Netflix Executives Beat Shareholder Lawsuit Over Tax Deductions

Even though the IRS never took action, a judge concludes shareholders raised plausible claims that the streamer violated U.S. tax law. But a complaint from shareholders nevertheless gets dismissed.
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For years, Netflix CEO Reed Hastings and other top executives at the streamer enjoyed massive bonuses tied to the company's growth. Netflix once deducted these payouts from its tax liability, but the compensation scheme may have violated an old law that prevented a more than $1 million deduction to executives when the performance goals weren't "substantially uncertain" to be reached. A federal judge has now ruled that shareholders have raised plausible claims that Netflix issued false and misleading statements about its tax compliance, but nevertheless the judge has dismissed a derivative complaint for lacking specific allegations about what Netflix's board knew about the company's noncompliance.

The lawsuit come from the City of Birmingham Relief and Retirement System, suing on behalf of Netflix, against Hastings, David Wells, Ted Sarandos, David Hyman and other executive officers. The complaint alleged these individuals violated securities laws and fiduciary duties by illegally rigging Netflix's performance-bonus compensation plan. The bonuses, it was claimed, were solely designed so that Netflix could receive tax deductions, and the achievement of performance goals was hardly in question. That may have risked prosecution from federal authorities.

"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," stated 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."

Reviewing the allegations in a redacted opinion released Friday (read here), U.S. District Court Judge Beth Freeman calls the alleged facts "damning," and adds she has no trouble discerning an alleged violation of a law. She also waives off the lack of any enforcement action by the Internal Revenue Service as immaterial, concluding that the IRS' failure to investigate "could be attributable to numerous factors" unrelated to compliance with tax laws.

On the other hand, in any suit where a stockholder seeks to vindicate the interests of the corporation, the plaintiffs must first demand action from the corporation's directors. Failing to do so is only excused when such demand would be futile.

Birmingham didn't make a demand, and while the pension fund argued that Netflix's board wouldn't have taken action because of a substantial likelihood of violating securities and tax laws, Judge Freeman rules that Birmingham should have at least alleged specific knowledge on the part of a majority of Netflix's board.

According to the opinion, "Ultimately, Birmingham has not alleged sufficient facts about 'what the directors knew and when,' or about 'the state of mind of individual director defendants' to determine whether a majority of the Board knew the bonuses did not comply...."

The complaint is dismissed. However, the judge is giving Birmingham until the end of the week to try again with an amended complaint if it so chooses and can cure the deficiencies.

As for future tax liability, the sweeping change of tax laws enacted last year got rid of any corporate deductions for performance-based bonuses, and Netflix swiftly restructured its compensation plan to reward executives with higher base salaries.