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July 1, 2013 Experts Corner

Minimizing litigation risk on compensation disclosure

Sabino Rodriguez
Glenn Dowd
By By: Sabino Rodriguez and Glenn Dowd

Public companies are required to present shareholders with the opportunity to express their assessment of senior executive compensation arrangements through an advisory vote commonly referred to as “say on pay.”

Some companies receiving a significant number of negative votes have been the subject of largely misguided class action lawsuits challenging the adequacy of the company’s compensation disclosure.

For the most part, these suits have been promptly settled or dismissed, but they can be a costly nuisance.

More recently, some plaintiffs’ lawyers have sought to challenge more esoteric alleged disclosure inadequacies. There have been suits, for example, alleging a company’s failure to follow its “section 162(m)” policy. Section 162(m) of the internal revenue code disallows a deduction for non-performance based compensation in excess of $1 million for the five named executive officers identified in the company’s proxy.

These suits generally allege that the company has a plan or arrangement that includes such disallowed compensation notwithstanding disclosure to the contrary. These suits too tend to be frivolous and divert resources.

On the positive side, expanded securities regulation of executive pay has improved compensation practices and disclosure. At the margin, there are fewer pricey perquisites, fewer tax gross ups, and there is a greater emphasis on so-called “pay for performance.”

More importantly, there is a perceptible shift in emphasis from annual cash bonuses tied to short-term financial performance to include longer term equity-based incentives, with the better practice including equity-based awards that vest only upon attaining performance criteria.

Increased scrutiny is now required of pay practices that could encourage inappropriate risk taking. While this requirement started for financial institutions, the risk evaluation is now required of all public companies. A concern would be a compensation program that overemphasizes short-term goals, often a risk where a compensation program relies too heavily on annual bonuses.

But it is important to distinguish shareholder action through the “ballot box” of a shareholder vote, which is open for participation by all shareholders, from litigation, which is very often narrow, focused on alleged procedural failings, and lawyer-centric.

Litigation has its place, but these suits largely have been a distraction. The best protection against these modern day strike suits is informed decision making by the company’s compensation committee anchored in a sound compensation process, and fulsome disclosure.

Boards of directors and compensation committees of the board are afforded substantial latitude in exercising their business judgment in compensation matters.

Courts generally avoid substituting their judgment for that of directors as long as the directors have complied with their fiduciary duties of care and loyalty.

The directors must take steps to be reasonably informed and act in good faith, disclosing to the other directors any possible conflicts and not acting out of self-interest.

Thus, a key in directors avoiding an adverse judgment in executive compensation related litigation is ensuring that they are well informed by appropriate independent compensation consultants and counsel, and follow sound procedures in their deliberations and decision making.

On the near horizon are anticipated rules, including rules on claw backs, which may provide a meaningful safeguard for shareholders. Rules comparing CEO compensation to a company’s financial performance are also late in coming, though some companies have created their own pay-for-performance disclosure.

And there will be increased disclosure on so-called “realizable pay” to facilitate cross-industry comparisons of compensation.

On the other hand, Congress should be encouraged to allow the U.S. Securities & Exchange Commission to abandon the yet-to-come burdensome rules on the disclosure comparing CEO pay to median employee pay, which will provide little meaningful information.

But without regard to the scope of executive compensation disclosure rules, as long as the plaintiffs’ attorneys believe there is money to be made, lawsuits will be filed.

The best protection against lawsuits is a meaningful executive compensation process, coupled with conscientious disclosure reflecting informed decision making, in particular with respect to named executive officer compensation arrangements and decisions.

These practices increase the likelihood that such a lawsuit can be timely dismissed.

Success in a shareholder say on pay vote and compensation related votes generally requires something more — a succinct and rational explanation of the executive compensation program, how it supports the institution’s business objectives, and how it assures that the interests of senior management are aligned with those of the shareholders, including avoidance of excessive or inappropriate risk taking.

While clear, compliant and thorough proxy disclosure is important, the increased focus on say on pay and compensation best practices often demands that the company’s senior management have an ongoing dialog with the company’s shareholders, especially where the institution is contemplating an action that may be perceived to be outside the norm by some, including the proxy advisory firms .

Sabino Rodriguez is a partner in the New York City office of Day Pitney LLP. He advises clients on executive compensation, governance and structure, and tax-sensitive transactions. Glenn Dowd is a partner in the Hartford office of Day Pitney LLP. He represents companies in employment and litigation matters.

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