The Advisors' Blog

– Ted Allen, RiskMetrics Group

An Alabama state judge recently temporarily froze executive payments at Regions Financial Corporation at the request of a Louisiana pension fund. While company officials say the order has been lifted and the lawsuit moved to federal court, the case is another example of how shareholders are using litigation to try to constrain executive pay.

In a derivative lawsuit filed in May, the Louisiana Municipal Police Employees Retirement System claimed that Regions executives were awarded excessive bonuses while the company was receiving $3.5 billion in assistance from the federal government’s Troubled Asset Relief Program. The lawsuit also alleged that management misled investors about its $10 billion acquisition of AmSouth Bancorp in 2006. The pension fund claimed that executives and directors breached their fiduciary duties, wasted corporate assets, and engaged in gross mismanagement, according to news reports. The defendants include CEO Dowd Ritter, two dozen current and former executives and directors, auditor Ernst & Young, and Merrill Lynch. The Louisiana pension fund, which is seeking to place $155 million in compensation into a trust, also urges Regions to adopt governance reforms and fully comply with TARP pay restrictions.

The Regions lawsuit is the latest example of what appears to be a resurgence in shareholder litigation over executive pay decisions this year. In other high-profile cases, investors filed suit in April over American International Group’s $165 million in retention bonuses and sued Bank of America over the $3.6 billion bonuses paid to Merrill Lynch employees shortly before the investment firm was acquired.

However, investor lawsuits over executive pay are not new. Shareholders filed more than 150 derivative lawsuits over misdated stock options at technology and health care companies in 2006 and 2007. While some of the backdating derivative cases were accompanied by securities class-action lawsuits, most of them were not.

Derivative lawsuits can be difficult to pursue because the laws of Delaware and other states generally require investors to file a demand that the company management bring the case before proceeding on their own, or show that such a demand would be futile. Lawsuits over compensation can be especially difficult, because Delaware courts generally have applied the “business judgment” rule to analyze pay decisions by independent directors. In perhaps the best-known Delaware case over pay, a Chancery Court judge ruled in 2005 that Walt Disney directors did not breach their fiduciary duties when they approved a multi-million dollar severance package for former executive Michael Ovitz.

However, there have been recent Delaware rulings for investors in lawsuits over misdated options at Maxim Integrated and Tyson Foods that have made it more difficult for companies to get derivative lawsuits dismissed and have increased the negotiating leverage for investor lawyers. In addition, there was the February decision in Delaware over the $68 million exit package received by former Citigroup CEO Charles Prince. While the court dismissed claims that executives and directors failed to properly monitor subprime mortgage risks, the court held that investors could proceed with their claims over Prince’s exit package.

In his ruling, Chancery Court Judge William Chandler noted that “the discretion of directors in setting executive compensation is not unlimited….Indeed, the Delaware Supreme Court was clear when it stated that ‘there is an outer limit’ to the board’s discretion to set executive compensation, ‘at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste.’”

While derivative lawsuits often result in governance changes, they usually don’t lead to large settlements or judgments. One recent exception is the $2.88 billion verdict issued on June 18 by a judge in Alabama against former HealthSouth CEO Richard Scrushy. In that case, the company’s new management participated in the derivative lawsuit, which re-litigated many of the same fraud allegations that were the subject of an earlier criminal trial where Scrushy was acquitted. While it’s unclear how much Scrushy still has, investor lawyers say they hope to recover $100 million.

Other notable settlements include UnitedHealth, where investors, who also filed a securities lawsuit, obtained an $895 million settlement over misdated options. At American International Group, investors obtained a $115 million settlement over commissions paid by AIG to C.V. Starr, a privately held affiliate controlled by former Chairman Hank Greenberg and other AIG directors.

Meanwhile, investors continue to negotiate settlements in securities class-action actions over alleged options backdating. Recent examples include a $72 million agreement obtained by Marvell Technology Group investors in early June and a $13.5 million accord negotiated by Sunrise Senior Living shareholders in February, according to RiskMetrics Group data.