Say on Pay May Lead to Closer Examination of Deductability

Don’t ignore the Wall Street protesters (Investment News, 10/17/2011)

Unlikely as it is that the Occupy Wall Street agenda (whatever that turns out to be) will be adopted wholesale by Congress, advisers can be sure that the group’s intensive illumination of stratospheric executive compensation and bank bailouts will translate into a public mood more conducive to higher taxes on the wealthy.

I’m betting that we will see many more suits like the following after the next say on pay round of votes, especially if Occupy Wall Street is still going strong. #OWS

From Jim Hamilton’s World of Securities Regulation, Shareholder Could Proceed with Derivative Claim that Proxy Statement Misled on Deductability of Executive Compensation under Federal Tax Code:

A federal court (DC Del) ruled that a shareholder derivative, but not direct, claim could proceed against company directors for issuing a false or misleading proxy statement regarding the tax-deductible status of executive compensation under the federal tax code. At this stage, the shareholder properly pled that a material misstatement interfered with shareholder voting rights and that the allegedly false proxy statement breached the directors’ duties of loyalty and good faith. Thus, the court permitted the derivative claims to proceed. (Hoch v. Alexander, DC Del, CA 11-217, July 1, 2011).

The problem the court had with the direct claim, however, is that there is no link between the alleged misstatements in the proxy statement and actual economic harm. A direct claim alleging a deprivation of the right to a fully informed vote and seeking only corrective disclosures and a new vote fails to meet the loss causation requirement.

The shareholder said that Internal Revenue Code Section 162(m) subjects public corporations to special restrictions regarding executive compensation. Although the Code generally allows companies to claim a deduction for a reasonable allowance for salaries or other compensation for personal services actually rendered, it also imposes conditions on the deduction of the annual compensation to named executives in excess of $1 million. Compensation in excess of $1 million per year is not deductible unless it is paid in compliance with the requirements of § 162(m) and its implementing regulations. For the deduction to apply, it must be objectively determined, performance-based, and approved by the shareholders

The shareholder claimed that the company’s long-term incentive plan (LTIP) does not qualify as tax-deductible. As outlined by the proxy statement, the LTIP would increase the number of shares that the company could issue and change the ratio used to count awards granted under the plan. The proxy statement also detailed how the LTIP would render performance-based compensation tax-deductible.

The proxy statement noted that the board retains the discretion to eliminate or reduce, but not increase, the performance-based compensation for covered employees in accordance with the Code and that a committee of outside directors must act with respect to performance awards to the extent compliance with Section 162(m) of the Code is desired.

The proxy statement also said that stock options granted under the LTIP qualify as performance-based compensation and that, from time-to-time, the company may pay compensation to Section 162(m) covered officers that may not be tax deductible if there are compelling business reasons to do so.

The shareholder alleged that these representations about the availability of tax deductions were materially false or misleading because payments made regardless of stockholder approval are not tax deductible. The shareholder alleged that the directors breached their duties of loyalty and good faith.

The shareholder asserted that Delaware law excuses the demand requirement when the challenged act of the board of directors is not the product of a valid exercise of business judgment and that the misrepresentations and omissions here are not protected by the business judgment rule.

When determining whether demand is excused under Delaware law, a court must answer: whether threshold presumptions of director disinterest or independence are rebutted by well-pleaded facts; and, if not, whether the complaint states particularized facts sufficient to create a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment. Demand is excused if either of these two inquiries is met.

The court concluded that the shareholder properly pled that demand is excused because he properly challenged directorial independence. According to the complaint, all of the members of the board of directors are eligible to participate in the LTIP and thus have an interest in receiving such payments. Additionally, three members of the board are members of the Compensation Committee and are charged with making recommendations about incentive compensation.

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