134RD YEAR NO.

41

RECORDER
www.therecorder.com

MONDAY, OCTOBER 31, 2011

Recent holding invites derivative suits

Federal courts refusal to dismiss a shareholder action following a negative say-on-pay vote may result in more of the same
a Georgia state court simultaneously calmed fears by dismissing a similar lawsuit while reaffirming the traditional prerogative of directors to determine corporate compensation. Teamsters Local 237 Additional Security Benefit Fund v. McCarthy (Beazer Homes), 2011-cv-197841, (Superior Court of Fulton County Sept. 16, 2011). voted against the compensation package in the SOP vote. As is customary in this type of case, the plaintiff did not make a demand on the companys board to bring the lawsuit, and the company filed a motion to dismiss the action on the ground that demand should not be excused. In denying the motion to dismiss, the court acknowledged that the business judgment rule normally protects board decisions from second-guessing by the courts. However, the court held that the plaintiff had adequately pleaded that the Cincinnati Bell board was not entitled to business judgment protection because the complaints factual allegations raise a plausible claim that the multimillion dollar bonuses approved by the directors in a time of the companys declining financial performance violated Cincinnati Bells pay-for-performance compensation policy and were not in the best interests of Cincinnati Bells shareholders and therefore constituted an abuse of discretion and/or bad faith. The court also held that the plaintiff was excused from making a demand on the board of directors to bring the lawsuit because [G]iven that the director defendants devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated sufficient facts to show that there is reason to doubt these same directors could exercise their independent business judgment over whether to bring suit against themselves. The court further concluded that the plaintiff had stated a valid claim for unjust enrichment. The Cincinnati Bell decision has already been so strenuously attacked that any additional criticism should be flagged for piling on and unnecessary roughness.

Jared L. Kopel

Securities
In July, I wrote an article for The Recorder noting that shareholder derivative lawsuits appeared to be the inevitable consequence following negative say-on-pay shareholder votes that are now required by the DoddFrank Wall Street Reform and Consumer Protection Act. In summary, Dodd-Frank added a new 14A(a)(1) to the Securities Exchange Act of 1934 that requires most do mestic companies at least once every three years to include in their proxies a separate resolution submitting executive officer compensation to a nonbinding SOP vote. Section 14(a)(2) also requires companies at least once every six years to include in their proxies a separate resolution for a nonbind ing shareholder vote on whether the SOP should be held every one, two or three years. The article discussed that seven such share holder derivative lawsuits had been filed with two settlements of $1.75 million and $525,000 and that more such actions would be forthcoming.

Unlike the court in Cincinnati Bell, the court in Beazer Homes held that the adverse SOP vote could not be used retroactively to rebut the presumption that the board had acted in the best interests of the company based on the facts and circumstances that existed at the time of the decision.

A recent federal court decision has created shock waves in corporate circles by refusing to dismiss a lawsuit alleging that directors breached their fiduciary duties by refusing to rescind a compensation plan that included bonuses to corporate officers after a negative SOP vote against the plan. NECA-IBEW Pension Fund v. Cox (Cincinnati Bell), 1:11-cv-451, (S.D. Jared L. Kopel is a partner at Wilson Sonsini Goodrich & Rosati in Palo Alto. Ohio Sept. 20, 2011). On the other hand,

In Cincinnati Bell, the plaintiff filed a shareholder derivative action on behalf of Cincinnati Bell against the board of directors for breach of fiduciary duty for granting the companys three senior officers significant bonuses on top of large pay raises in a year in which the company experienced substantial declines in net income, earnings per share and a reduction in its share price. In May, nearly twothirds of Cincinnati Bells shareholders

Indeed, the decision is flawed in so many ways that it resembles my Chevy Vega from years gone by. First, as discussed in my prior article, the section of Dodd-Frank that created the SOP also expressly provided that the SOP vote shall not be binding on the company or the board and may not be construed as overriding a decision by the company or the board; creating or imply ing any change in the fiduciary duties of the company or the board; or creating or implying any additional fiduciary duties for the company or board. W the stat hile utory language should be sufficient, the legislative history also makes clear that the SOP vote is not binding on the compa ny or the board. Nothing in Dodd-Frank supports the plaintiffs argument that the court appeared to accept, namely that the adverse SOP vote rebutted the business judgment presumption. Second, the analysis of the boards deci sion to approve the compensation pack age cannot be viewed with the benefit of hindsight events, including the nega tive SOP vote, but rather must be viewed based on the circumstances that existed at the time of the decision. In determin ing whether demand should be excused, a court must examine whether a chal lenged transaction was the product of a valid business judgment. But the court in Cincinnati Bell failed to examine what information was considered by the board or the contemporaneous rationale for the boards decision. The mere fact that pay was increased in a year that net income decreased is not dispositive. As commen tators have pointed out, the incentive pay was linked to earnings before interest, taxes, depreciation and amortization, rev enue and individual performance not to net income, which was depressed by one-time events. The decision does not provide any basis for concluding that the boards decision lacked an informed ba sis, lacked good faith or was not undertak en in the best interests of the company. Third, the court failed to cite any facts alleged by plaintiff that should be suf ficient to overcome the protection of the business judgment rule, other than mere ly noting that Cincinnati Bells earnings had decreased and the fact of the nega -

tive SOP vote. The court thus elided over the instruction of the Supreme Courts decisions in Bell Atlantic v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009), that a complaint must plead facts that show a claim is not merely possible but facially plausible. A plaintiff must plead factual content that allows the court to draw the reasonable inference the defendant is liable for the alleged misconduct. While at the plead ing stage allegations must be accepted as true, the court should not accept as true a legal conclusion couched as a factual alle gation. Ashcroft, 129 S. Ct. at 1949-50. But the court in Cincinnati Bell failed to cite any specific facts showing that it was more plausible than not that the board had vio lated its fiduciary obligations. On the other hand, the state court in Beazer Homes undertook the correct anal ysis and reached the right result. Plaintiffs alleged that the directors of Beazer Homes USA Inc. had breached their duties of loy alty, candor and good faith by approving allegedly excessive 2010 executive com pensation and recommending that the shareholders approve the pay package in the SOP vote. Plaintiffs made the quotid ian argument that the negative SOP vote rebutted the presumption that the direc tors decisions regarding the compensa tion reflected valid business judgments. Applying the law of Delaware, the state in which Beazer is incorporated, the court held as a threshold matter that plaintiffs had failed to satisfy requirements for contemporaneous and continuous stock ownership, and therefore lacked standing to challenge the 2010 compensation. The court, however, further found that plain tiffs had not pleaded sufficient particular ized facts demonstrating that demand on the companys board should be excused. In particular, the court found that plaintiffs had failed to provide sufficiently specific allegations showing that the boards deci sion approving the compensation was not made in good faith, on an informed basis, and in an honest belief that the decision was in the companys best interests.

board had acted in the best interests of the company based on the facts and circum stances that existed at the time of the de cision. As the court pointed out, the SOP vote had not been held when the chal lenged board decisions were made, and therefore the votes outcome could not undermine the business judgment pre sumption. Further, and again unlike the Cincinnati Bell court, the court in Beazer Homes found that Dodd-Frank expressly and unambiguously stated that the SOP vote is nonbinding and does not affect the fiduciary duties of directors. The court additionally held that Dodd-Frank did not require the board to rescind the chal lenged compensation despite the adverse SOP vote, and that the board had no basis to rescind the pay when in fact Beazers executives had satisfied their in centive compensation targets. The Beazer Homes court correctly ap plied Delaware law. In fact, the Delaware Chancery Court recently held that deci sions on how much compensation is appropriate to retain and incentivize em ployees, both individually and in the ag gregate, is a core function of a board of di rectors exercising its business judgment. In re The Goldman Sachs Group, Inc. Shareholder Litig., 5215-VCG, Slip op. at 38 (Del. Ch. Oct. 12, 2011). In that matter, the Chancery Court rejected claims that the directors of Goldman Sachs had ap proved a compensation structure for manage ment that created excessive business risks that ultimately injured the firm, and that management benefited far more from the risky business strategy than did the stock holders. The court held that plaintiffs al legations, even if true, supported only the conclusion that the directors made poor business decisions, which are protected from liability by the business judgment rule. The critical aspect of the Cincinnati Bell decision is that companies may be under greater pressure to settle share holder actions following a failed SOP vote now that a federal court has lent cre dence to the argument that an adverse vote rebuts the presumption under the

Unlike the court in Cincinnati Bell, the court in Beazer Homes held that the ad verse SOP vote could not be used retro actively to rebut the presumption that the

business judgment rule protecting board decisions on compensation. As noted above, there have been two prior settle ments of actions that involved SOP votes prior to Dodd-Frank. A lawsuit filed by shareholders of Keycorp, a bank hold ing company that was required to hold an SOP vote under the Troubled Asset Relief Program, settled for $1.75 million. Another action filed by stockholders of Occidental Petroleum Corp., which ap pears to have voluntarily submitted an SOP vote to shareholders, settled for $575,000. The payments in each case were made to the plaintiffs attorneys as a settlement fee, while the companies also agreed to modifications in their cor porate governance and compensation practices. The decision in

could very likely increase the amount of plaintiffs settlement demands in these types of actions. Perhaps the critical difference between the Cincinnati Bell and the Beazer Homes decisions is that the latter applied Dela ware law, whose richly developed au thority tends to cabin a court that may be tempted to stray and color outside the lines. By contrast, the Cincinnati Bell court applied Ohio law, which, based on the decision, appeared to have significantly less-developed authority concerning the boards ability to set executive compen sation, which permitted the court much greater freedom of action. As the prior article pointed out, the best -

the appropriate measures to prevent an adverse vote in the first place. Such steps include avoiding a negative recommen dation by the major shareholder advisory services, like Institutional Shareholder Services and Glass Lewis, and reaching out to major institutional stockholders prior to the vote in order to address any concerns about the compensation prac tices.

In Practice articles inform readers on developments in substantive law, practice issues or law firm management. Contact Vitaly Gashpar with submissions or questions at vgashpar@alm.com.

way to avoid a shareholder derivative ac Cincinnati Bell tion following a failed SOP vote is to take