A Solution to Executive Over-Compensation?

Many television commentators and academics claim that executive compensation is skyrocketing out of control. While the commentary on television is most likely rooted in populism, academics explain this contention by resorting to board capture theory. According to board capture theory, corporate boards of directors are dominated by their firm’s top executives. Thus, when an executive negotiates his compensation, he is effectively negotiating with himself and people who want to keep him happy. Therefore, executives get substantially more favorable compensation packages than they would if their contracts were negotiated in an arms-length and adversarial manner.

A solution to this problem was recently presented to the Illinois Corporate Colloquium by Harwell Wells. In their working paper available on SSRN, “Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties,1 Professor Wells and Professor Randall Thomas argue that the courts can step in to solve the problem of executive over-compensation based on board capture.

Noting that “most courts have…claimed that they are reluctant to closely examine executive pay levels and practices,” (P. 6) Wells and Thomas propose that Delaware courts do what they are comfortable with and competent to do: “evaluate the negotiation process used in reaching a compensation agreement.” (P. 46)

Wells and Thomas argue that the Delaware decision in Gantler v. Stephens recognizing fiduciary duties for corporate executives allows judges to “ask whether officers upheld their fiduciary duties when negotiating their compensation agreements.” (P. 37)  Later Delaware decisions make clear that officers’ fiduciary duties require them to negotiate subsequent compensation agreements “in a manner that is fair to the company from a procedural perspective,” that is, in an adversarial and arms-length manner. (P. 39)

There are two distinct problems with this proposal. The first is that only subsequent compensation agreements made with current executives are susceptible to examination based on executive fiduciary duties. Thus, a new executive’s initial compensation agreement would be insulated from judicial scrutiny based on executive fiduciary duties. Yet a paradigm case of alleged executive over-compensation, and one relied upon by Wells and Thomas to formulate their argument, involved a shareholder challenge to a CEO’s initial compensation agreement. That case concerned the compensation agreement made between Disney and its short-term CEO Michael Ovitz. Because Ovitz was not an executive when he negotiated his contract, he had no fiduciary duty to Disney shareholders and his contract could not be challenged using the approach advocated by Wells and Thomas. Thus, their solution does not address some of the most egregious cases of alleged executive over-compensation. So a question is left to be answered: how can compensation agreements made between firms and new executives be scrutinized (and by whom?) when shareholders feel the board of directors negotiated ineffectively?

The second problem is that the authors do not propose a workable remedy that is likely to be applied. Let us consider the potential remedies for this sort of breach of executive fiduciary duties. The authors proffer two possibilities: restitution or rescission of the agreement. Rescission seems like a remedy judges will be unlikely to apply. To require disgorgement of all compensation derived from the corrupted agreement is a very harsh punishment, especially considering that the board of directors will likely have breached their fiduciary duties to shareholders during the negotiation process as well. Basically, judges will not want to impose such a harsh penalty on one executive when the executive is not solely responsible for the agreement.

If a court chooses a restitution remedy, it would require the executive to return to the corporation any sum above what she would have received in a fair (adversarial and arm’s-length) negotiation. But this method of determining damages requires the court to do what the authors say courts are not good at and don’t like doing: deciding what constitutes a “fair” executive compensation package. This suggests judges will be unwilling to order restitution in cases where a compensation agreement seems to have been corrupted. The low probability that courts will impose restitution or rescission in cases like this raises a problematic question: how can courts determine what damages an executive owes his or her firm in a way that does not require their reaching conclusions on the substance of executive compensation?

Professor Larry Ribstein has already questioned whether courts are actually well-equipped to determine the process by which executive pay should be negotiated. Prof. Ribstein points to the Delaware Supreme Court’s decision in Smith v. Van Gorkom, which nullified a seemingly fair agreement on procedural grounds. Considering courts’ frustration at their inability to determine what constitutes appropriate or fair compensation, giving them a tool to evaluate the process of negotiation may be the only way to get courts to address board capture problems.

Overall, the paper is encouraging because it presents a new approach by which judges can scrutinize alleged executive over-compensation. The paper also includes an historical section pointing to instances in the past when judges have shown a willingness to examine executive compensation practices. Focusing on the process of negotiations rather than the substance of agreements does directly address the problem articulated by board capture theorists. However, Wells and Thomas’ approach does not address compensation packages given to new executives. It also does not yet offer an effective remedy that judges will be likely to apply. Thus, future research may have to directly address a question judges and academics remain unable to answer: by what method can a judge effectively and fairly determine what constitutes appropriate pay for an executive officer of a particular company?

1. The full and recommended citation to this article is as follows: Thomas, Randall S. and Wells, Harwell , Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties (March 15, 2010). Vanderbilt Law and Economics Research Paper No. 10-10; Temple University Legal Studies Research Paper No. 2010-5. Available at SSRN: http://ssrn.com/abstract=1571368