Saturday, September 24, 2011

Federal Court Rules that Plaintiff Stated a Claim for Breach of Duty of Loyalty in Wake of Shareholder Negative Say-on-Pay Vote

In the wake of a negative shareholder advisory vote on a company's executive compensation package, a federal judge ruled that company shareholders adequately stated a claim for breach of the duty of loyalty against the company's board of directors for granting $4 million in bonuses on top of $4.5 millon in salary and other compensation in the same year the company incurred a $61.3 million decline in net income, a drop in earnings per share from $.037 to $.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8 percent shareholder return. Normally a board is protected by the business judgment rule when making decisions about executive pay, said the judge, and a court will not inquire into the wisdom of actions taken by a director in the absence of fraud, bad faith, or abuse of discretion. But the business judgment rule is a presumption that can be rebutted by a plaintiff with factual evidence that board members acted disloyally. NECA-IBEW Pension Fund v. Cox, et al, SD Ohio, No. 1:11-civ-451, Sept 20, 2011.

The court also ruled that pre-suit demand on the directors was futile and hence not necessary. The plaintiff alleged specific facts raising a doubt the the directors could make an unbiased independent business judgment about whether to sue. The directors devised the challenged compensation, approved the compensation, recommeded that the shareholders approve the compensation in the Dodd-Frank mandated vote, and then suffered a negative shareholder vote on the compensation.

Dodd-Frank requires public companies to include a shareholder advisory vote on executive pay in their proxies at least every three years. Pursuant to this provision, the company included a say on pay provision in the proxy seeking shareholder approval of the 2010 compensation package. The board recommend that shareholders support the executove compensation. But 66 percemt of the company's voting shareholders voted against the 2010 executive compensation. Citing the shareholder rejection of the executive compensation, plaintiff alleged that the board breached its fiduciary duty of loyalty when it approved large pay raises and bonuses for senior officers in a year when the company performed dismally.

The court ruled that the plaintiffs adequately pled that the board is not entitled to business judgment protection for its 2010 executive pay hikes. The factual allegations raised a plausible claim that the multi-million dollar bonuses approved by the board at a time of declining corporate performance violated the company's pay for performance compensation policy and were not in the best interests of the shareholders and thus constituted an abuse of discretion and/or bad faith.

The court noted that the directors may offer the business judgment rule defense at trial, where the plaintiff may well not be able to prove by clear and convincing evidence that the directors acted with a deliberate intent to cause injury to the company or reckless disregard for the best interest of the company.

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