Recent Corporate Aircraft Litigation Raises SEC Perquisite Disclosure Issues

A recent shareholder derivative action alleges that the directors of Chesapeake Energy breached their fiduciary duties to shareholders by, among other things, misleading shareholders about the true extent and true cost of personal use of the company’s aircraft.  The complaint raises questions about disclosure practices that could affect how public companies determine the aggregate cost of perquisites on proxy statements.  It appears that the plaintiffs’ bar is already targeting potential plaintiffs for similar cases using the lure of whistleblower recoveries.

Alleged Basis for Claim

The complaint filed against the company and its directors alleged that the amount of personal use of the aircraft was significantly higher than the figures disclosed in the company’s proxy statement and that such use constituted a “significant” portion of the total use of the aircraft.  The complaint also alleged that the total aggregate cost disclosed to shareholders as compensation in the Summary Compensation Table should have included a portion of the company’s fixed costs, including the purchase price for fractional ownership of the aircraft as well as the non-variable monthly fees.  The plaintiff further claimed that the additional aggregate incremental cost to the company associated with the directors travelling on corporate aircraft to board meetings should also have been reported as compensation.

Determining the Amount to Disclose as a Perquisite

SEC rules under Item 402 of Regulation S-K require registrants to calculate and disclose the “aggregate incremental costs” of providing perquisites.  Unfortunately, there is virtually no guidance as to how exactly to determine what expenses should be treated as part of the aggregate incremental cost attributable to personal travel.  Typically, incremental costs are considered to be the increase of costs due to a particular activity.

The predominant practice at public companies is to only include the variable costs for a particular personal flight, such as fuel, hanger fees and pilot overtime, as aggregate incremental costs for personal use of corporate aircraft.  For example, if the company owns the entire plane or a fractional interest in the plane, the actual cost of purchasing the airplane or fractional interest, as well as other fixed monthly costs, is typically not included, because those are considered as not changing due to the addition of the executive’s personal flights.

Disclosure Practices Attacked by the Chesapeake Complaint

A.         Failure to Disclose a Portion of the Fixed Costs

The shareholder derivative action described above alleges, more or less, that fewer fractional interest shares (each fractional interest is akin to owning a separate plane) would have been purchased had there been no personal use by the executives and, therefore, that the full costs of those additional fractional interests, as well as a percentage of the full fixed costs such as monthly management and fixed maintenance costs, should be included.

Oddly, the example used in the complaint was that the smallest fractional interest of 1/16th of an aircraft allows for the usage of 50 hours per year, and that if there were 25 personal hours and 25 business hours, that it is possible to allocate the fixed cost on a 50-50 basis to both categories of use.  This illustration does nothing to support treating the 25 personal hours as anything other than incurring additional variable costs because, in fact, that particular 1/16th interest would need to have been purchased to provide the business travel even if some hours went unused.

Other noteworthy aspects of the complaint and observations:

1. In alleging that fixed costs such as the purchase cost of the fractional interest should have been disclosed due to the fact that personal use was “significant,” the complaint claims that personal use for purposes of deciding whether to include fixed costs as “aggregate incremental costs” includes use of corporate aircraft by all other individuals, not just the executives in question.
2. There is no explanation of the method the shareholder would propose in allocating the costs related to the purchase of the fractional interests.  Although the tax depreciation rules allow for an allocation of the cost over five years, the useful life of this asset is much longer and accounting rules typically allow for their costs to be allocated over periods exceeding 25 years.
3. Companies with multiple planes or multiple fractional interests can use those planes simultaneously for an important business meeting, i.e., where executives or employees are flying to a single destination from multiple locations, and therefore it is not expected that an additional plane or fractional interest would be purchased and dedicated only to personal use.

B.         Failure to Report Costs of Director Travel to Board Meetings

The complaint characterizes the directors’ travel to board meetings as a personal commuting expense, regardless of the circumstances.  SEC rules provide that expenses incurred by the company for an executive to commute to work are generally considered to be a perquisite.  Travel from any personal location such as an individual’s residence which is not a work location, or a vacation trip to the individual’s primary place of business or other work location, will normally be treated as personal travel.  However, the facts are rarely that straightforward with respect to a director.  A director may easily be traveling from one business location—such as instances where the director’s residence is in fact his primary place of work—to another location, i.e., the site of the board meeting.  Accordingly, the complaint overgeneralizes when it alleges that all travel to board meetings should be treated as a perquisite, because it is likely that such travel is not in fact a commute.

Whistleblower Risks

It remains to be seen whether this case will be an outlier.  What we do know is that the plaintiffs’ bar has identified this case as one that can be pursued against other public companies.  Websites are already touting the ability to pursue a whistleblower claim to obtain recoveries.  Significant compensation may be awarded to whistleblowers, and federal law protects whistleblowers from retaliation by employers.  For additional details regarding whistleblower rules, please see SEC Adopts Final Rules on Dodd-Frank Whistleblower Program.

Conclusion

This case bears close monitoring, as it alleges that practices commonly used to report perquisites with respect to personal use of corporate aircraft were misleading and constituted a breach of fiduciary duty.  In the meantime, consider determining what percentage of corporate aircraft usage is for personal travel and providing more disclosure regarding what is not included in the company’s methodology for determining the cost of perquisites.  It may also be appropriate to disclose this information to protect against future claims alleging that the proxy disclosure is misleading.