Section 951 of the Dodd-Frank Act states that the results of a shareholder say-on-pay advisory vote will not trigger or imply a breach of fiduciary duty. Because Congress went out of its way to be explicitly clear on this point, most legal commentators felt that shareholder derivative suits based on failed say-on-pay votes, without more, would likely never be successful. To further support this position, a number of derivative lawsuits were in fact filed on this very basis in 2011 but none have been successful to date. However, a recent decision by the Federal District Court for the Southern District of Ohio may have breathed new life back into the debate.
In NECA-IBEW Pension Fund v. Cox, the plaintiff shareholders (suing derivatively on behalf of Cincinnati Bell) alleged the company’s board of directors breached its duty by approving and recommending approval of an executive compensation package to the shareholders in its annual proxy statement. The compensation package included significant bonuses and pay increases for executives despite a $61 million decrease in the company’s net income and a drop in earnings per share from $0.39 to $0.07. The plaintiffs alleged that the board-approved executive compensation, which was subsequently rejected by 66% of the shareholders in the say-on-pay vote at the annual meeting, was contrary to the company’s written compensation policy which stated “a significant portion of the total compensation for each of our executives is directly related to the Company’s earnings and revenues and other performance factors” and that at-risk compensation should be “tied to the achievement of specific short-term and long-term performance objectives, principally the Company’s earnings, cash flow, and the performance of the Company’s common shares, thereby linking executive compensation with the returns realized by shareholders.”
The director defendants filed a motion to dismiss the complaint for failure to state a claim for which relief could be granted arguing, among other things, that executive compensation determinations are board decisions protected by the business judgment rule. The business judgment rule generally protects directors that make informed business decisions absent a deliberate intent to cause injury to the company or reckless disregard for the best interests of the company. In dismissing the defendants’ motion, the court stated that the business judgment rule may ultimately protect the board’s executive compensation decision, but at the pleading stage, the plaintiffs satisfied the minimum requirements of the federal pleading standards which only requires well-plead factual allegations which, on their face and if true, support a reasonable inference that the defendants are liable for misconduct. What is most interesting here is that one of the factual allegations cited and considered by the court, whether proper or not, in denying the motion was the fact that the say-on-pay vote was rejected by a majority of the shareholders. Despite the express language in Dodd-Frank prohibiting failed say-on-pay votes from triggering director liability, at least one court has considered it as one factor for the purpose of ruling on a motion to dismiss.
Although a minor victory for the plaintiffs in this particular case thus far, we believe that it would be highly unlikely that this court or other courts would find that a board breached its duty of care based on a failed say-on-pay vote alone. Had this been the plaintiffs’ sole allegation, the lawsuit may not have survived the motion to dismiss but because of the other factual allegations presented, the court was not able to dismiss the complaint at this stage of the proceedings. We do not feel that this decision in and of itself should be concerning to public companies that have had failed say-on-pay votes. However, it should serve as a reminder that directors must be prudent in determining compensation packages for their executives because, despite the express prohibition on failed say-on-pay votes alone creating any presumption of a breach of a board’s legal duties, at least one court has considered a failed say-on-pay vote as a single factor among many upon which a plausible inference of liability could be drawn.