Clawbacks, advance legal fees, and director compensation were among the topics covered by Arthur H. Kohn, Esq., a partner at Cleary Gottlieb Steen & Hamilton LLP, New York, NY, in his annual survey of late-breaking develop- ments in executive compensation. Kohn’s talk was part of ALI-CLE’s course entitled “Executive Compensation 2019: Strategy, Design, and Im- plementation,” held in New York City on June 20–21.
Clawbacks. Under Section 954 of the Dodd- Frank Act (P.L. 111-203, 7/21/2010), the national securities exchanges must require companies to adopt clawback policies for current and former executive officers in case of a material financial restatement. Although the SEC issued a proposed rule implementing Section 954 on July 1, 2015, it has not yet been finalized. In Kohn’s view, final rules are not coming soon.
Even without a legal requirement, many companies have adopted clawback policies. Litigation about those policies is now begin- ning to reach the courts. Kohn pointed to City of Tamarac Firefighters’ Pension Trust Fund v. Corvid, a case decided in February by the Delaware Court of Chancery. This was a shareholder derivative suit for alleged breaches of fiduciary duty, waste, and unjust enrichment in connection with separation agreements between United Continental Holdings and its former CEO, Jeffrey Smisek.
The agreements, under which Smisek received about $37 million in payments and benefits, followed a federal investigation into allegations that Smisek had conspired with the chairman of the Port Authority chairman to obtain approval of United’s development projects in exchange for reinstituting a Newark- to-Columbia flight.
In granting the defendants’ motions to dismiss, the court affirmed that a board’s decision to refuse a pre-suit demand to exercise a clawback was subject to the business judgment rule. The court pointed out that United’s directors were disinterested, they exercised due care, and they had valid business reasons for entering into the separation agreements.
According to Kohn, the business judgment rule should protect directors in the unusual situation of claims arising from their decision not to pursue a clawback claim. Kohn suggested that pressure on companiesto pursue clawbacks would not come from the courts, but could come from shareholders or from shareholder advisory firms such as Institutional Shareholder Services (ISS).
“Tone at the top.” Kohn noted a trend in which clawbacks could be triggered not by specific actions of executives but by their failure to maintain a proper “tone at the top.” As an example, Kohn pointed to complaints that The Hertz Corporation filed in New Jersey and Florida courts against four of its top executives arising from a restatement of the company’s financials for fiscal years 2011, 2012, and 2013. The complaints seek recovery of $70 million in incentive compensation paid to three of the executives and more than $200 million in damages resulting from the financial restatement.
Kohn emphasized that Hertz’s claim was almost entirely about an “inconsistent and inappropriate tone at the top.” The CEO was alleged to have exerted too much pressure to reach the company’s financial goals, and the CFO and general counsel were alleged to have failed to push back against that pressure.
Kohn suggested that companies consider whether employment agreements should refer to maintaining an appropriate “tone at the top.” It may be difficult to negotiate such a provision as part of a definition of “cause” because of the vagueness of the concept, which could allow companies too much leeway to dismiss executives for cause. “Tone at the top” is more likely to appear in agreements as part of the list of an executive’s responsibilities.
Legal fees. As part of the same dispute, the four former Hertz executives sued Hertz in the Delaware Court of Chancery, seeking advancement of their expenses and legal fees. In a May decision, the court sided with the executives, finding that Hertz’s bylaws entitled them to advancement of legal fees “by reason of the fact” that the company’s allegations were connected to their conduct as officers.
Kohn expressed mild surprise at the seeming ease with which the court reached its conclusion. He noted that the dispute between Hertz and the executives was over compensation and suggested that such a dispute could be viewed as a contractual matter not subject to the company’s bylaws. The lesson of the case for companies is to make sure that their executive agreements clearly reflect their intentions about advancement and indemnification in clawback disputes.
A different kind of dispute over legal fees arose in Computer Sciences Corporation v. Pulier, decided by the Delaware Court of Chancery in May. Computer Sciences Corporation (CSC) had acquired ServiceMesh, Inc. in 2013. Under the purchase agreement, the equity holders agreed to indemnify and hold CSC and ServiceMesh harmless for certain categories of losses.
In 2015, CSC filed an action against Eric Pulier, the founder and former CEO of ServiceMesh, claiming that he had entered into a secret agreement with executives at an Australian bank to increase his payout from the deal. Pulier demanded that CSC and/or ServiceMesh advance his legal fees for defending this suit, and the court agreed.
In the 2019 case, CSC sought indemnification from ServiceMesh under the terms of the purchase agreement for a portion of the amounts it had advanced to Pulier on ServiceMesh’s behalf. The Delaware Court of Chancery denied CSC’s motion, finding that legal fees did not relate to the board’s “authorization and approval” of the sale transaction, as the purchase agreement required.
Here too, Kohn expressed surprise that the language of the indemnification clause, which seemed quite broad, was not deemed to cover the legal fees in this case. But an M&A lawyer whom Kohn consulted felt that the court had reached the right decision, because the clause was only meant to cover disputes about the valuation of the deal. The takeaway for Kohn was to review and possibly revise the boilerplate indemnity language used in M&A agreements.
Director compensation. In May, the Delaware Court of Chancery denied Goldman Sachs’ motion to dismiss a shareholder derivative suit, Stein v. Blankfein. The plaintiff claimed that Goldman’s non-employee directors breached their fiduciary duties by paying themselves excessive compensation.
The complaint alleged that the Goldman equity plans did not set a limit on director compensation and permitted directors to use their discretion to set their own compensation. Shareholders were not informed about the specifics of the director compensation package.
The court determined that the entire fairness standard should apply instead of business judgment. It found that the compensation plan at issue “manifestly” failed the test enunciated by the Delaware Supreme Court in its 2017 Investors Bancorp decision. Under that test, the business judgment standard applies “only where stockholders approve a compensation plan that does not involve future director discretion in setting the amount of self-payment.”
The plaintiff claimed that Goldman directors’ annual compensation averaged $605,000, more than twice that of peer companies. While setting salaries above a peer average is not evidence of excessive compensation, the court said that plaintiff’s claims nonetheless met their “low pleading burden.”
Kohn noted that most companies have not seemed to change their director compensation practices in the wake of Investors Bancorp. One notable exception is JP Morgan, which established a multi-year limit in 2018, with increases in the amount of the director retainer limited to $25,000.
In setting reasonable limits on discretionary director pay, Kohn said he used to advise clients to use 2-3 times regular pay as the standard; now he advises that 1-2 times regular pay be used instead.
For Kohn, the open question is whether most companies should routinely obtain shareholder approval of director pay, with no discretion permitted. Kohn believes that the Delaware law does not yet suggest that they should.
Fund Sponsor’s Use of IRA Assets. In March, the U.S. Bankruptcy Court in the Northern District of Texas in in re Correra analyzed whether a debtor’s assets in IRAs are exempt property in bankruptcy. Texas law provides that an IRA is exempt from attachment, execution, or other seizure if it is a qualified plan under the Internal Revenue Code.
The court held that the IRAs had engaged in prohibited transactions under Code Sec. 4975, which caused them to lose their tax-exempt status and therefore their bankruptcy exemption. The bankruptcy debtor managed a hedge fund that consisted of three entities and owned more than 50% of each entity. This made the entities disqualified persons under the Code and made transactions between the IRAs and the entities prohibited transactions. The court also found that exception in Code Sec. 4975(d)(2) for payment of reasonable administration expenses was inapplicable here. For Kohn, this case serves as a warning to exercise caution when a hedge fund manager proposes to invest IRA assets in the hedge fund. The risks of such an action usually outweigh the benefits, because a fund owner can easily be deemed a disqualified person. For lower-level hedge fund employees, who are less likely to be disqualified persons, the risk/benefit analysis may shift in favor of making the investment.
Sustainability metrics. Kohn ended his presentation by noting the emerging trend of including sustainability metricsin incentive compensation plans. In November 2018, the Sustainability Accounting Standards Board (SASB) issued its first-ever set of 77 industry-specific sustainability standards. They can be downloaded at https://www.sasb.org/standards-overview/download-current-standards/.
The SASB standards include typical environmental concerns as well as social concerns such as diversity. They also include quantitative and qualitative measures for determining success in these areas. For Kohn, this development raises the question of which performance metrics related to the intangible value that sustainability concerns are intended to address should be considered in setting executive compensation.
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Scott E. Weiner, J.D., is a Senior Editor/Tax Analyst with the Tax and Accounting Professionals business at Thomson Reuters. He has been writing about legal and tax matters for more than 30 years.
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