Ninth Circuit Rules that Say-On-Pay Suit Belongs in State Court

In a recent ruling, the United States Court of Appeals for the Ninth Circuit concluded that certain related shareholder derivative suits arising out of a say-on-pay decision involving Pico Holdings, Inc. (the “Company”) were improperly removed from California state court to the federal district court. This ruling, captioned Dennis v. Hart et al., No. 12-55241 (July 31, 2013), et seq., further impacts where say-on-pay cases and presumably other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) will be litigated in the future.

These particular shareholder derivative cases were part of the wave of cases arising from the say-on-pay provisions in Dodd-Frank, requiring public companies to conduct periodic advisory votes on executive compensation. The statute provides that, at least every three years, public companies must conduct a shareholder vote “to approve the compensation of executives.”  15 U.S.C. § 78n-1(a)(1). These “say-on-pay” votes “shall not be binding on the issuer or the board of directors of an issuer, and may not be construed . . .

  1. as overruling a decision by such issuer or board of directors;
  2. to create or imply any change to the fiduciary duties for such issuer or board of directors; [or]
  3. to create or imply any additional fiduciary duties for such issuer or board of directors.”  Id. § 78n-1(c). 

Plaintiffs initially filed these related derivative suits in California state court, alleging that the Company’s compensation policies gave rise to state law claims for breach of fiduciary duty, gross mismanagement, contribution and indemnification, abuse of control, waste, and unjust enrichment. The complaints alleged that although the Company had reported negative net income and free cash flow in 2010, the Company’s board of directors increased executive compensation in 2010. In an advisory vote pursuant to Dodd-Frank, sixty-one percent of shareholders voted against the 2010 compensation package. The Board subsequently took no action. 

The defendants removed the cases to federal court and moved to dismiss, while plaintiffs moved to remand. The district court dismissed portions of each case and declined to exercise supplemental jurisdiction over the remaining claims. On appeal, the Ninth Circuit vacated the district court decisions with instructions to remand the cases to state court. 

When a company, its directors, or its officers are sued in state court, defense counsel has long considered removal to federal court as one of the first strategic decisions made in the suit. Under 28 U.S.C. § 1441(a), unless Congress has expressly provided otherwise, a defendant may remove to federal court “any civil action brought in a State court of which the district courts of the United States have original jurisdiction.”  If a case is improperly removed, the federal court must remand the action if the court does not have subject-matter jurisdiction to decide the case. 

Defendants argued that the federal court had jurisdiction under the well-pleaded complaint rule because the say-on-pay vote fueled the derivative suits and the complaints were peppered with references to the vote. The Ninth Circuit found that this argument was insufficient to confer federal jurisdiction because the plaintiffs’ complaints alleged state, not federal, causes of action. The Ninth Circuit also rejected Defendants’ arguments that federal jurisdiction nevertheless existed under (i) Section 27 of the Securities Exchange Act of 1934 (the “Exchange Act”); (ii) the “significant federal issue” rule; and (iii) the complete preemption doctrine. 

First, the Court determined that Section 27, which vests federal courts with exclusive jurisdiction over actions “brought to enforce any liability” created by the Exchange Act, 15 U.S.C. § 78aa(a), was inapplicable because the complaints did not allege a violation of the say-on-pay provision or any other provision of the Exchange Act. 

Second, the Court rejected Defendants’ argument that the suits dealt with a significant federal issue. Defendants argued that in enacting Dodd-Frank, Congress intended to ensure that say-on-pay votes were merely advisory and to bar any adverse consequences from a negative vote. Although noting that Defendants “might have a very strong federal defense,” the Court held that a federal defense is “‘inadequate to confer federal jurisdiction’” — even when the defense is that federal law preempts the state law claim. 

Third, the Court rejected Defendants’ argument that the doctrine of complete preemption conferred federal jurisdiction, explaining that it applied only where Congress intended the scope of a federal law to be so broad as to entirely replace any state-law claim. The Court found that the Exchange Act does not fully displace state law, and that Section 78n-1 did not create a federal cause of action or a complex federal regulatory scheme. Indeed, the parties agreed that there was no federal cause of action in these cases. Thus, the Ninth Circuit ruled that these suits belonged in state court. 

The threat of shareholder derivative suits generally and say-on-pay suits specifically continues to be a concern for directors and officers. In light of the Ninth Circuit’s decision, counsel for companies, their board members, and executives should not assume that such cases will be easily removed to federal court and must be prepared to defend these cases in state court.

 

Topics:  Board of Directors, Derivative Suit, Dodd-Frank, Executive Compensation, Fiduciary Duty, Jurisdiction, Removal, Say-on-Pay

Published In: Business Torts Updates, Civil Procedure Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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