August 10, 2005
Is Executive Compensation Special?
Posted by S_Griffith

It is. After all, Elkins and Disney, both good faith cases, are also executive compensation cases. What’s special about it?

First, executive compensation is a unique context where ordinary (that is, large) deference to board decision-making is not appropriate. Ordinarily, the question of how much to deliberate—the key indicator, by proxy, of bad faith (see my previous posts)—is a matter, like the decision whether to manufacture bottles or bricks, up to the board to decide and therefore protected by the business judgment rule. At the limits, this means a board can decide not to deliberate on most matters—that is, it can delegate the decision to management or a specialist. The rare exception to this principle is for those matters (like mergers, see the Chancellor’s discussion at page 150) that the DGCL says must be determined by the board. Executive compensation, although not carved out as unique by the statute, is another exception to the board’s ability to decide (by delegating) not to deliberate. As the court in Elkins stated:

While there may be instances in which a board may act with deference to corporate officers' judgments, executive compensation is not one of those instances. The board must exercise its own business judgment in approving an executive compensation transaction.

Why is executive compensation different? Why is board deference appropriate in other matters but not here? The answer, obviously, is that management has an overwhelming interest in setting its own compensation as high as it possibly can and cannot be trusted to act in the best interests of the corporation. Because of this conflict of interest, the board cannot blandly defer to management’s judgment.

Executive compensation, in other words, is a special case where management’s loyalty cannot be trusted. If the board does not exercise its own judgment to constrain management, we cannot be confident that the resulting decision is not the product of self-interest. Here again, the traditional duties of care and loyalty overlap (see Disney, footnote 402).

Second, executive compensation has recently become a hotly contested issue where the laxity of Delaware courts has been publicly criticized and calls have been made for federal intervention into corporate governance. Note, for example, that the very first footnote in the opinion cites these issues, in the context of a recent Bebchuk-Bainbridge exchange. Chancellor Chandler has previously shown himself to be highly sensitive to these matters, writing in an academic article with Vice Chancellor Strine that:

[I]t can be argued fairly that Delaware's common law did not react quickly or aggressively enough to changes in compensation practices during the last two decades, changes that were so substantial quantitatively that they required a qualitatively more intense form of judicial review…. In the past, the Delaware courts had generally taken a hands-off approach to executive compensation based on the assumption that this was a matter of business judgment, which could also be factored into the electorate's voting decisions.

William B. Chandler & Leo E. Strine, Jr., The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State, 152 U. Pa. L. Rev. 953, 1001 (2003).

Going forward, however, Chandler and Strine wrote that state law policymakers “including judges shaping the common law” will be responsive to the concerns raised by the recent federal intervention and “reflect more deeply on whether their own policies need adaptation to better protect stockholders.” Id.

What Disney does, as I have argued elsewhere ( is to make a pre-emptive strike against the possibility that the federal government will further usurp Delaware’s role as the fundamental corporate law-maker. Good faith is a rhetorical device to permit greater judicial intrusion into a specific area of concern—executive compensation. What today’s opinion does is to confine the further judicial intervention to that specific area. Whether this will stem the threat of further federal intervention is a debatable question, and it is distinct from the question of whether it will actually do anything to fix the problem of executive compensation (if indeed it is a problem).

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