The third proxy season of the Dodd-Frank Act’s mandatory shareholder "say-on-pay" advisory votes is well underway, and "round two" of shareholder say-on-pay litigation is in full swing. Unlike the first round of say-on-pay lawsuits, which were based on negative advisory votes that had already occurred, this second wave of shareholder litigation, which began in 2012, seeks to enjoin advisory votes on executive compensation based on allegedly deficient proxy disclosures. Some cases seek also to enjoin binding shareholder votes on proposals to issue additional shares of stock for equity incentive plans.

Because these lawyer-driven suits do not allege an actual violation of a disclosure statute or rule, every public company with a shareholder vote scheduled for the second half of 2013 is a potential target. The tight timeframe between the filing of a proxy statement and the annual shareholders’ meeting (usually 30 to 50 days) gives plaintiffs attorneys leverage to pressure targeted companies and boards to agree to a quick settlement to avoid the costly delay and disruption of their annual meeting. Such settlements usually involve the company’s agreement to amend its proxy with additional disclosures and payment of a plaintiff attorney fee. In many of these cases, however, courts have denied the plaintiff’s motion to enjoin the shareholder vote, and several courts have granted the defendants’ motion to dismiss the case altogether. Therefore, companies and their boards should develop a litigation strategy early on and be prepared to defend their proxy disclosures should they be sued.

Say-On-Pay Lawsuits Based On Negative Advisory Vote

Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 15 U.S.C. § 78n-1, mandates that, at least once every three years, public companies permit their shareholders to cast an advisory vote at their annual meeting to approve or disapprove of the compensation paid to the CEO and four other named executive officers during the prior fiscal year. Pursuant to the U.S. Securities and Exchange Commission’s implementing regulations, adopted in April 2011, a company must report the results of its shareholders’ say-on-pay vote on Form 8-K within four business days after the annual meeting and, in its proxy statement for the next annual meeting, disclose whether and, if so, how the company’s policies and decisions took into account the results of the say-on-pay vote.

The Dodd-Frank Act expressly states that shareholder say-on-pay votes "shall not be binding" on either the company or its board of directors and may not be construed as (1) overruling any decision by the company or its board; (2) creating or implying any change to the fiduciary duties of the company or its board; or (3) creating or implying any additional fiduciary duties for the company or its board. Notwithstanding these statutorily-imposed restrictions on the legal effect of say-on-pay votes, plaintiffs lawyers immediately began filing shareholder derivative actions against directors and officers of companies that failed to obtain a majority shareholder vote in favor of the recommended executive compensation. This first wave of say-on-pay lawsuits alleged that the companies’ directors and officers breached their fiduciary duties by adopting executive compensation plans notwithstanding the shareholders’ negative advisory vote.

Most of the cases in this first round of say-on-pay litigation resulted in dismissal for failure to plead the two prongs of demand futility: (1) that the directors are not disinterested or independent, and (2) that the challenged transaction was not the product of a valid exercise of business judgment. (See, e.g., Robinson Family Trust v. Greig, No. 5:12 CV 1713, 2013 U.S. Dist. LEXIS 66995, at *8-19 (N.D. Ohio May 10, 2013) (citing cases); Raul v. Rynd, No. 11-560-LPS, 2013 U.S. Dist. LEXIS 35256, at *28-32 (D. Del. March 14, 2013) (same).) As the court explained in the most recent of these dismissals, Robinson Family Trust:

"The fact that plaintiffs’ interpretation and application of the ‘pay for performance’ policy differs from that of the board does not equate to bad faith on the part of the board. Nor is ‘bad faith’ demonstrated simply because the shareholders disagree with the board’s compensation decisions. It is well-established that setting executive compensation is a determination that rests with the Board. Nor are there any facts whatsoever suggesting that the board was inadequately informed in setting compensation … Accordingly, demand is not excused."

Lawsuits Seeking To Enjoin Annual Shareholder Meeting

When say-on-pay lawsuits based on negative advisory votes failed to gain traction, plaintiffs attorneys began suing companies and their directors and officers before the shareholder advisory say-on-pay vote. By styling their complaints as class actions, these inventive lawyers are able to avoid the demand futility pleading requirement that resulted in the dismissal of most of the initial wave of say-on-pay lawsuits. This second version challenges the adequacy of a company’s proxy disclosures on executive compensation and seeks to enjoin the shareholder say-on-pay advisory vote until the company makes additional disclosures that, according to the plaintiffs, provide sufficient information regarding executive compensation for shareholders to make an informed vote. More recent cases have focused on alleged deficiencies in disclosures relating to the authorization or issuance of additional shares of stock for equity incentive plans, and seek to enjoin binding shareholder votes to adopt or amend stock equity plans or increase authorized shares. Generally speaking, the complaints in these lawsuits do not allege that the defendants violated any disclosure statute, rule or regulation. Instead, the complaints aver that the directors breached their state law fiduciary duties (e.g., duty of candor), and that the companies "aided and abetted" the alleged breach.

After a targeted company files an annual meeting proxy statement, plaintiffs lawyers will usually issue a press release to notify prospective shareholder-plaintiffs that they are conducting an investigation into whether the company’s board breached its fiduciary duties in connection with its disclosures regarding the upcoming say-on-pay vote. According to a recent Cornerstone Research report, "Shareholder Litigation Involving Mergers and Acquisitions," (February 2013 update), plaintiffs attorneys filed 24 of these say-on-pay disclosure suits in 2012 and, by February 2013, had filed two more. As Cornerstone has observed, plaintiffs law firms continue to issue press releases announcing investigations of potential breaches of duties related to annual shareholder votes, including investigations of 16 companies in December 2012, and 17 additional companies in January 2013. Most recently, between May 1 and May 29 of this year, Faruqi & Faruqi, the plaintiffs law firm that has led the charge in filing these actions, announced investigations of five more companies (T-Mobile US Inc., The Jones Group Inc., Progenics Pharmaceuticals Inc., ACADIA Pharmaceuticals Inc. and Cheesecake Factory Inc.), according to the firm’s website.

Cornerstone reports that, as of February, plaintiffs have obtained settlements in seven cases, voluntarily dismissed five and lost their motions for preliminary injunction in six actions. In the first case that settled, Knee v. Brocade Communications Systems, No. 1-12CV-220249, (Cal. Sup. Ct. Santa Clara, Apr. 10, 2012), the Superior Court of California enjoined Brocade’s annual meeting, and shortly thereafter Brocade agreed to amend its proxy and pay $625,000 in plaintiff attorney fees. The six settlements that followed reportedly included plaintiff attorney fees ranging from $125,000 to $450,000.

The tide may be turning against plaintiffs in this litigation, however. Courts in two cases recently entered orders dismissing the complaints. On February 22, the same California Superior Court judge who issued the preliminary injunction in Knee granted the defendants’ motion to dismiss in Gordon v. Symantec, Case No. 12-CV-231541, (Cal. Sup. Ct. Santa Clara, Feb. 22, 2013). The court in Gordon earlier denied the plaintiff’s motion to enjoin the advisory vote on Symantec’s say-on-pay proposal, and the shareholders subsequently voted to approve the proposal; therefore, according to the court, the plaintiff’s direct disclosure claim was moot. As the court explained: "A breach of the disclosure duty leads to irreparable harm. Once this irreparable harm has occurred — i.e., when shareholders have voted without complete and accurate information — it is, by definition, too late to remedy the harm." Moreover, the court reasoned, the plaintiff failed to allege facts showing how any of the omitted details (e.g., a fair summary of the analysis by Symantec’s compensation consultant, the consultant’s non-compensation services, the criteria used to select peer companies and target goals) were material.

For similar reasons, on April 3, the court dismissed the complaint in Noble v. AAR, No. 12 C 7973, 2013 U.S. Dist. LEXIS 48075, at *9-19 (N.D. Ill. April 3, 2013). As the court explained:

"Plaintiff does not dispute that defendants have complied with the federal disclosure requirements under the Dodd-Frank Act nor does he point to any statutes, regulations, or case law that require corporations to disclose more than the federal disclosure requirements. Indeed, plaintiff does not identify how the alleged omissions are even arguably covered under Item 402 or Item 407 [of SEC Regulation S-K]. Instead, plaintiff attempts to create additional disclosure obligations for ‘say on pay’ votes without citing legal precedent other than case law involving the required disclosures for shareholder actions outside of the context of executive pay. … Plaintiff’s bare-boned arguments are without merit, especially in light of the business judgment deference accorded directors when setting executive compensation."

Perhaps in light of these recent defense successes, plaintiffs attorneys appear to have narrowed the focus of their investigations (and future lawsuits) on companies’ disclosures related to binding shareholder votes on proposals to increase shares for the companies’ stock equity plans. Indeed, this was the central claim in Knee, where the court enjoined a stockholder vote on Brocade’s proposal to increase the reserves of its 2009 stock plan by 35 million shares. In reaching this decision, the court agreed with the plaintiff that Brocade’s shareholders were entitled to a "fair summary" of the compensation projections and analysis the board relied upon in deciding to propose a potentially dilutive issuance of additional shares. Therefore, not surprisingly, all of the Faruqi law firm’s executive compensation investigations announced in May pertain to the company’s recommendation that shareholders vote to approve an increase in the number of available shares under the company’s equity incentive plan. Each of these announcements asserts that, "The issuance of the additional shares could have a substantial dilutive effect on the shares of [the company's] common stock." If any of these investigations results in a lawsuit, the complaint likely will assert allegations similar to those asserted against Brocade, e.g., that the company’s proxy fails to disclose the full dilutive impact that issuing additional shares may have on existing shareholders.

Preparing For Battle

Because of the current prevalence of executive compensation disclosure litigation, all public companies should be prepared to mount a defense in the event that they and their boards are sued. The following are some of the steps companies should consider:

• Ensure that the proxy disclosures are transparent, thorough and in compliance with all applicable requirements.

• Where applicable, provide a clear explanation of why the company is proposing that shares be increased and provide an analysis of the dilutive impact of the proposed share increase.

• Ask experienced securities litigation counsel and disclosure counsel to review the draft proxy.

• Consult with experienced securities litigation counsel regarding litigation risk and develop litigation strategy.

• Advise the board and compensation committee of the potential litigation risk.

• If the company receives notice that plaintiffs lawyers are investigating company’s proxy disclosures, contact outside litigation counsel immediately. •

Robert L. Hickok is a partner in the commercial litigation practice group of Pepper Hamilton and co-chair of the firm’s litigation and dispute resolution department. He can be reached at 215-981-4583 or hickokr@pepperlaw.com.

Gay Parks Rainville is of counsel in the firm’s commercial litigation practice group and co-chairs, with Hickok, the securities and shareholder litigation section of the practice group. She can be reached at 215-981-4952 or rainvilleg@pepperlaw.com.