Say-on-Pay Failures; Say-on-Pay Strategies

Corporate America is facing new challenges this proxy season in winning shareholder approval for executive compensation, thanks to provisions in the Dodd-Frank Act that give shareholders a non-binding vote on executive pay packages. But companies have a corollary headache thanks to those provisions, as well: They have led to a host of shareholder lawsuits.

Section 951 of the Dodd-Frank Act spells out the say-on-pay provisions, and states that such votes do not create any new fiduciary duties of boards to change pay practices. Still, five companies so far this year—Umpqua Holdings Corp., Beazer Homes, Jacobs Engineering, KeyCorp, Occidental Petroleum—have been the target of shareholder lawsuits after their directors proceeded to award the pay packages despite “no” votes from shareholders.

But shareholders aren't stopping there; the complaints also name the companies' directors, compensation consultants, and other senior officers.

“These lawsuits really fly in the face of Dodd-Frank, which was explicit in saying that these are advisory, non-binding votes,” says UCLA law professor Stephen Bainbridge. “I think these are very opportunistic, frivolous lawsuits in most cases.”

Notably, the lawsuits stem from both this year's and last year's proxy seasons. In May 2010, for example, shareholders filed the first of three separate lawsuits in Delaware federal court against Occidental Petroleum, alleging corporate waste and breach of fiduciary duty stemming from excessive bonus compensation standards. In its Form 10-K annual report filed in February 2011, Occidental said the first case was settled and the other two suits were dismissed with prejudice.

In the latest claim filed on May 25 in Oregon District Court, two union pension funds sued bank holding company Umpqua, its board members, four of its senior executives, and its compensation consultant, PricewaterhouseCoopers, over allegations that the company violated its duties to investors by approving its 2010 executive pay hikes despite a 61.8 percent no vote during the company's April 19 annual meeting.

Nearly identical in language to the other four lawsuits, the complaint asserts that the Umpqua board's approval of the pay hikes “violated its own pay-for-performance policy and, as intended, favored the interests of Umpqua's CEO and top executives at the expense of the corporation and its shareholders.” The complaint further stated that the board's decisions to increase executive pay, “despite the company's severely impaired financial results, were disloyal, irrational, and unreasonable, and not the product of a valid exercise of business judgment.”

According to the lawsuit, Umpqua experienced a negative 7.7 percent 2010 shareholder return, while the pay of its senior executive officers saw increases of 61.1 percent to as high as 161.2 percent. Additionally, at this time, the company's stock price dropped from $13.41 in 2009 to $12.18 in 2010.

In an April 22 Form 8-K filing that singled out proxy advisory firm Institutional Shareholder Services as the driver behind the say-on-pay “no” vote, Umpqua said it disagreed with the “formulaic approach” ISS used in reaching its recommendation, “including a comparison of a one year increase in CEO compensation from 2009 to 2010.”

“2009 is an inappropriate year with which to compare 2010 CEO compensation, because it takes it out of context,” the filing stated. “In 2009, CEO compensation appropriately decreased 28 percent as Umpqua experienced a loss that year.” Umpqua also argued that the plan is reasonable in light of the company's overall performance relative to its peers.

Active Response

In addition to Umpqua, several other companies have responded to ISS's “no” recommendations by filing additional proxy solicitation materials outlining their disagreement with the methodologies and analysis that ISS and other advisory firms use. In particular, many companies take issue with the performance test ISS uses to gauge a company's compensation package, which is achieved by comparing a company's three-year total shareholder return and CEO pay with a peer group of ISS's choosing.

However, “the TSR test is not the only way to assess a company's performance, and ISS typically does not does not consider the dynamics of the particular situation in reviewing CEO pay changes,” says Deborah Lifshey, a managing director at compensation consulting firm Pearl Meyer & Partners. “As such, ISS applies a one size fits all screening test to very different companies, causing many companies—that otherwise have very clean programs—to fail the assessment,” And yet, proxy advisory firms like ISS exert such significant influence over these votes that failure to pass ISS's performance test often serves the basis of a “no” vote, she says.

“These lawsuits really fly in the face of Dodd-Frank, which was explicit in saying that these are advisory, non-binding votes. I think these are very opportunistic, frivolous lawsuits in most cases.”

—Stephen Bainbridge,

Law Professor,

UCLA

Some companies that have recently filed Form 8-Ks reporting painfully high “no” votes, for example, have included Helix Energy Solutions (34 percent); Cincinnati Bell (34 percent); Constellation Energy (38 percent); Superior Energy (39 percent); Weatherford International (44 percent); and Talbots (47 percent).

“Given this vote is advisory, no immediate action is required,” says Julie Lorigan, head of investor and media relations at Talbots. “That said our board of directors takes the results of this vote seriously.”

The good news: the vast majority of say-on-pay proposals result in “for” votes. According to ISS data updated as of June 7, only 31 Russell 3000 companies have flunked their say-on-pay votes this year—accounting for only 1.6 percent of the 1,923 companies that have held pay votes this season and where ISS has results.

In the greater scheme of things, as of May 20, approximately 92 percent of 1,600 companies that have filed proxy statements including say-on-pay proposals have reported “for” votes, according a memo released by law firm Womble Carlyle, which has been keeping a tally on say-on-pay votes.

In many of these cases, companies have gained support by agreeing to change their pay practices. Alcoa, Pfizer,  and Johnson & Johnson successfully pressed their institutional shareholders for support by drafting detailed rebuttals to criticism of their compensation decisions. Alcoa also secured support for their executive pay plans by placing performance hurdles on their chief executives' stock-option grants, a tactic also used by General Electric and Lockheed Martin to gain the support of their shareholders.

“The action we took to amend our CEO's compensation package was in response to shareholder concerns on the company's executive compensation program, and the link to company performance,” says Jennifer Whitlow, vice president of worldwide media relations for Lockheed. “While we believed we had a strong connection between executive compensation and performance, we listened to our shareholders' concerns, and we took action.” 

DETAILS ON UMPQUA

The following excerpt is from the shareholder complaint in the case of Umpqua Holdings:

Umpqua has been severely injured by the Umpqua Board's excessive 2010 CEO and top executive compensation. In 2010, Umpqua's stock price trailed the stock performance of its industry peers and its annual shareholder return declined significantly to negative 7.7 percent for 2010. Yet, incredibly, Umpqua's CEO and top executive compensation increased,

on average, by 118.8 percent.

When asked by the Umpqua Board to appraise the Umpqua Board's

2010 pay hikes as m the best interest of the Company, Umpqua

shareholders rejected the 2010 executive compensation. Instead, Umpqua shareholders concluded, in their own independent business judgment, that the 2010 CEO and top executive pay hikes were not in the best interest of Umpqua and its shareholders, and were only in the interest of the company's executives. This notwithstanding, however, the Umpqua Board has not publicly rescinded or amended the 2010 executive compensation to

the detriment of the company. By contrast, Umpqua's CEO and top

executives have been unjustly enriched by the windfall profits they received in 2010.

By this action, plaintiffs seek to recover damages and other

relief for Umpqua against the Umpqua Board members for their breach of loyalty, Umpqua's CEO and top executives for unjust enrichment, and Umpqua's compensation consultant for aiding and abetting breaches of fiduciary duty and breach of contract. Absent this action, the company's rights against its wayward fiduciaries and/or their advisor.

Source: Umpqua Action, May 25, 2011.

“Cash generation and return on invested capital are leading indicators of a corporation's performance and are the right metrics to ensure we are generating shareholder value,” Whitlow adds.

In another example, Disney Co. agreed to drop its tax gross-up provision for four of its senior executive officers. Following that move, ISS reversed its recommendation against the company's say-on-pay proposal.

One of the lessons to gain from the companies above is that “how you go about reaching out to your shareholders community depends a lot on who is in your shareholder community,” Bainbridge says.

“A company with a heavy institutional shareholder base can reach out to a relatively small number of players,” he continues. In these circumstances, one-on-one communication with shareholders may be most effective.

A company that has predominately individual investors, on the other hand, “faces a somewhat more difficult task for education their shareholders simply because there is so many more people that you have to communicate with,” says Bainbridge. This is when letter writing, conference calls, or web seminars might work most effectively.

Looking Ahead

As for the shareholder derivatives lawsuits that are pending, experts predict that the number of those lawsuits will continue to rise this proxy season and beyond. “We'll probably have a good number of shareholders derivatives suits by the time this is all over,” says Lifshey.

That's not to say the outcome of them will be successful for the shareholders. “I fail to see how they will have any merit going forward,” she adds.

Bainbridge says the most likely scenario is that these cases will be dismissed at summary judgment, if not the motion-to-dismiss stage. “If you see courts doing that,” he says, “these types of cases will be a very short-lived phenomenon.”