Decisions regarding executive compensation fall squarely within the discretion of a public company’s board of directors. Recently, however, plaintiffs’ firms have been trying to invade the board’s purview by bringing shareholder derivative actions challenging such decisions. Many of these claims are based on Section 162(m) of the Internal Revenue Code of 1986, as amended (“IRC”), which limits the deductibility of executive compensation over $1 million. At least thirteen such cases were filed in 2011 and 2012, seven of which were filed in Delaware. We expect the number of these cases to increase in 2013. So far this year, the plaintiffs’ firm at the forefront of this movement has issued at least twelve press releases announcing investigations of companies and their boards in connection with executive compensation. Plaintiffs in the cases already on file are tenaciously pursuing these 162(m) claims even as the nascent body of law develops. We are currently defending a public company in such a case in the Federal District Court of Delaware.

Under Section 162(m), compensation exceeding $1 million paid to a “covered employee” of a public company is not tax deductible. “Covered employees” include the chief executive officer and the company’s four highest-paid employees for the tax year. Importantly, however, certain performance-based compensation is exempt from the $1 million limit on deductibility. To be exempt: (i) the compensation must be paid solely on account of the attainment of one or more performance goals determined by a compensation committee; (ii) the material terms of the executive compensation plan must be disclosed to shareholders and approved by a majority; and (iii) the compensation committee must certify that the performance goals were satisfied. If these requirements are met, executive compensation may be deducted.

In these Section 162(m) complaints, plaintiffs use straight-forward decisions about executive compensation and tax-planning—which fall squarely within a boards’ broad authority—to form the basis of shareholder derivative complaints in which they claim the directors breached their fiduciary duties, wasted corporate assets and permitted executives to be unjustly enriched, all to the company’s detriment. Plaintiffs dress up their claims in a variety of forms, from challenging the role of Section 162(m) in structuring a company’s incentive plan to claiming that awards to executives exceed the limits in those plans. Complaints may also challenge the discretion of the compensation committee to grant compensation in excess of $1 million under Section 162(m). Further, plaintiffs have pursued claims against directors for allegedly issuing false or misleading proxy statements relating to an incentive plan’s compliance with Section 162(m) or to the performance-based nature of certain compensation grants.

Regardless of the nature of the claim, the relief requested generally includes damages, injunctive relief, and rescission or disgorgement of allegedly excess compensation. Because plaintiffs are challenging a decision which has supposedly injured the corporation, plaintiffs usually file the claims as derivative actions, purportedly on behalf of the corporation. Before a plaintiff is allowed to usurp a board’s authority to decide whether to litigate, however, he must make a demand on the board of directors or plead particularized facts raising a reasonable doubt that a majority of the board is capable of properly considering a demand. Many plaintiffs are unable to meet this burden, though, because of the stringent requirements for pleading demand futility and the strong presumption of validity afforded a board’s decisions under the business judgment rule.

As such, the case law appears to be developing in favor of defendants due to the strong presumption of the business judgment rule. For example, in Freedman v. Adams, the Delaware Court of Chancery rejected the plaintiff’s claim for fees and explained that the complaint would not have survived a motion to dismiss, emphasizing that the court’s “deference to directors’ business judgment [was] particularly broad in matters of executive compensation.” Similarly, in the shareholder derivative suit Seinfeld v. Slager, the Delaware Court of Chancery granted defendants’ motion to dismiss in part for failure to plead demand futility, emphasizing that “a decision to pursue or forgo tax savings is generally a business decision for the board of directors.” The court continued, “Delaware law is clear that there is no separate duty to minimize taxes, and a failure to do so is not automatically a waste of corporate assets.”  

Not all Section 162(m) cases, however, have been defeated at the dismissal stage. For example, in the District of Delaware, courts scrutinized the proxy statements and ultimately denied motions to dismiss in Resnik v. Woertz and Hoch v. Alexander. In Hoch, the plaintiff alleged that the company would not be eligible for tax deductions even if the shareholders voted in favor of the company’s long-term incentive plan because, among other reasons, the proxy stated that if shareholders did not approve the plan, the prior plan would remain in effect. The court held that the plaintiff properly pled that material misstatements interfered with the voting rights of shareholders, breaching defendants’ duties of loyalty and good faith and constituted waste. This case is still in discovery.

Similarly, the plaintiffs in Resnik brought claims regarding a compensation plan that provided for incentive compensation of up to $90,250,000 per board member. The court denied defendants’ motion to dismiss, focusing on allegations of waste, potentially excessive compensation, as well as material misstatements in the proxy used to solicit shareholder approval of an incentive plan without adhering to Section 162(m). The parties recently filed a stipulation of settlement, which was preliminarily approved on January 28, 2013. The defendants stipulated to limits under the plan of $45 million per executive officer and $5 million per non-employee director. In addition, the defendants agreed to disclose the calculations underlying the company’s financial goals and targets and to pay plaintiffs’ lawyers up to $1.5 million in attorneys’ fees. 

Until the case law is more settled, it is likely that plaintiffs’ firms will continue to file Section 162(m) cases. Companies and their boards of directors, particularly members of compensation committees, should take note of the increasing litigation in this area and should remain apprised of how the case law develops with respect to these issues. Companies and their boards also should assess their exposure to these types of cases by analyzing their proxies and other public filings in order to avoid definitive statements that could be interpreted to suggest that all executive compensation will be structured to ensure it is tax-deductible. In the meantime, courts’ rulings in these Section 162(m) cases will be instructive in pending and future executive compensation litigation, as well as corporate governance matters involving these board decisions.

Given our broad experience in defending and defeating derivative cases, including those involving executive compensation and Section 162(m), Dechert is uniquely positioned to assist in the defense of any such suit, as well as to advise companies with respect to related corporate governance decisions.