Executive Compensation in the Courts

In the paper, Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties, forthcoming in the Minnesota Law Review, my co-author, Harwell Wells, and I identify a theoretical impasse in our understanding of executive compensation and looks to recent developments in corporation law to find a practicable way out. At present, debates over executive compensation are waged between two scholarly camps. Advocates of Board Capture theory claim that, because boards of directors are dominated by corporations’ chief executive officers, those CEOs are able to set their own compensation and take home pay packages that are both too high and provide too few incentives for improved corporate performance. Optimal Contracting theorists disagree; while admitting that some compensation packages are inequitable, these theorists contend that, given the constraints of the current legal and regulatory system, most current CEO compensation agreements should be pretty good, rewarding CEOs appropriately and, equally important, providing for increased shareholder value. Despite vigorous scholarly debate, however, little progress has been made in the theory of, and little done in practice to curb, excessive compensation packages.

A new avenue has been opened up by recent developments in corporation law that brings to life a neglected area, officers’ fiduciary duties. In the Gantler decision, Delaware‘s Supreme Court has recognized that corporate officers have the same fiduciary duties as do directors, and in two recent decisions its Chancery Court has set out a road-map showing how courts can review executive compensation agreements by scrutinizing the ways in which they were negotiated. While agreements between top executives and their corporations may never be truly at arm‘s-length or adversarial, the Chancery decisions describe what would be necessary in such negotiations for a court to conclude that an agreement was not the product of an executive‘s power over the board of directors.

We derive from these Delaware decisions a new approach to review of executive compensation agreements, one that should cheer both Board Capture and Optimal Contracting theorists. For Board Capture theorists, the Delaware courts’ approach will provide a searching review of just the situation that they have been decrying for decades, CEO domination of the compensation process, with the promise that compensation agreements produced through managerial power will be struck down. Optimal Contracting theorists will welcome such review as well, not only because it will ex post strike down agreements that result from illegitimate influence, but because it should ex ante improve the negotiating environment.

One important question remains: will the courts actually engage in rigorous review of compensation agreements? Board Capture theorists may be skeptical, as they have in the past held out little hope that courts are willing or able seriously to review excessive compensation. Yet as this Article has shown, the true history of judicial review of compensation agreements is more complicated than a simple refusal to scrutinize compensation. Courts have in the past imposed closer scrutiny on aspects of executive compensation, and warned at other times that such scrutiny may be forthcoming. The Disney and Elkins decisions should give hope than such scrutiny will again be forthcoming. For one thing, their focus is on officers, not directors. If courts have been reluctant to place legal liability on directors because of fears that highly qualified individuals will be unwilling to take part-time positions and put their personal wealth at risk, this concern should be mitigated where we are talking about full time, highly paid employees who can avoid significant legal exposure by making full disclosure and engaging in arm‘s length negotiations with fully informed boards of directors. Moreover, there are persuasive arguments that officers’ direct involvement in the management of the firm should result in greater scrutiny of their actions than those of outside directors. These claims seem particularly compelling in conflict of interest situations such as overreaching in the negotiation of the officer‘s own employment contract. For these reasons, we are hopeful that courts will monitor executive employment contract negotiations in a meaningful way. If we are right, this would not only resolve the theoretical impasse discussed here but have a significant practical impact on executive compensation.

The full paper is available for download here.