June 2011

When Congress passed the Say-on-Pay provision in Dodd-Frank, there was some concern whether the required vote, even though advisory, would increase the risk for Boards.  As it turns out, the risk is real.  Approximately 35 companies have received a vote of less than 50% in support of their executive compensation programs.  Of these 35 failed votes, five companies were sued by shareholders on a derivative basis.

We believe that the derivative litigation will ultimately fail.  Say-on-Pay is merely advisory – Congress went out of its way to state that the vote would not cause additional liability for directors.  If Congress wanted to make it binding, it could have done so.  Thus, nothing in Dodd-Frank changes the well-established law in all 50 states that a Board has the protection of the business judgment rule when, after deliberating on an issue such as executive compensation, it can exercise its fiduciary duties as it sees fit. 

That said, the Compensation Committee, should seek out advice from its shareholders after a company receives a negative Say-on-Pay vote to understand shareholders’ concerns.  This should be done for obvious public relations reasons, but also to help the directors fulfill their fiduciary duties to determine whether the executive compensation packages need to be adjusted.  However, nothing prevents the Board of Directors from summarily rejecting the shareholders’ contentions after having properly debated the issue.  Based on existing jurisprudence, we do not believe a company would lose a lawsuit as a result of such a decision; however, the costs in defending the litigation should be considered. 

Ultimately, the best defense against a derivative lawsuit based on a failed Say-on-Pay vote is to prevent the negative vote from occurring.  To the extent companies can make small changes to improve its ISS GRId score, those changes should be made given ISS’s undue influence over the proxy solicitation process.  In addition, if a company expects a significant vote against the executive compensation proposal (greater than 20%), we would strongly encourage reaching out to shareholders before a Proxy Statement is distributed.