January 2014 will mark the third anniversary of the SEC’s enactment of shareholder “say on pay” rules for public companies. For most companies, “say on pay” has created little controversy. The experience of the past three years shows that shareholders regularly approve the executive compensation proposals put before them.
In a significant number of cases, however, they have not. When that has occurred, boards of directors have often decided to adopt the proposals anyway. In many of those cases, the boards’ decisions have been challenged through litigation. Affirming the application of the business judgment rule in the face of the say on pay rules, courts have largely upheld the authority of boards of directors to make informed decisions about executive compensation even in the absence of favorable shareholder votes. Nevertheless, the say on pay rules have re-focused the attention of the securities plaintiffs’ bar on the area of executive compensation.
The SEC adopted the say on pay rules pursuant to section 951 of the Dodd-Frank Act, requiring public companies to hold shareholder votes on executive compensation matters at least once every three years. Since implementation of the rules, approximately 150 public companies have failed to secure majority shareholder support for their executive compensation proposals. According to Semler Brossy, a consulting group that tracks these votes, more than 5 percent of public companies conducting say on pay votes failed to secure majority shareholder approval at some time in the last three years.
Section 951 of Dodd-Frank expressly states that a say on pay vote is a non-binding, advisory vote, and that it cannot be used to “create or imply any change to the fiduciary duties” of the company or its board of directors. Nevertheless, litigation often follows board adoption of executive compensation proposals that fail to achieve majority shareholder approval. In 2011, for example, about half of the companies that failed to secure majority shareholder support for their executive compensation proposals were immediately sued by shareholders alleging that the companies’ directors breached their fiduciary duties in adopting the proposals.
For the most part, companies and their directors have been successful in having these lawsuits dismissed at early stages of the proceedings. In a significant development, the California Court of Appeal recently became the first appellate court in the country to address the issues raised in these cases. The court ruled in favor of the company and its directors, upholding the trial court’s grant of the defendants’ motion to dismiss. In that case, Charter Township of Clinton Police & Fire Retirement System v. Martin (PDF), the shareholder-plaintiffs alleged that the directors breached their fiduciary duties in instituting an executive compensation program that failed to secure majority shareholder approval in a say on pay vote and that the company provided misleading disclosures about the new compensation program. The court recognized that these allegations were founded upon an assumption that a board must respond to a negative say on pay vote either by disapproving the compensation plan or, at least, issuing supplemental disclosures. The court rejected this premise, stating that a say on pay vote is explicitly nonbinding, and as such, does not require a response from the company.
While most trial courts have reached similar conclusions, those defeats have not discouraged plaintiffs from filing new cases. Instead, plaintiffs are shifting their tactics in an effort to find a formula that will work. In the 2012 and 2013 proxy seasons, for example, there was a wave of lawsuits alleging that the executive compensation disclosures in companies’ proxy statements were materially deficient, and seeking to enjoin the companies’ annual meetings and say on pay votes until those disclosures were updated.
In 2012 and 2013, plaintiffs also experimented with different claims involving a variety of executive compensation issues, such as compliance with shareholder-approved equity compensation plans and/or policies, approval of tax “gross-up” provisions in employment contracts, and the implementation and/or timing of equity awards. Lately, plaintiffs have challenged directors’ independence where non-employee directors are compensated via equity-based plans that they approve and implement in accordance with the plan.
As with the original wave of lawsuits challenging approval of compensation proposals in the face of the failed 2011 say on pay votes, these new claims have largely been dismissed based on the business judgment rule. In some instances, however, trial courts have granted injunctive relief and/or denied defendants’ motions to dismiss. In those cases, companies have responded by making supplemental disclosures and, sometimes, making payments to settle the lawsuits.
Three years of “say on pay” lawsuits have shown that courts will honor the nonbinding nature of say on pay votes and uphold the principles of the business judgment rule as it applies to directors’ decisions about executive compensation. Nevertheless, the plaintiffs’ bar has shown itself to be both resilient and creative in adapting its arguments, and appears to believe that executive compensation will offer fertile ground for shareholder litigation in the years ahead.