Say-On-Pay Lawsuits - Is This Time Different?

Previously published on December 22, 2011.

Say-on-Pay – A Role for the Courts?

In the aftermath of the first proxy season of shareholder "say-on-pay" votes under the Dodd-Frank Act, shareholders have filed derivative suits against the boards of several of the companies failing to win majority approval. Many observers have been quick to dismiss the plaintiffʼs likelihood of success given the well-established principle that decisions on compensation lie within the boardʼs business judgment. While a federal judgeʼs recent refusal to dismiss a say-on-pay suit involving Cincinnati Bell1 may therefore have given some pause, at roughly the same time a Georgia court, in the Beazer Homes USA litigation, relied on the business judgment rule and other traditional grounds to reach the opposite result.2 In light of these unfolding and, thus far, conflicting developments, how should directors and compensation committees assess and respond to the risk of suit? In our view, boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay vote. A closer analysis of the rationales underlying the courtsʼ traditional deference on compensation matters reveals that the unique circumstances presented by say-on-pay may lead to a different outcome.

For starters, consider the procedural obstacles facing the derivative suit plaintiff – the most significant of which is the requirement of a pre-suit demand on the board. Grounding the demand requirement in "issues of business judgment and the standards of that doctrineʼs applicability," the Delaware court in Aronson v. Lewis3 made it exceedingly difficult for plaintiffs to circumvent that obligation and proceed to discovery and the merits. For demand to be excused as futile, the plaintiff must allege "particularized facts" that create a reasonable doubt that "(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment."4 Thus, derivative plaintiffs face the difficult choice between forgoing demand, and risking dismissal of their suit on that basis – as occurred in the Beazer Homes case – or making demand and having the board refuse to allow the suit – a decision that is then protected by the business judgment rule.

Admittedly, by granting each individual shareholder (and his or her attorney) the ability to sue on the corporationʼs behalf, the derivative suit creates a distinctive risk of abuse. The challenge for the law has been how to identify those derivative suits that are truly in the best interests of the corporation and the other shareholders. Viewed from that perspective, Aronson v. Lewis can be seen as yet another in a long series of mechanisms (some blunter than others) to weed out abusive suits.5 It would therefore be wrong to infer – at least as a matter of history – that the decision whether to sue the directors for breach of their fiduciary duty warrants the same status of exclusive board prerogative afforded more conventional questions of business policy. Until roughly the 1970s, the demand requirement was more often seen simply as a procedural step that needed to be exhausted, rather than an absolute bar to the courthouse door, with defendants often not bothering to raise the point.6 The notion of exclusive board prerogative is further called into question by the requirement in some jurisdictions that demand be made on the shareholders themselves – a requirement that continues to be referenced in the Federal Rules of Civil Procedure.7

Unlike the typical derivative action, the say-on-pay lawsuits uniquely present the court with direct evidence on the policy consideration fundamental to deciding whether the suit should be allowed to proceed – that is, the extent to which other shareholders have already expressed similar concerns through their proxy votes. Faced with that reality, will courts be content to rely on purely procedural grounds to foreclose the shareholder-plaintiff from access to discovery and the opportunity to at least argue the merits? Judge Blackʼs opinion in the Cincinnati Bell case illustrates how courts might find grounds, within the confines of existing doctrine, for permitting the case to proceed. While the case law holds that demand is not rendered futile simply because the defendant directors themselves approved the challenged transaction,8 the judge emphasized that the Cincinnati Bell directors did not merely approve the challenged compensation – they devised the arrangement and recommended it to the shareholders for approval.

Of course, overcoming the demand requirement is one thing, prevailing on the merits presents a more formidable challenge. Yet here as well, the distinctive characteristics of say-on-pay litigation call into question whether the obstacles to plaintiff recovery should retain their traditional force. Transactions between the corporation and its CEO or other board members have historically been singled out for rigorous judicial scrutiny. Corporate law has, however, taken a more deferential approach to CEO compensation than other forms of self-dealing, largely as a matter of necessity.9 The unique nature of personal services, particularly at the most senior leadership levels, coupled with the difficulty in quantifying the causal relationship between individual and corporate performance, means there will inevitably be substantial room to debate the true market value of a CEOʼs contribution.10 Lacking hard and fast standards, courts would be faced with a classic "floodgates" problem if shareholders were allowed to litigate the issues of fairness and reasonableness every time the board set or revised the compensation of senior management. Importantly, this is not to say that compensation decisions pose less risk of abuse than other forms of self-dealing. Indeed the same uniqueness and lack of unambiguous market "comparables" that make judicial review a challenge also create the opportunity for greater bias.

In light of that background, we believe that some courts could be inclined to distinguish the current round of say-on-pay suits from the traditional reasons for deference. Basing the suit on a negative shareholder vote necessarily addresses the floodgates risk. Out of the more than 2500 companies that held say-on-pay votes in the first proxy season of the requirement, only about 40 failed to receive majority support. With the advantage of this de facto docket control, some judges might well be willing to rethink the traditional judicial reluctance to enter the compensation thicket. This would not necessarily require courts to get into the business of second guessing boards as to the proper amount of compensation. In other areas – M&A being the most visible example – courts have demonstrated an increasing willingness to review the boardʼs decision process, while deferring to the outcome of that process once satisfied that the board proceeded in a rational and reasonably diligent fashion. The detailed explanation of the companyʼs compensation policies and decisions now required in the Compensation Discussion & Analysis (CD&A) section of the proxy statement11 lends itself to this sort of process-based review.

In the derivative suits filed to date, the plaintiffs have argued that the negative shareholder vote rebuts the presumptions embodied in the business judgment rule. Whether courts will be willing to go this far is open to question. More likely, in our view, is that at least some judges might be willing to consider the development of an intermediate standard of review, as an alternative or pre-condition to the application of the business judgment rule. This has been the Delaware courtʼs solution to other settings where directors, while lacking the direct conflict of interest that calls for application of the fairness test, are nonetheless called upon to decide matters of significant personal and financial importance to their board colleagues.12

Evaluating Competing Arguments for an Intermediate Standard of Review

We do not presume to predict the path that courts will ultimately take – or to advocate for any particular formulation of the appropriate test. Our point is simply that the times are much riper for a reconsideration of the courtsʼ approach to executive compensation than most observers seem to assume. Regulatory changes have made relevant board decision factors more transparent; public anger over disproportionately spiraling executive compensation during an extended recession is putting pressure on the...