Corporate Governance

Excessive Compensation and the Responsibility of the Delaware Courts (Part 2)

By J. Robert Brown

As the issue of executive compensation continues to occasionally surface (most recently in connection with some financial institutions foregoing bonuses), it is worth noting the role that the Delaware courts have played in the problem. Delaware allows shareholders to inspect corporate documents but requires that they have a proper purpose. In construing proper purpose, the Delaware courts have added their own restriction.

There not only must be a proper purpose but the shareholder must come forward with "credible evidence" of the purpose, particularly if alleging mismanagement, waste or wrongdoing. It is a burden difficult to meet without having any opportunity to explore the facts surrounding board activity. Nonetheless, the standard might be appropriate if it was applied in a reasonable manner, which it is not. Which brings us back to Seinfeld v. Verizon, a case previously discussed on this Blog.

In that case, the shareholder wanted to inspect corporate documents to explore the reasons behind executive compensation decisions made by the board. The shareholder presented evidence indicating that the top three officers had made over $200 million during a three year period. The Supreme Court held that these allegations were not enough. The court reaffirmed the need for affirmative evidence of wrongdoing.

• The only way to reduce the burden of proof further would be to eliminate any requirement that a stockholder show some evidence of possible wrongdoing. That would be tantamount to permitting inspection based on the "mere suspicion" standard that Seinfeld advances in this appeal. However, such a standard has been repeatedly rejected as a basis to justify the enterprise cost of an inspection.Said another way, the Court viewed plaintiffs efforts to examine the basis for $200 million in compensation as an "indiscriminate fishing expedition[]". That pretty much summed up the attitude of the courts towards shareholders. Not only could they not examine compensation decisions when they produced facts indicating that the amounts were "excessive," the Court treated the effort with derision.

The effect of the decision was to allow boards to keep their decisions shrouded in secrecy. Thus, boards may use compensation consultants who arguably lack independence without having to worry about disclosing the details. Boards may allow the CEO to participate in the decision making process without having to disclose the involvement.

Denial was simply a judicial mechanism designed to protect the facts surrounding executive compensation from coming to the surface. It was a good decision for managers, a bad one for shareholders. In other words, it is explained not by the purposes of the inspections right statute but by a race to the bottom mentality that inexorably protects the interests of management, particularly in the realm of executive compensation. In the era of financial market turmoil and concern over excessive compensation, the decision looks even worse. They demonstrate the one reason for the excessiveness is that shareholders can't get the facts because the Delaware courts won't let them.

Full post as published by The Race to the Bottom on November 21, 2008 (boomark / email).