Revised January 24, 2012

Say-on-Pay Lawsuits Is This Time Different?

By Kenneth B. Davis, Jr. & Keith L. Johnson*

Say on Pay A Role for the Courts?

In the aftermath of the first proxy season of shareholder say-on-pay votes under the Dodd-Frank Act, shareholders have filed derivative suits against the boards of several of the companies failing to win majority approval. Many observers have been quick to dismiss the plaintiffs likelihood of success given the well-established principle that decisions on compensation lie within the boards business judgment. While a federal judges recent refusal to dismiss a say-on-pay suit involving Cincinnati Bell1 may therefore have given some pause, at roughly the same time a Georgia court, in the Beazer Homes USA litigation, relied on the business judgment rule and other traditional grounds to reach the opposite result.2More recently, a federal magistrate judge likewise recommended dismissal of a say-on-pay suit against the board of Umpqua Holdings.3 As these developments continue to unfold, how should directors and compensation committees assess and respond to the risk of suit?

* Davis is of counsel, and Johnson a shareholder, in the firm of Reinhart Boerner Van Deuren s.c. Davis is also Fred W. & Vi Miller Dean Emeritus and Professor of Law at the University of Wisconsin Law School. Johnson is the former General Counsel of the State of Wisconsin Investment Board. 1 2

NECA-IBEW Pension Fund v. Cox, Case No. 1:11-cv-451 (S.D. Ohio Sept. 20, 2011).

Teamsters Local 237 Additional Sec. Benefit Fund v. McCarthy, Civil Action No. 2011-cv-1 97841 (Ga. Super. Ct. Sept. 15, 2011), appeal docketed, A12A0894 (Ga. Ct. App. Jan. 5, 2012). Plumbers Local No. 137 Pension Fund v. Davis, Civ. No. 03:11-633-AC (D. Ore. Jan. 11, 2012). Another federal court recently declined to hear a say-on-pay suit and remanded it to state court, on grounds that the Dodd-Frank Act did not create an independent basis for federal jurisdiction. Dennis v. Hart, Case No. 11cv2271 WQH (WVG) (S.D. Cal. Jan. 6, 2012) (PICO Holdings, Inc.).
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In our view, boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay vote. No doubt some courts will be inclined to treat these suits as ordinary challenges to compensation, and follow the reasoning of the Beazer Homes and Umpqua Holdings decisions. Yet a closer analysis of the rationales underlying the courts traditional deference on compensation matters reveals that the unique circumstances presented by say-on-pay may lead to a different outcome. Perhaps equally important, our advice to boards and compensation committees would be essentially the same, even if the risk of suit were off the table. The reason, as we elaborate below, is the singular importance that executive compensation arrangements assume in the current thinking of institutional investors. Companies that fail to adequately explain and support their compensation awards will increasingly find themselves targeted for follow-up, through whatever means and remedies investors have available.

Why Are Say-on-Pay Suits Different?

For starters, consider the procedural obstacles facing the derivative suit plaintiff the most significant of which is the requirement of a pre-suit demand on the board. Grounding the demand requirement in issues of business judgment and the standards of that doctrines applicability, the Delaware court in Aronson v. Lewis4 made it exceedingly difficult for plaintiffs to circumvent that obligation and proceed to discovery and the merits. For demand to be excused as futile, the plaintiff must allege particularized facts that create a reasonable doubt that (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.5 Thus, derivative plaintiffs face the difficult choice between forgoing demand, and risking dismissal of their suit on that
4 5

473 A.2d 805, 812 (Del. 1984).

Id. at 814. Although Aronson phrased the test in the conjunctive, later case law has clarified that the two prongs are disjunctive demand is excused if either is satisfied. See, e.g., Brehm v. Eisner, 749 A.2d 244, 256 (Del.2000).

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basis as occurred in the Beazer Homes and Umpqua Holdings cases or making demand and having the board refuse to allow the suit a decision that is then protected by the business judgment rule. Admittedly, by granting each individual shareholder (and his or her attorney) the ability to sue on the corporations behalf, the derivative suit creates a distinctive risk of abuse. The challenge for the law has been how to identify those derivative suits that are truly in the best interests of the corporation and the other shareholders. Viewed from that perspective, Aronson v. Lewis can be seen as yet another in a long series of mechanisms (some blunter than others) to weed out abusive suits.6 It would therefore be wrong to infer at least as a matter of history that the decision whether to sue the directors for breach of their fiduciary duty warrants the same status of exclusive board prerogative afforded more conventional questions of business policy. Until roughly the 1970s, the demand requirement was more often seen simply as a procedural step that needed to be exhausted, rather than an absolute bar to the courthouse door, with defendants often not bothering to raise the point.7 The notion of exclusive board prerogative is further called into question by the requirement in some jurisdictions that demand be made on the shareholders themselves a requirement that continues to be referenced in the Federal Rules of Civil Procedure.8 Unlike the typical derivative action, the say-on-pay lawsuits uniquely present the court with direct evidence on the policy consideration fundamental to deciding whether the suit should be allowed to proceed that is, the extent to which other shareholders have already expressed similar concerns through their proxy votes. Faced with that reality, will courts be content to rely on purely procedural grounds to foreclose the shareholder-plaintiff from access to discovery and the opportunity to at least argue the merits? Judge Blacks opinion in the Cincinnati Bell case illustrates how courts might
6 Those mechanisms include the requirement of fair and adequate representation, contemporaneous and continuing ownership, security for expenses, and judicial approval of settlements. 7 Professors Thomas and Martin have shown that in Delaware cases challenging executive compensation, the issue of demand futility was raised in only 14 percent of the cases before Aronson, but jumped to 75 percent after the decision. Randall S. Thomas & Kenneth J. Martin, Litigating Challenges To Executive Pay: An Exercise In Futility?, 79 Washington U. L.Q. 569, 579 & table 1 (2001). 8

Fed. R. Civ. P. 23.1(b)(3)(A).

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find grounds, within the confines of existing doctrine, for permitting the case to proceed. While the case law holds that demand is not rendered futile simply because the defendant directors themselves approved the challenged transaction,9 the judge emphasized that the Cincinnati Bell directors did not merely approve the challenged compensation they devised the arrangement and recommended it to the shareholders for approval. Of course, overcoming the demand requirement is one thing, prevailing on the merits presents a more formidable challenge. Yet here as well, the distinctive characteristics of say-on-pay litigation call into question whether the obstacles to plaintiff recovery should retain their traditional force. Transactions between the corporation and its CEO or other board members have historically been singled out for rigorous judicial scrutiny. Corporate law has, however, taken a more deferential approach to CEO compensation than other forms of self-dealing, largely as a matter of necessity.10 The unique nature of personal services, particularly at the most senior leadership levels, coupled with the difficulty in quantifying the causal relationship between individual and corporate performance, means there will inevitably be substantial room to debate the true market value of a CEOs contribution.11 Lacking hard and fast standards, courts would be faced with a classic floodgates problem if shareholders were allowed to litigate the issues of fairness and reasonableness every time the board set or revised the compensation of senior management. Importantly, this is not to say that compensation decisions pose less risk of abuse than other forms of self-dealing. Indeed the same uniqueness and lack of unambiguous market comparables that make judicial review a challenge also create the opportunity for greater bias.

9 See, e.g., Lewis v. Graves, 701F.2d 245, 248 (2d Cir. 1983); Drage v. Procter & Gamble, 694 N.E.2d 479, 485-86 (Ohio Ct. App. 1997). 10

(1992).
11

See ALI, Principles of Corporate Governance: Analysis & Recommendations 5.03 comment c

The classic statement of the courts difficulty in setting the appropriate amount of a CEOs compensation is Heller v. Boylan, 29 N.Y.S.2d 653, 679-80 (Sup. Ct.), affd mem., 32 N.Y.S.2d 131 (App. Div. 1941).

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In light of that background, we believe that some courts could be inclined to distinguish the current round of say-on-pay suits from the traditional reasons for deference. Basing the suit on a negative shareholder vote necessarily addresses the floodgates risk. Out of the more than 2500 companies that held say-on-pay votes in the first proxy season of the requirement, only about 45 failed to receive majority support. With the advantage of this de facto docket control, some judges might well be willing to rethink the traditional judicial reluctance to enter the compensation thicket. This would not necessarily require courts to get into the business of second guessing boards as to the proper amount of compensation. In other areas M&A being the most visible example courts have demonstrated an increasing willingness to review the boards decision process, while deferring to the outcome of that process once satisfied that the board proceeded in a rational and reasonably diligent fashion. The detailed explanation of the companys compensation policies and decisions now required in the Compensation Discussion & Analysis (CD&A) section of the proxy statement12 lends itself to this sort of process-based review. In the derivative suits filed to date, the plaintiffs have argued that the negative shareholder vote rebuts the presumptions embodied in the business judgment rule. Whether courts will be willing to go this far is open to question. More likely, in our view, is that at least some judges might be willing to consider the development of an intermediate standard of review, as an alternative or pre-condition to the application of the business judgment rule. This has been the Delaware courts solution to other settings where directors, while lacking the direct conflict of interest that calls for application of the fairness test, are nonetheless called upon to decide matters of significant personal and financial importance to their board colleagues. 13

Evaluating Competing Arguments for an Intermediate Standard of Review

12 13

See Regulation S-K Item 402(b).

Leading examples include responses to takeover bids, see Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954-57 (Del. 1985), and special litigation committees, see Zapata Corp. v. Maldonado, 430 A.2d 779, 787-89 (Del. 1981).

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We do not presume to predict the path that courts will ultimately take or to advocate for any particular formulation of the appropriate test. Our point is simply that the times are much riper for a reconsideration of the courts approach to executive compensation than most observers seem to assume. Regulatory changes have made relevant board decision factors more transparent; public anger over disproportionately spiraling executive compensation during an extended recession is putting pressure on the courts; and existing case law provides support for use of an intermediate standard of judicial review for say-on-pay derivative lawsuits. However, any such departure from unmitigated protections of the business judgment rule is likely to provoke three lines of objection. Let us consider each in turn. Policy Considerations The first is a variation on the floodgates concern identified above. While the initial round of suits might be confined to companies with negative say-on-pay votes, any intermediate test that emerged would likely have more general application. Though maybe not. Courts reluctant to open the door to judicial review of board compensation decisions on an across-the-board basis might limit the application of any newly crafted intermediate standard to a review of the boards response to the negative shareholder vote. But even in the case of a more broadly applicable standard, how wide open are those floodgates likely to be? Out of the roughly 45 negative votes this season, fewer than 10 derivative suits have been filed. Given the amounts at stake in compensation cases, coupled with the various procedural obstacles facing the derivative plaintiff, attorneys may see such suits as far less attractive than alternative forms of shareholder litigation. Even admitting, however, a material increase in the volume of litigation, the fundamental question becomes one of costs versus benefits. In other writings, one of us has expressed skepticism about the continuing role of derivative suits, in comparison to alternative means of addressing misconduct or nonperformance at widely traded

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companies.14 But in the case of excessive CEO compensation, what realistic alternatives exist? Dramatically rising compensation levels and the disconnect between pay and performance have been front-burner issues for at least two decades, but the gap between CEOs and average workers continues to widen. In this years ISS Survey, both investors and companies again rated executive compensation as the most important governance issue they faced.15 Why do we believe that courts, in particular, may now be more willing to fill this void? Under our common law system, the benefits of enhanced judicial review extend well beyond the particular case at bar. For corporate directors, there is no established code of best practices simply general precepts of good faith, care and loyalty. Only through case law do these precepts evolve into a tangible and fact-specific understanding about what the directors job entails. In our experience, nothing has the potential to generate and focus an effective, profession-wide dialogue on how to counsel directors better than a leading judicial opinion on an emerging legal issue. In the absence of that highly visible meshing of legal principles with specific facts, bar committees, CLE programs and professional journals are necessarily confined to the general and abstract. Imagine, for example, an analysis by the Delaware Court of Chancery of the kinds of questions a compensation committee should be asking when faced with the inherent conflicts between shareholder and management interests that are involved in deciding whether to significantly increase the CEOs compensation in the face of declining corporate financial performance the circumstance that underlies so many of the say-on-pay derivative suits filed thus far. That discussion, enhanced by the subsequent attention, analysis and debate within the profession, would not only improve the quality of legal counseling, but should also strengthen the resolve of board

See Kenneth B. Davis, Jr., The Forgotten Derivative Suit, 61 Vanderbilt L. Rev. 387 (2008); Kenneth B. Davis, Jr., Structural Bias, Special Litigation Committees, and the Vagaries of Director Independence, 90 Iowa L. Rev. 1305 (2005).
14

ISS, 2011-2012 Policy Survey Summary of Results 9-10 (Sept. 11). Specifically, executive compensation was rated as one of the top three governance topics by 60 percent of North American investors and 61 percent of North American companies. No other issue was identified by more than 50 percent of either group. By way of comparison, far fewer investors and companies in Europe, the Asia Pacific or Developing Markets cited executive compensation as important.
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and committee members to recognize inherent behavioral biases in the process and ask the tough questions.16 Existing Case Law The second objection looks to existing doctrine. Even if lower courts are inclined to consider a less restrictive approach to demand futility or an intermediate standard of review, as discussed in the first part of this article, how much freedom do they have to do so? At least for Delaware corporations, that freedom is constrained by the Delaware Supreme Courts relatively recent reaffirmation of the business judgment rules application to compensation issues. The two leading decisions involve Walt Disney Co.s severance arrangements with Michael Ovitz, who left the company only 14 months after being hired as its president. In re Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006); Brehm v. Eisner, 746 A.2d 244 (Del. 2000). As described in those opinions, two narrow avenues are available to the shareholder who seeks to challenge a compensation decision by the board. One is to rebut the business judgment rules presumption that the directors acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. The burden then shifts to the directors to prove that their decision was entirely fair to the corporation and its shareholders. Disney, 906 A.2d at 52 If the shareholder is unable to rebut the application of the business judgment rule, the alternative is to establish that the compensation constituted corporate waste. To recover on a claim of waste, the plaintiff must prove an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration. Disney, 906 A.2d at 74; Brehm, 746 A.2d at 263. In describing the operation of the waste test, the court in Brehm quoted at

16 For example, inherent conflicts of interest in the process that can feed behavioral biases include compensation consultant loyalties to corporate executives as their primary client base, ineffective executive succession planning that limits a boards alternatives, the personal interests of board members who are executives at other companies in the knock-on effect of increased peer compensation on their own pay, and the influence of personal interaction with management as opposed to absent outside shareholders with whom there is little direct communication.

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length from Chancellor Allens opinion in Lewis v. Vogelstein, 699 A.2d 327, 336 (Del. Ch. 1997): Roughly, a waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade. Most often the claim is associated with a transfer of corporate assets that serves no corporate purpose; or for which no consideration at all is received. Such a transfer is in effect a gift. If, however, there is any substantial consideration received by the corporation, and if there is a good faith judgment that in the circumstances the transaction is worthwhile, there should be no finding of waste, even if the fact finder would conclude ex post that the transaction was unreasonably risky. 746 A.2d at 263 (emphasis in original). While the Brehm court acknowledged that there are outer limits on the boards discretion, they are confined to unconscionable cases where directors irrationally squander or give away corporate assets. Id. The resulting interaction of the business judgment rule and waste test, as summarized in Brehm, means that directors decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available. 746 A.2d at 246 n.66. Brehm and Disney were decided before the recent credit crisis. Even then, the Disney boards sloppy governance practices and the size of the payout to Ovitz led Chief Justice Veasey to describe Brehm as a very troubling case on the merits and a close case as to both the boards process and the waste test. He then added: But our concerns about lavish executive compensation and our institutional aspirations that boards of directors of Delaware corporations live up to the highest standards of good corporate practices do not translate into a holding that these plaintiffs have set forth particularized facts excusing a pre-suit demand under our law and our pleading requirements. Brehm, at 746 A.2d at 249. Might the experience of the last few years the escalating levels of CEO compensation in the face of broader economic slowdown and job loss, the role of
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compensation incentives in contributing to excessive risk, etc. today cause the supreme court to favor a less deferential approach? Only time will tell. At least one sign of a possible change is Chancellor Chandlers decision in the Citigroup case.17 There, notwithstanding the courts restrictive language in Brehm, the Chancellor concluded that a reasonable doubt existed whether the severance package awarded retiring Citigroup CEO Charles Prince exceeded the outer limit, and on that basis, he singled out the plaintiffs waste claim to survive dismissal on grounds of demand futility. Citigroup, 964 A.2d at 137-39. Nonetheless, for shareholders in Delaware corporations, until the supreme court reconsiders the approach followed in Brehm and Disney, challenges to executive compensation that lack the basis for a colorable claim of waste will continue to face the conventional business judgment rule. Perhaps lower courts will nonetheless be able to develop a workable framework, within the contours of Aronson, for incorporating a negative say-on-pay vote into the criteria for excusing demand. The Cincinnati Bell opinion illustrates one possibility; no doubt there are others. Indeed, repeat shareholder majority votes against approval of pay practices at the same company, when they occur, are likely to present compelling facts that increase the pressure for a judicial response. Absent that, efforts to establish the reasonable doubt required for demand futility will necessarily focus on the independence of the compensation committee and the quality and integrity of its decision process. That is why, in the final section of this article, we stress the importance of the CD&A section of the proxy statement. Lacking access to discovery and confined to the tools at hand,18 plaintiffs principal means to raise questions as to the directors good faith and diligence will be to identify inconsistencies or material omissions in the justification for their compensation decisions as set forth in the companys public statements, notably the CD&A and statement supporting the say-on-pay proposal.

17

In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106 (Del. Ch. 2009).

18 See Grimes v. Donald, 673 A.2d 1207, 1216 (Del. 1996); Rales v. Blasband, 634 A.2d 927, 93435 n.10 (Del. 1993).

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Dodd-Frank The final line of objection derives from the language of the Dodd-Frank Act itself. New section 14A(c) of the Securities Exchange Act, as created by Dodd-Frank section 951, provides: (c) RULE OF CONSTRUCTION. The shareholder vote referred to in subsections (a) and (b) shall not be binding on the issuer or the board of directors of an issuer, and may not be construed (1) as overruling a decision by such issuer or board of directors; (2) to create or imply any change to the fiduciary duties of such issuer or board of directors; (3) to create or imply any additional fiduciary duties for such issuer or board of directors; or (4) to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation. Does this necessarily mean, as many have argued, that a negative say-on-pay vote is to provide no additional ammunition to the shareholder challenging CEO compensation? Not to engage in a semantic quibble, but we see a difference between the content of the directors fiduciary duty which before and after Dodd-Frank, is to act in good faith, in a manner the director reasonably believes to be in the best interests of the corporation, and so forth and the procedures employed to enforce those duties. For example, can incorporating the negative say-on-pay vote into the circumstances necessary to establish demand futility realistically be described as a change or addition to the directors fiduciary duty? More fundamentally, nothing in Dodd-Frank forecloses a state court from reconsidering the standard for judicial review of the boards compensation decisions in response to the very same concerns over escalating CEO compensation and the mismatch between pay and performance that led to the enactment of section 951. Preserving the opportunity for such periodic reconsideration is the reason that fiduciary duties a product of the courts equity jurisdiction have always been framed only by reference to the core attributes of good faith, loyalty and care. Their role over the years
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has been not only to protect existing investors but to assure that prospective investors have the requisite trust and confidence that their money will be used properly. As investor concerns change over time, so must the protections necessary to assure that continuing trust and confidence. In the words of the Delaware Supreme Court: [O]ur corporate law is not static. It must grow and develop in response to, indeed in anticipation of, evolving concepts and needs. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 957 (Del. 1985).

How Should Boards and Compensation Committees Respond?

If our assessment is correct, those responsible for executive compensation decisions need to prepare for a period of substantial uncertainty until the issues raised by the say-on-pay suits are definitively resolved. Because that definitive resolution must come from the Delaware courts, and plaintiffs have thus far chosen to file elsewhere, answers may be a while in coming. Further, given the continuing damage to company reputations and investor relations as their pay practices are the focus of judicial and public scrutiny, companies at least those that fail to have the suit dismissed at the demand stage will be under strong pressure to settle rather than to pursue the case to the merits.19 Thus, for the foreseeable future, we should not be surprised by a variety of alternative and often conflicting outcomes, as the early examples of Cincinnati Bell and Beazer Homes suggest. In the meantime, we expect that the volume of this litigation will likely increase. The fact that only 1.6 percent of Russell 3000 companies experienced a negative majority vote in 2011 may have led to some to assume that shareholders are generally
For example, the parties have recently agreed to settle a second say-on-pay suit involving Cincinnati Bell this one in state court. Among other measures, the proposed settlement calls for the company to detail its implementation of pay for performance, rotate the members of its compensation committee and retain an independent compensation consultant. See Cincinnati Bell Inc., Form 8-K, filed Dec. 23, 2011.
19

The incentives to settle go beyond the avoidance of adverse publicity and additional litigation expense. For individual directors, an adjudication of liability negates their entitlement to indemnification. See, e.g., Delaware Gen. Corp. Law 145(b). Further, to the extent that executives are found to have received an improper personal benefit, they may be excluded from coverage under the companys D&O insurance policy. As to this latter point, is it noteworthy that some D&O insurers have begun offering additional coverage protecting against liability for compensation that is "clawed back" pursuant to the Dodd-Frank Act.

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content with existing compensation arrangements. However, the early reports are that, with the experience of the first season of say-on-pay behind them, many institutional investors are now prepared to take a more active role in identifying and opposing the compensation arrangements they find troublesome. Further, the success of some of the early suits (such as Cincinnati Bell) in surviving dismissal may encourage other disgruntled to investors to consider litigation as a possible option. Finally, this seasons proxy statements will include the companys response to last years votes, which may lead some investors to reconsider their prior approval, as well as create a fresh basis for legal challenge. Other developments in corporate governance are likely to push shareholders toward greater say-on-pay focus, as the best remaining avenue for challenging ineffective boards. SEC regulations to implement the Dodd-Frank Act proxy access provisions allowing long-term shareholders to place director candidates on company proxies were struck down.20 Although 76 percent of companies in the S&P 500 now have a majority shareholder vote requirement for election of directors, boards are free to ignore majority shareholder votes against election of director candidates and do so overwhelmingly, even at companies that have adopted majority vote requirements. In 2010, 106 directors who were rejected by a majority of shareholder votes remained on their boards. 21 Under these circumstances, corporate governance officers at numerous institutional investors have expressed to the authors their intent to ramp up focus on advisory shareholder executive compensation votes and vote against directors on boards that are unresponsive to shareholder concerns about executive compensation issues. Executive compensation has long been viewed by shareholders as a key indicator of whether a board is independent and effective.
20 In Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011), the United States Court of Appeals for the District of Columbia vacated the SECs rulemaking order as not meeting standards for analysis of economic impact under the Administrative Procedure Act (5 U.S.C. 551). 21 In City of Westland Police & Fire Retirement System v. Axcelis Technologies, 1 A.3d 281 (Del. 2010), the Delaware Supreme Court effectively authorized boards of Delaware companies with a director resignation policy for implementing majority shareholder votes against director candidates to reject the candidates resignation and keep the director in office by making an informed business judgment that doing so is in the best interests of the corporation. Indeed, the Council of Institutional Investors and Institutional Shareholder Services report that nearly all director candidates who are rejected by shareholders remain in office. (See CII report at http://www.cii.org/MajorityVotingForDirectors and ISS 2011 Postseason Report at http://www.issgovernance.com/docs/2011USPostseason

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Consequently, companies should continue to consider litigation risk among the many costs of failing to win substantial shareholder support for their executive compensation arrangements. In deciding how best to prepare for this scenario, each companys situation is of course different. But we believe that three strategies in particular should receive serious consideration by every company. Refined CD&A Disclosure First, the company should make every effort to assure that the proxy statement describes the fundamental principles that underlie its executive compensation practices, and explains the performance basis for compensation awards and their alignment with larger corporate goals and policies, in as candid and complete a manner as possible.22 If particular pay practices are likely to be questioned by investors, the company should seize the opportunity to address those questions directly and preemptively.23 This reflects the view that prospective plaintiffs will look principally to the CD&A and statement supporting the say-on-pay proposal in assessing whether a plausible claim of demand futility exists. More generally, it represents our belief that too many companies fail to take full advantage of the opportunity to use the proxy statement to tell investors their governance story. In the current governance climate, companies cannot afford to approach the proxy statement with the goal of keeping the narrative as general as possible to minimize the risk of 14a-9 liability, especially when it comes to the CD&A. Better Engagement B0th the Large and Small E Second, companies, particularly those whose pay practices have been questioned or criticized by investors in the past, need to significantly ratchet up the their level of engagement. The 2011 proxy season featured stories of companies caught by surprise by a proxy advisers negative say-on-pay recommendation, and their resulting scramble
In a study commissioned by the Council of Institutional Investors following the 2011 proxy season, investors cited poor disclosure as their reason for voting against a say-on-pay recommendation in 35 percent of the cases. See Council of Institutional Investors, Say on Pay Identifying Investor Concerns 12 & Appendix I (Sept. 2011).
22

On at least one occasion the Delaware courts have held that a lack of candor in describing the CEOs compensation renders the directors interested for purposes of excusing demand. In re infoUSA, Inc. Shareholders Litigation, 953 A.2d 963, 990-91 (Del. Ch. 2007).
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to address it. While those surprises should be rarer in the 2012 season, the basic lesson remains the same: Companies need to make engagement with their principal shareholders a year-round process.24 In the case of compensation, that begins with a specific understanding of their shareholders current proxy voting guidelines - whether the recommendations of a particular proxy adviser or customized internal criteria and how they apply to the companys own program. But effective engagement is not confined to specific issues and voting guidelines, which is why we distinguish between the large and small e. In our view, companies can be successful in their investor relations only if they make a genuine effort to understand how the governance environment looks from their shareholders vantage point. That is the reason we believe that say on pay will, if anything, loom even larger on institutional investor agendas in the proxy seasons ahead. Last seasons results confirm that investors have not responded on a knee-jerk basis to press for lower or better aligned executive compensation whenever the opportunity presents itself. Out of the 300-plus companies for which ISS issued negative say-on-pay recommendations, only about one in eight received majority opposition. On the other hand, investors overwhelming supported holding the say-on-pay vote on an annual basis. In our experience, institutional investors tend to view say on pay through a wider lens one that embodies their broader philosophy of the role that effective boards (and in particular effective independent directors) can and should play. Specifically, these investors view CEO succession and compensation as the key areas in which independent board members can, on an ongoing basis, realistically affect the companys long-term value. When investors perceive a significant disconnect between the pay and performance, they wonder whether it portends broader weaknesses in governance and oversight. 25 Concerns over companies lack of commitment to genuine engagement (in

24 For companies that received significant say-on-pay opposition in 2011, ISS has proposed taking into account the companys [d]isclosure of engagement efforts with major institutional investors regarding the compensation issue(s) in determining whether to recommend a no vote on say-on-pay and the election of compensation committee members. See ISS, 2012 Draft Policies for Comment Board Response to Management Say-on-Pay Vote (US).

For example, Governance Metrics International publishes an annual report that rates companies on exposure to securities fraud litigation risk. A key factor in securities class action risk
25

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both large and small e senses) regularly come up in our conversations with institutional investors. Effective investor engagement is the responsibility of the CSuite and board leadership, not just the investor relations staff. In discussing the results of the recent proxy season, investors have told us of situations in which they agreed to depart from their regular voting guidelines after one-on-one conversations in which senior management explained the companys compensation rationale. Further, even if the conversation does not result in changing an investors vote, managements willingness to engage and explain will no doubt play a significant mitigating role when the investor identifies which companies to target for possible follow-up. Enhanced Sensitivity to Conflicts of Interest Finally, the most direct way for derivative suit plaintiffs to bypass the demand requirement, under existing case law, is to create a reasonable doubt about the boards independence. If, as we have discussed, courts do become increasingly open to suits challenging executive compensation, the independence of those involved in the compensation process will be a focal point of scrutiny. Thus, companies should undertake a fresh review of whether circumstances exist that impinge, or might appear to impinge, on the capacity of each participant in that process to exercise independent judgment. This review begins with the members of the compensation committee. Independence requirements for directors responsible for setting executive compensation are now included in the listing standards of almost all stock exchanges. Further, the SEC has proposed rules under new section 10C of the Securities Exchange Act, added by Dodd-Frank, requiring exchanges to develop a special definition of independence applicable to compensation committee members.26 However, compliance with present or future exchange listing standards does not foreclose a court from determining that the director is not independent for purposes of the demand
exposure is a companys executive compensation practices. See http://www2.gmiratings.com/reports.php?reportid=307&keyword=litigation.
26 Listing Standards for Compensation Committees, Securities Exchange Act Release No. 64,149 (Mar. 30, 2011).

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requirement of business judgment rule. Thus, in reviewing the compensation committees independence, boards need to take into account any relationship with the company or its senior executives that might affect the members judgment.27 In the case of outside compensation consultants, on the other hand, neither existing law nor listing standards mandates independence. What Exchange Act section 10C(b) now requires, however, is that before engaging the consultant, the compensation committee must take into account various factors that might affect the consultants independent judgment, including others services provided to, and fees received from, the company. This requirement applies, as well, to the engagement of legal counsel or other advisers to the committee. Again, the SECs proposed rules direct the exchanges to develop listing standards to carry out this requirement. Further, as required by new section 10C(c)(2), the SEC is proposing to expand the required disclosure of whether the consultants work raised any conflicts of interest and how those conflicts are being addressed. In determining whether a conflict exists, the company is instructed to consider the statutory list of factors referred to above.28 Thus, while the existence of a potential conflict of interest does not preclude the committee from engaging a particular consulting firm, those conflicts can be expected to assume a greater role in investor voting decisions, and if litigation ensues, will almost certainly be a focus of the plaintiffs case.29 Conclusion While the first wave of say on pay derivative cases moves through the courts, directors of public companies would be well served to closely examine their practices in setting and evaluating executive compensation. Courts are likely to experience growing
A good description of how board member conflicts of interest, personal relationships, selfdealing and related party transactions can establish grounds for overcoming protections of the business judgment rule in executive compensation decisions is provided in In re infoUSA, Inc. Shareholders Litigation, 953 A.2d 963 (Del. Ch. 2007).
27 28 Proposed S-K item 407(e)(3)(iii) & instruction 2, Listing Standards for Compensation Committees, supra.

For an illustration of how the consultants lack of independence can contribute to a courts decision to invalidate the boards compensation award, see Valeant Pharmaceuticals International v. Jerney, 921 A.2d 732, 747-48 (Del. Ch. 2007).
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pressure from shareholders and the public to strengthen standards for judicial oversight of executive compensation by boards. Given recent regulatory changes that have increased transparency of the key factual considerations involved in these actions and existing case law which allows a more exacting standard of review to be applied to board decisions on key governance matters, the environment is ripe for adoption of a stricter standard of review in say-on-pay cases. In order to reduce litigation risk and also garner the long-term support of their investor base, boards might want to improve their disclosures around executive compensation, engage with and respond to legitimate shareholder concerns and attend to removing both conflicts of interest and behavioral biases from the boards compensation oversight practices.

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