Corporate Governance

Executive Compensation, the Delaware Model and a Proposed Solution (Part 3)

By J. Robert Brown

We have proposed a solution to the executive compensation problem.  It entails an amendment to Section 13 of the Exchange Act to prohibit the payment of excessive compensation.  The provision defines excessive and contains a safe harbor that requires the board to implement meaningful procedures for ensuring the integrity of the executive compensation approval process.

The first critical issue is the definition of excessive.  For that, we propose the following definition:

• Excessive shall include any compensation that is significantly greater than what is ordinary for companies in the same peer group (taking into account, among other factors, the published industry or line-of-business index of the company and companies whose equity securities are traded on the same exchange or are of comparable market capitalization) and where the board of directors does not provide a substantial justification for the compensation.

The test is largely taken from ideas articulated, ironically, by the Delaware Court in Julian v. Eastern States.  In that case, the Chancery Court found that the compensation was unfair because it neither reflected past practices of the company nor was accompanied by an explanation for the deviation that the court deemed adequate. 

This approach would eschew caps.  It would allow the board to determine compensation but increase the obligations on the board.

The provision would permit an amount of compensation that is ordinary for a peer group (conceding that there is plenty of interpretive room and manipulative potential in the peer group concept). 

To the extent that the board authorized an amount greater than what was ordinary, the board would have the burden of providing a "substantial justification" for the increase.   The Commission would presumably have enforcement/rulemaking authority that would provide guidance on the concept of substantial justification.  To the extent boards provided justifications and they were inaccurate (the company had a better year than in the past when it didn't), the Commission could bring an enforcement proceeding and, presumably, there would be a cause of action under the antifraud provisions. 

In addition, however, the proposed section provides a safe harbor.  That will be discussed in the next post.

Full post as published by The Race to the Bottom on April 03, 2009 (boomark / email).