not disinterested and independent, or (2) the challenged transaction was not the product of a valid exercise of business judgment. Moreover, as the Southern District of California noted in Hart, Dodd-Frank s express language (and Delaware law) suggest that failed say-on-pay votes do not impose additional fiduciary duties and, therefore, should not affect excessive compensation derivative 33 Id. at *6 ( Although a say on pay vote may be reasonably considered as a factor in the demand futility analysis, it is not conclusive in this case. ) 34 Id. 10

claims. Whatever the rationale, the legal landscape seems to be settling into a consistent pattern of dismissing derivative say-on-pay claims. However, even if the legal basis for say-on-pay lawsuits is waning, there may be other business and practical reasons to file such claims. Indeed, shareholders have undoubtedly used say-on-pay as a tool to influence changes to a company s executive compensation policies and practices. In particular, shareholders seem to be looking to tie executive compensation more directly to the company s overall financial performance. Failing to do so, may spur shareholders to file derivative lawsuits (i.e., CitiGroup) even though the legal basis for such claims seems increasingly weak. Shareholders are increasingly using the court of public opinion to exert external pressures on corporation s executive pay policies. The media circus and public outcry surrounding executive compensation may be enough to make directors think twice about ignoring a failed say-on-pay vote, lest they find themselves on the wrong side of a scathing article (or lawsuit). And, in some circumstances, failed say-on-pay votes may signify the need for leadership change or highlight more systemic corporate issues. 35 Conclusion Whether it is just an evolutionary time of populist sentiments, or a genuine new period of potential legal steps to control a robber baron mentality, it is likely that the public, and particularly shareholders, will seek to affect compensation levels they deem unrelated to corporate performance. And, the political wrangling over the taxing of the 1% will only increase pressures to control or effect executives compensations. 35 See Susan Adams, Did Say On Pay Cost A CEO His Job?, Forbes (May 8, 2012), available online at: http://www.forbes.com/sites/susanadams/2012/05/08/did-say-on-pay-cost-a-ceo-his-job/ 11