Standards for Executive Compensation

I had intended the second post on this blog to begin a discussion of the benefits of Sarbanes-Oxley but George Bush's speech on the State of the Economy gave me a different idea. He criticized executive compensation and called on "America's corporate boardrooms" to  " step up to their responsibilities" in approving these packages. 

A fundamental legal problem with executive compensation is the standard of review adopted by the Delaware courts.  Delaware courts provide (as a matter of common law) that conflict of interest transactions approved by a majority of "independent" directors are entitled to the protection of the business judgment rule. Requiring only a majority means that the interested influence can remain a part of the decision making process. Moreover, the definition of independent (coupled with the onerous pleading standards) used by Delaware courts is inadequate to ensure that the directors are in fact independent. As a result, the courts in that jurisdiction give business judgment protection to interested party transactions approved and/or influenced by interested, non-independent directors.  Fairness no longer matters and compensaton has no substantive limits (unless one thinks the waste standard is really a limit).  The results of such a standard are predictable and obvious.  Read more on this here.

In all of the litigation around the Michael Ovitz transaction at Disney, for example, the courts never actually analyzed whether the execution of a contract that provided for the payment of $140 million after a little over one year of work was fair to the company.  

Those who see Delaware as exclusively a race to the top ignore these problems.  Congress does not. Sarbanes-Oxley amounts to a congressional rejection of the race to the top, preempting state (read Delaware) law in a number of places. More on that here. If the courts in Delaware continue to apply a standard of review for executive compensation that ignores the fairness of the transaction and allows for interested influence in the approval process, it will likely find itself again ousted from the regulatory process, with Congress continuing the process of shifting corporate governance principals away from the states.  This blog ranks executive compensation as the #1 area of state corporate governance most likely to be preempted.  We will keep a list.  If you have other examples, send them to the blog.