A federal magistrate (DC Ore) ruled that a shareholder derivative action alleging that board members breached their fiduciary duty of loyalty with regard to executive compensation failed to show the futility of pre-suit demand on the board because, despite a negative shareholder say on pay vote, the challenged action was protected by the business judgment rule. The shareholder advisory vote on executive compensation, mandated by the Dodd-Frank Act, resulted in 62 per cent of the shareholders rejecting the pay package. (Plumbers Local No. 137 Pension Fund, et al. v. Davis, et al, DC Ore, Civ. No. 03: 11-633-AC, Jan. 11, 2012)
The shareholders’ allegations did not dispel the presumption that the board’s compensation decisions could be attributed to a rational purpose. Specifically, the allegation that the board violated the company’s pay for performance policy was not sufficient to overcome the business judgment presumption. The fact that the board’s compensation decision does not square with the shareholder’s interpretation of the pay for performance policy is not the equivalent of an allegation that the board intentionally misled shareholders that it would follow the policy when it actually had no intention of doing so.
Compensation determinations are typically within the business judgment of the board and the allegations here were not sufficient to overcome the presumption that the board exercised business judgment. The board’s actions did not directly defy or violate any company by-law, any shareholder agreement, or any legally mandated disclosure or reporting requirement, noted the magistrate. The shareholders rely on a pay for performance policy that does not establish a binding standard for compensation.
Citing Delaware precedent, the magistrate noted that futility of demand can be shown in one of two ways. First, demand is futile when the directors are not independent or disinterested. Second, demand is futile when there is a reasonable doubt that the challenged transaction was not the product of a valid exercise of business judgment. The shareholders failed to satisfy either test.
In this situation, only one director, the CEO, stood to personally benefit from the compensation decision. Thus, a majority of the board was not interested in the decision. The magistrate rejected the contention that the interest needed to excuse demand existed because the board members face a substantial likelihood of liability.
The court similarly rejected the contention that the board lacked independence because it was subject to the outsized influence of the CEO, the only director with a personal interest in the compensation package. To accept that contention, reasoned the magistrate, would effectively erase the demand requirement and negate its purpose.