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E-MailOne of the most interesting aspects of the recent conviction of Gregory Reyes, the former CEO of Brocade, concerns the use of federal criminal law to police executive compensation matters. Reyes was accused of participating in a backdating scheme. The most intriguing fact in the case was that Reyes himself didn’t benefit from the backdating at issue. (A pending civil case alleges that Reyes benefited from other backdating; that case is analyzed in a recent post here.) In other words, Reyes used backdating as a form of compensation for other employees–and is now going to jail because of it. The case is part of a pattern of increased federal intervention in compensation decisions.
How did this happen? At least some of the blame can be placed at the feet of the Delaware courts. It has been clear for quite awhile that the Delaware courts have gradually eliminated any meaningful limits on executive compensation. They have done so by replacing substantive review with deference to procedural niceties, rendering the process largely meaningless. Under Delaware law, a derivative suit asserting claims of self-interested behavior will generally be dismissed if a majority of the board is deemed independent. The merits of the transaction itself–that is, the terms of the self-interested transaction–hardly matter. For example, Chancery recently reminded the shareholder plaintiffs in In re InfoUSA that “a derivative plaintiff, recognizing the institutional advantages and competency of the judiciary reflected in our law, [may] place[] before the Court allegations that question not the merits of a director’s decision, a matter about which a judge may have little to say, but allegations that call into doubt the motivations or the good faith of those charged with making the decision.”
While this approach can be criticized on a number of levels–for instance, note that, by only requiring a “majority” of independent directors, Delaware courts allow the interested influence to remain in the decision making process–the most serious flaw is how the courts go about determining whether a director is independent. Chancery places on shareholders the burden of producing, at the pleading stage, facts that give rise to reasonable doubt about a director’s independence. Given the way the Delaware courts evaluate those facts, it is all but impossible for plaintiffs to make such a showing. For example, in determining whether a director has received a “material” income stream from the company, the courts use a subjective test. The test is often impossible to meet at the pleading stage, requiring detailed evidence of the director’s net worth and the compensation formula the firm used to pay him; it is applied in an inconsistent fashion, so that directors’ fees are not considered a “material” payment even for those directors for whom the fees are a substantial portion of their income (so called “regular folks”); and ignores non-family and outside business relationships that may compromise the director’s independence. At The Race to the Bottom Blog, we have produced a top 10 list of ways Delaware courts have found to dismiss challenges to board independence, and I have written a piece, Disloyalty without Limits, that explores these issues in detail.The consequences of making it impossible to challenge a director’s independence are obvious. Self-interested transactions, including those in the area of executive compensation, are often approved by a board that includes directors who are not independent–the interested influence remains a part of the decision making process. These transactions, in turn, receive almost absolute deference from the Delaware courts.
An example? The $400 million in loans that the WorldCom board approved for former CEO Bernie Ebbers. The loans occurred at a time when the company needed its cash and apparently did not take place on commercially reasonable terms. But, of course, the merits of the loan didn’t matter. The only thing that mattered to the Delaware courts was the independence of the board and the compensation committee. Under the law at the time of the loan, both were apparently “independent.” Yet when Richard Breeden, the former Chairman of the SEC, authored a report on the company’s collapse, here is what he said about two of WorldCom’s “independent” directors:
“Both Kellett [chair of the compensation committee] and Bobbitt [chair of the audit committee] appeared to satisfy the “independence” standards for directors of the time, and might well satisfy current definitions used by the New York Stock Exchange (“NYSE”) and NASDAQ. However, both men had received millions of dollars worth of WorldCom stock when Ebbers acquired predecessor companies. Both men had been involved in business with Ebbers for years, and both owed a substantial portion of their net worth to his actions. This made them uniquely poor choices to represent the interests of WorldCom’s shareholders in exercising oversight responsibilities over Ebbers. As demonstrated by their actions in extending stockholder loans to bail out Ebbers’ personal debts, both men seemed to be more solicitous of Ebbers’ wishes than shareholder interests.”
Given the presence of these directors in the decision making process, is it any surprise that the board gave Ebbers exactly what he wanted–including $400 million in loans on highly favorable terms? Had the definition of “independence” been more meaningful, perhaps truly independent directors would have insisted at least on reasonable terms for Ebbers’s loans.
The consequence of the absence of meaningful state-law review has been, of course, federal intervention. Congress added Section 402 to Sarbanes-Oxley, largely prohibiting personal loans to directors and executive officers. While this approach unquestionably cut off a sometimes-beneficial practice, it has also prevented abuses that state law was apparently not robust enough to prevent. Had there been meaningful review of board independence in state law–review by actually independent directors, for example–this provision would never have made it into SOX. So we return to the Reyes case. Reyes operated in an environment in which there was little independent oversight of the compensation process. Specifically, with respect to backdating, early Delaware decisions have indicated little interest in establishing and enforcing meaningful standards for evaluating such options. The recent Chancery opinion in Desimone v. Barrows is a noteworthy example. Without meaningful standards for reviewing executive-compensation arrangements, the Delaware courts all but invite federal intervention. It is perhaps unsurprising, then, that the federal authorities–whether the SEC or the United States Attorney’s Offices–have been actively involved in prosecuting violations associated with backdating. Moreover, with say on pay percolating around in the House, there is growing risk that Congress will step directly into the compensation arena and preempt state law.
The best way to prevent further federal intrusion into the governance process–particularly in the executive compensation area–is to impose meaningful standards of review at the state-law level. In a recent paper, Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure, I describe the interaction between declining substantive state-law standards and the increased prospect of federal intervention. The federal government is likely to intervene in substantive corporate-governance lawmaking unless the Delaware courts adopt meaningful procedural standards for evaluating board decisions–including meaningful standards for determining director independence. Note that this is not a diatribe on excessive executive compensation. In general, deference to board processes used to make such decisions is wise; the courts should have a very limited role in assessing executive pay. But the Delaware courts’ failure meaningfully to evaluate the independence of the directors who make those decisions raises serious questions about the integrity of board procedures and the ability of the board to supervise corporate conduct. Those questions are still very much up in the air–something Gregory Reyes is now learning.
