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Posted on: 9/12/2024
6 Recent Court Cases Reshaping Executive Compensation
In just a short time, a series of lower and upper court decisions have altered the executive compensation landscape. Historically, courts haven’t played much of a role in the trajectory of executive compensation policymaking—the main actors have been proxy advisors, Congress and, of course, the markets. Today’s landscape is even more dynamic.
Add the upcoming presidential election and the landscape may change even more. But regardless of who wins in November, the courts have transformed the balance of power held by the SEC, independent proxy advisors, and even activist investors.
What does this mean for the future? With Dodd-Frank rulemaking complete and the courts’ escalating involvement, we believe the “rush to regulate” will be replaced by a market-driven North Star that results in less, but more rigorously vetted, rulemaking. Tighter rules translate into better usability, compliance auditing, and even enforcement action.
If our prediction comes true, we think it will in turn elevate the strategic orientation of executive compensation functions. To be sure, compliance and reporting will remain a major functional responsibility on the heels of a decade-plus-long expansion in SEC rulemaking and investor scrutiny. But there will also likely be more runway to exercise discretion and creativity in setting compensation strategy. We’re cautiously optimistic.
In this article, we run through six recent legal developments that are relevant in some fashion to executive compensation and corporate governance. There are plenty of others not covered here, from judicial review of the SEC’s proposed climate rule to a pending appellate decision on Nasdaq’s board diversity rule. But we think these six are a good set to focus on.
We’ve structured the content by delineating the background to an issue, the litigation bringing it into the court system, and the implications and action items for SEC registrants. There’s a TL;DR (too long; didn’t read) introduction to each section and hyperlinks throughout for easy navigation.
Share Repurchases
TL;DR: The SEC’s share repurchases modernization project is dead in the water. What happened is a case study of how courts may interpret ambitious regulation that lacks a clearly articulated cost-benefit value proposition.
Background
The SEC requires companies to disclose share buybacks in both the 10-Q and 10-K. Disclosures must include a table showing, among other things, total shares repurchased and average price per month.
The SEC proposed a new rule in December 2021, then re-proposed a similar version a year later after a technology glitch caused the loss of comments on the earlier rule. The commission offered only 30 days for comments the second time around.
The SEC issued a final rule on May 3, 2023 with an effective date of July 31, 2023. The rule required daily disclosure of repurchase activity, substantially expanding the cost of compliance. It also compelled companies to explain their rationale for each repurchase decision.
Synopsis of Litigation
The US Chamber of Commerce filed suit, taking its case to the US Court of Appeals for the Fifth Circuit. The court sided with the plaintiff and gave the SEC 30 days to cure the deficiencies noted in its opinion. The SEC was unable to cure, so on December 19, 2023, the court vacated the new rule. Companies therefore remain subject to the existing rule involving monthly-level disclosure of share repurchase activities.
The Chamber of Commerce litigated the SEC rule on two grounds. First, it argued the requirement to disclose the subjective purpose behind a repurchase was a violation of the First Amendment. Second, the chamber argued the rule was arbitrary and capricious due to an incomplete cost-benefit analysis as well as a materially shorter comment period than what was ordinary and customary.
The court sided with the SEC on the First Amendment point, but not on the more important one that the rule is arbitrary and capricious under the Administrative Procedure Act (APA).
Implications and Action Items
Since this case has run its full course (unlike the others we’ll cover next), there’s a lot we can learn from it. This was a technical decision that specifically dealt with how the SEC approached its cost-benefit analysis. For this reason, we anticipate the SEC will make fewer rules, but the ones they do make will have more rigorous justification. This may or may not lower the complexity of future rules, as the outcome isn’t necessarily simple rules, but rather, more fully vetted rules that reflect iteration via the comment letter process.
There’s also a lesson to companies that their comments on proposed rules matter. The argument that ultimately prevailed was that “the SEC had acted arbitrarily and capriciously…when it failed to respond to petitioners’ comments and failed to conduct a proper cost-benefit analysis.”
Regulation of Proxy Advisors
TL;DR: Proxy advisor regulation is coming, but it remains to be seen how much impact it will have on compensation decisions and the way proxies are drafted. A recent court decision reinstated the “notice and awareness” conditions of a 2020 SEC rule, allowing companies to raise objections to proxy advisor recommendations they believe are factually or conceptually flawed, and have those objections included in proxy advisor reports.
Background
In 2020, the Clayton-led SEC issued a rule marking the culmination of a decade-long effort to rein in the growing influence of proxy advisors. Before the rule went live, the Gensler-led SEC paused implementation and later rescinded many of the requirements in the 2020 rule.
Proxy advisors have outsized influence over shareholder voting outcomes. The SEC’s 2020 rule focused on whether proxy advisors engage in the act of proxy solicitation, which isn’t a far-fetched question given the influence they wield. If so, the argument went, they should be subject to the proxy solicitation rules in the Securities Exchange Act of 1934.
Folding proxy advisors under the Exchange Act would have (among other things) required them to share their reports with companies, then include any responses from those companies in the reports provided to institutional clients. These components of the 2020 rule are called the “notice-and-awareness” provisions.
The notice-and-awareness provisions in the 2020 rule were a compromise aimed at preserving proxy advisor independence and reducing the risk of delay in their efforts to disseminate information. Nonetheless, the provisions promised to shift the balance of power by giving companies a stronger platform for defending their compensation decisions.
The SEC’s 2022 rescission didn’t altogether eliminate the 2020 rule. It preserved the view that a proxy advisor is engaged in the act of solicitation. But it materially removed the rule’s teeth by dropping the notice-and-awareness provisions and a binding link to the anti-fraud rules in the Exchange Act.
Synopsis of Litigation
This topic has been litigated six ways to Sunday.
ISS sued the SEC in 2019 as soon as the agency began issuing interpretive releases signaling their rulemaking intent. When the SEC watered down the rule in 2022, ISS opted to continue its litigation because the revised rule retained the view that proxy advisors engage in solicitation.
Those in favor of proxy advisor regulation didn’t like the 2022 rule either. Within weeks of the SEC’s decision, the National Association of Manufacturers (NAM) and Natural Gas Services Group (NGSP) initiated litigation against the SEC for backpedaling. Their position was that the rule was perfectly valid, and the SEC’s decision to undo it was arbitrary, capricious, and an act of partisanship that undermined due rulemaking.
In February 2024, the United States District Court for the District of Columbia sided with ISS in its lawsuit against the SEC, thereby eviscerating the remnants of the 2020 rule. The court held that the SEC exceeded its authority and the law by including fee-based proxy voting advice under the proxy rules’ definition of “solicit” and “solicitation.”
Then on June 26, 2024, the US Court of Appeals for the Fifth Circuit ruled on the parallel case NAM and NGSP initiated against the SEC. The court concluded the SEC’s rapid rescission in 2022 was arbitrary and capricious because the bar is high for a new administration to undo existing rules without a clear and compelling explanation of how the facts have changed. However, the ruling only vacated the notice-and-awareness provision of the 2022 rescission. The link to the anti-fraud provision in the Exchange Act remained rescinded.
As if that wasn’t enough, on September 10, 2024, the US Court of Appeals for the Sixth Circuit sided with the SEC on a split 2-1 panel. Now that two appeals courts are divided, it’s possible this topic could find its way to the Supreme Court.
Implications and Action Items
Unless the plaintiffs choose to drop their suit, an appeal to the Supreme Court could be the next logical step. For now, let’s unpack what the notice-and-awareness provisions entail since this is primarily what the plaintiffs have sought to get reinstated.
The notice provision requires proxy advisor firms to share their voting guidance with registrants “at or prior to” the time they share it with their own subscription clients. This largely already occurs insofar as registrants simply sign up with proxy advisory firms to ensure they get immediate access to reports.
The awareness provision is more important. Under that provision, if a registrant chooses to formally rebut a proxy advisor’s report with factual or qualitative arguments, then the proxy advisor is obligated to share the rebuttal with subscription clients. This dissemination requirement is time-bound in that it must occur before the annual shareholder meeting where voting occurs on the items in the report.
If the plaintiffs’ position prevails post a subsequent appeal, the effect of reinstating the notice-and-awareness provisions is likely to be more incremental than radical. It will give companies a new platform for explaining their positions, and proxy advisor subscribers will need to consider those explanations in forming their voting decisions.
What effect will that have? If the subscribers to those services receive company rebuttals, this would likely sway voting outcomes. The institutional investors who subscribe to proxy advisor services are under immense regulatory and market pressure to form their own views and not simply robotically follow the recommendations of proxy advisor firms. It’s plausible and probable that they would review company rebuttals when forming their voting decisions.
So for companies who aren’t doing it already, now is the time to invest in more robust fact-checking and analysis of proxy advisor reports. Besides disputing matters of fact, it’s also possible to argue with the underlying premises. A good example is Abbott’s shareholder letter in 2018.
Otherwise, stay tuned for the possibility of an executive compensation topic charting a path all the way to the Supreme Court.
Shareholder Proposals
TL;DR: An SEC staff legal bulletin cleared the deck for a surge in shareholder proposals, but litigation by Exxon against an activist investor may have an offsetting effect. This topic is imminently in flux as preparations for 2025 proxy season begin.
Background
Exchange Act Rule 14a-8 provides shareholders the right to include proposals in a company’s proxy statement. The rule sets the bar high by spelling out thirteen bases through which the company can choose to exclude the proposal. To exclude a proposal, a company must file its reasons with the SEC and receive a “no action” letter from the SEC indicating the SEC won’t recommend enforcement action against the company for excluding the proposal.
That was the status quo until November 2021, when the SEC’s Division of Corporation Finance issued Staff Legal Bulletin No. 14L (SLB 14L). SLB 14L made it substantially tougher for companies to exclude proposals because it rescinds prior staff guidance that proposals could be excluded on the basis that they interfere with ordinary course business and are not relevant. SLB 14L states that proposals touching on significant social policy issues may be applicable despite their having little to do with ordinary course business decision-making.
Unsurprisingly, the number and diversity of proposals skyrocketed after 2021, especially on environmental and social topics. Also unsurprisingly, this matter found its way into the courts.
Synopsis of Litigation
The most notable case occurred in January 2024, when Exxon filed a lawsuit in the Northern District of Texas against Arjuna Capital and Follow This. The defendants were shareholders who had submitted similar ESG-related proposals that failed to gain majority support. Exxon’s complaint sought to prevent these shareholders from submitting a new proposal aimed at accelerating Exxon’s emission reduction targets. The company argued that the proposal could be excluded under Rule 14a-8(i)(7) (ordinary business operations) and Rule 14a-8(i)(12) (resubmission of proposals that previously failed to garner sufficient votes).
Exxon explicitly chose litigation over a “no-action” letter from the SEC, citing SLB 14L as having fundamentally gutted a company’s ability to exclude what are clearly invalid proposals. Said differently, Exxon went directly to the courts to plead for relief on the basis that an agency statute (SLB 14L) had gone too far.
After Exxon filed its lawsuit, the shareholders withdrew their proposal. But Exxon continued pursuing its case anyway, arguing that a court ruling was necessary to prevent similar future proposals. However, Arjuna made enforceable promises to never refile a proposal of similar nature with Exxon at any time in the future. With Exxon’s claim now moot, the district court dismissed the case on June 17, 2024.
Implications and Action Items
In its opinion, the court indicated that while Exxon couldn’t press forward on its case, the next recipient of similar activist behavior probably could. But litigation isn’t for everyone. It’s time-intensive, costly, and fraught with reputational and public relations risk.
For companies concerned about frivolous shareholder proposals, the better scenario would be for the SEC to proactively revise SLB 14L. That may happen. In summary, watch this space as the complex world of shareholder proposals continues to evolve.
The Chevron Doctrine
TL;DR: Now that the Supreme Court has struck down the Chevron doctrine, plan for government agencies (like the SEC) to take a more methodical, textual approach to rule making. A final rule will likely reflect a more precise effort to incorporate public comments and a quantitative cost-benefit analysis of the rule’s alternatives.
Background
The Chevron doctrine was established in a 1984 Supreme Court case related to the degree of judicial deference given to federal agencies in interpreting ambiguous statutes. As Congress passed legislation, federal agencies were often stuck interpreting intent as they worked to implement specific rules, policies, and protocols. This created ample opportunity for disputes as parties asserted an agency overstepped its bounds in enforcing the statute. Many of these disputes then found their way into the court system.
Under the Chevron framework, if Congress passed a law that was unclear or silent on a specific issue, courts were required to defer to the agency’s interpretation of the law as long as that interpretation was reasonable. The rationale behind this doctrine was that agencies, with their specialized expertise, were better equipped than courts to handle complex regulatory issues. However, the Chevron doctrine didn’t prevent agencies from introducing policies that went further than what Congress intended (though failed to specify via statute).
Synopsis of Litigation
On June 28, 2024, the Supreme Court overturned the Chevron doctrine, fundamentally altering the balance of power between the judiciary and federal agencies. The court ruled that the doctrine had granted too much unchecked power to administrative agencies, leading to regulatory overreach. The majority opinion emphasized that it was the role of the judiciary, not agencies, to interpret laws passed by Congress.
Implications and Action Items
Courts will now take a more active role in interpreting ambiguous statutes, rather than automatically deferring to agency expertise. This has radical implementations for every regulatory agency in the US, including those involved with executive compensation rulemaking.
Agencies like the SEC or the Federal Trade Commission (FTC) introduce rules that are either direct requirements under law (think the Dodd-Frank Act directing the SEC to take action) or matters of their own derivation (think the FTC choosing to ban noncompete agreements based on its interpretation of its statutory charter). The overturning of Chevron affects both.
For example, courts will no longer automatically defer to the FTC’s interpretation of its authority to regulate employment contracting techniques. There will be less deference to the FTC (or any agency) in interpreting its own statutory authority. Instead, courts will apply a stricter standard of scrutiny in assessing what authority an agency has under its charter.
Presumably this means regulators will tighten up their vetting process before releasing a rule. As a consequence, the rules they do issue may be narrower in scope but more enforceable.
For example, it’s hard to imagine the climate rule as proposed seeing the light of day. But some form of climate rule may materialize. If it does, compliance may become even more important because there’ll be a clearer framework for auditing and testing for noncompliance.
The same is true for the SEC’s human capital management revisions. It’s not an accident that the long-anticipated revisions have been delayed. To survive litigation, any rule revisions must reflect a rigorous cost-benefit analysis, comment process, and justification for fitting within the statutory charter of the agency.
SEC Administrative Law Judges
TL;DR: Although tangential to executive compensation, the Supreme Court’s Jarkesy decision illustrates the broader tailwind to refine government agency authority. That said, when the SEC initiates enforcement actions, they’ll be more nuanced, stickier, and harder to defend against because they’ll be carried out in federal jury trials.
Background
On June 27, 2024, the Supreme Court ruled in SEC v. Jarkesy that defendants in SEC enforcement actions involving civil penalties have a constitutional right to a jury trial in federal court. This decision marked a shift away from SEC administrative law judges (ALJs) adjudicating such cases in administrative proceedings. The ruling was grounded in the Seventh Amendment, which guarantees the right to a jury trial in certain civil cases.
Litigation arose from concerns about the fairness and impartiality of administrative proceedings in which the SEC serves as both prosecutor and judge. By affirming the right to a jury trial, the Supreme Court’s ruling fundamentally alters how the SEC can pursue enforcement actions, requiring the agency to bring more cases to federal court.
Synopsis of Litigation
George Jarkesy was a hedge fund manager who had been fined and barred from the securities industry by the SEC. The court’s majority opinion focused on the Seventh Amendment flaws related to ALJs.
Implications and Action Items
This decision is expected to have widespread implications for how the SEC enforces securities laws. The result may be less, but more rigorous, litigation now that there’s a greater burden of proof and a greater likelihood of judiciary review.
It’s tough to anticipate all the implications of this decision. Companies may face higher legal expenses as they prepare for the possibility of defending themselves in federal court, which is more complex and costly than administrative hearings. There may also be more settlements to avoid the uncertainties and publicity of a jury trial.
For these reasons, the bar seems to only rise in the areas of corporate governance, financial reporting, and internal controls. Directors and officers would face increased personal accountability. The deterrent effect alone is likely to lead to more planning and preparation.
FTC Ban on Noncompetes
TL;DR: The FTC’s noncompete ban is still playing out. At this writing, our best bet is that the national ban remains struck down and efforts to regulate noncompete agreements resume at the state level.
Background
The FTC’s landmark regulation banning noncompete agreements touched off a rash of litigation. Originally intended to take effect on September 4, 2024, the FTC’s rule allowed for limited grandfathering and very few exceptions.
Noncompetes remain common even though state laws limit their use. They’re often negotiated in equity compensation (and similar) award agreements. Beyond the effect on executive compensation, the possibility of a national ban would have major process and unwinding implications across large and small organizations alike.
Synopsis of Litigation
The most widely followed court case has been Ryan LLC v. FTC, taking place in the Northern District of Texas.
The court issued a preliminary injunction on July 3, 2024, preventing the FTC from enforcing its noncompete rule against the plaintiffs in the case. The court found that the FTC likely exceeded its statutory authority and that the rule was “arbitrary and capricious.” But since this ruling only applied to Ryan LLC, it left the rest of the country wondering whether that was it or a broader decision would be forthcoming.
Then, on August 20, 2024, the court issued a final decision, setting aside the rule entirely. The national ban on noncompetes could not take effect on September 4, 2024. It’s hard to imagine a scenario where the FTC doesn’t appeal this decision.
In a similar case, ATS Tree Services LLC v. FTC, the Eastern District Court of Pennsylvania reached the opposite conclusion. The court’s July 23, 2024 decision denied the plaintiff’s request for an injunction and ruled that the FTC was within its statutory authority in implementing its noncompete ban. But so far, the Northern District Court of Texas’ opinion governs. The reason is that the Pennsylvania Court’s ruling was preliminary and specific to whether the rule could go live during ATS Tree Services’ own noncompete lawsuit.
Implications and Action Items
As compensation and financial reporting professionals, we leave the lawyering to our friends who serve as corporate counsel. But it’s clear this matter is far from over. It may even find its way to the Supreme Court, where the current 6-3 conservative majority would be expected to side with companies’ ability to impose and enforce noncompete agreements.
At the same time, we may see bold action among the states. This will add its own complexity as states adopt a variety of frameworks, prompting national and multinational companies to pick between a universal policy and state-level customization.
