The Attack on Executive Compensation: New Approach Unlikely to Avoid the Business Judgment Rule

On August 17, 2012, a shareholder filed a derivative suit in Delaware federal court against Viacom Inc.’s board of directors, alleging they wasted corporate assets by awarding lavish corporate bonuses. In a novel approach that hardly mentions the “say-on-pay” provisions of Dodd-Frank, the plaintiff argued that the company violated §162(m) of the Internal Revenue Code. Section 162(m) limits corporate tax deductions that can be taken by a company for any senior executive compensation over $1 million to that which is determined by objective, performance-based criteria such that a “third party having knowledge of the relevant facts could determine whether the goal is met.” 26 CFR § 1.162-27(e)(2)(ii).

The complaint alleges that Viacom’s tax deductions for the compensation in excess of $1 million paid to executive chairman Sumner Redstone and two other senior executives were based on subjective criteria like “leadership and vision” and therefore violated Section 162(m). The complaint seeks to force repayment to Viacom of $36 million in past compensation. The complaint also seeks broader voting rights on executive compensation issues. Specifically, the plaintiff wants Class B shareholders to have voting rights on executive compensation (currently, only Class A shareholders have them).

The complaint further alleges that Viacom’s Compensation Committee awarded these annual bonuses to its senior executives in a manner that violated its own shareholder-approved 2007 compensation plan, which required the Committee meet the requirements of §162(m).

Lawsuits like this one are testing the waters for a different approach to attacks on executive compensation. However, like the say-on-pay derivative suits, this lawsuit seems likely to fail pursuant to the judicial deference afforded to board members under the business judgment rule. Although Viacom’s Compensation Committee arguably did exercise some discretion and relied on non-objective judgments in setting executive bonuses, its judgments (based on the complaint’s own allegations) appeared to rest almost entirely on underlying, objective financial metrics. Accordingly, the plaintiff’s allegations would seem to go straight to the board’s business judgments regarding its handling of tax policies and other related issues.

In addition, the complaint never alleges (or even suggests) that the company has faced any actual tax problems related to the deductions taken on the bonuses paid. In essence, the complaint seems to challenge a hypothetical tax issue.

Section 162(m) derivative suits crop up from time to time. Although this and other similar suits are not likely to be effective on the merits, they are part of increased media attention and overall scrutiny surrounding executive compensation, and therefore are well worth watching.