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In Cincinnati Bell, the United States District Court declined to grant a motion to dismiss a law suit resulting from a failed say-on-pay vote (a copy of the decision is available on thecorporatecounsel.net).  A Georgia Court reached the opposite result in the Beazer case (a copy of the decision is available on thecorporatecounsel.net).  We have prepared a high-level summary of the differences between the two decisions.

Demand Excused Requirement

A precondition to a derivative suit is plaintiffs must usually make a pre-suit demand on the company’s board that it investigate and evaluate whether to bring the claims or to plead facts demonstrating legal excuse from the demand requirement.

Beazer

Under Delaware law, shareholders must plead particularized facts demonstrating legal excuse from the demand requirement.  While different tests can apply under different circumstances, the plaintiffs here rely on the proposition that the challenged decisions were not the result of a valid exercise of business judgment.  Here, the plaintiffs must allege particularized facts that rebut the presumption of the business judgment rule.  The plaintiffs appear to hang their hat on the theory that the failed say-on-pay vote constitutes evidence that rebuts the presumption that the Beazer directors’ decisions approving the challenged compensation and recommending the shareholders approve the executive compensation were valid business judgments.  The Beazer court rejected this reasoning because:

  • The say-on-pay vote had not yet been held when the challenged decisions were made.  The outcome of the vote, which was not known, does not therefore suggest the directors failed to act on an informed basis.
  • The Dodd-Frank Act explicitly provides that a say-on-pay vote shall not be construed as overruling a decision by the board of directors or create or imply any additional fiduciary duties.
  • Plaintiffs cite no authority that the say-on-pay vote is evidence when determining whether the business judgment rule is rebutted.

On another prong of the demand excused test, the Beazer court notes that the plaintiffs have failed to allege facts that a majority of the Beazer board face a substantial likelihood of personal liability.  No material undisclosed facts were alleged regarding the challenged executive compensation.  The challenged executive compensation was pubic knowledge because it was disclosed in the proxy statement.

Cincinnati Bell

Under Ohio law, the plaintiff must point to facts which show that the presumed ability of the directors to make unbiased, independent business judgments about whether it would be in the corporation’s best interests to file the action does not exist.  Ohio courts have consistently rejected the idea that demand is always futile when directors are targeted as the wrongdoers of the suit.  However demand is presumptively futile where the directors are antagonistic, adversely interested, or involved in the transactions attacked.  Here the court found these tests were met where the directors are the same persons who approved the pay hikes and bonuses, and recommended the shareholders approve the compensation.  As a result there were sufficient facts to show there is reason to doubt these same directors could exercise their independent business judgment over whether to bring suit against themselves.

Failure to State a Claim

Beazer

The court dismissed the complaint for failure to state a claim for the following reasons:

  • For reasons set forth above, the plaintiffs failed to allege particularized facts rebutting the business judgment rule.
  • The plaintiff failed to allege any material omitted facts were withheld from Beazer shareholders or any misrepresentations were made regarding Beazer’s executive compensation policies.

Cincinnati Bell

Under Ohio law, the business judgment rule imposes a burden of proof, not a burden of pleading, and that plaintiffs are not obligated to plead operative facts that would rebut the presumption.  The court noted that while it must apply federal law on matters of procedure, the federal law is much the came.  We have noted our doubts about the court’s analysis here – both as to the shallowness of facts alleged and the analysis under the federal rules.  The court also buys into the notion that the say-on-pay vote can provide evidence regarding exercise of business judgment despite the clear language of the Dodd-Frank Act.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The staff of the SEC has issued a report summarizing the staff’s observations and concerns arising from the examinations of ten credit rating agencies registered with the SEC as Nationally Recognized Statistical Rating Organizations, or NRSROs, and subject to SEC oversight.

The SEC staff conducted the examinations as required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which imposed new reporting, disclosure and examination requirements to enhance the regulation and oversight of NRSROs. Among other things, the Dodd-Frank Act requires the SEC staff to examine each NRSRO at least annually and issue an annual report summarizing the essential findings of the examinations.

The report notes that, despite changes by some of the examined credit rating agencies to improve their operations, SEC staff identified concerns at each of the NRSROs. These concerns included apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest. The report notes that the staff made various recommendations to the NRSROs to address the staff’s concerns and that in some cases the NRSROs have already taken steps to address such concerns.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Dodd-Frank Act established the Federal Insurance Office, or FIO, within the Treasury Department.  FIO Director Michael McRaith recently explained the FIOs current and expected activities.

The FIO advises the Secretary of the Treasury on major domestic and prudential international insurance policy issues.  As part of this work, it monitors all aspects of the insurance industry, including the availability of affordable insurance to traditionally underserved communities and consumers.  The FIO also assists the Secretary in administering the Terrorism Risk Insurance Act, which helps support the market for terrorism risk insurance products.

Congress gave the FIO authority to identify issues or gaps in the regulation of insurance that could contribute to a systemic crisis in the insurance industry or the broader U.S. financial system, and to make recommendations to the Financial Stability Oversight Council, or FSOC, regarding whether an insurer or its affiliates should be subject to supervision by the Board of Governors of the Federal Reserve.

Over the next several months, FIO will focus on preparing a statutorily-mandated study and report due to Congress in January 2012 on how to modernize and improve the U.S. system of insurance regulation.  Treasury also intends to announce members of the Federal Advisory Committee on Insurance, or FACI.  The FACI will provide advice and recommendations to the FIO.  The FIO will also soon be submitting two statutorily required-reports to Congress: one regarding the state of the insurance industry and another on whether in the last year FIO has acted to preempt any state insurance laws, which it has not.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

A handful of companies have received SEC comments on their say-on-pay proposals in their proxy statements.  The comments we found are outlined below.  In general, they can be summarized as follows:

  • Issuers can be sloppy by not following the technical wording of the rule (or worse yet, in ignoring it altogether), and the SEC is capable of making silly comments.
  • Issuers depart from having the advisory vote cover anything other than “compensation of its named executive officers, as disclosed pursuant to Item 402 of Regulation S-K” at their own risk..
  • Most of the comments were on preliminary proxy statements so the SEC policy on correcting in future proxies is unclear.
  • The SEC will look closely at the language in the proxy card as well.

Issuer A

Comment:

Please include separate resolutions providing shareholders with an advisory vote to approve the compensation of your named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, and whether the shareholder vote should be held every 1, 2, or 3 years.  Alternatively, tell us why you are not required to comply with Exchange Act Rule 14a-21 at this time.  Refer to Item 24 of Schedule 14A, Exchange Act Rule 14a-21(a)-(b).  For additional guidance, see Securities Act Release 33-9178.

 Response”

The Company inadvertently omitted the proposals from its preliminary proxy statement and the proposals are now included as Proposal Number Five and Proposal Number Six.

Issuer B

Comment:

Rule 14a-21(a) of the Exchange Act of 1934 requires that you provide shareholders with an advisory vote to approve the compensation of your named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including related narrative disclosure. It does not appear that the resolution on page 48 meets the requirements of Rule 14a-21(a), given that it seeks approval only for your “overall executive compensation policies and procedures” (emphasis added).  Please tell us how you intend to address this apparent noncompliance or tell us why you believe that your present disclosure is in compliance with Rule 14a-21(a).

Response:

The Company recognizes that the wording of the Resolution which is presented to the stockholders in the Proxy Statement filed April 21, 2011 did not satisfy the requirements in Rule 14a-21(a) of the Exchange Act of 1934.  In light of this, the Company has filed and mailed to its stockholders an Amendment to its Proxy Statement amending Proposal 3 to specifically ask the stockholders to vote, on an advisory basis, on the Company’s executive compensation, as disclosed pursuant to the compensation disclosure rules of the Securities and Exchange Commission.

Issuer C

Comment:

Please revise your proxy statement to include the proposals required by Item 24 of Schedule 14A or provide us with an analysis as to why you are not required to include these proposals.

Response:

The Company advises the Staff that it is a “smaller reporting company” as such term is defined in Rule 12b-2 (“Rule 12b-2”) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), because the Company had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter (i.e., June 30, 2010). On such date, the Company’s public float, computed in accordance with the definition of “smaller reporting company” set forth in Rule 12b-2, was $28,046,748. Pursuant to Securities Act Release No. 9178/Exchange Act Release No. 63768 (Jan. 25, 2011), companies that qualify as “smaller reporting companies” as of January 21, 2011, are not subject to Exchange Act Section 14A(a) and Rule 14a-21(a) and (b) until the first annual or other meeting of shareholders at which directors will be elected and for which the rules of the Commission require executive compensation disclosure pursuant to Item 402 of Regulation S-K occurring on or after January 21, 2013. Accordingly, the Company is not required to include such proposals in its proxy statement for its 2011 annual meeting.

Issuer D

Comment:

Please include a separate resolution subject to shareholder advisory vote to approve the compensation of your named executive officers, as disclosed pursuant to Item 402 of Regulation S-K. See Rule 14a-21(a) of the Exchange Act and Instruction to Rule 14a-21(a) of the Exchange Act.

Reponse:

During our telephonic conversation on April 25, 2011, we indicated that we will file an amended preliminary proxy statement to include a separate resolution to approve the compensation of our named executive officers.  The resolution we will include is as follows:

RESOLVED, that the shareholders of this corporation approve, on an advisory basis, the compensation of the named executive officers for the fiscal year ended February 26, 2011, as described in the “Compensation Discussion and Analysis” section of and the compensation tables and related material disclosed in the corporation’s proxy statement for its 2011 Regular Meeting of Shareholders pursuant to the compensation disclosure rules of the Securities and Exchange Commission.

Issuer E

[T]his letter is in response to your telephone call on Friday, April 22, 2011 relating to our proxy statement for the 2011 Annual Meeting of Stockholders. In such call you stated that the resolution of the stockholders contained in the Advisory Vote on Executive Compensation (Proposal 10) on page 54 of the proxy statement did not adequately comply with the requirements of Rule 14a-21(a) adopted last February by Securities and Exchange Commission Release No. 33-9178 (the “Release”), Shareholder Approval of Executive Compensation and Golden Parachute Compensation, because it did not directly approve the actual compensation of our named executive officers as disclosed in the proxy statement.

In drafting the resolution, the Company intended to clearly and broadly seek stockholder approval, on an advisory basis, of the actual compensation of our named executive officers as disclosed in the proxy statement. The first sentence of the third paragraph of the proposal makes the scope of the vote explicit:

We are asking for stockholder approval of the compensation of our named executive officers as disclosed in this proxy statement in accordance with SEC rules, which disclosures include the disclosures under “Executive Compensation—Compensation Discussion and Analysis,” the compensation tables and the narrative discussion following the compensation tables.

The fifth paragraph of the proposal similarly refers to the vote as addressing “named executive officer compensation as disclosed in this proxy.”

The language of the formal resolution included in the proposal is not limited to an approval of executive officer compensation policies and procedures as prohibited by the Release. By including the language “practices of the Company as disclosed in this proxy statement” in the resolution we intended to cover the actual compensation of our named executive officers, rather than the Company’s general approach to compensation.

Finally, our proxy card say-on-pay item seeks approval for the “Advisory Vote on Executive Compensation.” The resolution language is not repeated on the proxy card. This further illustrates our intent to obtain stockholder approval of the compensation of our named executive officers and not solely to approve our policies and philosophy.

Notwithstanding the above, we acknowledge your comment. We note that Rule 14a-21(a) does not require any specific form of resolution, and indeed, per Compliance & Disclosure Interpretation Q&A 169.04, a formal resolution is not even required under Rule 14a-21(a). We believe the current disclosure in the proxy statement is not materially inconsistent with the intention of the Release and Rule 14a-21(a), that shareholders are likely to understand the scope of the proposed vote to include a vote on the compensation of the named executive officers as disclosed in the proxy statement, and therefore, we cordially request that no changes be required for this year’s proxy statement. We do, however, undertake that any formal resolution included as part of our Rule 14a-21(a) advisory vote in our future proxy statements shall clearly state that the Company is seeking approval of our stockholders, on an advisory basis of “compensation paid to the company’s named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including the Compensation Discussion and Analysis, compensation tables and narrative discussion” when obtaining future advisory votes as required by the Release.

Issuer F

Comment

We note that Proposal 3 on the proxy card is described as a vote to “[p]rovide an advisory vote on executive compensation.” Using the word “provide” to describe the proposal implies that shareholders are voting on whether they should be provided an advisory vote on executive compensation in the future. But the discussion of the proposal starting on page 5 indicates that you are providing a shareholder advisory vote on the compensation of your named executive officers. Revise your proxy card to more clearly describe the effect of Proposal 3 as required by Rule 14a-4(a)(3). Refer to the example in the instruction to Rule 14a-21(a).

Response

The Company has revised the preliminary proxy card to delete the reference to “provide”.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

As we noted, the United States District Court for the Southern District of Ohio recently declined to grant a motion to dismiss filed by the officers and directors of Cincinnati Bell that resulted from a failed say-on-pay vote required by the Dodd-Frank Act.  The Court’s decision appears to be poorly reasoned.  A link to the decision can be found on thecorporatecounsel.net.

Did the Court Understand the Facts?

The Court found that plaintiff made adequate pleadings that the Cincinnati Bell board is not entitled to business judgment protection for its 2010 executive pay hikes.  In footnote 2, the court pointed to the allegations made by the plaintiffs.  In sum, the allegations amount to noting more than (i) pay increased and (ii) net income dropped.

Wow.  Given this precedent, any company that increases pay in a year when net income drops will not be able to defend a derivative law suit at the motion to dismiss stage.

Notwithstanding the gapes in the Court’s decision from a policy perspective, the Cincinnati Bell compensation program had nothing to do with net income.  In 2010, incentive payments were tied not to net income, but to EBITDA, revenues and individual performance.  In 2010, Cincinnati Bell met or exceeded the EBITDA and revenue targets for the incentive compensation program.  Net income declined because of one time events associated with an acquisition and refinancing of debt.  These key factors are absent from the Court’s reasoning.

The Court Did Not Properly Consider the Role of the Business Judgment Rule in a Motion to Dismiss

In Cincinnati Bell, the Court held that “the business judgment rule imposes a burden of proof, not a burden of pleading.”  Admittedly, the role of the business judgment rule in a motion to dismiss in Federal courts has been much more confused than more refined law in Delaware courts.  However, the Supreme Court of the United States in the 2007 Twombly decision and the 2009 Iqbal decision arguably requires that plaintiffs must rebut the presumptions of the business judgment rule in their pleadings.  See Federal pleading standards and the business judgment rule after Twombly and Iqbal, Journal of Securities Law, Regulation & Compliance, Vol. 3 No. 4 (2010).

In the Cincinnati Bell decision, the Court appeared to rely on decisions which predated the Twombly and Iqbal decisions.  The uninformed “pay up, net income down” rational, coupled with the specifics of the Cincinnati Bell incentive plans, which have nothing to do with net income, seem to be clear error by the Court, as there were not enough facts pled to overcome the presumptions of the business judgment rule.

What Did Say-on-Pay Have to Do With This?

Section 951 of the D0dd-Frank Act provides the say-on-pay vote shall not be binding on the issuer or the board of directors of an issuer, and may not be construed:

  • as overruling a decision by such issuer or board of directors;
  • to create or imply any change to the fiduciary duties of such issuer or board of directors;
  • to create or imply any additional fiduciary duties for such issuer or board of directors; or
  • to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.

In Cincinnati Bell, the Court appears to give weight to the plaintiff’s contention that the failed say-on-pay vote provides evidence that the compensation decisions were a breach of the director’s duties (See footnotes 1 and 4).  That appears contrary to the Dodd-Frank Act.

As we noted, were glad the Georgia courts have dismissed a similar law suit brought against Beazer.  The likely result of the Cincinnati Bell decision is the defendants there are going to be forced to settle the non-meritorious litigation rather than face the unknown risks of a trial.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Congress required the Government Accountability Office, or GAO, to report on the relative independence, effectiveness, and expertise of federal Inspector Generals, or IGs, appointed by the President and confirmed by the Senate (presidential) and those appointed by agency heads in designated federal agencies.  The Dodd-Frank Act also calls for GAO to report on the effect that provisions in the Dodd-Frank Act have on the independence of the IGs.  GAO has recently issued its report.

GAO found that the IGs had:

  • taken actions to implement statutory provisions intended to enhance their independence;
  • reported billions of dollars in potential savings and other measures of effectiveness, including actions taken to help prevent fraud in the distribution of American Recovery and Reinvestment Act of 2009; and
  • a range of expertise and qualifications in the areas specified by the Inspector General Act of 1978.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The United States District Court for the Southern District of Ohio recently refused to grant the defendants’ motion to dismiss litigation resulting from Cincinnati Bell’s failed say-on-pay vote required by the Dodd-Frank Act. 

Business Judgment Rule

The court noted that Ohio courts follow the “business judgment rule.”  Directors face liability only if it is shown by clear and convincing evidence that actions were undertaken with a “deliberate attempt to cause injury to the corporation” or “reckless disregard for the best interest of the corporation.”

The court also noted however that, in its view, the “business judgment rule imposes a burden of proof, not a burden of pleading.” Explaining further, the court stated the business judgment rule would require the plaintiff to present evidence at trial to rebut the presumption the rule imposes.  However, according to the court, the plaintiff is not required to plead operative facts in their complaint that would rebut the presumption.

Here, the court found the plaintiff’s allegations raised a plausible claim that the multi-million dollar bonuses approved by the directors during a time of declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and therefore constituted an abuse of discretion or bad faith.  The court continued that the defendants may offer the affirmative defense of the business judgment rule at trial.

Pre-suit Demand

The court also found pre-suit demand was not futile because the plaintiff pled specific facts to give reason to doubt that the directors would make an unbiased decision about whether to sue themselves.  The directors, the court noted, were the very same people who voted to approve the pay hikes and bonuses.  It seemed critical to the court that the directors not only approved the transactions, but that they also recommended to the shareholders that the shareholders approve the compensation.

Unjust Enrichment

The plaintiff also claimed three defendants were unjustly enriched as a result of the executive compensation.  According to the plaintiff, the unjust enrichment flowed from the Cincinnati Bell board’s breach of fiduciary duty.  The court rejected the argument that the defendants could not have been unjustly enriched merely because they rendered services.  The court found that the plaintiff sufficiently pled facts of beach of fiduciary duty. It is “axiomatic” that plaintiff has also sufficiently pled a case for unjust enrichment according to the court.

Beazer Litigation

In the court docket, the defendants also submitted information regarding the Beazer say-on-pay litigation pending in the Superior Court of Fulton County Georgia. In that case the defendants noted that the court had granted the defendants’ motion to dismiss, but no formal order had yet been signed.  A proposed order by the Beazer defendants, found in the Cincinnati Bell docket, indicates the judge’s decision may have been based on:

  • Failure to properly allege excuse from the pre-suit demand requirement
  • Failure to state a claim.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Federal Reserve Board has issued a final rule amending Regulation B to provide that motor vehicle dealers are not required to comply with new data collection requirements in the Dodd-Frank Act until the Board issues final regulations to implement the statutory requirements.

The Dodd-Frank Act amended the Equal Credit Opportunity Act to require creditors to collect information about credit applications made by women- or minority-owned businesses and by small businesses. The Consumer Financial Protection Bureau, or CFPB, must implement this provision for all creditors except certain motor vehicle dealers who are subject to the Board’s jurisdiction. The CFPB previously announced that creditors are not obligated to comply with the data collection requirements until the CFPB issues detailed rules to implement the law. The Board is amending Regulation B to apply the same approach to motor vehicle dealers.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has proposed a rule intended to prohibit certain material conflicts of interest between those who package and sell asset-backed securities, or ABS, and those who invest in them.  According to the SEC, the proposed rule is designed to ensure that those who create and sell asset-backed securities cannot profit by betting against those same securities at the expense of those who buy them.

Proposed Rule 127B would implement the prohibition under Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is codified as Section 27B of the Securities Act of 1933.  The prohibition under Securities Act Section 27B applies to both registered and unregistered offerings of ABS.

The proposed rule would prohibit:

  • Securitization participants — underwriters, placement agents, initial purchasers, sponsors, or any of their affiliates or subsidiaries …
  • of an ABS — including a synthetic ABS …
  • for a designated time period — ending on the date that is one year after the date of the first closing of the sale of the ABS …
  • from engaging in certain transactions — including effecting a short sale of the securities offered in the ABS transaction or its underlying assets …
  • that would involve or result in any material conflict of interest — with respect to any investor in a transaction arising out of such activity.

A transactions involves a material conflict of interest if:

  •  a securitization participant would benefit directly or indirectly from the actual, anticipated or potential
    • adverse performance of the asset pool supporting or referenced by the relevant ABS,
    • loss of principal, monetary default or early amortization event on the ABS, or
    • decline in the market value of the relevant ABS (i.e., a “short transaction”); or 
  •      a securitization participant, who directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS, would benefit directly or indirectly from fees or other forms of remuneration, or the promise of future business, fees, or other forms of remuneration, as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction.

In addition to the above, there must be a “substantial likelihood” that a “reasonable” investor would consider the conflict important to his or her investment decision (including a decision to retain the security or not).

As required by the Dodd-Frank Act, the proposed rule would exempt from the conflict of interest prohibitions risk-mitigating hedging activities, liquidity commitments, and bona fide market-making.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The CFTC’s Division of Market Oversight (Division) has issued a letter providing temporary relief from the requirements of the CFTC’s regulations regarding large trader reporting of physical commodity swaps (§§20.3 and 20.4). Because this is the first time that swaps data is being collected, this temporary relief is intended to provide sufficient time to enable both the industry and the CFTC to develop and refine systems and processes that will be able to report these complex transactions.

On July 22, 2011, the CFTC published large trader reporting rules for physical commodity swaps and swaptions. The rules require daily reports from clearing organizations, clearing members and swap dealers, and become effective on September 20, 2011. The letter provides temporary relief from reporting, as long as parties are making a good faith attempt to comply with the reporting requirements, until November 21, 2011, for cleared swaps, and January 20, 2012, for uncleared swaps. Upon the conclusion of applicable relief periods, such reporting parties must become fully compliant.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.