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.
The article, among other things, would take the executive pay issue out of the internal affairs doctrine and put it into the morass of general choice of law rules for contracts (footnotes omitted):
[B]ecause they are not matters of internal affairs, they would be governed by the law of the state having the greatest interest. Managers could name Delaware as the choice of law by contract and maintain Delaware’s quasi-monopoly that insulates the devices from judicial scrutiny. Yet contractual choice-of-law clauses are but one factor relevant to determining what law governs a contract.
To be sure, says Cunningham,
investors may recoil at the prospect of gadfly fellow shareholders challenging corporate pay contracts.
But he sees this as
a way to restore a modicum of external pressure on the State of Delaware, the leading promulgator of corporate law for national use. * * * [T]he practical reality is that the competition has ended, and Delaware faces no such pressure today.
There is, of course, a substantial literature questioning the Bebchuk-Fried-Walker conclusion on which this proposal is based that executive pay is out of whack. And another substantial literature on whether or not the market for corporate law is out of whack. But let’s put those questions aside and play along with the premises of the proposal. Consider the consequences:
- Under this proposal, an executive, having negotiated her pay with a corporate board, would have no way of knowing whether, at some point, the pay might be challenged under standards to be named later in some state (her residence state, the corporation’s main place of doing business, somewhere else?) at the instigation of a lawyer seeking to extort a payment from the company.
- Executives would retain whatever power they supposedly had over the corporation in negotiating their contract to negotiate protection from or payment for this litigation risk. Shareholders, of course, would pay.
- Firms would surely find some way to deal with this new rule. Would the result be better than the system we have now of entrusting the decision to directors?
I guess you could say I’m not convinced. I prefer to take this article as an interesting thought-experiment on why regulation of corporate pay is misguided.