Nobody can accuse the plaintiffs' shareholder bar of suffering from a lack of creativity. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. Section 951 of Dodd-Frank requires a shareholder advisory vote on executive compensation (a "say-on-pay" vote). The Dodd-Frank Act, however, specifically provides that the say-on-pay vote (1) "shall not be binding on the issuer or the board of directors," and (2) does not "create or imply any change to the fiduciary duties of the board members." 15 U.S.C. § 78n-1(c). Nonetheless, following implementation of the law, the plaintiffs began filing derivative lawsuits alleging breach of fiduciary duty following negative say-on-pay votes. All but one of these cases was dismissed because the plaintiff failed to make demand on the company's board of directors before bringing suit. See , e.g., Gordon v. Goodyear, 2012 WL 2885695, *10 (N.D. Ill. July 13, 2012) (collecting cases).
The plaintiffs' bar has thus resorted to a new attack: Filing class action lawsuits to enjoin the say-on-pay votes based on allegedly incomplete and misleading proxy disclosures under Delaware law. In many cases, they also add allegations that the proxy statements omit information regarding votes to increase the number of shares available for issuance under a company's certificate of incorporation, votes to increase the number of shares authorized or reserved in connection with equity incentive plans, and votes setting performance goals to obtain tax deductible status for executive compensation under IRC § 162(m).
Plaintiffs' Modus Operandi
Plaintiffs have begun noticing investigation as soon as companies release their proxy statements. Plaintiffs have noticed more than 40 investigations in the last two months, all looking for a stockholder willing to serve as a named plaintiff. As of October 26, 2012, counsel had found stockholders to bring suit in 20 cases; though, of note, counsel appears to be using serial plaintiffs (a single stockholder who repeatedly serves as plaintiff for the same firm) in many of these cases.
The lawsuits share certain common characteristics. For the most part, plaintiffs bring suit: (1) based on purported omissions of material information in a company's proxy statement, not as an attack on the merits of the underlying actions; (2) for injunctive relief, not damages; (3) as putative class actions, not derivative actions; and (4) in the company's principal place of business, not Delaware.
In connection with the say-on-pay vote, the complaints generally allege that the following additional information should have been disclosed:
- A "fair summary" of the compensation consultant's analysis provided to the company's board of directors.
- The reasons that the company selected and/or changed its compensation consultant.
- The reasons that the company selected the particular mix of salary, cash incentive compensation, and equity incentive compensation.
- The reasons that the company selected particular companies as peers for purposes of benchmarking executive compensation.
- Details concerning financial and/or compensation metrics concerning the peer companies.
In connection with votes to increase the number of shares available for issuance under equity incentive plans, the complaints generally allege that the following additional information should have been disclosed:
- A "fair summary" of any compensation consultant analysis provided to the company's board of directors.
- Any projections considered by the company's board of directors concerning shares to be granted under equity incentive plans in the future.
- The reasons that the company determined the number of additional shares requested to be approved for issuance.
- The potential equity value and/or cost of the issuance of the additional shares.
- The potential dilutive impact of the issuance of the additional shares.
Because these cases are fairly new, the plaintiffs' bar has seized the opportunity to frame the terms of the litigation. For the most part, plaintiffs are bringing these as claims for "material omissions," which - if taken at face value - makes it difficult (though not impossible) to obtain dismissal at the pleading stage, because materiality is ordinarily viewed as a matter for the trier of fact. See Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309. As a result, many defendants have been answering the complaints, instead of moving to dismiss, even following decisions by the courts denying expedited relief.
It is a mistake to allow plaintiffs to seize control of the discussion and frame the analysis only in terms of materiality. Plaintiffs have specifically stated they are not bringing suit under Rule 14a-9 of the Securities Exchange Act of 1934 (if they were to do so, the cases would be removable to federal court and subject to the Securities Litigation Reform Act's mandatory discovery stay). Instead, they bring suit under Delaware law based on alleged violations of the duty of candor, a duty recognized by the Delaware Supreme Court in Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998). Malone has been interpreted by the Delaware Court of Chancery as requiring plaintiffs to plead and prove all the elements of common law fraud, including: (1) material misrepresentations; (2) intent to deceive; (3) reliance; and (4) damages. See Metro Communication Corp. BVI v. Advanced Mobilecomm Technologies Inc., 854 A.2d 121, 131-32 (Del. Ch. 2004) (noting that the Supreme Court in Malone required plaintiffs to "show reliance and scienter" so that Delaware does not "encourage a proliferation of disclosure claims"). We believe that, when plaintiffs bring suit for a breach of the Malone duty, it is critical to hold them to the heightened standards for pleading and proof set forth by the Delaware courts in interpreting Malone.
It is an error to allow plaintiffs to characterize these claims as direct disclosure violations; rather, the claims should be considered derivative. A derivative claim belongs to the corporation and can be brought by a stockholder only if he or she first pleads specific facts establishing that the shareholder has either made a demand for litigation on a company's board (and the demand has been wrongfully refused) or that demand is excused. The proxy disclosure claims are derivative because any harm suffered by a less than fully informed say-on-pay vote or the authorization of excessive options is a harm suffered by the corporation itself and is actionable only as a claim for waste or dilution. See Feldman v. Cutaia, 951 A.2d 727, 732 (Del. 2008) (claims for dilution and based on a failure to disclose material information in connection with a vote on an employee stock option plan are derivative); Abrams v. Wainscott, 11-297-RGA, 2012 WL 3614638, *3 (D. Del. Aug. 21, 2012) (executive compensation disclosure claims are derivative). Further, because the facts alleged are properly cognizable only as claims for waste or dilution, the claims are not ripe until the defendant boards actually issue compensation or shares following the votes.
Plaintiffs have had limited success on these cases. A plaintiff obtained an injunction stopping a shareholder vote by Brocade Communications Systems, Inc., on increasing the number of shares available under an equity incentive plan and was awarded attorneys' fees of $625,000. Plaintiffs have obtained settlements in cases involving H&R Block, Martha Stewart Living Omnimedia, Inc., NeoStem, Inc., and WebMD, LLC for amounts between $125,000 and $450,000. In contrast, plaintiffs voluntarily dismissed a case against Amdocs after defendants opposed the preliminary injunction motion and moved to dismiss and plaintiffs also failed to enjoin shareholder meetings of Ultratech and AAR.
Despite plaintiff's mixed results, as companies with calendar year-ends enter the 2013 proxy season, filings are expected to accelerate. Plaintiffs, in general, have had more success on claims involving stock issuance than on claims involving just say-on-pay votes, and likely, moving forward, the plaintiffs will focus the lawsuits accordingly. Further, if the heightened burdens discussed above are adopted by the courts, plaintiffs may find it more economical to select their claims with more care.