In my book, Corporate Governance after the Financial Crisis, I explained that the federal Dodd-Frank Act of 2010 included a new "say on pay" provision requiring shareholder approval of executive compensation.
Dodd-Frank § 951 creates a new § 14A of the Securities Exchange Act, pursuant to which reporting companies must conduct a shareholder advisory vote on specified executive compensation not less frequently than every three years. At least once every six years, shareholders must vote on how frequently to hold such an advisory vote (i.e., annually, biannually, or triannually). The compensation arrangements subject to the shareholder vote are those set out in Item 402 of Regulation S-K, which includes all compensation paid to the CEO, CFO, and the three other highest paid executive officers. In addition, a shareholder advisory is required of golden parachutes. Both such votes must be tabulated and disclosed, but neither is binding on the board of directors. The votes shall not be deemed either to effect or affect the fiduciary duties of directors.
Despite the clear legislative intent that the vote be non-binding and should not affect the fiduciary duty of directors and officers, plaintiff lawyers started bringing suits where say on pay votes failed. A I noted:
... the preliminary results from say on pay votes in 2010 and 2011 strongly suggest that say on pay will be turned into a club with which activists will beat boards of directors. In 2010, when several hundred companies voluntarily conducted say on pay votes, two companies at which the vote was negative were subsequently hit with lawsuits alleging waste and breach of fiduciary duty. Given the business judgment rule and the express Congressional statement that say on pay is supposed to be nonbinding, it is difficult to imagine that such suits will have much more than nuisance value. Even so, they may generate negative publicity and withhold vote campaigns against directors. The costs to shareholders of say on pay thus may turn out to be quite significant.
Once mandatory say on pay went into effect, even more lawsuits were forthcoming.
As Alison Frankel reports, moreover, the creativity of plaintiff lawyers to bring clearly frivolous suits based on say on pay has reached even greater heights:
As my Reuters colleague Nate Raymond reported Friday in a comprehensive piece on the trend that’s spawned a recent round of law firm client alerts, the New York shop Faruqi & Faruqi has filed almost two dozen suits asserting that corporate boards breached their fiduciary duties in connection with shareholder advisory votes on executive compensation. But unlike last year’s mostly unsuccessful suits against the boards of companies whose shareholders voted down pay packages, the Faruqi suits have been filed in advance of say-on-pay votes at annual shareholder meetings, with claims based on allegedly inadequate disclosures in proxy materials. As leverage, the suits seek to enjoin shareholder meetings. So far, according to Raymond, these say-on-pay injunction suits have produced a few beefed-up disclosures but no cash for shareholders. They’ve also netted the Faruqi firm legal fees, including $625,000 in one settlement.
Of course, defense lawyers can be pretty creative too. As Frankel reports, Boris Feldman of Wilson Sonsini has laid out a strategy for beating these cases:
Dodd-Frank does not include mention of any private cause of action deriving from say-on-pay votes. So if federal courts have jurisdiction over say-on-pay disclosure cases, he said, defendants will have powerful arguments that the suits should be tossed for failure to state a claim. And according to Feldman, even if Delaware corporate law does impose state law say-on-pay disclosure obligations — a question that will ultimately have to be answered by the Delaware Supreme Court — he will argue that the state law claims are pre-empted by Dodd-Frank. “I’m going to get this to federal court regardless,” he said.
The trouble with Feldman's argument, of course, is that existing implied private rights of action under Section 14(a) and/or Rule 10b-5 may provide the requisite cause of action. But that's a question for another day.
In the meanwhile, these cases have all the hallmarks of abusive litigation. As a report from Stanford's Center for Leadership Development and Research observes, "The lead plaintiff in the case, Natalie Gordon, is involved in similar lawsuits against Cisco Systems and Symantec, and has a long his- tory of shareholder lawsuits against companies ...." In my humble and First Amendment-protected opinion, that's a bad sign.
In addition, as the Center suggests by quoting a DLA Piper analysis, these suits can put companies on the horns of a dilemma:
The rationale for the nascent claims in these lawsuits is troubling. Such suits suggest a bottomless demand. Regardless of the amount and detail of information a company may disclose in its proxy statement, a plaintiff may assert that even more disclosure is required. Indeed—paradoxically— a company that chooses to disclose more rather than less may be penalized for its candor, because every piece of information it discloses may provoke a plaintiff to argue that yet more backup information is required.
Lastly, the Center raises some important questions about these suits that need answering before we allow them to go forward:
- The shareholder disclosure lawsuit against Microsoft alleges that the company’s proxy is “materially misleading and incomplete.” However, the deficiencies identified by the plaintiffs in Exhibit 3 include information that is often considered proprietary and extreme in its detail. How much disclosure is too much disclosure? If a company follows SEC guidelines, why is this not sufficient?
- The Microsoft lawsuit calls for the release of the report prepared by the compensation consultant and all internal memos regarding discussions about executive compensation. Are there any other board decisions that have this level of disclosure? Would the release of this information improve shareholder judgment about the quality of the board’s decision on compensation?
- If compensation litigation alleging misconduct by the board of directors is successful, what other board decisions would be subject to potential suits?
Say on pay was sold as an advisory process that would not change a board of directors' liability exposure. Plaintiff lawyers are trying to remake that bargain into a cash machine on which they will annually draw every proxy season. It's time to nip that effort in the bud. Throw these suits out of court and hit those who bring them with exemplary sanctions.