Criminalizing Compensation: Lax Standards, Delaware Law, and the Conviction of Gregory Reyes

Earlier this week a jury convicted Gregory Reyes, the former CEO of Brockade of 10 counts of fraud.  Reyes will likely spend a significant portion of the next decade in jail.  

Reyes is going to jail not because he benefited from the backdating.  In fact, he was never awarded any of the backdated options.  He is going to jail largely because of the lax, anything goes standards under Delaware law in the area of executive compensation.  Had Delaware had anything approaching meaningful standards for the payment of executive compensation, Reyes would likely not have engaged in the backdating and not be going to jail.  There would be no need to criminalize compensation practices. 

With Delaware engaging in a "race to the bottom" and relentlessly reducing the obligations imposed on management, the state has largely allowed any type of compensation to pass muster and any level of board involvement (or uninvolvement) to be sufficient.  As Disney shows, the board can have marginal involvement and still fulfill its duties.  As Desimone shows, the board can delegate compensation practices to a committee and the committee can delegate them to officers, washing its hands of any improper practices that result.

In addition, Delaware has held that approval of compensation by a board with a majority of independent directors will result in the application of a the business judgment rule, an almost insurmountable standard.  The definition of "independent" under Delaware law does not ensure directors are in fact independent (see my article here).  Despite pretenses to the contrary, the definition does not, for example, screen adequately for friendship or for the payment of exorbitant fees to directors.  The result is often inattention and/or approval by a board or committee dominated by persons beholden to the CEO.  It is no surprise that in this environment, one without any real legal obligations on the board, executive compensation has skyrocketed.  In other words, there are no real limits on compensation. 

Backdating is only the latest example.  Before SOX, it was loans to top executives.  With the $400 million loan to Bernie Ebbers the poster child, board committees could provide loans of extraordinary amounts on term that no bank would give yet easily pass muster under Delaware standards.  It was enough that the loans were approved by an "independent" committee of the board.  Forget that the Worldcom compensation committee included one director who was a longstanding friend of Ebber's and got a good deal on the use of the corporate jet.  It didn't matter.  The loans were still proper.

Two things happened with respect to these practices.  Dennis Kozlowski and Mark H. Swartz at Tyco went to prison in part because of loans that were "forgiven", apparently without board approval.  In other words, practices became so "relaxed" and the board so uninvolved that ultimately they resulted in the application of criminal laws to penalize the practices.  Second, SOX prohibited almost all loans to directors and executive officers.  In other words, Congress stepped in and preempted state law. 

The same thing is going on with backdating, the latest executive compensation scandal.  In Desimone, the Chancery Court all but said anything goes.  The Court, in dicta, validated backdating and spring loaded options (not to mention bullet dodging), more or less labeling them as just another form of compensation.  The opinion even went so far as to opine that spring loaded optionsdid not violated federal prohibitions on insider trading.  In the aftermath of SOX, the Delaware courts have not tightened up the standards for independence or for board review of compensation decisions.  If anything, they have gotten worse.

As a result, we are seeing the criminalization of backdating.  It is also possible that ultimately there will be federal preemption to further prohibit the practice (SOX has already made it much tougher by requiring directors and executive officers to report changes in ownership, including new options, within two days).  The House has already passed "say on pay."  The best way to ward off criminalization and federal preemption?  Establish meaningful standards for director review and involvement in compensation decisions.  That, as Desimone indicates, is not likely to happen any time soon.

Comments

[Jack Payne]

It's hard to see how Delaware could remain the corporate haven that it is without these executive compensation tax advantages. in my writings on scams, this is a top reason for filing there.