Corporate Governance

Delaware and the Use of Process to Permit Unfair Compensation

By J. Robert Brown

One of the fallacies of Delaware law has been an excessive reliance on procedural mechanisms to avoid examining the merits of self interested transactions.  This has been particularly true in connection with the approval of these transactions by independent directors.  Compensation approved by an "independent" compensation committee with the requisite report from a consultant renders the merits all but unreviewable.  Since, as we have often written, the directors approving the transaction are not in fact independent and because reports by a consultant can be found to justify almost any decision, there is no real guarantee for companies that the transaction was in fact fair.  This fosters an attitude of "anything goes" no matter how unreasonable or unfair. 

We catch a glimpse of this in Valeant Pharmaceuticals International v. Jerney, 921 A.2d 732 (Del Ch 2007).  The  Delaware Chancery court actually examined the merits of a transaction where the compensation committee approved large bonuses for management arising out of a decision to spin off a portion of the business.  The decision to pay the bonuses was supported by an opinion from an outside consultant.  The court ultimately concluded that the payments were not fair.  Had the board gone to the trouble of obtaining independent director approval, the case would have come out differently.  The merits would not have been examined, only the process.  This "unfair" set of bonuses would have been sustained.   

We thought of this aspect of Delaware law when we read Gretchen Morgenson's column in theSunday New York Times.  She wrote about a hearing in the bankruptcy case of Delphi, the auto parts manufacturer.  Bankruptcy Judge Robert Drain reviewed the company's request for a compensation package for officers that included $87 million in cash bonuses.  The board used a consultant to design the pay plan.  As the article noted: 

• the consultant could provide no explanation for why he tied the $87 million to the sole criterion of Delphi's emergence from bankruptcy protection.  "The question raised by the unions, and frankly by me, is whether that analytical process bears any relation to reality, the judge said in the hearing according to a court transcript.  "[The consultant] was candid in saying that the approach was a 'novel one.' He had not seen it before in his lengthy experience in Chapter 11 cases.  To the contrary, he testified that as far as emergence cash bonus awards were concerned, such rewards were rare or not the norm in Chapter 11 cases and in far lower amounts."

The Judge's objections ultimately resulted in the bonuses being reduced from $87 million to $16.5 million. 

In addition to another example of excessive pay, the bigger question is why it took a federal bankruptcy judge to prevent the payments from occurring?  Where was the board in all of this?  One answer is that under Delaware law, anything goes, as long as its done right procedurally.  We suspect that these payments were approved by "independent" directors.   It is an illustration of just how irrelevant "fairness" has become under Delaware law with respect to compensation decisions and how much companies are in fact protected by the procedural standards put in place by the Delaware courts.  Is it any surprise that there is a problem with boards approving excessive compensation?

Full post as published by The Race to the Bottom on January 31, 2008 (boomark / email).