Avoiding Compensation-Related Legal Actions

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Avoiding Compensation-Related

Legal Actions

Arthur H. Kohn, Elena C. Norman, and Erica E. Bonnett

October 14, 2021

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The Business Judgment Rule

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The Business Judgment Rule

— The business judgment rule is a standard of judicial review of corporate director conduct. It generally

provides that a court “will not substitute its own notions of what is or is not sound business judgment”

if “the directors of a corporation acted on an informed basis, in good faith and in the honest belief that

the action taken was in the best interests of the company.”

• The purpose of the rule is to shield directors from personal liability and insulate board decisions from judicial

review. Decisions that fall within the protection of the rule are presumed to be valid and will not be subject

to judicial review, even if the directors’ decision proves to have yielded poor results in retrospect.

— Informed decisions made by independent boards regarding employee compensation are generally

protected under the business judgment rule.

— However, the rule’s protection depends on the assumption of impartial decision-making by the board.

Where a plaintiff can show that the board did not exercise good faith and was not informed, a higher

standard of review will apply.

— A board’s failure to follow appropriate processes and procedures risks the time and expense of a

lengthy litigation and the possibility of a court finding that the business judgment rule was

not satisfied.

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The Importance of Process

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Process Matters

CONFLICTS

— Explore potential conflicts and ensure disclosure of the

relevant facts to the board.

— Conflicts with outside advisors, including compensation

consultants, should be considered.

BOARD MATERIALS

— Create helpful board materials and give directors time to

review materials in advance of a meeting.

— Directors should be provided with a summary of the key

features of an agreement. Consider presenting information

in a chart or tabular format where appropriate.

— Provide redlines when changes are made.

ACTIVE DIRECTORS

— Directors should not be passive and should ask

management pressing questions.

MINUTES

— Decisions should be carefully documented in the board

minutes.

— Better or more complete documentation can help to

resolve a case favorably at an early stage of the process.

Process is often a critical component in a court’s determination of whether fiduciary duties have been

satisfied.

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COVID-19

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Covid-Related Litigation

— Healthcare Industry – As of the beginning of June, more than one in five of every pandemic-related

lawsuit filed across the country had been filed against healthcare employers: 540 out of just over

2,400 cases, or 22.5% of all claims filed. And of those hundreds of claims, whistleblower retaliation

lawsuits are among the most common type brought against healthcare employers, generally alleging

failure to follow appropriate COVID-prevention protocols.

— Americans with Disabilities Act Discrimination – Claims under the ADA do not necessarily have to

plead actual disability and substantial impairment of a major life function, if the plaintiff can show that

the defendant believed that the employee is disabled, without regard to whether the defendant believes

that the disability limits any major life function.

— Americans with Disability Act Failure to Provide Reasonable Accommodation – These are claims

that employees with a disability under the Act were not provided with the reasonable accommodation

of work-from-home eligibility during the pandemic.

— Age Discrimination in Employment Act – Claims alleging prima facie case of age discrimination

based on staffing back up after COVID layoffs with younger employees.

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Covid-Related Litigation

— Public-policy Based Wrongful Termination Claims – Claims alleging wrongful termination based

on employer actions that are alleged to be in conflict with COVID-related public policy decisions

(e.g., employee decisions to quarantine).

— FFRCA Leave Claims – Under the Families First Coronavirus Response Act, certain employers were

required to provide eligible employees with emergency paid sick leave and expanded family medical

leave (EFMLA) for specific COVID-19-related reasons. In exchange, those employers would be

eligible for refundable tax credits.

— Vaccine Mandate Claims – Most efforts to overturn employer vaccine mandates have failed, but new

theories continue to be asserted. In a recent case, plaintiffs allege mandatory vaccinations are "a fraud

upon the entire American public,” claim a vaccine mandate requires them to “participate in a medical

experiment,” constitutes a “fraud in the concealment” on the basis that the employer was “fully aware

and/or recklessly ignored the inaccuracy of both the internal and external reporting regarding COVID-

19” and constituted a violation of the Nuremberg Code of 1947.

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Recent Litigation

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Garfield v. Allen, et. al., C.A. No. 2021-0420-JTL: Complaint

— Lawsuit involves 2019 Long term incentive plan adopted by Board of the ODP Corporation and

approved by Company’s stockholders. The plan imposed “annual limits” on the amount of equity

awards that could be granted to an individual participant during a fiscal year. Lawsuit involved grant

of equity awards to Smith, ODP’s CEO and a member of the Board.

— Plan provided that the number of shares of ODP common stock subject to award granted in a fiscal

year to an individual participant shall not exceed 3,500,000.

— In March 2020, Board’s Compensation & Talent Committee granted Performance Share awards to

Smith under the 2019 Plan pursuant to which he could earn various amounts of ODP common stock

upon the achievement of performance goals during a three-year performance period. In granting the

awards to Smith, the Committee allegedly exceeded the 2019 Plan’s 3,500,000-share cap. Awards had

three scenarios: (i) threshold; (ii) target; and (iii) maximum. Scenarios referred to the Company’s

achievement of certain metrics during a three year period. Grant #1 based on total shareholder return

of the Company. Grant #2 based on Company’s free cash flows. Shareholders approved the grant to

CEO.

— Board allegedly decreed that only 2,366,929 “target” shares were subject to the Performance Limit.

Not the shares that would be awarded for meeting threshold goals or maximum goals.

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Garfield v. Allen, et. al., C.A. No. 2021-0420-JTL: Motion to Dismiss

— Complaint alleges Breach of Fiduciary Duty, Unjust Enrichment and Breach of Contract Claims

— Multiple arguments in support of dismissal:

• Ripeness – Claims are not ripe because size of Smith’s equity award has not yet been determined.

• Business judgment rule protects the decisions of the committee that administers the 2019 plan to make awards and

to determine how shares are counted to comply with limits in the 2019 plan.

• Unjust enrichment fails because Complaint does not allege enrichment, impoverishment, or lack of remedy at law

that is required to state a claim.

• Breach of contract fails because number of common shares associated with the Performance Shares granted to

Smith is not known. Cannot plead damages because no common shares have been given to Smith.

• ODP’s shareholders ratified the grant made to Smith.

• Claims are duplicative of one another and cannot coexist.

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Man Ho v. Roku Inc., C.A. 2021-0731

— Books and records action seeking records relating to equity awards issued to four company

executives. Seeks to investigate:

1) whether members of board breached fiduciary duties in granting equity awards in Aug 2019 to executive

officers and employees of Roku

2) whether Board timed the issuance of awards just prior to the public release of material non-public

information to its benefit and to the detriment of he Company and its stockholders

3) whether violation of Company’s 2017 Equity Incentive Plan, which prohibits awards priced below fair market

value of the stock on the day of the grant

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— August 2019 Compensation Committee granted equity awards to certain named executive officers

— Exercise price of $100.85, which reflected Company’s closing price on August 1, 2019

— August 7, Company issued a press release announcing 2Q results reporting that year over year, total

net revenue rose 59% and gross profit rose 47%, vastly exceeding market expectations

— Company’s stock price rose, and again following 2Q results earnings call

— Stock price ultimately rose about 35%

— Four executives gained $14.5 million in value less than two weeks after the awards.

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— Purposes of demand:

1) investigate wrongdoing;

2) assess ability of board to consider demand;

3) take appropriate action if Board did not properly discharge duties;

4) discuss proposed reforms with Board.

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Dos Ramos Alvarado v. Lynch, et. al., C.A. 2020-0237-AGB

— Complaint alleged that Board of bluebird bio adopted a compensation plan which grossly

overcompensated Non-Employee director defendants in relation to companies of comparable market

capitalization and size. Not approved by stockholders.

— Compensation plan failed to take into account metrics such as revenue and profit in setting

compensation.

— Despite companies losses, Non-Employee director defendants were allegedly paid fair beyond the

range of compensation of their peers at similarly sized, publicly traded companies. Amounts paid

represented more than three times what plaintiff contended were appropriate peer companies.

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Dos Ramos Alvarado v. Lynch, et. al., C.A. 2020-0237-AGB

— In a transcript ruling dated November 12, 2020, Court denied the Motion to Dismiss

— Defendant argued that comparison drawn by plaintiff was not a comparison with Company’s peer

group companies set forth in the proxy statement, and plaintiff failed to plead any facts that suggests

that the peer group was inappropriate: “There is nothing about the peer group. There is nothing about

other life sciences companies. There is nothing to put it into context.”

— Court denied motion to dismiss (but granted for waste claim). Case governed by entire fairness. “And

at least to date, this Court has not embraced a rule along the lines defense counsel advocated for today

that would necessitate that the plaintiff engage in a direct rebuttal of the peer companies a corporation

uses in its proxy statement in order to state a claim for relief.”

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Attorney-Client Privilege

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Tornetta v. Musk, et. al., C.A. No. 2018-0408-JRS

— In May 2021, Vice Chancellor Slights issued a ruling on attorney-client privilege in the executive

compensation context, ordering the production of certain documents but protecting others. The

documents were sought in a lawsuit in which plaintiffs was challenging Elon Musk’s 10 year

compensation package, under which he could potentially be awarded $55 billion.

— The Court held that documents shared between General Counsel or Deputy General Counsel and Musk

had to be produced. Musk was adverse to the company with respect to the negotiation of his

compensation package. Waiver included documents containing legal advice relating to the negotiation

and approval of the compensation package:

— “To the extent that documents . . . Reflect communications in which Mr. Musk is involved, either as

the source or recipient, prior to board approval of the 2018 plan, including documents that may capture

legal advice about the 2018 award or disclosure of that award, those documents must be produced.

Any privilege between in-house counsel, outside counsel, and the committee or the company on this

subject attaching to these documents was waived.”

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Tornetta v. Musk, et. al., C.A. No. 2018-0408-JRS

— Plaintiff also attempted to get documents under the Garner exception to the attorney-client privilege.

Specifically, plaintiff sought production of communications among the committee, in-house counsel,

and/or the committee’s outside counsel. Plaintiff did not overall meet the requirements of the standard,

which looks to:

1) whether shareholder’s claim was colorable (yes);

2) whether the privileged information was necessary and unavailable from other sources (no);

3) whether plaintiffs were seeking the documents through a fishing expedition (no).

— Delaware courts may also consider whether a conflict of interest exists in connection with the alleged

breach of fiduciary duties.

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Compensation Clawbacks

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The SEC’s Proposed Clawback Rule

— In July 2015, the Securities and Exchange Commission (the “SEC”) proposed a clawback rule under Dodd-Frank

which would direct the stock exchanges to adopt listing standards requiring companies

to implement clawback policies to recover incentive-based compensation from executive officers in the event they

are required to issue a financial restatement to correct a material error, and which requires disclosure if a clawback is

triggered.

• The proposed rule would apply to all listed companies and expands SOX clawback provisions by (i) expanding the class of covered

persons from the CEO and CFO to all executive officers, (ii) increasing the clawback period from 12 months to 3 years, and (iii)

eliminating misconduct as a prerequisite

to the application of a clawback.

• “Executive officer” includes a company’s president, principal financial officer, principal accounting officer, any vice president in charge of a

principal business unit, division or function, and any other person who performs policy-making functions for the company.

• Incentive-based compensation includes any compensation, including cash and equity, granted, earned or vested “based wholly or in part upon

the attainment of any financial reporting measure”.

• Companies failing to comply with the rule could be delisted from their exchange, and may not be listed on a different exchange prior

to coming into compliance.

— Final clawback rule has not been adopted.

• In late September 2021, SEC Chair Gary Gensler announced that he is intent on finalizing the long-stalled rule

• Gensler did not provide a timeline, but asked the SEC Staff to conduct a review and provide recommendations on the proposed

clawback rule (as well as other parts of the mandatory Dodd-Frank rules that were never finished)

Avoiding Compensation-Related Legal Actions

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Disclosure requirements under the proposed rules include to following, which must be included in the

registrant’s annual proxy statement:

— Aggregate amount of excess incentive-based compensation attributable to accounting restatement and

portion of such amount that remains outstanding at the end of the last completed fiscal year.

— Estimates used to determine excess incentive-based compensation attributable to accounting

restatement, if the financial reporting measure related to a stock price or total shareholder return

metric.

— If during the last completed fiscal year the registrant decided not to pursue recovery from any

individual subject to recovery of excess incentive-based compensation attributable to an accounting

restatement, for each such individual, the name and amount forgone and a brief description of the

reason the listed registrant decided in each case not to pursue recovery.

— The name of each individual from whom, as of the end of the last completed fiscal year, excess

incentive-based compensation had been outstanding for 180 days or longer, and the dollar amount

thereof.


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— Numerous comments were submitted with respect to the proposed rules, addressing issues practical,

legal and philosophical issues. It remains to be seen how, if at all, the final rules will address these

issues identified in 2015.

— By way of example, an issue identified from an enforceability perspective is that, while the proposed

rules provide a narrow exception for conflicting non-U.S. law, the rules do not recognize or provide

accommodation for state wage and hour laws that would bar recovery of earned wages

• One comment letter pointed specifically to California Labor Code §221 (it is “unlawful for any employer to collect

or receive from an employee any part of wages theretofore paid by said employer to said employee”) and New

York Labor Code §193 (“No employer shall make any charge against wages, or require an employee to make any

payment by separate transaction unless such charge or payment is permitted as a deduction from wages under the

provisions of subdivision one of this section.”)


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Clawback Policies

— In the absence of a final clawback rule under the Dodd-Frank legislation, the last several years have seen the

implementation of broad clawback policies by many public companies

• Unlike the proposed Dodd-Frank rule, the policies are often not limited to circumstances in which a financial restatement has occurred

and generally do require misconduct on the part of the executive

— Business Judgment Rule

• Alleged executive misconduct in recent years has resulted in increased pressure on boards and compensation committees to exercise

their rights to claw back compensation in the event of a corporate scandal.

• To date, the case law supports the application of the business judgment rule to decisions relating to enforcement of clawback policies.

In 2015, the Delaware Court of Chancery, in City of Tamarac Firefighters’ Pension Trust Fund v. Corvi, affirmed that a board’s

decision to refuse a pre-suit demand to exercise a clawback is subject to the business judgment rule. There was a similar outcome in

Andersen v. Mattel, Inc., a 2017 Delaware Court of Chancery case involving a pre-suit demand and a request that the board exercise a

clawback.

— ISS U.S. Proxy Voting Guidelines indicate that, in considering whether to support shareholder proposals to recoup

compensation payments from senior executives, it will consider various factors, including:

• If the company has adopted a formal recoupment policy

• The rigor of the recoupment policy focusing on how and under what circumstances the company may recoup incentive or stock

compensation

• Whether the company’s policy substantially addresses the concerns raised by the proponent


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Clawback Policies – Enforcement

— There are significant legal and practical limitations on enforceability of clawback policies (some of

which could also apply to the Dodd-Frank rule):

• Prohibitions on recovery of wages under state wage and hour laws (as noted above with respect to the proposed

Dodd-Frank rule)

• Difficulty of proving executive misconduct and objectively demonstrating other requirements of the policy (e.g.,

causal link between misconduct and harm to the company, existence of material reputational harm, etc.)

• Challenge of enforcing a judgment in order to actually recover compensation previously paid to an executive

— Absence of disclosure around enforcement of policies makes it challenging to assess overall trends

and broad experiences, but anecdotally it appears that many public companies use their policies

largely for their deterrent effect and as leverage in connection with negotiation of separation terms

with departing executives


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Clawback Policies – Enforcement

— Enforcement Case Studies – Financial Institutions

• In 2012, in connection with the “London Whale” incident, JPM reportedly clawed back compensation from the

three traders who had direct responsibility, in an amount representing about two years of total annual

compensation. Amounts were reportedly recovered from restricted shares and cancelled stock options.

• In 2017, as a result of the fraudulent account scandal, Wells Fargo reportedly recouped tens of millions of dollars

of compensation from two executives, including through foregone bonuses, reduced performance share payouts,

and cancellation of stock options.

• Earlier this year, in connection with the Archegos Capital Management scandal, Credit Suisse said that it

terminated nine executives and recouped about $70 million in pay, including bonus clawbacks.

— Query whether public companies outside of the financial services industry will begin to adopt policies

that allow them to take “self help” in enforcing clawback policies, e.g., by imposing a holding period

on after-tax shares delivered pursuant to equity awards


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Clawback Litigation

Update on Hertz Clawback Case

Following a 2015 restatement of financials, in March 2019 The Hertz Corporation and Hertz Global

Holdings, Inc. (collectively, “Hertz”) filed complaints seeking to claw back compensation from certain

former executives, including the former CEO and GC.

— Among other claims, Hertz’s complaints included contractual claims under its clawback policies,

alleging that the executives’ failure to maintain an appropriate “tone at the top” constituted misconduct

and gross negligence, causing the need for a restatement and triggering its clawback policies.

— In May 2020, Hertz filed an amended complaint, describing the CEO’s inappropriate tone and its

impact with greater specificity, as well as the GC’s failure to elevate the CEO’s conduct.

— In June 2020, the defendants filed a motion to dismiss the amended complain and, after an

unsuccessful mediation attempt in late 2020, in June 2021 the New Jersey District Court denied the

motion to dismiss, allowing the plaintiffs’ claims to proceed as limited by the opinion.

— The case remains pending.


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Clawback Litigation

Update on Hertz Clawback Case

The recent ruling on the motion to dismiss evidences some of the pitfalls – from the nuanced to the

mundane – that may arise where a company actually brings a lawsuit to enforce a clawback policy. For

example:

— The former CEO argued that plaintiffs are estopped from arguing that his actions were grossly

negligent and in violation of the company’s standards because Hertz had, in defense of itself in other

litigation and before the SEC and Hertz’s shareholders, represented the opposite. The court

acknowledged the potential inconsistencies but determined that, in light of different claims and

pleading standards, it is not apparent that the positions are irreconcilably inconsistent or that the

change in position was made in bad faith.

— Defendants argued that Hertz had failed to identify the relevant versions of the company’s standards of

business conduct that formed the basis for their claim. After detailing the inconsistencies in Hertz’s

statements in the amended complaint, at oral argument and in the opposition brief relating to the

various versions of the standards in effect over the period 2009-2014, the court concluded that the

amended complaint was sufficient with respect to claims under the 2011 and 2012 versions, but failed

to put defendants on notice of any claim based on the 2009 version.


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Hypothetical Employment Litigation Scenario

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Hypothetical Employment Termination Scenario

— A senior executive is being strongly encouraged to retire a few years before planned because of as-yet

unsubstantiated allegations of misconduct.

— The facts of the situation are not public, but there have been rumors about the executive’s questionable behavior

circulating within the workforce.

— The executive is reluctantly willing to leave, but only on the basis that his/her reputation not be publicly impugned.

— There is a concern that if the full scope of the misconduct allegations were investigated and publicly disclosed, there

could be reputational, regulatory and litigation risk for the company.

— There is also a concern that the executive’s behavior could give rise to a basis for clawback of previously paid

compensation, if the issues were to be substantiated. Although very unlikely, there is a chance the clawback

obligation might arise under SOX Section 304.

— The executive has demanded that, as a condition to any departure, he/she be permitted to continue to vest in

outstanding unvested options scheduled to vest with two years and be provide with a lump sum severance payment

equal to 2x the executive’s total average annual compensation for the preceding two years. The executive does not

have an individual employment agreement that defines “cause” or that promises a severance benefit. These would

require Board approval and disclosure in the next proxy statement.

— The Chairman of the Board has been briefed on the facts by the General Counsel, and asks for your advice to how to

mitigate potential litigation risks arising from the situation.

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Hypothetical Employment Termination Scenario –Polling Question

Which of the following most closely approximates the advice that you would give?

— A: Do not conduct an investigation and pay the executive what he/she is requesting in

order to get to an agreed separation and obtain a release of claims

— B: Terminate the executive’s employment without providing any severance or equity

award acceleration and without obtaining a release, and launch an investigation with

accompanying public disclosure that the investigation is pending

— C: Conduct a quick, high-level investigation and make a decision based on the results

— D: Other

© 2021 Young Conaway Stargatt & Taylor, LLP and Wachtell, Lipton, Rosen & Katz. All rights reserved.

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Avoiding Compensation-Related Legal Actions