We recently welcomed Harwell Wells to the Illinois Corporate Colloquium to discuss his and Randall Thomas’s Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties.
The paper suggests a new approach to controlling executive compensation: the courts. The paper is partly historical, noting that courts have, in fact, been “surprisingly willing to second-guess decisions on executive compensation,” although after doing so they ultimately withdraw from the field to avoid becoming “entangled in setting pay.” The article says Delaware’s recent Gantler v. Stephens, which recognizes fiduciary duties of corporate officers, “opens the door for courts to monitor executive compensation by scrutinizing rigorously officers’ actions in negotiating their own compensation agreements.” Thomas & Wells also draw on Delaware holdings “that corporate officers are bound by their duty of loyalty to negotiate employment contracts in an arm’s-length, adversarial manner.”
Thomas & Wells suggest their “approach should be welcomed by the courts, which will not be required to determine whether compensation packages are fair or merited, but will instead be asked to engage in a familiar task, examining whether proper procedures were followed in setting compensation.” The abstract concludes:
This approach . . . promises to break an impasse between the two major academic approaches to executive compensation. Advocates of “Board Capture” theory have long argued that senior executives so dominate their boards that they can effectively set their own pay. “Optimal contracting” theorists doubt this, contending that, given legal and economic constraints, executive compensation agreements are likely to be pretty good and benefit shareholders. The approach advocated here should, surprisingly, please both camps. To Board Capture theorists, it offers to cast light on pay negotiations they believe are largely a sham; to Optimal Contracting theorists, it offers a way to improve the already adequate negotiating environment.
Given the ongoing focus on executive compensation, which shows no sign of abating, this is a timely suggestion. It’s also an intriguing idea which sparked a lot of discussion in class. I agree that focus on board procedure offers some benefits over attempting to set pay. But I also have some skepticism and questions about the proposal.
First, are courts any better suited to determining how pay should be negotiated than what it is? The Delaware Supreme Court thought it knew in Smith v. Van Gorkom when it threw out a seemingly fairly priced transaction solely because it didn’t like the negotiation process. The post-Van Gorkom fallout in Delaware, including 102(b)(7), and the cases insisting that price be considered with procedure, indicated the problems with the court’s assumption.
Second, I question characterizing the officers’ duty in this situation as fiduciary. As I’ve written, the fiduciary duty is properly conceived of as a duty of unselfishness. This doesn’t fit with an officer negotiating for what is essentially an exception to the duty – that is, the officer’s compensation. The officer should have some disclosure duty in this situation, but that’s not the same thing as the hard-core duty of unselfishness.
Third, what would a fiduciary duty of fair negotiation entail beyond disclosure? There would certainly be a substantial period of unpredictability while courts figure this out, and firms likely would have to tack a premium onto pay packages to reflect the risk of judicial second-guessing.
Fourth, it’s worth observing that the duty Thomas & Wells describe is similar to the one Judge Easterbrook tried to set in the mutual fund investment adviser context – disclosure and no “tricks.” See my paper, Federal Misgovernance of Mutual Funds. The Supreme Court shot the Easterbrook test down in Jones v. Harris. The Court reasoned more or less that the statute says “fiduciary duty” and disclosure-no-tricks isn’t a fiduciary duty. This is a cost of trying to apply a fiduciary duty where it doesn’t really belong. The same issues of containing a “fiduciary duty” of fair negotiations would apply here.
I suspect that if courts recognized this duty firms would comply by having their compensation consultants concoct a rigid set of procedures that would protect pay from second-guessing. On the bright side, this could protect firms from judicial second-guessing of the size of pay packages, which Thomas & Wells show does happen periodically. Since it’s probably not enough anymore in this regulatory environment just to say markets work, maybe Thomas & Wells is the best we can do.