Shareholder “Say on Pay” – Can it Expose Directors to Liability?

[Editor’s Note: Over the past month, faculty members have been posting on upcoming judicial decisions of particular interest. This is the fourth post in the series.]

In January of 2011, the Securities and Exchange Commission, as part of its implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, began requiring U.S. public companies to provide their shareholders with a non-binding vote on the compensation of certain executive officers. This “say on pay” gives shareholders an advisory say on the amount of compensation paid to those executives. Related disclosure is also designed to prompt the board to consider how the “say on pay” vote affects its broader executive compensation policies and practices.

The Dodd-Frank Act specifically provides that the shareholder say-on-pay vote is not intended to affect directors’ fiduciary duties. Despite this, in at least two cases, shareholders have sued directors for breaches of their fiduciary duties, primarily on the basis that they implemented compensation practices that shareholder had voted against.

In one of these cases, Beazer Homes, a Georgia state court, applying Georgia law, dismissed the breach of fiduciary duty claim brought by a shareholder. The court held that a failed say-on-pay vote alone is not sufficient to rebut the presumption that directors acted in the best interest of shareholders.

However in another case, an Ohio district court, applying Ohio law, refused to dismiss a similar claim against the directors of Cincinnati Bell. As in the Beazer Homes case, the shareholders in Cincinnati Bell alleged that the board of Cincinnati Bell breached their fiduciary duties in deciding to pay executives compensation despite a decline in net income for the year and a shareholder vote against that pay. The court viewed the failed shareholder say-on-pay vote as highly probative of the fact that the compensation payments were not in shareholders’ best interest, at least for purposes of denying the directors’ motion to dismiss. Thus despite Congress’ intent, as expressed in the Dodd-Frank Act, of not altering directors’ fiduciary duties as a result of a failed shareholder say-on-pay vote, the court in Cincinnati Bell did consider such a failed vote in finding a plausible fiduciary duty claim.

The Cincinnati Bell court’s rationale obscures an important reality: that is, a shareholder vote that opposes a matter of director business judgment does not, by itself, establish that the board was not acting in shareholders’ best interest. Indeed as I have argued elsewhere, many shareholders are short-termists, meaning that they focus primarily on a firm’s generation of short-term profits and not on its creation of long-term true value. Shareholders with such a short time horizon would undoubtedly prefer compensation arrangements that rewarded executives for achieving short-term, rather than long-term, performance targets. Thus, weak shareholder support for a board’s proposed executive compensation package might to some extent reflect shareholders’ desire for compensation arrangements that reward executives for being myopic rather than long-termists.

That is not to say that a failed shareholder vote on executive compensation should not play any role in establishing directors’ breach of fiduciary duties. For example, a failed vote, followed by no inquiry on behalf of a board’s compensation committee for the reasons for that failed vote, might help show a lack of diligence that fiduciary duties are intended to police. However, a failed say-on-pay vote should not alone prove that directors were not acting in shareholders’ best interest. Hopefully the court, with a fuller factual record, will come to the same conclusion.

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