Corporate Governance

"Crazy Compensation" and the Source of the Problem

By J. Robert Brown

On Thursday, Alan Blinder, an economics professor and former vice chairman of the Fed, published an editorial in the WSJ titled "Crazy Compensation and the Crisis."  In the course of his challenge to the system of executive compensation, he rhetorically asked, "Whoever dreamed up this crazy compensation system?"  In later characterizing the problem, he describes the system this way:  "The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke."

True enough.  From an economist, the system is centered around perverse incentives that encourage top officers to take excessive risk in order to maximize their compensation.  These sorts of base instincts have always existed yet the problem seems today more severe and more recent.  What is the explanation?

The answer is the evisceration of the legal protections for shareholders.  While top officers may have an economic incentive to role the dice, the legal system imposes a countervailing obligation:  To act in the best interests of shareholders.  There is little question that the rolling of the dice will not be in the best interests of shareholders yet the legal system has, in the hands of the Delaware legislature and courts, become an anemic guarantor of the rights of shareholders.  It is this absence of meaningful protection for shareholders that has allowed the excessive compensation problem to reach its latest heights.

The examples in this area are legion.  Waiver of liability provisions have all but eliminated the duty of care (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom ).  The duty of loyalty (particularly the approval of executive compensation) had largely been reduced to a procedural standard, without consideration of the substance of the transaction at issue (or the terms of the executive compensation package) (see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).  As we have noted time and time again, the Delaware courts have declined to make the standards meaningful and have provided firm economic (yes economic) incentives on the part of directors to back the demands of management (in other words, to support their "perverse incentives"). 

Finally, we note the resolute refusal of the Delaware courts to impose specific responsibilities on the board with respect to corporate oversight.  In Citigroup, the Chancery Court could have defined the responsibilities of the board with respect to the oversight of excessive risk taking.  Instead, the decision merely repeated that the board has no such responsibility.  In San Antonio Fire & Policy v. Amylin Pharmaceuticals the Delaware Chancery Court held that a board did not even have an obligation to be told about provisions in agreements that effectively restrict in a substantial way the voting rights of shareholders. 

It is, in short, a legal system that provides for capture of the board by top officers and provides little incentive for boards to be informed.  In other words, it is a system that imposes few if any limits on the natural instincts of top executives to enhance their own compensation by taking excessive risks at the expense of shareholders.  Isn't the system of "crazy compensation" a predictable consequence?  Isn't federal preemption an obvious solution?

Full post as published by The Race to the Bottom on May 30, 2009 (boomark / email).