Friday Editorial: Delaware, SOX, and the Prospect of Future Federal Intervention

We will, next week, begin a series of posts on the involvement of the Securities and Exchange Commission in the corporate governance process.  In a process that was accelerated by the adoption of SOX, there has been increasing pressure on the Commission to get more involved, essentially to address deficiencies that come from the lack of standards at state law.  For my essay on the topic, go here.

For all of the criticism of SOX, the Act was in part an effort to fill a void at state law.  The ban on loans to directors and executive officers, as a prior post has illustrated, arose because of the lack of standards applied under Delaware law for the review of these conflict of interest transactions.  The audit committee provisions also arose from an absence, at state law, of meaningful obligations imposed on directors.  It took SOX to require a system that allowed employees to anonymously report problems to the board, that required a more meaningful level of director independence, and that more or less required financial expertise on the board.  SOX also, more or less, stripped from Delaware the regulation of reporting systems within public companies, a product of the dismally low stands imposed under the duty to monitor.  We will write more about this in the future.

Had the standards at state law been sufficiently meaningful, it is doubtful that Congress would have needed to include these provisions in SOX and to increase the role of the SEC in the corporate governance process.  Assessing SOX, therefore, is not only a matter of addressing the particular provisions in the Act but also a matter of examining the alternatives.  In fact, it is in many ways a product of the race to the bottom at state law.

Where is all of this going?  SOX fixed some areas but not others.  SOX did not, for example, fix the problem of the standard of review that applies to conflict of interest transactions (most notably executive compensation).  As the passage of HR 1257 (advisory votes on executive compensation) illustrates, Congress remains quite interested in this area and, over time, likely to intervene further.  Intervention may take the form of absolute bans on certain practices (as was done in the case of loans) or greater regulatory discretion for the Commission to regulate the matter. 

Unless the standards at state law become more meaningful, continued preemption and a continued rise in the role of the SEC in the governance process is inevitable.  It is this role that we will begin discussing next week.

Comments

[Harry Gerla]

I'm not so sure a fairness review by a court (a) will add much to steps such as insuring truly independent boards and getting shareholders to vote on executive compensation, and (b) is even feasible for a court to do.

The traditional standard for what is a "fair" transaction (aside from fair dealing, i.e., complete disclosure of all material facts about a transaction) is that the terms are at least as good as would be obtained in an arms length transaction between unrelated parties. When it comes to classic self dealing transactions, e.g., buying property from or selling property to the corporation, taking a loan from the corporation or making a loan to it, courts can at least make a fair guess as to what a "market rate" for the transaction would be based on various appraisal techniques. (This is not to say that there is not a tremendous amount of judgment and "wiggle room" in the appraisals--there is.) When it comes to executive compensation, the amount of judgment that must go into a call on how much an executive is worth is infinitely greater. As economist Lester Thurow argued several decades ago, a board which used formulas, such as simply tying compensation to a firm's earnings or worse stock price, in place of using careful judgment about the long term value of an employee's services, was not doing its job.

The problem of the amount of judgment which must go into setting executive compensation caused courts to shy away from second guessing boards on compensation (at least in publicly held corporations) long before Delaware began to gut the duty of loyalty. After all, the New York case of Heller v. Boylan, with its famous language on how difficult it is to tell what an executive is "worth" dates from 1941.

Of course one can point to cases such as Ovitz' compensation for his one year at Disney, or Nardelli's golden parachute from Home Depot, to say that no matter how tough it might be to make a call on executive worth, it's a no brainer to find that deals like those are far outside the range that parties to an arms length deal would arrange. I fully agree. However, if we did institute meaningful standards for director independence and even advisory shareholder votes on executive compensation, how many deals such as those would ever get made?

So, I guess my bottom line is that while steps such as putting truly rigorous standards for board independence into place, or requiring advisory shareholder votes on compensation will be very helpful in curbing excessive executive compensation, I'm not sure having fairness reviews by courts will add very much except litigation costs.

[J. Robert Brown]

You gave two examples (Ovitz and Nardelli) as outside the arms length range. But we know from Ovitz, the contract was ultimately sustained without any real examination of the terms. At least fairness would establsh some limits. It seems to me that if directors know the terms matter, they will avoid these types of compensation packages (as well as loans with the type of terms given to Bernie Ebbers). As things stand, it won't be long before some board of directors provides compensation that makes the payments to Ovitz and Nardelli look paltry.