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From Securities Regulation Daily, June 2, 2014

Class B shareholder cannot use federal tax law as “backdoor” to voting rights

By Anne Sherry, J.D.

A Third Circuit panel held that federal tax law does not confer voting rights on otherwise non-voting shareholders or preempt Delaware’s law permitting corporations to issue shares without voting rights. The plaintiff, who held only non-voting Class B shares, challenged $36 million in alleged “excess compensation” awarded to senior Viacom executives pursuant to a compensation plan approved by voting shareholders in 2007. The court rejected his argument that Internal Revenue Code (IRC) Section 162(m) required that all shareholders be eligible to vote on plans to award tax-deductible compensation (Freedman v. Redstone, May 30, 2014, Greenberg, M.).

Deductible compensation. Under IRC Section 162(m), compensation exceeding $1 million may be deducted if an independent board committee approves the compensation on the basis of objective performance standards and the compensation is approved by a majority of the vote in a separate shareholder vote. Between 2008 and 2011, Viacom paid three senior executives more than $100 million in bonus or incentive compensation pursuant to a compensation plan approved by voting shareholders in 2007. Robert Freedman sued Viacom and its eleven board members derivatively for not complying with the 2007 plan and directly for allowing a shareholder vote that he maintained was invalid under Section 162(m).

Derivative claim. Freedman brought his derivative claim without first making demand on the board. The district court had dismissed this claim on the basis that demand was not futile, and the appellate court agreed, finding that Freedman did not plead with particularity his efforts to convince the directors or his reasons for not taking such efforts. The parties disputed the independence of one member of the 11-director board, who Freedman alleged was a longtime close friend and adviser to one of the executives receiving the compensation at issue. However, Freedman could not rely on a previous New York Supreme Court case ruling on the director’s independence because the issues were not identical. As to the second prong of the demand futility test, the exercise of valid business judgment, Freedman failed to plead with particularity any violations of the stockholder-approved plan.

Direct claim. The appeals court rejected Freedman’s argument that Section 162(m) creates shareholder voting rights or preempts Delaware corporate law allowing corporations to issue non-voting shares. First, the tax code provision does not provide voting rights to stockholders, the court held, but merely establishes limits (and exceptions to those limits) on the deductibility of compensation. With no mention in Section 162(m) of voting rights or hints that Congress intended to require that a corporation provide for voting rights, Freedman had “an uphill climb to show that Congress intended both to require that corporations grant shareholders certain voting rights, and to do so by displacing Delaware corporate law,” which expressly grants corporations the right to issue stock with limitations on voting rights.

Freedman’s argument that the Delaware law was preempted because “the Internal Revenue Code has occupied the field of federal taxation” was unavailing because that field does not include corporate governance and shareholder rights; the Supreme Court has consistently reiterated that corporate law is a field traditionally left to the states. The court also rejected his conflict preemption argument, reading the House Conference Report’s mention of approval by “shares voting in a separate vote” to mean “voting shares,” rather than an intention to displace longstanding state corporate law. Furthermore, while Freedman invoked by analogy regulations implementing other tax provisions, the prefatory language to those rules made clear that Congress did not intend to displace existing state law.

The case is No. 13-3372.

Attorneys: Daniel E. Bacine (Barrack, Rodos & Bacine) and Brian E. Farnan (Farnan Law) for Robert Freedman. Jaculin Aaron (Shearman & Sterling) and John P. DiTomo (Morris, Nichols, Arsht & Tunnell) for Sumner M. Redstone, Philippe P. Dauman, Thomas E. Dooley, George S. Abrams, Alan C. Greenberg, Shari R Edstone, Frederic V. Salerno, Blythe J. McGarvie, Charles E. Phillips, Jr., William Schwartz, Robert K. Kraft, and Viacom, Inc.

Companies: Viacom, Inc.

MainStory: TopStory CorporateGovernance FederalPreemption ExecutiveCompensation DelawareNews NewJerseyNews PennsylvaniaNews VirginIslandsNews

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