Academic

Brown on Fairness in Executive Compensation

By Lawrence Solum

J. Robert Brown Jr. (University of Denver Sturm College of Law) has posted Returning Fairness to Executive Compensation on SSRN.  Here is the abstract:

The current waive of turmoil in the financial markets has cast attention on the problem of executive compensation. Companies that have failed or disappeared in shot-gun mergers have nonetheless paid exorbitant sums to officers who arguably played a substantial role in their demise. In response, Congress for the first time established federal standards for determining compensation, including clawbacks and limits on golden parachutes.

The congressional efforts, although mild, represent a deep frustration with the system used by the Delaware courts in assessing executive compensation. With the CEO on the board, executive compensation has traditionally been examined under the duty of loyalty. Through legal legerdemain, the Delaware courts have accorded the decisions the all but insurmountable protection of the business judgment rule, requiring only that the board contain a majority of "independent directors." By largely reducing the test to a rote head count, the courts did little to ensure that compensation decisions were unaffected by the interested influence. At the same time, the courts did little to ensure that independent directors were in fact independent.

The paper provides some suggested reforms. The efficacy of the process must be improved. Most importantly, however, fairness needs to be returned to the analysis. Only with some obligation to show the fairness of the compensation decision with the interests of shareholder be adequately protected.

I was intrigued by the abstract, and the question it raises: "What constitutes fairness?"  Of course, from the point of view of corporate law, "fairness" is "fairness to stockholders" and not "fairness to other employees."  In theory, a fair salary is the salary that would have been paid if the board of directors had been motivated to maximize shareholder value and entered into an arms-length transaction, but the question is "How could that be determined by a court?"  The footnote on "entire fairness" (the doctrinal approach that Brown suggests could be adapted to this purpose) reads as follows:

 Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del. 1995)(?In this case, because the contested action is the sale of a company, the ?fair price? aspect of an entire fairness analysis requires the board of directors to demonstrate ?that the price offered was the highest value reasonably available under the circumstances.?")

But this would seem to beg the question--how would a court determine "the lowest salary reasonably available under the circumstances" without know the worth of the executive to the corporation?  I'm not making an objection--just asking a question.

Full post as published by Legal Theory Blog on November 26, 2008 (boomark / email).