AIG, the Delaware Model, and the US Government

The US Government owns 80% of the equity of AIG but if standard rules apply, it cannot successfully sue to get back the hundreds of millions of bonuses paid out to employees.  This is the point made by Carl Icahn in a recent editorial in the Sunday NYT.  He rightfully makes the point that any effort by shareholders to change the board of directors will ultimately founder on the shoals of cost and time.  The editorial mostly argues for shareholder access to the proxy statement for nominees, something that will reduce the costs associated with a proxy solicitation. 

Mentioned but less discussed are the limits on bringing a law suit against the board.  As the editorial notes: 

• Sadly, though, under American corporate law share ownership does not count for much. Mr. Frank might be surprised to learn that a lawsuit would have almost no chance of success in court, even for a majority shareholder like the government. A.I.G. would most likely argue that the oft-cited “business judgment” rule gives management wide latitude to set compensation without shareholder interference.

True enough but the problem is far deeper and more invidious.  AIG is incorprated in Delaware.  Actually what management would argue is that shareholders did not make demand and that there was no basis for demand excusal.  Demand excusal merely requires management only to show a board with a majority of "independent" directors. 

Delaware uses a definition of independent that in fact does not ensure that the board is independent at all (for more on this take a look at Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).  In most instances, director independence will only be lost if the directors have an economic interest in the decision they are making.  So long as the bonuses were paid to others, the directors will be treated as independent. 

And, in fact, it would have been OK if the directors authorized bonuses for some of the directors.  Delaware merely requires a majority of independent directors.  Thus, even if the board authorized hundreds of millions of dollars in bonuses and paid some of those millions to directors on the board, the Delaware courts would dismiss the case, acting as if the board was a neutral decision making body.

The effect of this approach is to have matters turn on the status of the directors, not on the underlying behavior.  It involves the fiction that boards with a majority of interested directors are nonetheless neutral decision makers.  As a result, the Delaware courts use these procedural mechanisms from ever letting shareholders uncover the true facts of what happened.