Netflix Directors Ask Judge to Reject Shareholder Lawsuit Over Executive Bonuses

Reed Hastings - H - 2016

About 99.9 percent of the time, there's nothing wrong with a company that accurately predicts its own growth. But one investment group in April attempted to allege that Netflix had violated U.S. tax law by tying its bonuses for top executives to performance targets that weren't "substantially uncertain" to be met.

Under the old tax law, companies were allowed to deduct performance-based bonuses to managers making more than $1 million so long as there was some uncertainty about reaching targets. When Congress passed sweeping tax changes at the end of last year, all that changed, and Netflix restructured its compensation so that executives would be earning higher cash salaries in lieu of bonuses.

But in a shareholder derivative complaint, the City of Birmingham Relief and Retirement System questioned what was happening before the tax changes went into effect, asserting that Netflix's board members had breached fiduciary duties and violated federal securities law by creating liability for Netflix on the tax front through the alleged rigging of its compensation process.

Netflix's board members — including CEO Reed Hastings — now moves to have the case dismissed.

On a threshold standpoint, Netflix contends that the plaintiff can't bring this derivative complaint challenging "somethng that benefited the company" because City of Birmingham hadn't made a demand on Netflix's directors to act. In the complaint, the plaintiff alleged that making a pre-suit demand would have been a "useless and futile act," with Netflix's board unlikely to take action against its own members. The defendants respond that the plaintiff has not met the standard under which a demand is excused. Specifically, the defendants say there has been no establishment that a majority of its board isn't disinterested or independent from the decision-making over the bonuses.

The defendants also say there's no substantial likelihood of violating federal tax law.

"Here, there has been no enforcement action or investigation against Netflix that could bolster Plaintiff’s conclusory allegations," states the dismissal brief. "The Complaint rests entirely on Plaintiff’s theory that if a company (allegedly) has reason to believe it may reach a certain performance target, bonuses awarded based on the achievement of that target are not performance-based and, thus, not deductible..."

Much of the rest of the memorandum (read here) emphasizes what board members knew — or more precisely, what they allegedly knew and didn't know — and raises everything from Treasury Dept. regulations to IRS guidance.

According to the brief, "Treasury regulations provide that 'a bonus contingent on profits is substantially uncertain even if a company has a long history of profitability,' and that a performance goal may be substantially uncertain where it amounts to 'maintaining the status quo.' Thus, Netflix’s history of accurately predicting growth in quarterly global streaming revenue — which more than doubled while the Plan was in use — does not render its performance targets 'substantially certain.'”