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March 11, 2013
Emerging Trends in Say-on-Pay Disclosure
By Juan E. Monteverde, Ross A. Appel, and Emily C. Komlossy – March 11, 2013
Proponents of Dodd-Frank’s say-on-pay provision envisioned greater corporate transparency and accountability and, as a result, “greater efficiency and social responsiveness.” Randall S. Thomas et al., “Dodd-Frank's Say on Pay: Will It Lead to a Greater Role for Shareholders in Corporate Governance?,”97 Cornell Law Review, 1213, 1228 (2012) [hereinafter Thomas]. Indeed, those who fought for the legislation did so because of the need for greater transparency. See Empowering Shareholders on Executive Compensation: Hearing on H.R. 1257 Before the H. Comm. on Fin. Servs., 110th Cong. 68 (2007). However, a cynical view and a dismissive attitude toward that spirit of transparency have hindered the ability of public shareholders to evaluate the information necessary to determine whether their interests are properly aligned with company executives. In recent months, shareholder challenges to disclosures in proxy statements containing say-on-pay advisory votes have raised questions that will be addressed in this article and in the courts.
Excessive Executive Pay
From 1970 to 1999, the average annual real compensation of the top 100 CEOs increased by over 2,800 percent, while the average annual salary in the United States increased by approximately 10 percent. See Paul Krugman, “For Richer,” New York Times, Oct. 20, 2002. Additionally, 97 percent of companies paid their executives bonuses in 2011, regardless of whether company performance fell below the median of industry peers. Nell Minow, “Executive Decisions: Why CEO Pay Spun Out of Control,” The New Republic, Feb. 8, 2012. Executive compensation not only has increased at an incredibly disproportionate rate from the average worker’s salary, but CEO compensation increased more than 725 percent between 1978 and 2011, nearly two times greater than stock market growth over the same period. See Lawrence Mishel and Natalie Sabadish, CEO Pay and the Top 1%: How Executive Compensation and Financial-Sector Pay Have Fueled Income Inequality, May 2, 2012, Economic Policy Institute.
Enter Dodd-Frank’s Say-on-Pay
Beginning in 2009, Congress required say-on-pay votes for all financial firms receiving Troubled Asset Relief Program (TARP) funds. All the while, advocates of a say-on-pay vote anticipated that providing shareholders with an advisory vote on executive compensation would stop executive pay from spiraling out of control. Id. at 1232. AFSCME, for example, expected that a say-on-pay vote might reduce excesses in executive pay. Harvard law professor Lucian Bebchuk projected that say-on-pay votes would make directors more attentive to shareholder views and could potentially deter some egregious compensation arrangements. See id. at 1232–33. Members of Congress similarly anticipated the potential positives that could flow from these votes, such as transparency, an ability to put a halt to pay structures that encourage excessive risk-taking and the potential alignment of pay with financial performance. Id. at 1235. With this backdrop of seeking transparency and accountability, the say-on-pay requirement was extended to all public companies when Congress passed Dodd-Frank. Id. at 1218.
While legislation concerning executive pay continues to evolve in the United States and around the world, the United Kingdom recently unveiled legislation that would give investors a binding vote on executive pay. It remains to be seen whether a binding vote on executive pay represents the next step taken in the United States to curb excessive executive pay.
Evolution of Disclosure Requirements
In 1977, the Supreme Court of Delaware decided Lynch v. Vickers Energy Corp., 383 A.2d 278 (Del. 1977), described by the court as “[t]he genesis of Delaware law regarding disclosure obligations.” Arnold v. Soc’y for Sav. Bancorp, 650 A.2d 1270, 1276 (Del. 1994). There, in the context of a self-dealing transaction, the court recognized the fiduciary duty of “complete candor,” of “complete frankness” under which “[c]ompleteness, not adequacy, is both the norm and the mandate[.]” Lynch, 383 A.2d at 281. This duty, which is actually simply “the application in a specific context of the board’s fiduciary duties of care, good faith and loyalty,” (See Malpiede v. Townson, 780 A.2d 1075, 1086 (Del. 2001)) has evolved over time and has been applied in many contexts. The importance of complete disclosure of material information is easy to comprehend in the context of a merger, a context in which it is often applied. The Delaware Court of Chancery explained this importance in Maric Capital Master Fund, Ltd. v. Plato Learning, Inc., 11 A.3d 1175, 1178 (Del. Ch. 2010), stating that the “question that . . . investors should be asking in determining whether to vote for the cash merger is clear: is the price being offered now fair compensation for the benefits I will receive as a stockholder from the future expected cash flows of the corporation if the corporation remains as a going concern?” Indeed, as Vice Chancellor Laster stated, “[t]his is it. This is the end. This is the only opportunity where you can depend upon your fiduciaries to maximize your share of that value.” Steinhardt v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. Jan. 24, 2011) (Preliminary Injunction Hearing Transcript at *6).
However, Delaware courts have also recognized the importance of shareholders’ right to vote on issues of corporate governance. Mainiero v. Microbyx Corp., 699 A.2d 320, 324 (Del. Ch. 1996). The Supreme Court of Delaware has held that “the stockholders control their own destiny” and that “[t]his is the highest and best form of corporate democracy.” Williams v. Geier, 671 A.2d 1368, 1381 (Del. 1996). To downplay the significance of a shareholder’s need for full disclosure simply because it is outside of the context of a merger not only unnecessarily diminishes the role of a shareholder, but it also mischaracterizes, or at least attempts to avoid, legal precedent. Delaware courts have held time and again that the duty of full and fair disclosure extends to material information even when no shareholder action is requested. Ciro, Inc. v. Gold, 816 F. Supp. 253, 266 (D. Del. 1993); Marhart, Inc. v. CalMat Co., No. 11,820, 1992 Del. Ch. LEXIS 85 (Del. Ch. Apr. 22, 1992); Malone,722 A.2d at 10. Delaware follows the federal standard for materiality. If there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available,” it is material and must be disclosed. Arnold, 650 A.2d at 1277. A plaintiff need not show that disclosure of the information would change their vote. David P. Simonetti Rollover IRA v. Margolis, No. 3694-VCN, 2008 Del. Ch. LEXIS 78, at *19 (Del. Ch. June 27, 2008). Rather, a fact is material and must be disclosed “if there is a substantial likelihood that a reasonable stockholder would consider it important in deciding how to vote.” Skeen v. Jo-Ann Stores, Inc., 750 A.2d 1170, 1172 (Del. 2000). In Malone v. Brincat, the Supreme Court of Delaware held that “[w]henever directors communicate publicly or directly with shareholders about the corporation’s affairs, with or without a request for shareholder action, directors have a fiduciary duty to shareholders to exercise due care, good faith and loyalty.” Malone, 722 A.2d at 10. Thus, courts have recognized that, under state law, directors owe a fiduciary duty of honesty or complete candor in their communications to shareholders—including proxy statement communication, and therefore communications regarding the say-on-pay advisory vote— regardless of whether shareholder action is required. See Knee v. Brocade Comm’ns Sys., Inc., No. 1-12-CV-220249, slip op. at 2 (Cal. Super. Ct. Santa Clara Cnty. Apr. 10, 2012) (Kleinberg, J.) (enjoining the 2012 shareholder vote because certain information relating to projected executive compensation (as related to an equity plan share increase that had a potential dilutive effect on shareholders) was not properly disclosed in the proxy statement).
A Federal Question?
Quite simply, directors are subject to the fiduciary duties of due care, good faith, and loyalty. The court in Malone further reasoned that this triad of fiduciary duties “is the constant compass by which all director actions for the corporation and interactions with its shareholders must be guided.” Malone, 722 A.2d at 10. Thus, the plaintiffs’ claims are governed by the notion that directors have an ever-present fiduciary duty to shareholders to deal with their stockholders honestly about the company’s corporate affairs, regardless of the context of the vote. See id. Accordingly, federal laws are not at issue regarding state law claims alleging breach of fiduciary duty in say-on-pay disclosure claims.
It has been hypothesized that peer benchmarking is one of the main forces behind the ever-rising executive salaries. See, e.g., Charles M. Elson & Craig K. Ferrere, “Executive Superstars, Peer Groups and Over-Compensation—Cause, Effect and Solution,” Journal of Corporation Law (forthcoming Spring 2013). Some say that significant competition to attract and retain executive talent exists. This competition, whether real or perceived, ultimately has the effect of inefficient benchmarking, with firms seeking to pay executives more and more while corporate performance remains stagnant. This “leapfrog effect” is the result of companies targeting compensation levels at a certain percentile of their peer companies’ executive pay, which inevitably leads to overpayment. See id. The leapfrog effect is the resultant carry-through of one company’s overpayment as it works its way through the market and simply leads to companies then offering even higher compensation to executives to outdo the first company. This fact alone necessitates the disclosure of peer benchmarking analyses so that shareholders can assess and determine the efficacy of the given analyses. Of course, every company is different, and directors will review and rely on different analyses prior to recommending shareholder approval of executive compensation. Thus, the information that must be disclosed can vary.
Should Shareholders Perform Their Own Analyses?
The holding in TWA is no outlier. In Turner v. Bernstein, 776 A.2d 530 (Del. Ch. 2000), plaintiff shareholders similarly alleged that company directors breached their fiduciary duties by failing to provide stockholders with information material to the decision of whether to approve a merger. Turner, 776 A.2d at 531. The board did not give shareholders any current financial information or explain why the merger was in their best interests. Instead, it told stockholders that they could call the company with any questions. Id. at 532. The court held that shareholders are not required to “ask a series of detailed questions to elicit the material fact[s].” Id. at 544.
More recently, in St. Louis Police Ret. Sys. v. Severson, 2012 U.S. Dist. LEXIS 152392 (N.D. Cal. Oct. 23, 2012), the plaintiff alleged that the proxy statement issued in advance of the annual shareholder meeting was misleading because it failed to disclose all material information relating to an amendment of an equity incentive plan. St. Louis Police Ret. Sys. v. Severson, 2012 U.S. Dist. LEXIS 152392, *1-2. The proxy statement did not include certain information about the incentive plan that had been included in a Form 8-K filed with the SEC approximately one month before the filing of the proxy statement; defendants argued that the information was already available to shareholders and did not need to be repeated. Id. at *4–5, 8. The court, granting an injunction, held that information included in an earlier Form 8-K was not “incorporated by reference” in the 2012 proxy statement and was not readily available to shareholders simply because it was filed with the SEC. Id. at *7-16. Similarly, where defendants in say-on-pay disclosure cases point to the fact that portions of the benchmarking data they review are contained in each of their peers’ SEC filings, that defense is unlikely to succeed. See Shaev v. Saper, 320 F.3d 373, 381 (3d Cir. 2003) (“Material not included in the proxy statement is generally not charged to the knowledge of the stockholder.”). By not disclosing information and relying on the fact that snippets of the information are disclosed in other SEC filings in piecemeal fashion essentially requires that shareholders ask a series of detailed questions and seek out a number of other SEC filings to find the sought-after material facts.
There is a counterargument, often raised, that additional disclosure may provide too much information. In Solomon v. Armstrong, 747 A.2d 1098, 1130 (Del. Ch. 1999), the court held that directors should not be “forced to bury the shareholders in an avalanche of trivial information” or “shareholder solicitations would become so detailed and voluminous that they will no longer serve their purpose.” Id. The fact that a given proxy statement may already contain 80 pages is no argument for withholding material information. It is the quality of the information that is important. Material information should be disclosed (and in fact, must be disclosed) at the expense of trivial information.
Advisory Nature of Say-on-Pay Vote Does Not Alter Its Significance
Most companies generally declare within their proxy statements that while the say-on-pay vote is indeed not binding, the compensation committee of the board and the board value shareholders’ opinions and will consider the outcome of the say-on-pay vote when establishing pay practices and making future compensation decisions. For example, the proxy statement filed by The Dow Chemical Company in March 2012, states that “[t]his advisory resolution is non-binding on the Board of Directors” and “[a]lthough non-binding, the Board and the Committee will review and carefully consider the voting results when evaluating our executive compensation program.” However, without disclosure of all material information to shareholders, the say-on-pay vote can potentially have the unintended effect of establishing and/or entrenching inefficient pay practices. Indeed, companies are currently required to disclose how they considered the results of the prior-year’s say-on-pay vote in determining compensation policies and decisions and how the compensation policies and decisions were ultimately affected. This underlies the significance of the Say-on-pay vote and demonstrates that genuine changes to corporate governance may result from the vote. In order to be meaningful, however, it is necessary to ensure that shareholders are not relying on incomplete information when voicing their opinions on executive compensation.
Others have pointed to the dismissal of cases that were brought post-vote as derivative cases regarding say-on-pay as an indication that cases regarding say-on-pay proxy disclosures will suffer a similar fate. The cases and the context are quite different. For example, Delaware courts have stated a preference for having proxy-related disclosure claims brought prior to the shareholder vote because once the vote has occurred on incomplete information, further disclosure may be of no use. Globis Partners, L.P. v. Plumtree Software, Inc., No. 1577-VCP, 2007 Del. Ch. LEXIS 169, at *37–38 (Del. Ch. Nov. 30, 2007). The post-vote cases have generally challenged the efficacy of a given company’s executive compensation practices, not the pre-vote disclosures made to shareholders. These cases have sought to cause corporate change regarding executive pay practices. See Assad v. Hart, No. 11cv2269 WQH (BGS), 2012 U.S. Dist. LEXIS 2366, at *5–6 (S.D. Cal. Jan. 6, 2012) (Plaintiffs alleged that defendants breached their fiduciary duties by failing to amend or alter executive compensation in connection with a negative say-on-pay vote). It simply does not follow that because reform cannot be forced upon a board following an advisory vote, that recognized fiduciary duties can simply be ignored and that shareholders need not be provided all material information in a proxy statement, as is always the requirement. Quite simply, the advisory nature of the vote and the inability to force change upon a board does not alter the legal requirements that proxy disclosures include all material information.
Are the Claims Derivative in Nature?
Similarly, on the second prong, which seeks to identify “who would receive the benefit of any recovery or other remedy . . . ?”, (Id.) the answer is again quite clear. The benefit of further disclosure inures to the shareholders, not the company, with a view towards ensuring that shareholders are able to cast informed votes regarding the say-on-pay proposal. The remedy—disclosure of material information—allows for shareholders to have their fully informed vote. Indeed, the Delaware courts have repeatedly held that disclosure allegations relating to proxy materials are direct claims. In In re J.P. Morgan Chase & Co. S'holder Litig., 906 A.2d 766, (Del. 2006), shareholder plaintiffs alleged that J.P. Morgan Chase & Co. issued a proxy statement that omitted material information in connection with a merger. In re J.P. Morgan Chase & Co. S’holder Litig., 906 A.2d at 768. Upon considering whether the proxy disclosure claim was direct, the court held that “where it is claimed that a duty of disclosure violation impaired the stockholders’ right to cast an informed vote, that claim is direct.” Id. at 772. Moreover, in In re Tyson Foods, Inc., 919 A.2d 563 (Del. Ch. 2007), plaintiffs challenged the disclosures regarding the directors up for election made in a 2004 proxy statement. In re Tyson Foods, Inc., 919 A.2d at 580. The court there held that “[w]here a shareholder has been denied one of the most critical rights he or she possesses—the right to a fully informed vote—the harm suffered is almost always an individual, not corporate, harm.” Id. at 601. The court expounded, noting that “[w]ithholding information from shareholders violates their rights even if it leads to them making the ‘right,’ and even highly profitable, result.” Id. at 602.
Perhaps in an attempt to sway public opinion, some make mention that while some lawsuits have provided additional disclosure upon which shareholders can base an informed say-on-pay vote, shareholders have not received any cash as a result of the litigation. Such a suggestion ignores the claims asserted in the litigation and the nature of the relief sought. These lawsuits seek the substantial benefit of achieving the disclosure of all material information so that shareholders can have their informed vote on executive compensation. Monetary damages cannot vindicate a shareholder’s right to cast an informed vote. The Delaware Court of Chancery has made clear its preference for supplemental disclosures to be made in advance of a vote because such a remedy “gives stockholders the choice to think for themselves on full information, thereby vindicating their rights as stockholders to make important voting and remedial decisions based on their own economic self-interest.” See In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171, 208 (Del. Ch. 2007). Indeed, Delaware courts have also recognized that the lack of monetary relief does not detract from the significance of non-monetary relief received in cases that achieve additional disclosure. See San Antonio Fire & Police Pension Fund v. Bradbury, C.A. No. 4446-VCN, 2010 Del. Ch. LEXIS 218, at *50 (Del. Ch. Oct. 28, 2010). It is thus disingenuous to suggest that shareholders are not benefited by additional disclosure of material information. While such lawsuits may not provide an immediate inflow of cash to shareholders, an informed vote on say-on-pay may very well have the effect of better aligning shareholder-executive interests, improving corporate governance, reducing agency costs, and leading to long-term increased value to the company and its shareholders.
The peripheral legal attacks described in this article (claims that the vote is non-binding and thus related information is immaterial, federal law preempts the allegations and that portions of the information are publicly disclosed) are likely nothing more than legal red herrings, unlikely to affect the outcome of a given case. In the end, the relevant legal question will be whether or not the information is material.