Derivative Suit Challenging Board's Approval of Executive Compensation Survives Motion to Dismiss
Erica Smith | Bloomberg Law
The U.S. District Court for the Southern District of Ohio denied the defendants’ motion to dismiss a shareholder derivative action alleging that the board of directors breached its fiduciary duty by approving certain executive compensation. The court found that the plaintiff adequately pleaded that the directors’ decision was not entitled to protection of the business judgment rule. Under the circumstances, the plaintiff was also excused from making pre-suit demand on the board to pursue the claims.
Shareholder Challenges Board’s Approval of Executive Compensation
NECA-IBEW Pension Fund, a shareholder of Cincinnati Bell, Inc., alleged that the board of directors breached its fiduciary duty of loyalty by approving sizeable pay raises and bonuses for three top officers in 2010, at a time when the company’s financial performance declined significantly. According to the complaint, the board approved total compensation increases of 71.7 percent for CEO John F. Cassidy (including a $1.3 million performance bonus, $600,160 special bonus, and $2.1 million retention bonus, for total compensation of over $8.5 million), 80.3 percent for CFO Gary J. Wojtaszek, and 54.3 percent for VP and general counsel Christopher J. Wilson. During the same year, Cincinnati Bell’s net income decreased by $61.3 million, earnings per share dropped from $0.37 to $0.09, the share price declined from $3.45 to $2.80, and the annual shareholder return was a negative 18.8 percent. See NECA-IBEW Pension Fund at 6, n.2.
The plaintiff claimed that the bonuses violated Cincinnati Bell’s compensation policy, which purportedly tied total executive compensation to the company’s performance and linked at-risk compensation to shareholder returns. In addition, the plaintiff alleged that approval of the executive compensation increases was not in the shareholders’ best interest, as evidenced by the vote by 66 percent of the shareholders at the 2011 annual meeting against a resolution to approve the 2010 executive compensation. The directors filed a motion to dismiss the complaint under Federal Rule of Civil Procedure (FRCP) 12(b)(6).
Business Judgment Rule
With respect to executive compensation decisions, judicial review of directors’ decisions is guided by the business judgment rule, which precludes scrutiny of “actions taken by a director in the absence of fraud, bad faith, or abuse of discretion.” Id. at 4 (quoting Radol v. Thomas, 772 F.2d 244, 257 (6th Cir. 1987)). The presumption of good faith inherent in the business judgment rule may be rebutted where a plaintiff offers factual evidence that the board acted disloyally, i.e., not in the company’s or shareholders’ best interests. Id. at 1 (citation omitted). The court noted that the plaintiff bears the burden of proof at trial to present such evidence, but is not required to plead with particularity facts that render the business judgment rule inapplicable. Id. at 5 (citations omitted).
In this case, the court found that the plaintiff adequately pleaded that the board of directors’ approval of the 2010 executive compensation increases was not entitled to protection of the business judgment rule. The plaintiff’s factual allegations regarding the size of the officers’ pay and bonuses and the company’s financial results “raise a plausible claim that the multi-million dollar bonuses approved by the directors in a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith.” Id. at 6. The court concluded that dismissal of the complaint was not warranted, although the defendants could seek to rely on the business judgment rule as an affirmative defense at trial.
The defendants also argued that the suit should be dismissed based on the plaintiff’s failure to make a pre-suit demand that the corporation pursue the claims. In a derivative action, the plaintiff must allege with particularity any efforts he made to obtain the desired action from the board, and why such efforts failed or were not made. See FRCP 23.1; Ohio Civ. R. 23.1. Demand may be excused as futile if the shareholder can show that the directors “cannot properly exercise their business judgment in determining whether the suit should be filed.” NECA-IBEW Pension Fund at 8 (quoting Carlson v. Rabkin, 789 N.E.2d 1122, 1128(Ohio Ct. App. 2003)).
The court determined that the complaint contained specific facts that created doubt regarding the directors’ ability to make unbiased, independent decisions about whether to pursue the claims. Seven of Cincinnati Bell’s eight directors were defendants in the suit, the eighth having joined the board after the 2010 executive compensation was approved. The court observed:
Given that the director defendants devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation, [the] plaintiff . . . demonstrated sufficient facts to show that there is reason to doubt these same directors could exercise their independent business judgment over whether to bring suit against themselves for breach of fiduciary duty in awarding the challenged compensation.
Id. at 9. From this, the court determined the directors had a “disqualifying interest” that excused the plaintiff from making a pre-suit demand.
The plaintiff also claimed that the executives were unjustly enriched by the directors’ approval of the 2010 executive compensation. In light of the fact that the plaintiff had sufficiently pleaded facts to support the breach of fiduciary duty claim, the court also found the plaintiff’s unjust enrichment claim to be viable at the pleading stage.
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
© 2011 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.