Netflix Accused of Violating U.S. Tax Law in Bonuses to Top Executives

Reed Hastings - Mobile World Congress Speech in Barcelona - Getty - H 2017
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When Congress passed sweeping tax changes at the end of last year, Netflix became one of the first companies to restructure its compensation to top executives. The amended tax law no longer allowed companies to deduct performance-based bonuses to those managers making more than $1 million. So in light of the change, Netflix scrapped cash bonuses in favor of a higher salary. A new lawsuit first filed under seal late last week questions what Netflix was doing before the change.

In a shareholder derivative complaint, the City of Birmingham Relief and Retirement System asserts that performance-based bonuses paid to executives like Ted Sarandos were essentially a sham. These bonuses, it's alleged, were solely designed so that Netflix could receive tax deductions, and the achievement of performance goals was a fait accompli.

"To qualify as 'performance-based,' the compensation must, among other requirements, be contingent on the attainment of one or more pre-established, objective performance goals," states the complaint. "Critically, in order for a performance goal to qualify under Section 162(m) [of the Internal Revenue Code], its achievement must be 'substantially uncertain' at the time it is set. In other words, a company may only pay exorbitant, $1+ million per year compensation to an employee and deduct those payments for tax purposes if the payments are tied to that employee achieving real accomplishments that serve the Company and its shareholders."

Given this is a derivative lawsuit, the shareholder is suing on behalf of Netflix against members of the company's board, which include Reed Hastings, David Wells, Richard Barton, and others. The plaintiff wants a judge to find that the board members breached their fiduciary duties by violating federal securities and U.S. tax laws and regulations. The lawsuit, asserting a rigging of the compensation process, further seeks relief by demanding damages as a result of the alleged breaches of fiduciary duty. Additionally, the plaintiff wants Hastings and other co-defendants to return to Netflix all compensation and remuneration of whatever kind during the time that they allegedly were in breach.

According to the complaint, the performance goals were attached to targets for global streaming revenue — and were nearly always hit.

"By July 2017, Netflix’s top officers had hit their target squarely in seven out of eight quarters, missing by just one percentage point in the other quarter," states the complaint. "This artificial precision resulted in the Company paying these officers approximately $18.73 million out of a target pool of $18.75 million."

The shareholder nods to how the Financial Times last year remarked on the "uncanny accuracy."

The plaintiff also acknowledges that no pre-suit demand upon the board was made because it would be a "useless and futile act," with Netflix's board unlikely to file suit against its own members.

Netflix hasn't yet responded to an opportunity to comment.