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Executive compensation litigation – nightmare or nuisance?

execLitigationv2Prologue — The Continuing Scourge of M&A Litigation

Resourceful plaintiffs’ lawyers are always on the hunt for strategies to extract quick payoffs from public companies. Mergers and acquisition (M&A) litigation has for the last couple of years provided a stylized and fairly predictable ritual for plaintiffs lawyers and public companies. Almost all the M&A claims are resolved prior to the deal’s closing, the plaintiffs’ lawyers are awarded fees based on a sliding scale of accomplishment (low-end: some additional disclosure; high-end: increased purchase price), and everyone goes home happy — except, in many cases, D&O insurers. D&O insurers have responded to the avalanche of M&A litigation — more than 90% of deals for more than $100M draw litigation — by imposing separate, higher M&A retentions that in typical deals will leave the insurers unscathed. While there is some anecdotal evidence of cases that continue beyond the deal’s closing and result in more expensive settlements, most selling companies that have undergone robust and thorough pre-deal processes structured by experienced counsel have found M&A litigation to be an expensive nuisance.

Executive Compensation Litigation — a Play in 3 Acts (So Far)

Plaintiffs lawyers have in the last couple of years tried to open another financial spigot by suing companies over their executive compensation disclosures and practices.

There have been a few broad categories of executive compensation lawsuits. Many of the early cases were based on the so-called “Say on Pay” provisions of the Dodd-Frank reforms enacted in 2010. These require public companies to conduct advisory (non-binding) shareholder votes on executive compensation plans every three years. Plaintiffs lawyers have asserted that allegedly inadequate disclosures in the targeted companies’ proxy statements prevent shareholders from making informed decisions about executive compensation. To increase their leverage, plaintiffs lawyers sought to enjoin the scheduled shareholder meetings until sufficient disclosures were made. These cases had at best a mixed reception in the courts (which noted that the shareholder votes were non-binding), and a recent decision in Noble v. AAR Corp. provided a strong foundation for dismissing such cases generally. Some commentators think that “Say on Pay” cases are likely to be filed less frequently and be dismissed more often.

A second type of executive compensation lawsuit involves companies seeking shareholder approval for new executive compensation plans or for increases in the shares available under existing equity plans. Because shareholder approval is required, some courts have been willing to consider enjoining shareholder meetings until the adequacy of disclosure can be assessed. In at least two cases, courts have issued preliminary injunctions; in one of these, the case settled for supplemental disclosures and the payment of $625,000 in plaintiffs’ legal fees.

Perhaps perceiving greater risk than in the pure “Say on Pay” cases, some companies have been willing to settle for additional disclosure and the payment of plaintiffs’ legal fees. A number of these cases have cost companies several hundred thousand dollars in the aggregate, or even more — often enough to pierce the applicable retention for their D&O program and cause some complications at renewal, but rarely enough to cause a serious erosion of coverage limits. This type of case has frustrated companies, as it is always possible for plaintiffs to assert that the targeted company’s Board should have disclosed more about the reasons and methodologies that underlay their decision to seek increases in their stock plans.

Many companies have tried to inoculate themselves by working especially closely with their legal counsel to craft broader and more extensive proxy statement disclosure about their equity compensation plans, in the hope that plaintiffs’ lawyers will consider them to be less attractive legal targets. This appears to be a wise strategy. And while it is impossible to eliminate the risk of a claim, some companies with already-robust disclosure have been able to settle their cases quickly, with minor additional disclosures, and relatively inexpensively.

It also appears that there may be a correlation between the degree to which the targeted equity compensation plans are weighted toward corporate executives and/or directors, the success of plaintiffs’ motions to enjoin the scheduled shareholder meetings, and the ability of the targeted companies to get the cases dismissed quickly. Most executive compensation cases are filed at least in part as shareholder derivative claims under state law — the plaintiffs are purportedly acting in the name of the targeted company in seeking a recovery from the individual directors and officers for the alleged breach of their fiduciary duties. As it is the company’s own right to recovery that plaintiffs are purportedly seeking to vindicate, in most situations plaintiffs must, before filing suit, make a demand on the Board of Directors to investigate the allegedly improper conduct and seek restitution for the company from the defendant directors and/or officers if warranted. The obligation to make this demand is generally waived only if the plaintiffs can convince the court that directors were so self-interested in the matter that the Board was not sufficiently independent and demand would have been futile. Board investigations take time, and speed is a crucial weapon for plaintiffs in executive compensation litigation — they are trying to prevent shareholder meetings from being held as scheduled. The cases are therefore filed with assertions that the requirement of a demand on the Board was excused because of its presumed futility. Many executive compensation cases have been quickly dismissed because the targeted companies successfully rebutted the plaintiffs’ claims of “demand futility.” It is not surprising that courts may look more favorably upon “demand futility” arguments when the questioned compensation plans or awards highly reward the company’s most senior executives or especially the directors themselves.

A subcategory of executive compensation cases has involved the tax deductibility of certain kinds of compensation paid to public company executives in excess of $1 million per year. Section 162(m) of the Internal Revenue Code preserves the deductibility of compensation beyond this amount if the compensation is awarded under shareholder-approved plans that establish performance goals (as compared with, for example, compensation that vests with the passage of time) and satisfy other statutory criteria. Section 162(m) plaintiffs have alleged many different breaches — for example, that directors should have adopted plans utilizing this deductibility, or that plans in effect didn’t comply with statutory requirements. Most of these cases have been dismissed because the plaintiffs have failed to establish that making the statutory demand on the Board would have been futile. It is not clear how strong this type of claim will prove to be.

A twist on executive compensation litigation involves cases in which plaintiffs have alleged that companies’ stock plan awards to executives simply violated the relevant equity compensation plans. At least ten companies — and their directors — have been sued based on charges that they simply exceeded the allowable limits on the award of equity compensation to their executives (thus allegedly making their proxy statement disclosures false and misleading). It is too early to know how these cases will fare — whether courts will be more sympathetic to plaintiffs’ “demand futility” arguments and therefore refuse to dismiss cases quickly, or whether the plaintiffs misunderstood the relevant compensation plans and are mistaken in their analysis — but some commentators believe that these cases have the potential to be more troublesome for the affected companies.

Will executive compensation litigation become a nightmare or an expensive annoyance for public companies – is it the latest fad in an ongoing series of quick-hit, nuisance-level efforts by plaintiffs’ lawyers to replace the income they have lost in the recent decline of more traditional securities class action litigation? Broadly speaking, it seems reasonable to predict that consistently more robust and thorough corporate processes and proxy statement disclosures relating to executive compensation will lead to a decline in cases that don’t present what courts are likely to interpret as some supposedly aggravating factor. It also seems reasonable to predict that, based on the current crop of cases, such aggravating factors may be compensation awards to directors or alleged violation of the relevant compensation plans’ terms. Many of the cases, even without aggravating factors, cost the targeted companies several hundred thousand dollars in defense costs and the payment of plaintiffs’ legal fees as part of a settlement. At these levels, this type of litigation therefore seems unlikely to have a lasting impact on D&O insurance at a time when retentions are often already higher than those aggregate costs. Yet the targeted companies will face the expense and aggravation of these claims in the perpetual game of cat-and-mouse between them and the corporate plaintiffs’ bar.

About the Author

John Doernberg is a Vice President working with inside and outside counsel as a Claims Advocate for clients on policy negotiation and the handling and settlement of claims. He also serves as a resource on privacy, information security and risk management issues. Prior to becoming an insurance broker in 1995, he practiced corporate law in New York and Boston for 12 years.

617.646.0336 | JDoernberg@wgains.com | Connect with John via LinkedIn

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