Say-On-Pay: Will It Turn Into Sue-On–Pay?

With this year’s annual shareholder meetings largely in the rear-view mirror, one of the issues worth taking a retrospective glance at is the advisory say-on-pay votes required by section 951 of the Dodd-Frank Act. The mandatory requirement of a shareholder vote on a corporate board’s compensation decisions (say-on-pay) has been controversial since its introduction given that, as a general principle of Corporation Law, directors enjoy discretion to set the compensation of company executives.

Recently, attention has been drawn to a budding amount of cases arising out of negative say-on-pay votes—a development Congress may not have foreseen or intended.  Empirical data shows that 98% of the Russell 3000 Companies’  say-on-pay proposals received shareholder approval.  However, in the instances where shareholders rejected compensation proposal, many of the boards ended up as defendants in derivative suits. Therefore, it is interesting to take a closer look at the risk of litigation and its probable outcomes to determine the practical significance of the say-on-pay votes.

Derivative suits by shareholders include claims resulting out of negative say-on-pay voting that mainly revolve around the alleged breach of fiduciary duty by the directors.  These shareholders’ claims characterize the breach itself as threefold. First, the directors are alleged to have violated their duty of loyalty by diverting corporate assets to the executives in a way that neglected the shareholders’ best interest.  Second, the directors are alleged to have granted excessive compensation awards that constituted corporate waste.  Finally, complaints also assert claims for breach of the duty of candor caused by the failure to disclose in the proxy statements that the compensation was not awarded according to pay-for-performance standards.

If one considers the plain language of Section 951 (c) of the Dodd Frank Act, which expressly provides that the say-on-pay vote neither expands directors’ fiduciary duties nor is binding upon them, the foregoing set of allegations may seem surprising. In light of rising litigation in this area, the business judgment rule may be a director’s ultimate defense. Working as a presumption under the business judgment rule, the plaintiff has the burden of proving that the directors behaved in a disloyal manner that was not in the best interest of the company or its shareholders. Additionally, hiring a compensation consultant could possibly protect the boards from being pulled into derivative suits, as it was stated in Brehm v. Eisner.  In that case the court found that hiring a compensation consultant satisfied the board’s duty of care regarding the determination of the CEO’s compensation package.

Although chances of succeeding in a say-on-pay lawsuit are considered rare in light of the foregoing, a recent order by the Ohio District Court denying defendants’ motion to dismiss astonished interested circles.  In that motion, the court considered a narrow set of facts to be sufficient to overcome the presumptions of the business judgment rule, stating that “the business judgment rule imposes a burden of proof, not a burden of pleading”. Douglas J. Clark, adjunct faculty member at Berkeley Law and securities litigation partner at Wilson Sonsini Goodrich & Rosati, addressed judicial treatment of say-on-pay suits:

“The Cincinnati Bell decision rendered in Ohio was disappointing in that it did not give credence to the Board’s discretion and heightened ability to set executive compensation correctly.   The bar still awaits a decision applying Delaware law to these cases, however.  Sadly, while a number of cases have been filed against Delaware corporations, none have been filed in Chancery Court – a possible indicator that plaintiffs’ lack conviction that their claims have merit.”

The natural consequence of derivative suits surviving a motion to dismiss is to increase the willingness of shareholders to sue. Even though the majority of the plaintiffs may fail if the cases went to trial, boards most likely will decide to settle. Faced with the immense costs and energy that such a trial would require, a settlement could be a director’s best option.

The conclusion is clear: the say-on-pay advisory votes can have significant practical consequences that should not be underestimated by boards when awarding compensation.  The language of the statute, the use of compensation experts and the principles of the business judgment rule may not preclude a trail. Say-on-pay satisfied Congress’ objectives of disclosure and shareholder review of board’s compensation decisions. However, it is unlikely that Congress intended Sue-on-pay scenarios. While the legal foundation for those suits may be wobbly, settlements may firm the foundation and encourage more suits.