Disgruntled shareholders shift litigation strategies as 'say on pay' lawsuits continue to fail. Canadian companies should learn from their US neighbours and ensure they are protected
The recent proliferation of Canadian companies adopting shareholder votes on executive compensation (so-called ‘say on pay’ votes) has the potential to alter Canadian corporate governance policies. It also creates potential risk for Canadian companies of litigation brought by enterprising shareholders, law firms or both. This article discusses the potential litigation implications of failed say on pay votes. We focus on recent say on pay votes in Canada, the experience in the United States with say on pay litigation, the potential application to Canadian companies and what Canadian companies can do to minimize litigation risk.
What is Say on Pay?
Say on pay is a non-binding, advisory vote by shareholders expressing their approval or disapproval for a company’s executive compensation policies. Unlike other countries, such as the United States, United Kingdom and Australia, say on pay advisory votes are not mandatory in Canada. In 2011, one of the principal securities regulators in Canada, the Ontario Securities Commission, sought comments on a variety of shareholder rights issues, including say on pay, but since then there has been no movement on this front, and there is no indication that this will change anytime soon.
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Nevertheless, say on pay is increasingly being voluntarily adopted by Canadian companies seeking more transparent corporate governance practices: a recent report published by the Shareholder Association for Research and Education (SHARE) indicates that the number of Canadian public companies that have adopted advisory say on pay votes has increased from 71 companies in 2011 to 99 in 2012 and up to 129 in 2013. While the actual impact of say on pay votes on executive compensation levels has been questioned (see, for example: Before and After Say on Pay: Say on Pay in Canada 2009‒2011, Clarkson Centre for Board Effectiveness), it appears that say on pay is here to stay in Canada.
Recent Say on Pay Failures:
Barrick Gold Corporation
A 2012 SHARE report indicates that shareholder approval levels of executive compensation policies appear to be declining as a whole in Canada. More recently, Canadian companies have started to experience say on pay failures. In the high-profile failure of Barrick Gold Corporation, a whopping 85 percent of shareholders rejected the company’s $47-million executive compensation plan. Shareholders took particular issue with the $17-million compensation package awarded to Barrick’s newly appointed co-chairman, John Thornton. Included in Thornton’s package was an $11.9-million signing bonus. This compensation package occurred in a year where Barrick’s share prices fell to a 20-year low.
Prior to Barrick’s say on pay vote, several institutional shareholders expressed their disapproval of the compensation plan. In an April 2013 press release issued by institutional investor Caisse de dépôt et placement du Québec, and endorsed by seven other large Canadian institutional investors, Thornton’s compensation was stated to be "unprecedented" and "inconsistent with the governance principle of pay-for-performance." The press release further stated that the bonus would set a "troubling precedent in Canadian capital markets." Days later, these shareholders put their dissatisfaction into action when they voted against the compensation package.
Given that say on pay votes are neither legally required in Canada, nor binding on the issuing corporation, the results of the vote did not impose any legal obligation on Barrick’s executives. However, results such as these cannot be ignored as they have the potential to raise significant implications within the Canadian legal landscape. Failed say on pay votes could lead to costly shareholder litigation premised on claims for breach of directors’ fiduciary duties and oppression.
Litigation in the United States
Say on pay lawsuits in the United States have been largely unsuccessful, and the number of lawsuits has waned recently (see: David F. Larker & Brian Tayan, "Shareholder Lawsuits: Where Is the Line Between Legitimate and Frivolous?" (2012) Stanford Closer Look Series). However, the evolving tactics used by plaintiffs have made them an interesting study from which Canadian companies can learn. The two classes of cases discussed below provide examples of the approaches taken by plaintiffs in the United States.
Challenges to Executive Compensation
The first class of cases deals with direct challenges to executive compensation plans based on say on pay votes. As an example, Gordon v. Goodyear 2012 WL 2885695 (N.D.Ill.) concerned Navigant Consulting Inc., a consulting firm that, ironically, provides risk management and financial advice to government agencies. Navigant was experiencing poor and declining financial performance, with its share price falling from more than $21 per share in January 2006 to $9.20 per share in December 2010. In response to the company’s financial performance, more than 55 percent of Navigant’s voting shareholders rejected the 2010 executive compensation plan. In response to the rejection, Natalie Gordon, a Navigant shareholder, brought a derivative lawsuit (an action in the name of the corporation) against Navigant’s board of directors.
Gordon alleged that Navigant’s board of directors awarded "excessive executive compensation despite the fact that Navigant shareholders [had] seen the value of their investment plummet." She claimed that each individual director owed, and was in breach of, fiduciary obligations requiring board decisions to be made in furtherance of the best interests of Navigant and its shareholders, rather than in furtherance of the directors’ personal interests. The plaintiff claimed that the shareholders’ rejection of the 2010 compensation package was "direct and probative evidence" that the board’s approval of the compensation plan was not in the best interests of Navigant shareholders.
The Federal District Court of Illinois, applying Delaware law, rejected Gordon’s claims. The court held that the plaintiff had failed to demonstrate "demand futility." Demand futility refers to Delaware law’s requirement that, to bring a derivative lawsuit, a shareholder must cast reasonable doubt that the majority of the directors are independent and disinterested, or the transaction was the product of a valid exercise of business judgment. Gordon failed to satisfy either requirement. First, she could not prove that a majority of the directors were not independent or disinterested as seven of the eight board members were not alleged to have received any personal benefit from the executive compensation package. Second, the court held that the plaintiff failed to rebut the presumption of the business judgment rule.
The business judgment rule refers to the concept that directors of a corporation are presumed to be motivated by a genuine regard for the interests of the corporation and its shareholders. Accordingly, directors’ decisions are presumed to be made in the best interests of the corporation (Gimbel v. Signal Companies Inc., 316 A.2d 599 (1974) at page 8). Under Delaware law, a board’s compensation decisions or business judgments are entitled to great deference. In Goodyear, the negative say on pay vote was held to be insufficient to find that the directors had not validly exercised their business judgment.
The court also rejected Gordon’s claim that section 951 of the Dodd-Frank Act imposed additional fiduciary duties on directors. The Act legislates mandatory say on pay voting in the United States as a means of promoting financial stability through improved accountability and transparency. The language of the Act is clear — it explicitly states that shareholder votes "shall not be binding on the issuer or the board of directors" and that votes do not "create or imply any change to the [directors’] fiduciary duties." Thus, while the plaintiff alleged that the negative shareholder vote was evidence that compensation decisions were not made in the best interest of Navigant shareholders, and was thus a breach of the directors’ fiduciary duties, the court viewed this claim as an attempt to circumvent the statutory protections afforded by the Act.
Challenges to Procedural Aspects of Say on Pay Votes
The second class of cases deals with challenges to the procedural aspects of say on pay votes. An example of this class of cases is Gordon v. Symantec Corp. (Case No. 1-12-CV-231541). The plaintiff, the same Natalie Gordon as above, sought an injunction restraining Symantec Corporation from proceeding with its say on pay vote for failure to disclose essential information. Symantec’s proxy circular, which recommended that Symantec shareholders vote to approve Symantec’s executive compensation plan, was alleged to be deficient as it did not specify "what exactly the Board considered in making [the] recommendation." Gordon claimed that the circular failed to provide a "fair summary" of the compensation consultant’s analysis and was deficient in terms of information relating to both the reasons Symantec changed its compensation consultant and the reasons Symantec chose particular peers as a basis of comparison.
Symantec, in turn, filed an expert report from Professor Robert Daines of Stanford Law School, who submitted a declaration that Symantec’s disclosures were consistent with industry standards and complied with regulatory requirements. In his declaration in opposition to the plaintiff’s motion for a preliminary injunction, Professor Daines stated that "not a single firm" provided all the disclosures the plaintiff requested and that if such disclosures were required "one would need to enjoin the vote at every single one of Silicon Valley’s largest firms." Professor Daines further explained that one method of determining whether additional disclosures are required is to examine whether such disclosures are included in a significant number of circulars filed by similar companies. If such details are not repeatedly provided by other companies, the omission can be viewed as "a collective professional judgment that the details are not considered useful or necessary to shareholder decision-making."
The Superior Court of California (County of Santa Clara), citing Professor Daines’ declaration, sided with Symantec and denied the plaintiff’s motion. The court held that there was no precedent enjoining a say on pay vote or imposing additional disclosure requirements beyond those contained in the Securities Exchange Act of 1934.
Implications for Canadian Companies
Canada has yet to see say on pay lawsuits as in the United States. However, Canadian courts have repeatedly held that management fees or compensation paid without approval, that are larger than industry norms, or that increase while a corporation is encountering financial difficulties, can be oppressive or constitute a breach of fiduciary duties (see: M. Koehnen, Oppression and Related Remedies (Thomson Canada Limited: Toronto, 2004)). Accordingly, companies may be at an increased risk for litigation, with failed say on pay votes used as evidence against the company.
An example of the impact dissatisfied shareholders can have on a company’s executive compensation was recently seen in the Ontario Superior Court case, Unique Broadband Systems Inc. (Re), 2013 ONSC 2953. This case arose following a proxy battle initiated, and won, by certain shareholders of Unique Broadband Systems Inc. (UBS). The prevailing shareholders, outraged by the amount of management compensation, ousted the UBS board and denied re-appointment to UBS’s CEO, Gerald McGoey. McGoey subsequently claimed he was terminated without cause and sued for recovery of $5.8 million allegedly owed to him under his UBS employment contract. UBS counterclaimed for breach of fiduciary duty and further claimed that decisions made by McGoey and the board were oppressive to the interests of UBS’s shareholders.
Central to UBS’s claim was a decision to replace an established Share Appreciation Rights Plan (SARs plan) with a fixed compensation payment to SARs holders. Initially, the SARs plan had been implemented as a type of incentive plan that purported to attract and retain people, such as McGoey, to serve as directors, officers and employees of UBS. Like a stock option plan, upon certain triggering events, SARs plan participants were to receive a cash award equal to the appreciation in the share value over the value of the unit when awarded. When a triggering event was set to occur and share prices were nowhere near anticipated levels, which would have resulted in the value of SARs units being close to 20 cents per unit, the UBS compensation committee replaced the SARs plan with a fixed compensation payment to SARs holders of 40 cents per unit. Five people were to receive the fixed compensation: four members of the board of directors (including the three members who made up the compensation committee) and an IT consultant.
The court sided with UBS and held that McGoey and the UBS board were in breach of their fiduciary obligations to UBS’s shareholders. The court came to the "inescapable conclusion" that the decision to replace the SARs plan was motivated by the board’s own self-interest, rather than the interests of the corporation. In short, "there was nothing in it for UBS shareholders."
The court outlined a number of factors that contributed to the UBS board’s breach of fiduciary duty. For example, although the board consulted with its corporate counsel, the board’s decisions were not consistent with any of the received recommendations. Further, the board did not consult with an independent compensation consultant prior to agreeing to the compensation plan. The court held that "having board members recognize their obligations to act in the best interests of the corporation and its shareholders is not the same as leading evidence to show that their actions were actually in those best interests." Further, the compensation committee was not independent, as it was composed entirely of individuals who would personally benefit from the replacement of the SARs plan. Finally, the SARs cancellation plan was held to negatively impact the value of the UBS shares, as it gave SARs holders a 40 cents guarantee per share while the shares were trading at less than 20 cents per share. The court responded to McGoey’s breach of fiduciary duty by setting aside his compensation package.
Unique Broadband Systems
reflects the increased willingness of shareholders to express their dissatisfaction with executive compensation plans. This is exacerbated by the recent say on pay failures experienced by Canadian companies: in addition to Barrick, discussed above, three other Canadian companies have had say on pay failures thus far: QLT Inc., Equal Energy Ltd. and Golden Star Resources Ltd. These failures suggest that Canadian companies and directors must take measures to protect themselves from the potential adverse consequences of shareholder litigation in the face of failed say on pay votes.
Distinctions Between Canada and the United States
There are a few important distinctions between Canada and the United States that warrant consideration in assessing the litigation risk of failed say on pay votes. The most obvious is that say on pay is not mandatory in Canada. This means that Canadian companies and directors would not have the same regulatory restrictions and protections afforded to their American counterparts. For example, as previously mentioned, in Goodyear the court held that section 951 of the Dodd-Frank Act made clear that say on pay does not impose any additional fiduciary duties on directors. The lack of a say on pay regulatory regime creates uncertainty as to the requirements a Canadian company must adhere to when adopting say on pay voting.
Another important distinction is the different approach to derivative lawsuits by Canadian and American courts. In most states in the United States, as discussed in the aforementioned Goodyear case, to bring a derivative lawsuit, a plaintiff must demonstrate "demand futility." However, in Canada, this procedural hurdle is absent. The specific requirements to bring a derivative lawsuit vary amongst the different federal and provincial statutes, but generally Canadian courts will grant approval of the commencement of a derivative lawsuit if satisfied that a plaintiff is acting in good faith, has given notice to the corporation and the corporation has refused to proceed with the action, and the action is in the best interests of the corporation. Canadian companies should note that procedural requirements may be less burdensome than in the United States and may mean that say on pay lawsuits are easier to bring for litigants in Canada.
The final, and perhaps most important, distinction between Canada and the United States is the existence of the oppression remedy in Canada. The oppression remedy allows a shareholder to bring a claim against a corporation if the corporation’s actions disregard the shareholder’s reasonable expectations and unfairly impacts the shareholder’s interests. While simple mismanagement of a corporation is likely insufficient to establish oppression, mismanagement severe enough to jeopardize the value of the corporation is oppressive (see: Koehnen, "Oppression" at page 121).
Although the type of mismanagement needed to undermine the value of a corporation varies, when mismanagement relates to charging management compensation without proper approval that is not based on objective criteria, or when large increases in compensation are approved during times of financial difficulty, a court may find the compensation oppressive.
Unsurprisingly, an oppression claim was advanced in Unique Broadband Systems, as UBS’s executive compensation had increased dramatically, despite the company’s poor financial performance. The court provided little discussion of the oppression claim, as the enhanced compensation package had already been set aside based on the finding of breached fiduciary duties. However, had the executive compensation plan not been set aside, it is likely UBS’ compensation decisions would have been oppressive. This is because, as the court explicitly stated, the 40 cents value per unit of the SARs cancellation plan "was not arrived at by any true objective means."
Companies and directors should be aware of the wide discretion afforded to courts when remedying oppression claims. If shareholders can successfully prove that compensation is oppressive, a court may set aside such compensation, or take other steps necessary to remedy the oppression. As courts are able to fashion flexible and creative remedies, it is difficult to predict, with any degree of certainty, the outcome of a given oppression claim.
Given that mismanagement of executive compensation, as occurred in Unique Broadband Systems, can support an oppression claim, it is not a stretch to imagine shareholders arguing that approval or continuation of an executive compensation plan in the face of a failed say on pay vote is evidence of oppressive conduct. While a failed say on pay vote by itself would likely be insufficient to sustain an oppression claim, it can serve as a factor for a court to consider when faced with such a claim by a shareholder. The existence of the oppression remedy therefore provides an alternative and likely simpler means for a shareholder to seek redress for a failed say on pay vote, and creates an additional factor directors must consider when assessing say on pay risk.
Minimizing Litigation Risk
The fact that the representative plaintiff was the same Natalie Gordon in both the Goodyear and Symantec cases discussed above is no coincidence. Enterprising counsel may attempt to bring opportunistic (and profitable) litigation in the face of a failed say on pay vote using a cherry-picked representative plaintiff. Canadian companies should be wary of this risk: in addition to the potential cost of litigation, the legitimate business and operational activities of a company may be disrupted, and the company and its directors may suffer reputational harm as a result of these lawsuits.
- Consider whether a say on pay vote is appropriate for the company, and what the likely outcome of a say on pay vote will be.
- Avoid making definitive statements regarding the outcome and potential actions to be taken as a result of a say on pay vote.
- Ensure that proxy disclosure complies with applicable corporate and securities laws and is clear and precise. Proxy disclosures should be clear that any shareholder vote on compensation is advisory in nature and not binding on the corporation. Keep directors informed of the litigation risk associated with say on pay votes.
- Ensure that any performance-based compensation is tied to clearly articulated performance criteria.
- Understand and consider competitors compensation practices to ensure that compensation levels are consistent with industry standards, and address any concerns about current executive compensation programs.
- Review compensation voting policies of proxy advisory firms and key institutional shareholders to identify factors that may influence a "no" vote.
- Ensure that the company’s compensation plans and policies are complied with.
As shown in Unique Broadband Systems, shareholders are increasingly willing to hold companies accountable when executive compensation plans disregard their interests. Say on pay is here to stay in Canada, and, as we have seen in the United States, failed say on pay votes provide new means and new evidence for a shareholder seeking to challenge executive compensation. Ultimately, it will be interesting to see how Canadian courts address these issues and the effects failed say on pay votes will have on both executive compensation levels and shareholder litigation.