Congress and Rule 14a-21 provided that say on pay was an advisory vote. Section 14A specifically provides that the advisory vote does not overrule a decision of the board of directors. It also provides that the Section does not change fiduciary duties or create an additional fiduciary duty. Section 14A(c), 15 USC 78n-1(c).
The provision was always an odd one. Fiduciary duties are matters of state law. Whatever limits Congress intended to impose on federal regulators, the provision was not designed to limit states and their right to develop fiduciary obligations. Nor did the provision prohibit courts from taking notice of the results of an advisory vote when considering alleged fiduciary violations.
And, indeed, in the aftermath of say on pay votes, shareholders have sued boards of at least ten companies for breach of their fiduciary obligations. In one case (Johnson and Johnson), the law suit was filed even though the pay package received majority support. The companies subjected to lawsuits include:
- Cincinnati Bell, the complaint was filed in federal court in Ohio (NECA-IBEW Pension Fund v. Cox, 1:11-cv-451 (S.D. Ohio, filed July 5, 2011))
- Dex One (Del; the voting results on the advisory vote are here), the complaint was filed in federal court in North Carolina (Haberland v. Bulkeley, 5:11cv-00463-D (E.D.N.C., filed September 1, 2011)).
- Jacobs Engineering Group Inc. (Del; the voting results on the advisory vote are here); the complaint was filed in California state court (Witmer v. Martin, BC454543 (Feb. 4, 2011 Ca. Super. Ct.))
- Hercules Offshore (Del; the voting results on the advisory vote are here); the complaint was filed in state court in Texas (Matthews v. Rynd, 2011 34508 (Tex. Dist., filed June 8, 2011)).
- Janus Capital (Del; the voting results on the advisory vote are here), the complaint was filed in the federal district court of Colorado (Pinsly v Scheid, 1:2011cv01732 (D. Colo. July 1, 2011)
- Johnson & Johnson (Del; the voting results on the advisory vote are here), the complaint was filed in federal court in the district of New Jersey (THE GEORGE LEON FAMILY TRUST v. Coleman, 3:2011 cv 05084 (D. NJ Sept. 1, 2011).
- Beazer Homes (Del; the voting results on the advisory vote are here), the complaint was filed in Georgia state court (Teamsters Local 237 v. McCarthy, 2011CV 197841 (Ga. Super., filed March 15, 2011))
- Umpqua Holdings (Ore; the voting results on the advisory vote are here); the complaint was filed in federal court in Oregon ((Plumbers Local No. 137 Pension Fund v. Davis, CV 11 633 AC (D. Or., filed May 25, 2011)). For a description of the case in the Company's quarterly report, go here.
In 2010, two other companies were subjected to actions following votes on say on pay, Occidental Petroleum, see Gusinsky v. Irani, BC442658 (Cal. Super., filed July 29, 2010), and KeyCorp, see King v. Meyer, CV 10 730994 (Ohio Com. Pleas, filed July 6, 2010).
So what has happened in these cases? Suits filed in 2010 have settled. As Davis Polk described:
- Last year, we saw shareholder derivative suits filed on behalf of KeyCorp (in Ohio state court) and Occidental Petroleum (in California state court) in connection with failed say-on-pay votes during the 2010 proxy season. KeyCorp agreed, according to Reuters, to pay $1.75 million in attorneys’ fees and expenses to settle related suits and Occidental Petroleum, faced with three suits, settled one for an undisclosed amount and had two dismissed. Both KeyCorp and Occidental announced significant changes to their executive compensation practices following the shareholder suits.
- In an order issued on Sept. 16, 2011, the Georgia state trial court granted the defendants' motion to dismiss the lawsuit on all counts. The court held, among other things, that the adverse shareholder say on pay vote failed to rebut the presumption under the business judgment rule that the directors acted in good faith when the board approved the executive officers' compensation. The court stated that the plaintiffs' complaint failed to allege particular facts that raised a reasonable doubt that the directors failed to exercise valid business judgment, and that the plaintiffs' "[h]indsight second guessing [was] fundamentally inconsistent with the business judgment analysis." The court also stated that the plaintiffs' contention that the Beazer's shareholders' "independent business judgment" rebuts (or indeed even serves as evidence to rebut) the presumption that the directors were entitled to business judgment protection had no support under Delaware law or the Dodd Frank Act, noting that the Dodd-Frank Act specifically provides that the shareholder vote is advisory only (i.e., nonbinding) and in no way alters a director's fiduciary duties.
In the case involving Cincinnati Bell, the trial court issued an order declining to dismiss the case. The court agreed that the allegations stated a claim for abuse of discretion or bad faith. The court also excused demand. With the shareholders alleging that the directors had "devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative vote on the compensation," the court found that they had alleged sufficient facts "to show there is reason to doubt these same directors could exercise their independent business judgment over whether to bring suit against themselves for breach of fiduciary duty in awarding the challenged compensation."
The decision in Cincinnati Bell has been criticized while the decision in Beazer has been viewed by some commentators as correct. The risk that compensation cases may, however, do better in jurisdictions outside of Delaware is nothing new. The case against compensation paid by Viacom is a case in point.
There are a number of observations that can be offered at this stage. First, there were seven lawsuits filed against companies where shareholders failed to approve the compensation package (shareholders approved the package submitted by Johnson & Johnson). This suggests that companies incurring an adverse vote will not always be sued (there were 38 instances where this occurred) but the risk is high. This provides directors with an additional incentive to structure pay packages in a manner that will garner shareholder approval.
Second, most of the companies subject to these suits were incorporated in Delaware. This is no surprise since 60% of the largest public companies are incorporated in the state (see Opting Only In: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom). The standards for derivative suits are determined by the state of incorporation. Delaware has particularly favorable law for management in this area (see the discussion of In re Goldman). Perhaps as a result, all of the cases have been filed outside of Delaware where plaintiffs presumably hope for a more favorable judicial reception.
Third, the dynamics will likely change in the next proxy season. For the first time, companies will have to disclose their response to the advisory vote. To the extent that companies effectively "ignore" the advice, the risk of a derivative suit likely increases. A negative vote is arguably a red flag that triggers a duty of good faith (part of the duty of loyalty). Directors who do not respond to a negative advisory vote or who respond, in the eyes of shareholders, in an inadequate fashion, may see themselves subject to a claim of breach for fiduciary duties.
We have posted pleadings and other primary documents on the Say on Pay cases filed in federal court (Cincinnati Bell; Johnson & Johnson; Umpqua Holdings; Dex One; and Janus Capital) on the DU Corporate Governance web site.