Directors and Officers Face Potential Liability under Section 14(a) for their Roles in Ohio’s Largest Bribery Scheme - Shareholder Advocate Summer 2021
On May 11, 2021, in Employees Retirement System of the City of St. Louis v. Jones, No. 2:20-cv-04813, 2021 WL 1890490 (S.D. Ohio May 11, 2021), Chief Judge Algenon L. Marbley of the U.S. District Court for the Southern District of Ohio upheld all claims in a shareholder derivative action seeking to hold certain current and former FirstEnergy Corp. (“FirstEnergy” or the “Company”) directors and officers accountable for their roles in orchestrating one of Ohio’s largest public bribery schemes. Specifically, the Court found Plaintiffs had sufficiently alleged Section 14(a) derivative claims under the Securities Exchange Act of 1934 concerning FirstEnergy’s issuance of false and misleading proxy statements from 2018 through 2020 related to its shareholders’ annual meeting and the re-election of the Company’s directors. This determination allows the Court to exercise supplemental jurisdiction over Plaintiffs’ state law claims, including breach of fiduciary duty and unjust enrichment related to the same criminal scheme. The Court then held that demand was futile on the majority of the FirstEnergy board of directors (the “Board”) under Rule 23.1 of the Federal Rules of Civil Procedure, and that Plaintiffs had standing to assert their state law claims too.
Cohen Milstein Sellers & Toll PLLC represents one of the Plaintiffs in the litigation. This decision represents an important victory for investors because the Court further expanded upon the view that a company’s directors cannot solicit shareholders’ votes using a misleading proxy statement that conceals a company’s illegal activities and the company’s true financial status. The Court held that a misleading proxy statement can provide an “essential link” in causing harm to a company for purposes of establishing Section 14(a) claims in the context of the re-election of directors.
Here, Plaintiffs alleged that between 2017 and 2020, FirstEnergy and its most senior officers paid more than $60 million in illegal contributions to Ohio’s Speaker of the House, Larry Householder, and other Ohio public officials, in exchange for favorable legislation designed to bail out FirstEnergy’s failing nuclear plants. The U.S. Attorney for the Southern District of Ohio described this plot as “likely the largest bribery, money laundering scheme ever perpetrated against the people of the State of Ohio.”
Notably, the bribery scheme began a few days after Householder assumed his office on January 3, 2017, when FirstEnergy flew him to Washington, D.C. on the Company’s private jet to attend President Trump’s inauguration. Within two months of this trip, FirstEnergy and its subsidiaries began making payments to Householder’s secret 501(c) (4) entity. Householder then pushed through House Bill 6 (“HB6”), which according to the FBI, was “essentially created to prevent the shutdown of [FirstEnergy’s] nuclear plants.” Notably, HB6 included a “decoupling” provision that ensured a guaranteed level of income for FirstEnergy, and therefore established a floor for Defendants’ performance-based compensation. Even before charges of misconduct arose, the public strongly opposed HB6, and it was called the “worst energy bill of the 21st century.” In fact, FirstEnergy spent $38 million to defeat a referendum of HB6, while the media publicly questioned the propriety of FirstEnergy’s relationship with Householder. Plaintiffs further alleged that the directors were aware of shareholders’ concerns about the Company’s lobbying efforts and campaign contributions and took affirmative actions to conceal them. None of these material facts were disclosed in the Company’s proxy statements and other public filings.
The bribery scheme was exposed on July 21, 2020, when formal criminal charges were brought against Householder and others, and reports of FirstEnergy’s involvement surfaced soon thereafter. The Company’s stock value fell 45% in the aftermath, eliminating approximately $12 billion of stockholder value. In addition, securities analysts estimate that the Company faces between $500 million and $1 billion in future sanctions. By late April 2021, the Company had disclosed that it was in early discussions with federal prosecutors about a deferred prosecution agreement.
In the May 2021 ruling, Judge Marbley found that Plaintiffs had satisfied all four elements for their Section 14(a) claims related to the Company’s 2018, 2019, and 2020 proxy statements used to solicit FirstEnergy shareholders’ votes for director re-election and executive compensation approval. Judge Marbley explained how Plaintiffs’ allegations meet the heightened pleading requirements of the PSLRA because they alleged that “the Director Defendants caused the Company to issue Proxy Statements that concealed an illegal bribery scheme, its implications for FirstEnergy’s overall business and financial health, and the deficient governance practices at the Company that allowed it to proceed.” The Court then rejected Defendants’ argument that Plaintiffs must plead scienter (intent to deceive) for their level of culpability. Instead, Judge Marbley held that negligence was the appropriate standard to apply for Section 14(a) liability against corporate insiders, like Defendants. The Court further determined that Plaintiffs had alleged that the directors were at least negligent due to the numerous “red flags” that put them on notice of the bribery scandal, including public news reports and concerns raised by the Company’s shareholders.
Next, the Court held that the proxy statements issued by the directors were an “essential link” to causing harm to FirstEnergy. As the Court acknowledged, the Sixth Circuit has yet to define “transaction causation” in the context of the re-election of directors and executive compensation approval and Section 14(a). However, the Court rejected Defendants’ argument that Plaintiffs cannot establish causation because other courts find that injuries caused by “mismanagement or breach of fiduciary duty” are not redressable under proxy rules. Instead, the Court relied on those cases where courts had found causation in similar circumstances to those alleged by Plaintiffs. In fact, Judge Marbley highlighted how “[h]ere, Plaintiffs allege far more than more mismanagement or an isolated bad act. Rather, they have set forth in detail that the Director Defendants perpetrated an illicit bribery scheme and caused substantial risk to the Company that eventually resulted in the loss of nearly half of its stock value.”
After upholding Plaintiffs’ Section 14(a) claims, the Court then determined that those claims shared a common nucleus of operative facts with Plaintiffs’ state law claims because they all related to the same criminal scheme. The Court, therefore, exercised supplemental jurisdiction over the state law claims to determine whether Plaintiffs had adequately alleged demand futility under Rule 23.1 of the Civil Rules of Procedure. Notably, the Court held that Plaintiffs had met their burden to show demand futility in two ways. First, the Court found that Plaintiffs’ allegations were plausible that a majority of the Board was directly overseeing the Company’s most senior officers’ illicit political activities, including the five members of the Corporate Governance Committee. Second, the Court found that the complaint’s allegations were also excused demand because a majority of the Board faces a substantial likelihood of liability, since they acted with reckless disregard for the Company’s best interest. Specifically, Judge Marbley held that Plaintiffs’ “allegations together support the Court’s inference that a majority of the Director Defendants recklessly disregarded their duties to the Company and allowed the criminal scheme to continue unchecked.” The Court then concluded that because Plaintiffs have sufficiently pled demand futility they had standing to bring all their state law claims. The Court, thus, denied Defendants’ motion to dismiss on all counts.
This decision as an important ruling in the area of proxy statement disclosures and solicitation of stockholder votes as the Court found a direct causal link between the misleading proxy statement and issues of voting on director elections and executive compensation—issues of paramount importance in the area of corporate governance.