“Say on Pay”: Shareholder “No” Votes Now Leading to Derivative Actions Challenging Executive Compensation

July 07, 2011

Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires companies subject to the proxy solicitation requirements of the Securities and Exchange Act to hold a shareholder advisory vote on executive compensation as disclosed in the company’s proxy statement. Since the advent of “say on pay,” shareholders in at least 39 companies have voted “no” on executive compensation. A number of those dissenting shareholders, have, in turn, filed derivative claims against those companies and their boards, claiming breach of fiduciary duty and corporate waste in awarding the pay packages. This trend raises the specter of litigation risk in addition to the reputational and shareholder-relations risks associated with “no” votes on executive compensation packages and “golden parachute” provisions. Notably, even the compensation consultants have been brought into the fray, with a number of suits alleging claims against them for aiding and abetting alleged fiduciary breaches by the board. Although these derivative claims appear specious, they can still usurp valuable corporate resources and increase the stakes for compensation committees and corporate boards when setting annual executive compensation. The spate of post-“say on pay” lawsuits lends weight to the predictions of those who warned that the Dodd-Frank legislation would inevitably increase shareholder activism through litigation.

A New Litigation Trend?

Between July 2010 and June 2011, shareholders have filed at least six state law shareholder derivative complaints targeting the company’s directors who approved executive compensation which subsequently received a majority of negative shareholder advisory votes. A number of plaintiff’s firms have also announced investigations into the potential for filing suit in the wake of a negative “say on pay” vote.1 The complaints share a common challenge to the boards’ decisions: that the compensation decisions were improper in light of the companies’ poor performance. The complaints generally allege the directors breached their fiduciary duties of loyalty and candor and committed corporate waste. Several of the suits name the companies' compensation consulting firms as defendants as well, alleging aiding and abetting breach of fiduciary duties and breach of contract.

Case Study — Hercules Offshore

On June 8, 2011, a shareholder of Hercules Offshore, Inc. brought the sixth such action against company directors challenging the approval of executive compensation in light of a failed shareholder vote. Hercules, a Delaware-incorporated contract driller with 2010 revenue of $657.5 million and operations located primarily in the Gulf of Mexico, paid its CEO a total of approximately $2,516,000, consisting of $630,000 in base salary, $519,900 in options awards, and $1,366,164 in non-equity incentive plan compensation. According to the complaint, this represented a 90.9% increase for the CEO, despite the company’s $145 million net operating loss and negative 27.2% annual shareholder return in 2010. The complaint alleges that the company also increased compensation for its executive officers by an average of 122.9% in the face of the company’s negative performance.

In its 2011 proxy statement, the company justified the increased compensation for its executives on grounds that “target total direct compensation was still 10% below the median overall for . . . executive officers” and based on the “achievement of performance goals under the annual incentive plan and under the Incentive and Retention Plan.” Hercules Offshore, Inc., Proxy Statement, dated March 25, 2011, at 18. It continued:

Our compensation committee will continue to design compensation arrangements with the objective of emphasizing pay for performance and aligning the financial interests of the executives with the interests of the long-term shareholders, and require executives to retain ownership of a significant portion of our common stock they receive as compensation.

Prior to the shareholder vote, the two leading proxy advisory firms, ISS and Glass Lewis, recommended that shareholders vote ”no,” citing the gap between pay and share performance.2 After 59% of the company shareholders voted “no,” one of them filed a derivative action against the Hercules board of directors and top executives for breach of fiduciary duty, and against the board’s compensation consultants for aiding and abetting the breach. Prior to the shareholder vote, the two leading proxy advisory firms, ISS and Glass Lewis, recommended that shareholders vote “no”citing the gap between pay and share performance.2 After 59% of the company shareholders voted “no,” one of them filed a derivative action against the Hercules board of directors and top executives for breach of fiduciary duty, and against the board’s compensation consultants for aiding and abetting the breach.

Viability of Post-“Say on Pay” Derivative Claims

The Hercules plaintiff, like others filing claims in the wake of a negative “say on pay” vote, clearly face an uphill battle. Since the Delaware Supreme Court's decision in Brehm v. Eisner, 746 A.2d 244 (Del. 2000), the Delaware courts have consistently rejected breach of fiduciary duty claims relating to executive compensation, even when much larger amounts were at stake.

The “say on pay” derivative suits generally raise two theories of liability: breach of fiduciary duty, and corporate waste. The Hercules shareholders allege that the decision by board members to award the executive compensation packages in the first place, and to thereafter ignore the unfavorable shareholder “say on pay” advisory vote, violated their fiduciary duty to the company. This claim faces significant challenges in light of the “cardinal precept of the General Corporation Law . . . that directors, rather than shareholders, manage the business and affairs of the corporation.” Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984). Only a board’s conscious disregard of its duties will rise to the level necessary to overcome the business judgment rule; the claims by the Hercules shareholders do not appear to rise to that level. Moreover, under section 951 of Dodd-Frank, the advisory vote may not create or imply any additional fiduciary duties on the part of the company’s board.

The Hercules plaintiff also focused heavily on the compensation criteria articulated in the proxy statement. The complaint alleged a disconnect between the board’s recitation that it was “emphasizing pay for performance” and the actual compensation package, as evidence for their claim that the board breached its fiduciary duty. Other shareholder complaints go further, and fashion a breach of fiduciary claim based solely on the allegation that the board violated its own stated policy in adopting the challenged compensation. While many components of executive compensation are based on subjective measures developed by the compensation committee, and are thus largely immune from attack under the business judgment rule, other components, such as stock option awards, may be governed by compensation plans approved by the shareholders. As cases decided in the options backdating context have demonstrated, violating objective hard-and-fast rules embodied in a shareholder-approved plan can provide a separate basis for liability.3

Other “say on pay” derivative suits have also included claims of corporate waste. Such claims are especially difficult to plead and prove: plaintiffs must show the exchange in question was “so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” Brehm, 746 A.2d at 263. The courts recognize “outer limits” of proper business judgment only in the “unconscionable case where directors irrationally squander or give away corporate assets.” Id. at 263-64.4 Thus, the waste claims filed by the Hercules plaintiff and other frustrated shareholders face slim prospects for success.

A New Class of Derivative Defendants? Compensation Consultant Liability for Aiding and Abetting Breach of Fiduciary Duty

Compensation committee reliance on executive compensation consultants is common practice. Indeed, Section 952 of Dodd-Frank requires the SEC to direct national securities exchanges to require listed companies to authorize compensation committees to retain their own compensation consultants. The consultants themselves, however, are beginning to face increased skepticism as well. As recently opined by the Southern District of New York: “too many compensation consultants have a skewed focus when it comes to executive compensation, concentrating on what they perceive is necessary to attract and keep ‘talent’ (however defined), and more generally favoring even larger compensation packages, while rarely taking account of limits that a reasonable shareholder might place on such expenditures.”SEC v. Bank of America, 09 Civ. 6829, 2010 U.S. Dist. LEXIS 15460 at 10 (S.D.N.Y. Feb. 22, 2010).

Until now, though, executive compensation shareholder suits naming consultants as defendants have been the exception, not the rule. That may be changing. Plaintiffs in all but one of the recent post-“say on pay” derivative suits have raised claims against the compensation consultants for aiding and abetting the boards’ alleged breach of fiduciary duty, and for breach of their contract with the board. Such claims present even higher hurdles because plaintiffs bringing them must prove both that the board breached its fiduciary duty and that the putative aider and abettor knowingly participated in the fiduciary breach. Crescent/Mach I Partners, L.P. v. Turner, 846 A.2d 963, 989 (Del. Ch. 2000). The inclusion of compensation consultants as defendants thus seems less designed for the purpose of finding actual liability than for the purpose of creating leverage to increase the overall settlement value of these suits.

The Indirect Consequences of “Say on Pay” Provisions of Dodd-Frank and What Boards Should Be Considering

Although the outcomes of shareholder “say on pay” votes remain only advisory, their mandatory introduction under Dodd-Frank potentially represents a sea change in two directions: the first is of growing federal regulation in an area – corporate governance – traditionally left to the states; the second is of shareholder influence in an area – executive compensation – traditionally left to the discretion of the board. While it remains to be seen how much “say on pay” voting will affect executive compensation, some have speculated that it “is a half step, and it is a slippery slope” that will “encourage shareholders to try to usurp board authority on other issues.” Claudia H. Deutsch, “Say on Pay: A Whisper or a Shout for Shareholders?”, New York Times, April 6, 2008, at BU9. If shareholders are unhappy, say these commentators, they should simply vote out the board members themselves. Id.

To some degree, the predictions of indirect interference by Dodd-Frank with state law corporate governance issues and the authority of corporate directors to direct the affairs of the company appear to have been borne out: the threat of (even specious) shareholder lawsuits as a tactical adjunct to the “say on pay” vote clearly raises the stakes for boards setting compensation where corporate performance lags. At a minimum, perceived deviations between the executive compensation actually disclosed and the compensation policies articulated in the CD&A provide additional fodder for the dissenting shareholders. The inclusion of claims against compensation consultants ups the ante further, though the only probable practical effect will be higher fees and stronger indemnification terms extracted from the company by the consultants.

Considering the high standards for proving claims of breach of fiduciary duty or waste by corporate boards, the recent “say on pay” complaints appear unlikely to succeed on the merits. Nonetheless, companies now assessing the initial impact of Dodd-Frank’s “say on pay” provisions should take heed of the new litigation risks raised by this distinct trend coming out of the recent shareholder proxy season. Now more than ever, compensation committees should be carefully scrutinizing their pay for performance policies, their compensation-setting deliberative processes, and the independence of their compensation consultants, taking care to meticulously document in their minutes such processes and the information they considered and relied upon in reaching their decisions.

For more information about the subject matter of this alert, please contact the lawyers listed below:

Michael Blanchard, Partner, Securities and Financial Institutions Litigation, 860.240.2945

David Balabanian, Co-chair, Securities and Financial Institutions Litigation, 415.393.2170

Dale Barnes, Co-chair, Securities and Financial Institutions Litigation, 415.393.2522

Jordan D. Hershman, Co-chair, Securities and Financial Institutions Litigation, 617.951.8455

Jeffrey Q. Smith, Co-chair, Securities and Financial Institutions Litigation, 212.705.7566 

1 See, e.g., “The Law Firm of Levi & Korsinsky, LLP Launches an Investigation Into Possible Breaches of Fiduciary Duty by the Board of Intersil Corporation in Connection With the Company’s Executive Compensation,” GlobeNewswire, June 28, 2011.

2 Daniel Gilbert, “Shallow Gulf Waters Get Lonely,” The Wall St. Journal, June 1, 2011.

3 See Conrad v. Blank, 940 A.2d 28, 39 (Del. Ch. 2007), noting compensation plan “gave no discretion to the compensation committee in setting exercise prices-the grant date controlled in all cases.”; Ryan v. Gifford, 918 A.2d 341, 354 (Del. Ch. 2007), noting the “board had no discretion to contravene the terms of the [shareholder approved] stock option plans” and the allegations that a violation occurred “raise a reason to doubt that the challenged transactions resulted from a valid exercise of business judgment.”

4 In Walt Disney, for example, the Delaware Supreme Court readily rejected the shareholders’ challenge of a $130 million severance package that had been paid to a departing president. Because the package had been included in the president’s original contract and had been approved by the board and outside consultants at the time of the president’s hiring, the court determined no waste had occurred when it was ultimately awarded. According to the court, “the payment of a contractually obligated amount cannot constitute waste, unless the contractual obligation is itself wasteful,” which was found not to be the case. Id. at 74-75. Cf. In In re Citigroup Inc., the Delaware court held that a shareholder demand on the board was indeed futile where the board had approved a $68 million dollar retirement payment and benefit package for a CEO who shareholders claimed was responsible for billions of dollars in losses to the corporation. In the court’s view, lack of sufficient information on the record about the total severance package raised a reasonable doubt as to the valid business judgment of the board and whether the board’s decision went beyond the “outer limit” of that judgment as described by the Delaware Supreme Court. Id. at 137-39.

This article was originally published by Bingham McCutchen LLP.