The Fed Proposals and Upending the Delaware Model

The Fed is considering rules that would effectively regulate compensation practices by the 5000 or so banks subject to its oversight.  Federalization of the compensation process, in short, and a death knell to the Delaware model of determining compensation.

Compensation decisions are made by the board.  The board is subject to fiduciary duties.  Fiduciary duties are determined under state law, specifically by the courts in Delaware.  The Delaware courts have resolutely declined to impose meaningful standards on the board in determining compensation.  The result has been compensation without limits.  For more on this, take a look at Returning Fairness to Executive Compensation. 

It is the lack of standards in the area of compensation that has given momentum to efforts at federal preemption.  Were it not for the compensation problem, access might not be on the table.  Similarly, Barney Frank has already induced the House to pass a bill that would not only tighten the board process in determining compensation but would also impose mandatory limits on compensation practices by financial institutions that result in excessive risk taking.

The Fed's efforts, which to a large degree mimic Barney Frank's Bill, would impose on the board far tougher standards than anything that exists at state law.  First, they would have to consider compensation practices that go much further down the chain than the top officers.  Second, they would have to consider the connection between compensation and risk, something that the anemic standards in Delaware currently does not require.  This would likely require increased expertise on the committee, including directors with risk analysis skills.  Third, and perhaps most important, the Fed would presumably enforce the rules.  Directors who were lax in oversight might find themselves pressured to leave the board. 

This is piecemeal federalization.  The current proposals would apply only to Fed regulated banks, although it is possible that they would become standard practice.  There is no reason why prohibitions on compensation practices that result in excessive risk taking ought not to be the standard for all public companies.