Are we seeing the start of a wave of executive compensation clawback lawsuits by the Securities and Exchange Commission? As Kevin LaCroix pointed out in his D&O Diary blog, last week the SEC filed two lawsuits to recoup compensation from former top executives of two companies. These actions are the latest examples of the SEC’s increased use of Section 304 of Sarbanes-Oxley, which has been interpreted to allow the SEC to recover incentive compensation paid to top executives at companies that restate their earnings as a result of wrongdoing, even if the executives aren’t the ones accused of the misdeeds.
The first case was filed April 2 against the former CEO and CFO of ArthroCare, an Austin, Tex.-based company that makes medical devices. In this case, the SEC wants to claw back an unspecified amount of compensation from former CEO Michael Baker and former CFO Michael Gluk, even though the two aren’t accused of wrongdoing. Instead, two former Arthro sales executives have been charged by the SEC with inflating revenue by channel stuffing.
The second case, filed on Friday, targets former leaders of the failed Franklin Bank of Houston: former CEO Anthony Nocella and former CFO Russell McCann. In contrast to the ArthroCare case, these two men are accused of wrongdoing in that they allegedly misrepresented the bank’s underperforming loans. Both cases were filed by the SEC’s Forth Worth office.
Section 304 of the Sarbanes-Oxley Act states that if a company has restated its financials because of misconduct, then the CEO or CFO must reimburse incentive compensation to the company. In 2009 a federal court ruled for the first time that this provision can be used against executives who aren’t charged with misconduct. That case was brought against Maynard Jenkins, the former CEO of CSK Auto Corporation. Last January the SEC used Section 304’s strict liability provisions to claw back $450,000 in compensation from the former CEO of Symmetry Medical Inc., and $185,000 from its chief financial officer, who were not themselves charged with wrongdoing. (You can read our article about that case here.)
The lawyers for the former ArthroCare executives blasted the SEC’s action as unconstitutional. Jay Pomerantz of Fenwick & West, who represents former CEO Baker, asserted that the SEC is relying on “a flawed interpretation of the Sarbanes-Oxley Act.” He added: “Such overreaching against an admittedly innocent person violates constitutional principles of fairness and due process.” Jason Lewis of Locke Lord, who represents former CFO Gluck also maintained that the SEC’s action “raises numerous constitutional and equitable concerns.” He stated: ” With its overreaching and broad interpretation of the Sarbanes-Oxley Act, the SEC is telling public companies and their officers that even being diligent and innocent of wrongdoing does not protect you from the SEC’s grasp. This certainly could not have been the intent behind the law and Mr. Gluk intends to vigorously defend himself against this unjust action.”
In the Franklin Bank case, Nocella is represented by James Munisteri of Gardere Wynne Sewell. Munisteri told the Wall Street Journal that the SEC’s complaint doesn’t tell the whole story. “Conspicuously absent from the SEC’s mischaracterization of events are many important facts that the SEC will not be able to ignore during a court proceeding,” he said. Barrett Reasoner of Gibbs & Bruns, who represents McCann, pointed out that a class action against Nocella and and McCann stemming from the bank’s failure was dismissed, and that ruling was upheld by the U.S. Court of Appeals for the Fifth Circuit. “Just as the class action claims were dimsissed, the SEC’s claims similarly will not pass muster,” Reasoner told the Litigation Daily.
A spokesperson for the SEC told us: “The SEC has staked out its legal position in cases like Jenkins. Our position is very clear.”
3. Florida State Board of Administration proxy voting guidelines [Among other changes, the guidelines advocate separation of CEO and chair roles “as part of any success planning event,” and indicates general support for proxy access proposals if they set a minimum equity ownership threshold of 1 percent and require at least a 1-year holding period]
As the other bloggers on this site were quick to point out, Citigroup was hit with a say-on-pay lawsuit within two days of the revelation that it had failed to garner majority support for say-on-pay at its annual shareholders meeting last week. In fact, Citi’s Form 8-K reporting the vote results was filed on Friday – and the complaint was filed in the US District Ct.- SDNY on Thursday. The lawsuit was filed before the 8-K!
With bank M&A heating up, the complaint against Encore Bancshares could be symptomatic of what to expect from the new “say-on-parachute” disclosure requirement. Encore filed its special meeting proxy statement on April 12th, and the complaint soon followed with allegations drawn directly from the say-on-parachute disclosure on page 55.
The complaint basically alleges breaches of fiduciary duties by officers and directors due to the compensation they receive from Encore’s sale. This litigation is a healthy reminder that, although the Dodd-Frank Act’s Say on Parachute disclosure and vote are not expected to derail transactions, they involve sensitive disclosures that warrant up-front diligence and thoughtful presentations to shareholders.
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 in these cases, given the well-established principle that decisions on compensation lie within the board’s business judgment. However, while a Georgia court, in the Beazer Homes USA litigation, relied on the business judgment rule to dismiss a say-on-pay shareholder derivative case, at roughly the same time a federal judge in Ohio reached the opposite conclusion, refusing to dismiss a say-on-pay suit involving Cincinnati Bell. In light of these unfolding and conflicting developments, how should directors and compensation committees assess and respond to the risk of suit?
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. The time might be coming for courts to start applying a stricter standard of review in these cases. Analysis of the rationale underlying the courts’ traditional deference to boards on compensation matters reveals that the unique circumstances presented by say-on-pay may lead to a different outcome.
For starters, consider the requirement of a pre-suit demand on the board. Prior to the 1970s, this was seen as merely a procedural step, not a bar to the courthouse door. Unlike the typical derivative action, 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?
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.
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. In other areas, mergers and acquisitions being the most notable, courts have already been increasingly willing to review the board’s decision process, without having to second guess a rational and reasonably diligent board determination.
Any such departure from unmitigated protections of the business judgment rule is likely to provoke three lines of objection: concerns over the resulting volume of litigation, inconsistency with existing case law, and the limiting language of the Dodd-Frank Act. However, we are not persuaded that, in the present context, any of these forecloses a more demanding standard of judicial review.
Confining judicial review to instances of a negative shareholder vote necessarily addresses the floodgates problem. Even in the absence of a new intermediate standard, investor backlash against spiraling executive compensation and growing economic inequality might spark courts to take a more aggressive approach to excessive compensation awards under the existing business judgment rule and corporate waste doctrines. While Section 951 of the Dodd-Frank Act makes it clear that a say-on-pay vote does not change the board’s fiduciary duties, nothing in the Act appears to preclude courts from adopting a stricter standard of judicial review.
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 will ultimately 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. Thus, for the foreseeable future, we would not be surprised by a variety of alternative and often conflicting outcomes, as the early examples of Cincinnati Bell and Beazer Homes suggest.
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 company’s situation is different. Nevertheless, we believe that three strategies in particular should receive serious consideration by every company.
First, the company should make every effort to assure that its proxy statement describes the fundamental principles that underlie executive compensation practices. The proxy statement should also explain the performance basis for compensation awards and their alignment with larger corporate goals and policies, in as candid and complete a manner as possible.
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. 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 key areas in which independent board members can, on an ongoing basis, realistically affect the company’s 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.
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 board’s 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. Board member conflicts of interest, personal relationships, self-dealing and related party transactions can provide the grounds for establishing bias or lack of independence. Consequently, boards should undertake a fresh review of whether circumstances exist that impinge, or might appear to impinge, the capacity of each participant in that process to exercise independent judgment.
Conclusion
Courts are likely to face growing pressure to strengthen their oversight of board compensation decisions, particularly where a shareholder vote reveals a significant perceived disconnect between pay and performance. In order to reduce litigation risk, 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 board’s compensation oversight practices.
Over the past week, Citigroup (45%) and KB Home (46%) joined the club of those failing to gain majority support for its say-on-pay. A list of the Form 8-Ks filed by the “failed” companies is posted in our “Say-on-Pay” Practice Area. Citi has not yet filed its Form 8-K reporting the voting results – but did address the failure in its “Citi Blog” (which oddly has no comments after this CEO pay entry). The Citi failure was front-page news for the WSJ, NY Times, etc. and I spoke at an event in NYC last night and it was the hot topic (besides the JOBS Act).
Here’s something that Mark Borges blogged last night: The shock waves from yesterday’s Citigroup “Say on Pay” vote continue to reverberate. For an insightful analysis of how to interpret the vote, see Professor J. Robert Brown’s latest post at his website “The Race of the Bottom.”
This turns out to be Citigroup’s fourth “Say on Pay” vote since 2009 – the first two were as a participant in the Troubled Asset Relief Program. I took at look at the support for the company’s executive compensation program over this entire period, which went from 82% in 2009, 89% in 2010, and 93% in 2011 to just 45% in 2012. So it appears that there was a fairly consistent level of support for the program, which spiked in 2011 (the second consecutive year in which the company’s CEO received essentially nominal compensation – $1 in 2010 and $128,000 in 2009) before the bottom fell out.
Still, it’s difficult to understand how this happened – or whether the company saw it coming, particularly when you look back on its Item 402(b)(1)(vii) disclosure from this year’s Compensation Discussion and Analysis:
As part of the process for making incentive awards to the named executive officers for 2011, the committee considered the most recent “say on pay” non-binding stockholder advisory vote held in April 2011 regarding the named executive officers’ 2010 compensation. The resolution approving 2010 executive compensation received a 92.9% favorable vote. Several key features of the 2010 program for named executive officers are carried forward to this year, such as substantial deferred amounts, performance-based vesting of certain deferred incentive awards, a four-year deferral period, significant stock awards that are subject to clawbacks and a stock ownership commitment, and limitations on perks. To better understand the reasons for the favorable say-on-pay vote and potential stockholder concerns for 2011, management engaged in stockholder outreach at various times during 2011 to discuss executive compensation in the context of Citi’s sustained profitability. In particular, management sought a better understanding of stockholder views on Citi’s disclosure and compensation processes and the priorities of our investors. The committee considered the outcome of the most recent say-on-pay vote and stockholder perspectives generally as factors in the 2011 compensation process in addition to currently applicable regulatory requirements, market considerations, and company and individual performance.
The recent issue of “Directors & Boards” ran this interview with consultant Don Delves, a frequent speaker at our week of executive pay conferences, repeated below:
With the advent of shareholder “say-on-pay” votes, has proxy statement disclosure of executive pay improved significantly?
Surprisingly, no, it has not changed all that much. Some companies have added an executive summary, or some useful tables showing the relationship between pay and performance. Most companies seem to be sticking with the traditionally dense legalese, painfully small type and extensive footnotes that make proxy statements so challenging to read and navigate.
Are there exceptions that stand out?
Yes, Coca Cola, Prudential, and Celanese really stand out. I am sure there are others, but I have found these three almost enjoyable to read. They actually seem to care about the reader and want the reader to understand and appreciate how – and why – their compensation programs are put together, and why they paid what they paid.
What stands out about these three proxy statements in particular?
Some of it is very simple. They all depart from the small, dense type and use more friendly, readable fonts and headings. They all use color well and intersperse well designed summary tables and charts which are easy to read and understand. The language is also different. While very thorough, the explanations are helpful and informative and written in relatively plain English. Coca Cola in particular seems to have adopted a no-footnotes standard. Instead of extensive footnotes, they have explanations.
Do you think this kind of disclosure will have an effect on shareholder voting?
That is unlikely, but the communication from these three companies is clear – we are proud of our pay programs; we have nothing to hide; we want you to understand how and why we pay our executives.
Are there other examples of disclosure that you find particularly helpful or useful?
Yes, Kimberly Clark has some excellent charts and tables that show the historical relationship between pay and performance. GE has a very good summary at the beginning of the proxy and shows both reported pay and “realized” pay. Best Buy and AT&T clearly describe the principles they operate by.
If a company was going to change one or two things to improve its proxy disclosure, what would you recommend?
Probably the most helpful thing is to answer most shareholders’ main question: How did you perform and how did that affect compensation? Provide a short, bullet-point summary, either at the beginning of the proxy, or the beginning of the CD&A, stating “here is how we performed…” and “this resulted in an annual incentive payout of X and a long-term incentive payout of Y.”
Secondly, look for opportunities, wherever possible, to summarize the design, goals, measures and payouts of incentive plans in tables, rather than verbally. Make it easy for the reader to understand your pay programs and pay actions. Also, look for opportunities to demonstrate the link between pay and performance.
Is there a trend you would like to see other companies follow in the future?
Yes, but it is not a trend yet. Follow Coca Cola’s example and have a communications expert, instead of a legal expert, prepare the proxy statement.
Here’s something I recently posted in Towers Watson’s blog: In the past, we’ve been critical of Compensation Discussion and Analysis (CD&A) disclosures containing boilerplate statements that don’t change from year to year. Not only has the SEC stated its disdain for boilerplate in its regulatory guidance, but we’ve long advocated that companies should omit repetitious disclosures that don’t add to shareholders’ understanding of pay decisions made or performance resulting in payments earned.
Now comes a recent say-on-pay court opinion that has us thinking that maybe that view should not apply to discussions of pay philosophy. Thanks to Mark Poerio’s blog that tracks executive pay litigation, we read the recent California Superior Count order dismissing the suit against Jacobs Engineering and were struck by how the judge reached his conclusion.
Among other claims, the plaintiff contended that the company’s board had authorized executive pay packages “in direct violation of the Board’s purported ‘pay for performance’ executive compensation policy and its own public statements, and it casts doubt upon the Board’s loyalty and business judgment.” The court cited favorably the fact that the company’s proxy statement for 2010 went into great detail about its compensation philosophy of using a mix of salary, short- and medium-term incentive compensation, equity-based compensation and benefits to:
– “Enable the Company to attract, motivate and retain highly-qualified executives by offering competitive compensation;
– Reward executives for superior performance through a performance-based cash incentive bonus program that places a substantial component of pay at risk based on the Company’s financial results;
– Provide retention and future performance incentives through the use of long-term equity based incentives and mandatory bonus compensation deferral vehicles;
– Encourage executives to have an equity stake in the Company; and
– Align the interests of the Company’s executives with shareholder interests.”
The California court found these disclosures set the stage for the actions taken by the compensation committee, guiding it to award a mix of stock options and longer-vesting restricted stock instead of relying predominantly on stock options. The court then cited the following passage from the Jacobs proxy:
“In the prior year, executive officers generally received stock options. Management and the HR&C Committee believe that the grants made in 2010 align executives with the Company’s and shareholder’s interests. In determining equity awards to executive officers for 2010 the HR&C Committee considered the survey data with regard to practices in the direct peer and general industry group, accounting impact on earnings, the CEO’s recommendations with respect to all executive officers other than himself, the HR&C Committee’s own evaluations of the individual contribution and performance of each of the executive officers and previous equity awards to executive officers.”
The court was then able to conclude that there was no reason for it to question that the business judgment rule protected the actions taken by the compensation committee, based on the CD&A description, and that the complaint should be dismissed.
It seems to us the statement cited by the court is rather generic, providing few details of why the compensation committee awarded equity of the magnitude it did at a time of declining returns to shareholders. But, the court did not see a need to get into such details because it was simply looking to see if there was some evidence from the proxy that the compensation committee had exercised its judgment. Once it found the evidence the committee had done so, the path was clear for it to honor the protections afforded by the business judgment rule.
The question at hand is whether the inclusion of the compensation philosophy was essential to the dismissal of the case. Said differently, would the court have dismissed the case anyway had the CD&A omitted the discussion of the compensation philosophy and instead simply mentioned the reasoning of the compensation committee in making the equity grants? These are open questions companies should ask of their litigation counsel as they determine how the say-on-pay lawsuits will influence their 2012 proxy disclosures.