Some Sense on Top Pay
posted by Lawrence Cunningham
Executive pay continues to spark heated debate: some want it curtailed across the board, the impetus of recent federal law, while others want no legal oversight whatsoever, the effect of Delaware corporate law. Contract law may provide an optimal solution, narrower than the overly broad federal regime yet targeting egregious cases ignored by Delaware.
Thanks to readers of this blog for comments, forthcoming in the Iowa Law Review is my paper, now available on SSRN, “A New Legal Theory to Test Executive Pay: Contractual Unconscionability.” The paper is available for free downloading here. The abstract follows below.
Lucrative pay to corporate managers remains controversial yet continues to evade judicial scrutiny for legitimacy. Although many arrangements likely would pass the most rigorous scrutiny, it seems equally clear that some would not. Some agreements are not the product of arm’s-length bargaining, can rivet managers on short-term stock prices at the destruction of long-term business value, and can misalign manager–shareholder interests.
Yet even such objectionable arrangements are immune from serious legal oversight. In theory, they are open to judicial review under corporate law, but shareholders challenging pay contracts face formidable procedural hurdles in derivative litigation and substantive obstacles from corporation law’s business judgment rule and the anemic doctrine of waste. A new legal theory would be useful to check board excesses in the population of clearly objectionable cases.
This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken.
This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.
For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd–Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.
February 15, 2011 at 12:51 pm
Posted in: Contract Law & Beyond, Corporate Law, Current Events, Law Rev (Iowa), Securities Regulation
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Responses (3)
Anonymous Coward - February 15, 2011 at 9:39 pm
It sounds like you want to make pay the executive who is being excessively compensated rather than the other executives who agreed to the excessive compensation. I don’t know if I agree with that.
It seems to me that if anything, you have to put the executives on the board who approved the excessive compensation on the hook for paying the company back anything over and above what would be unconscionable. That better protects the new hire executive’s reliance interest in being compensated as agreed, and it puts the duty not to approve excessive compensation on the parties who have a fiduciary duty to the company rather than the not-yet-executive who doesn’t. The alternative would seem not to deter excessive compensation very much at all, because the executive merely loses the pay he wasn’t entitled to in the first instance and then only after litigation. Whereas the executives approving the excessive compensation would have everything to lose personally by approving excessive compensation if they were the ones who had to compensate the company for the excess.
Incidentally, it seems like there really isn’t any way for the shareholders to win here. If you initiate these kinds of lawsuits then you create personal divisions between board members at the company and consume the time of directors and executives who might otherwise be spending that time running the company. That seems likely to harm the company more than any recovery of excessive compensation could help it.
Lawrence Cunningham - February 15, 2011 at 11:09 pm
The suggestion in comment 1 is radical and would require substantial changes in existing law. The proposal the article makes is modest, explaining how existing law can be applied. Existing law authorizes rescission of unconscionable contracts. It does not impose penalties on those who foolishly make them or protect the reliance interest of those who would reap windfalls. The comment makes valid points about a legal world that could possibly exist, but it is not the world that does exist and, on this subject, proposals to change the world to match ideal theoretical visions have failed. On the “incidental” point, shareholders of companies whose boards form contracts that would attract scrutiny under this proposal would benefit from boards not “spending time running the company.”
Anonymous Coward - February 16, 2011 at 4:33 pm
I take it you have no sympathy for the executive who is wooed to a new company by an “unconscionably” large compensation package which is not much larger than the e.g. stock options the executive would have to give up at his previous company. Or the prospect that the alternative could cause executive pay to go up because executives demand higher compensation to account for the risk that their compensation is declared unconscionable and rescinded.
That sounds enough like “the status quo must not be questioned” to make someone feel uncomfortable.
Three points here: First, an executive who negotiated such high compensation is far more likely to be competent than the board who approved it, and it is the executive’s time that is most likely to be wasted. Second, the board may or may not be optimal, but having a bad driver is far better than having a distracted bad driver. Lastly, the idea that only those deserving of it will attract scrutiny ignores the substantial harassment value that such suits would have to hecklers and agents of competitors.
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