Executive compensation is a hot topic. Congress entered the fray with the Dodd-Frank Act's "say-on-pay" requirements and with Section 162 of the Internal Revenue Code's limits on deductions for some executive compensation payments.
Yet, neither of those measures actually limits what companies may pay their top executives. To do so, stockholders have filed suits arguing it is a breach of fiduciary duty to not follow stockholder votes on say-on-pay resolutions or to not meet Section 162's requirements to obtain a deduction for executive pay.
Those suits have been notably unsuccessful. Indeed, these so-called "Section 162 claims" rarely get beyond the pleading stage, where they are regularly dismissed. The business judgment rule usually insulates from attack the directors' decisions on executive compensation. For example, the Delaware Supreme Court's 2005 opinion in In re The Walt Disney Co. Derivative Litigation, 906 A2d 27 (Del. Sup. 2006), upheld a board decision to pay a $130 million severance package to a single individual. Just a few weeks ago, the Court of Chancery dismissed a similar claim alleging excess compensation in Zucker v. Andreessen, C.A. 6014-VCP (June 21, 2012).
Recently, however, the Delaware Court of Chancery indicated that not all board of director decisions on compensation are immune from attack. When directors vote on their own compensation, there is ample Delaware precedent that the vote may be set aside and the directors ordered to return the funds they received to their company. Awards of attorney fees in those cases are also well established. See Valeant Pharmaceuticals International v. Jerney, 921 A.2d 732 (Del. Ch. 2007), and Julian v. Eastern States Construction Service, 2008 WL 2673300 (Del. Ch.).
What, then, may a board of directors do to protect itself from litigation risk when determining its own compensation? Asking the stockholders to approve director compensation each year is cumbersome at best and itself is expensive, requiring detailed proxy materials for publicly traded companies. In closely held corporations where the directors may own a majority of the stock outstanding, their vote of approval as stockholders may not be enough to insulate their decision from minority stockholder attack. Moreover, in smaller companies, the nonmanagement owners may object to management compensation that they feel should have been shared with them through dividends.
There are at least two ways to solve this potential dilemma. The first method is illustrated by the June 29 Court of Chancery decision in Seinfeld v. Slager, C.A. 6467-VCG (June 29, 2012). In SeinfeldSeinfeldSeinfeld
"A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board's compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair."
The clear lesson from Seinfeld
The second method to uphold director decisions about their own compensation on a case-by-case basis involves inserting a disinterested decision-maker into the process, such as an outside director or a compensation committee of outside directors. The decision-maker should be aided by independent advisers and should not participate in any award. Of course, the decision must be carefully considered and documented.
For smaller or closely held companies, this is not as easy as it may sound. For those companies, finding a truly outside, independent director or two is sometimes difficult. Serving as a conscientious director is time-consuming and smaller companies do not pay directors very much. Management, who often also hold a majority of the company stock, may be reluctant to trust a stranger with important business decisions. Yet, turning to a longtime friend out of trust in his or her judgment may not work to establish the necessary independence from the insiders. Any business relationship with the outside director is also problematic as a threat to his or her independence.
The best way to approach the problem of director compensation is to be very open about it. If there is a legitimate need for special compensation, that should be reflected in a stockholder-approved compensation plan. That plan should specify the criteria for any award. The decision, in any case, should be made by disinterested directors. When all of that is done, the decision should be given deference by the courts.