THE FUTURE OF SAY-ON-PAY DERIVATIVE LITIGATION

Vol. 45 No. 7 April 11, 2012 THE FUTURE OF SAY-ON-PAY DERIVATIVE LITIGATION Negative say-on-pay advisory votes in a number of cases have spawned shareholder derivative litigation claims that directors breached their fiduciary duties in approving pay raises and bonuses to executives despite poor corporate performance. With one exception, courts deciding such cases have granted defendants motions to dismiss for failure to make a pre-suit demand on the board or by invoking the business judgment rule. But many cases remain undecided and the 2012 proxy season is likely to generate more litigation, especially in cases of two negative votes. By Michele D. Johnson and Colleen C. Smith * The 2011 proxy season was the first year that, under Section 951 of the Dodd-Frank Act, most publicly traded companies were required to seek a non-binding shareholder vote to approve the company s executive compensation plan, a so-called say-on-pay vote. About 40 companies failed to receive support from a majority of their shareholders for their executive compensation proposals. 1 Almost half were promptly sued. In each case, shareholders filed derivative actions claiming that the directors breached their fiduciary duties by approving pay raises and bonuses to executives in a year when, according to the plaintiffs, the companies performed poorly and the executive recipients of the compensation were unjustly enriched. Only a few courts have addressed these claims. Of the seven rulings so far, a consensus is emerging that an 1 See Council of Institutional Investors, Say on Pay: Identifying Investor Concerns, Farient Advisors LLC (Sept. 2011). MICHELE D. JOHNSON is a partner in the Orange County, California office of Latham & Watkins LLP and COLLEEN C. SMITH is an associate in the firm s San Diego office. Their email addresses are michele.johnson@lw.com and colleen.smith@lw.com. April 11, 2012 adverse shareholder say-on-pay vote does not give rise to a valid breach of fiduciary duty claim and is not a sufficient basis to overcome the business judgment rule. These rulings seem to be consistent with Congress s express instruction in Dodd-Frank that the shareholder vote is not to be construed as changing or adding to the fiduciary duties of the company or its board of directors. 2 Within some of these decisions, however, dissension remains regarding the extent to which a negative shareholder say-on-pay vote may be construed as evidence sufficient to rebut the business judgment rule that normally presumes that directors conduct was undertaken in good faith. Courts have not yet ruled in a number of pending cases presenting this issue, leaving substantial uncertainty as to the viability of these claims. Adding to this uncertainty is whether derivative claims based upon 2 15 U.S.C. 78n-1(c). IN THIS ISSUE THE FUTURE OF SAY-ON-PAY DERIVATIVE LITIGATION SEC AND FINRA: PRIORITIES AND ENFORCEMENT TRENDS, Page 75 Page 69

RSCR Publications LLC Published 22 times a year by RSCR Publications LLC. Executive and Editorial Offices, 2628 Broadway, Suite 29A, New York, NY 10025-5055. Subscription rates: $1,197 per year in U.S., Canada, and Mexico; $1,262 elsewhere (air mail delivered). A 15% discount is available for qualified academic libraries and full-time teachers. For subscription information and customer service call (866) 425-1171 or visit our Web site at www.rscrpubs.com. General Editor: Michael O. Finkelstein; tel. 212-876-1715; e-mail mofinkelstein@hotmail.com. Associate Editor: Sarah Strauss Himmelfarb; tel. 301-294-6233; e-mail shimmelfarb@comcast.net. To submit a manuscript for publication contact Ms. Himmelfarb. Copyright 2012 by RSCR Publications LLC. ISSN: 0884-2426. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained by The Review of Securities & Commodities Regulation from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, The Review of Securities & Commodities Regulation does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions, or for the results obtained from the use of such information. not one, but two, failed shareholder votes might be more durable. As the 2012 proxy season begins, new questions will likely emerge regarding directors and officers obligations to shareholders following a failed say-on-pay vote: What steps must a company take following a negative vote? Are two negative votes sufficient evidence to rebut the business judgment rule? These and similar questions loom large for the 2012 proxy season. The 2011 Cases: Courts Are Divided Regarding the Viability of Say-on-Pay Derivative Claims Although many say-on-pay cases are pending, relatively few courts have reached decisions regarding the viability of these novel claims at the pleading stage. Six of the seven decisions issued so far have concluded that say-on-pay derivative claims should not proceed, either because the shareholder plaintiffs failed to make the required pre-suit demand on the board of directors, or because the complaint failed to allege facts sufficient to rebut the business judgment rule, or both. The one case reaching a contrary conclusion was not decided under Delaware law. It remains to be seen how the many courts currently considering motions to dismiss in other say-on-pay cases will come out. Teamsters Local 237 Additional Security Benefit Fund v. McCarthy (Beazer Homes) Beazer Homes was one of the first companies to report a negative say-on-pay vote, after 54% of the voted shares disapproved of the company s executive pay program. A shareholder promptly filed a derivative action in Georgia state court, alleging that the Beazer Homes board approved pay increases for its top four executives in 2010, including a 7.2% increase for the CEO, in a year when Beazer Homes suffered a loss of $34 million and a decline in share price of more than 17% as a result of the collapse of the housing market. The plaintiff alleged that the board breached its fiduciary duties by approving excessive executive pay, by recommending that shareholders approve the executives compensation, and by not rescinding the compensation program following the negative say-on-pay vote. The defendants and the company moved to dismiss, arguing that under Delaware law the shareholder plaintiff failed to plead that a demand on the board to file suit on behalf of the company would have been futile, and that the complaint did not allege particularized facts sufficient to rebut the business judgment presumption. The Georgia Superior Court agreed and dismissed the suit. 3 Applying Delaware law, the court first considered whether the plaintiff was required to make a pre-suit demand on the board, or whether a demand was excused because the complaint raised a reasonable doubt either that a majority of the board was disinterested, or that the challenged decision was the result of a valid exercise of business judgment. 4 The court concluded that the plaintiff had not raised a reasonable doubt on either score. Where only one member of the seven-member board received the challenged pay, and the plaintiff did not allege that this insider controlled the other board members, the fact that the directors had approved the challenged compensation was not sufficient to establish that the board could not faithfully evaluate a litigation demand. 5 The court similarly held that the adverse say-on-pay vote did not raise a reasonable doubt that the compensation decisions were the product of a valid exercise of business judgment, holding instead that [h]indsight second-guessing and Monday morning quarterbacking of the sort Plaintiffs urge are fundamentally inconsistent with the business judgment analysis. 6 The directors could not have taken the shareholders views into account when making compensation decisions because the say-on-pay vote had not yet occurred. And because Dodd-Frank expressly provides that the say-on-pay vote is not binding and does not change directors fiduciary duties, the directors were 3 Teamsters Local 237 Additional Security Benefit Fund v. McCarthy, No. 2011-CV-197841 (Ga. Super. Fulton County Sept. 16, 2011). 4 See Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984). 5 McCarthy, slip op. at 8-9, 16-17. 6 Id. slip op. at 11. April 11, 2012 Page 70

not obligated to rescind the executives compensation following the later vote. 7 In addition to failing to plead that a demand on the board would have been futile, the complaint also failed to state a claim, according to the Georgia court, because no alleged facts justified departure from the business judgment rule or established that the directors misled shareholders regarding the company s pay-forperformance compensation policy. 8 NECA-IBEW Pension Fund v. Cox (Cincinnati Bell) Within days of the McCarthy decision, the United States District Court for the Southern District of Ohio reached the opposite result under Ohio law, refusing to dismiss a similar say-on-pay derivative action filed by shareholders of Cincinnati Bell, Inc. 9 The suit was filed after 66% of Cincinnati Bell s shareholders voted down the company s plan to increase executive compensation for its top three executives by between 54.3% and 80.3% for 2010, the same year that the company suffered an allegedly dismal $61 million decline in net income, a drop in earnings per share, and a negative shareholder return of almost 19%. In their motion to dismiss, the Cincinnati Bell defendants made arguments similar to those advanced in McCarthy: both that a pre-suit demand on the board would not have been futile, and that the complaint failed to state a claim in light of the business judgment rule. Applying Ohio law, according to the state of incorporation of Cincinnati Bell, the district court held that the plaintiff had stated a plausible claim that the multi-million dollar bonuses approved by the directors in a time of the company s declining financial performance violated Cincinnati Bell s pay-for-performance compensation policy and constituted an abuse of discretion or bad faith. 10 The court found the negative shareholder advisory vote on executive compensation to be direct and probative evidence that the 2010 executive compensation was not in the best interests of the Cincinnati Bell shareholders. 11 In contrast to Delaware law, under Ohio law, the plaintiff was not required to plead with particularity facts sufficient to rebut the business judgment presumption, leaving the 7 Id. slip op. at 11-13. 8 Id. slip op. at 19. 9 NECA-IBEW Pension Fund v. Cox, No. 11-CV-451, 2011 WL 4383368 (S.D. Ohio Sept. 20, 2011). 10 Id. at *3. 11 Id. at *3 n.4. court to conclude that although the defendants may offer the business judgment rule as an affirmative defense at trial or on a summary judgment motion, dismissal on this 12 ground was not warranted. The district court also rejected the defendants contention that the plaintiff failed to plead demand futility. In another departure from Delaware law, demand under Ohio law is presumptively futile when the directors are involved in the challenged transaction. 13 The district court reasoned that demand was futile because the directors devised, approved, and recommended the challenged compensation, and then suffered a negative shareholder vote on the plan. The court also held that the three top executives, though they rendered valuable services to the company, may have been unjustly enriched as a result of the directors alleged breaches of fiduciary duty. 14 Two subsequent rulings from the Ohio district court in Cox cast some doubt on the precedential value of its ruling sustaining the complaint. First, the court denied the plaintiff s application for a preliminary injunction that would have enjoined the board from effectuating the 2010 executive compensation plan and would have placed the increased compensation into a constructive trust. 15 Although having found that the plaintiff alleged plausible claims at the pleading stage, the court was unable to conclude on the merits that the plaintiff was likely to overcome the business judgment rule or prove that the defendants acted with intent to injure the corporation. Second, the defendants brought another motion to dismiss that questioned the diversity of citizenship between the parties and, thus, the federal court s subject matter jurisdiction to hear the case in the first place. In response, the court issued an order to show cause why its earlier order sustaining the complaint should not be vacated, and afforded the plaintiff an opportunity to demonstrate that it should be permitted to file an amended complaint dismissing the non-diverse defendant. In the meantime, the precedential effect of the court s order denying the defendants initial motion to dismiss remains in question. 12 Id. at *2-3. 13 Id. at *4. 14 Id. at *4-5. 15 NECA-IBEW Pension Fund v. Cox, No. 11-CV-00451, 2011 WL 4467661 (Sept. 26, 2011). April 11, 2012 Page 71

Plumbers Local No. 137 Pension Fund v. Davis (Umpqua Holdings) The five decisions in say-on-pay cases reached since Cox have declined to follow that court s reasoning. In Davis, Umpqua Holdings executive officers allegedly received pay increases in 2010 of 60% to 160%, while shareholder return decreased by 7.7%, and about 62% of the shares were voted against the company s compensation proposal. 16 The District of Oregon concluded, primarily under Delaware law, that the plaintiffs did not plead demand futility, as only one member of the 10-member board received the challenged compensation, and the fact that the other directors were involved in determining or approving the challenged compensation did not raise a reasonable doubt regarding their independence and disinterestedness under Oregon and Delaware law. 17 The court rejected the plaintiffs reliance upon Cox, both because of the defendants subsequent challenge to that court s subject matter jurisdiction, and, as a matter of substance, because plaintiff s argument amounted to a contention that every pre-suit demand would suggest impending liability, thereby effectively erasing the demand requirement altogether. 18 The court similarly concluded that because compensation determinations are typically within the business judgment of the board, neither the allegation that executive compensation was not aligned with corporate performance, nor the negative say-on-pay vote, raised a reasonable doubt that the directors exercised their good faith business judgment. Furthermore, plaintiff s view that the board s compensation decision violated the company s pay-forperformance policy was insufficient to allege that the board intentionally misled shareholders. 19 Laborers Local #231 Pension Fund v. Intersil Similar to the plaintiffs in Davis, the shareholder plaintiff in Intersil alleged that the company s executive compensation plan for 2010 raised the compensation of 16 Plumbers Local No. 137 Pension Fund v. Davis, No. 11-CV- 633-AC, 2012 WL 104776, *2 (D. Ore. Feb. 23, 2012). 17 Id. at *3. While the controlling law was that of Oregon the state of Umpqua s incorporation, because this area of Oregon law is undeveloped and Oregon courts routinely look to Delaware law for guidance, the findings and recommendations depend heavily upon Delaware law. Id. at *3 n.3. 18 Id. 19 Id. at *6. the company s named executives by an average of 41.7% in a year when net income and earnings per share fell by 30%, and Intersil s shareholders rejected the company s say-on-pay proposal by 56%. 20 Applying Delaware law, the Northern District of California granted a motion to dismiss based on the plaintiff s failure to plead facts sufficient to excuse a pre-suit demand on the board. After surveying the say-on-pay cases decided to date, the court embraced the majority view that a shareholder vote alone is insufficient to rebut the presumption of the business judgment rule. The decision left open the possibility that a negative shareholder vote may be used as evidence albeit insufficient by itself to raise a reasonable doubt that a company s directors exercised their good faith business judgment in setting executive compensation. 21 Weinberg v. Gold (BioMed Realty Trust) In Weinberg v. Gold, the District of Maryland also recently rejected a shareholder say-on-pay lawsuit. Applying Maryland law, the court held that the BioMed directors participation in issuing the proxy statement and approving the challenged compensation, and their refusal to modify the executive compensation in response to a negative say-on-pay vote, did not excuse a pre-suit demand. 22 The Weinberg court soundly rejected the plaintiff s reliance on Cox, given that Cox was decided under Ohio law and was therefore not persuasive. 23 Jacobs Engineering Group Inc. & PICO Holdings The final two courts to have decided motions to dismiss say-on-pay litigation as of the date of this writing support the defendants, but not conclusively so. In Jacobs Engineering, the California state court twice sustained the defendants demurrer for failure to plead demand futility under California (and identical Delaware) law finding the reasoning of the Cox court unpersuasive and noting that executive compensation 20 Laborers Local #231 Pension Fund v. Intersil, No. 11-CV- 04093 EJD, 2012 WL 762319, *1-2 (N.D. Cal. Mar. 7, 2012). 21 Id. at *8. 22 Weinberg v. Gold, F. Supp. 2d, 2012 WL 812348, *5 (D. Md. Mar. 12, 2012). Latham & Watkins represents BioMed in this case. 23 Id. April 11, 2012 Page 72

is generally a matter of business judgment which the courts will not second-guess. 24 In the PICO Holdings cases, originally brought in California state court, the defendants removed to federal court and moved to dismiss. The federal court dismissed the claim under the Dodd-Frank Act, which did not create a private right of action or create new fiduciary duties, but remanded the state law claims to state court. 25 The 2012 Proxy Season: Predictions for the Future While many say-on-pay lawsuits filed in the wake of the 2011 proxy season remain undecided, the consensus so far suggests that other courts will reject such claims. Less clear is how courts will address these issues following the 2012 proxy season. A few principles drawn from the cases that have been decided provide some clues to the future of say-on-pay litigation. First, the Cox court s denial of a motion to dismiss has encouraged plaintiffs lawyers to pursue say-on-pay claims against directors of other companies with failed say-on-pay votes. Thus far, almost half of the companies with failed say-on-pay votes during 2011 have been named in shareholder suits, with the most recent lawsuit having been filed in January 2012. 26 This wave of litigation is probably not over. Given Cox, still more lawsuits will surely be filed by shareholders of other companies that experience negative say-on-pay votes in 2012. 24 Jacobs Eng ing Group, Inc. Consol. S holder Deriv. Litig., No. BC457808 (Los Angeles Super. Ct. Mar. 6, 2012 & Nov. 11, 2011). 25 Assad v. Hart, No. 11-CV-2269 WQH (BGS), at 5; Dennis v. Hart, No. 11-CV-2271 WQH (WVG), at 5 (S.D. Cal. Jan. 6, 2012). 26 In addition to the cases discussed in this article, the lawsuits filed following 2011 say-on-pay votes are collected here: Gordon v. Goodyear, No. 12-CV-00369 (N.D. Ill. filed Jan. 18, 2012); Woodford v. Mizel, No. 11-CV-00879-UNA (D. Del. filed Sept. 28, 2011); Haberland v. Bulkeley, 11-CV-00463 (E.D.N.C., filed Sept. 1, 2011); Swanson v. Weil, No. 11-CV-02142 (D. Colo. filed Aug. 16, 2011); Wyrick v. Redling, No. 11- CV-05036-PD (E.D. Pa. filed Aug. 5, 2011); City of Sterling Heights Police & Fire Ret. Sys. v. Kratz, No. 11-CV-02537 (S.D. Tex. filed Jul. 8, 2011); Freedman v. Bruch, No. 0651721/2011 (N.Y.S. filed June 21, 2011); Matthews v. Rynd, No. 11-CV-2706 (S.D. Tex. filed June 8, 2011). Second, the outcome of these cases may depend substantially upon the applicable law. In McCarthy and Davis, the courts application of Delaware s demand futility pleading principles led to dismissals. Courts applying Delaware law seem unlikely to depart from these courts reasoning, although the Intersil court s reasoning leaves open the possibility that a plaintiff might satisfy Delaware s pleading standards by alleging something more than just a failed say-on-pay vote. In contrast, the less stringent requirements of Ohio law enabled the plaintiff in Cox to survive the pleading stage. Future decisions will inform whether Cox is an outlier, or whether say-on-pay claims can survive motions to dismiss under any other state s laws. Third, the decisions so far address only claims premised upon a single failed say-on-pay vote. No company has yet failed two votes. While the existing decisions will be instructive in such cases, the new issues presented by two consecutive failed (or narrowly successful) say-on-pay votes are yet to be tested. Several of the decisions to date have concluded that the shareholder plaintiffs failed to allege facts sufficient to rebut the business judgment rule, because a shareholder vote of disapproval after the fact cannot establish that the directors acted in anything but good faith at the time they set executive compensation levels. But how directors respond in the following year to shareholders expression of dissatisfaction with executive compensation will likely be central to any court s analysis of the business judgment rule. Indeed, regulations adopted in January 2011 implementing Dodd-Frank require disclosure of whether and how consideration of the most recent say-on-pay vote affected a company s executive compensation policies and decisions. 27 Moreover, many companies have voluntarily committed in their 2011 proxy statements to taking their shareholders views into account in making future compensation decisions. Whether any of the 40 companies with failed say-onpay votes, or the many others that received narrow majority support for their executive compensation proposals in 2011, will fail to obtain majority shareholder support in 2012 remains to be seen. So far, two of the companies that experienced failed votes last year Beazer Homes and Jacobs Engineering were fortunate to receive overwhelming support for their sayon-pay proposals in 2012. If one of the 40 again fails its say-on-pay vote, the issues presented may be more challenging for those companies and their directors to overcome at the pleading stages. 27 17 C.F.R. 229.402(b)(1)(vii) (2011). April 11, 2012 Page 73