Corporate Governance

Executive Compensation and Federal Preemption of Delaware Law

By J. Robert Brown

We have discussed often on this Blog about  the resolute failure of Delaware courts to impose meaningful standards in connection with the determination of executive compensation.  Under Delaware law, the compensation of the CEO, who is invariably on the board of directors, ought to involve application of the duty of loyalty.  The duty of loyalty imposes on the board the obligation to show fairness.  But the Delaware courts have eliminated fairness from the analysis through the use of process.  If the conflict of interest transaction (in this case the CEO's compensation) is approved by an independent board committee on an informed basis, it is subject to the duty of care and the business judgment rule.  In other words, fairness is eliminated as part of the analysis.  Because the business judgment rule is primarily a matter of process, it also means the terms of the transaction are largely irrelevant.  In other words, the amount of compensation doesn't matter.

As we have discussed often, and at length in the paper, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty, the Delaware courts do not ensure that the procedural requirements are meaningful.  Directors approving compensation are not necessarily independent (both because of a definition that does not screen for all disqualifying relationships and because of excessive pleading standards) and are not necessarily informed.  As a result, Delaware courts have effectively removed all limits on executive compensation (waste, an impossibly high standard, the only exception).  

By refusing to impose meaningful standards, the Delaware courts have invited federal intervention.  Yet they have remained largely oblivious.  As one member of the Chancery Court said publicly:

• "There's a lot of things that keep me up at night related to my work, but the possibility of [a federal corporate law] isn't one of them."
  

Pressure for federal preemption, however, has continued to build.  Say on pay legislation has already passed the House, been sponsored in the Senate by Barak Obama, and is part of the Democratic Platform.  Things, however, have escalated a notch higher.  According to the WSJ, the bailout for the financial system may include limitations on executive compensation.  

• As the U.S. Treasury asks Congress for about $700 billion to bail out troubled financial firms, key Democratic lawmakers including House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd say they want the bill to include curbs on what executives can earn.

While Treasury has pushed back, even Secretary Paulson has admitted that "there had been 'excesses' of executive pay, adding, 'Pay should be for performance, not for failure.'" 

Whatever happens, the financial crisis and the renewed spotlight on excessive compensation has provided fresh impetus for allowing shareholders greater opportunity to elect their own nominees to the board.  In short, the crisis has made some form of access to the company's proxy statement inevitable, either because the SEC puts it in place or because Congress commands.  Indeed, as Richard Ferlauto, head of corporate governance and pension investment at the American Federation of State, County and Municipal Employees, indicated, "AFSCME will push harder for legislation that will require public companies to put executive compensation packages to a shareholder vote, as well as laws that would make it easier for investors to nominate independent directors to corporate boards."   

Ultimately, if Congress commands access, it will likely result in far greater shareholder authority than the limited access proposals debated by the Commission.  In other words, those like former Commission Paul Atkins who spearheaded the effort to prevent the SEC from adopting the limited form access proposed in 2007, may have ultimately provided the impetus for far greater shareholder rights.  It is, as we have called it here, the rule of unintended consequences.

Full post as published by The Race to the Bottom on September 22, 2008 (boomark / email).