Test Executive Pay by Contract Law, not Delaware Corporate Law

In a post last summer that attracted helpful comments, I reported on research investigating whether corporate board decisions costing enormous resources for negligible gain, that invariably pass the anemic corporate law waste test, could be challenged under contract law’s unconscionability doctrine.

Having advanced that research, I find that a handful of identical contracts that pass corporate law’s waste test would fail contract law’s unconscionability doctrine in most states—though not Delaware’s, where contractual unconscionability law is practically as anemic as its corporate law of waste.

So I’ve focused on whether there is a route to scrutinize some classes of Delaware corporate board decisions under the contract law of another state rather than the corporate (or contract law) of Delaware. An important class concerns executive compensation, particularly stock option pay.

Delaware judges applying its corporate law do nothing to police these.  There is a way that courts of other states could provide scrutiny by applying their doctrine of contract unconsionability to obnoxious stock option pay contracts.

Challenges to corporate pay decisions are invariably seen to involve the internal affairs of a corporation. The story usually is that the arrangements involve boards seeking to align executive incentives with shareholder interests.

That implicates a conflicts-of-law principle making applicable the law of the corporation’s state of incorporation. Under Delaware corporate law’s anemic waste doctrine, that means the case is a loser.

The pay cases also invariably assert claims against the corporate board that authorized the compensation and seek damages for fiduciary breach. That means the case is classified as a derivative shareholder suit.

Under Delaware law, that classification puts most power in the board rather than shareholders. The board can take charge of the lawsuit, investigate it, and recommend its dismissal, which Delaware courts are inclined to grant under Delaware corporate law.

These obstacles to judicial scrutiny of stock option pay contracts can be overcome. First, everyone now knows that stock option pay contracts do not align manager and shareholder interests. By riveting managerial attention pathologically on stock price, manager incentives actually diverge from shareholder interests.

Today, the better rationale for stock option pay is to attract and retain managerial talent. That removes the contract from the realm of internal corporate affairs and makes it like all other external corporate contracts. Governing law is not determined by the internal affairs doctrine, but according to factors like the place of contract formation and performance.

Second, shareholders challenging stock option pay contracts as unconscionable would not sue the board seeking damages for breach of duty that make the claim derivative. They sue the executive, seeking a declaration of contractual unconscionability and the remedy of rescission (plus, if amounts have been paid, restitution). The case is a direct shareholder claim, not derivative , and may proceed without board interference inherent in derivative litigation.

Ultimately, the case is decided not under Delaware corporate law’s anemic waste standard subject to procedural usurpation by the corporate board, but under another state’s contract law that enables scrutiny for unconscionability, free of director interference. Will this work?

Rarely, but that is enough.  The serious legal difficulties with both the conflict of law and litigation classification raise the broader challenge of comity. Non-Delaware courts, even those clearly having jurisdiction based on factors like place of contract formation and performance, could find each of those issues too close to call so  defer to Delaware.

But that may be a desirable feature of prescribing this route around Delaware corporate law’s jealous and provincial grasp on stock option pay contracts. Only a few courts, and only in cases challenging the most odious contracts, would deign to entertain the claim. And that may be all it takes.

One big case, or a few small ones, holding a stock option pay contract unconscionable would deter boards from granting extravagant payouts to executives for negligible corporate gain.

Consider the notorious Delaware corporate law case of Disney for comparison. Delaware judges faced ten years of shareholder derivative litigation challenging a stock option pay contract against directors for breach of duty. They finally rejected all claims, including that of waste, filtered entirely through Delaware’s lenient corporate law lens.

Talk in the cases indicated that the judges thought the contract obnoxious, as it paid an executive $140 million for about a year’s work of negligble value.  Other state courts readily would have taken that thought to declare the contract unconscionable under contract law and ordered rescission and restitution.

No one can say that such judicial rebuke to board extravagance would have diminished other manifest corporate excesses we see mounting up daily.  But it could have helped a bit.

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5 Responses

  1. A.J. Sutter says:

    An ignorant question: could you please expand on why the shareholder contract claim against the executive would necessarily be a direct action and could not be construed as a derivative one? The shareholders aren’t in direct privity.

  2. ohwilleke says:

    Sutter’s question is hardly ignorant. A shareholder challenge to a contract between an executive and the corporation is the classic example of a derivative action. It is a shareholder effort to compel the corporation exercise a corporate right for the benefit of the corporation. No direct right of a shareholder vis-a-vis the corporation has been breached.

    In contrast, a suit alleging a breach of duty by a director is not a derivative action. It is a direct against by a shareholder seeking to impose director liability arising out of the duties that directors owe to shareholders.

    There is a good argument that derivative actions, like actions to set aside unconscionable contracts between executives and corporations are a good idea, and that barriers in current law to them should be lowered. But, this post fails to distinguish the two accurately.

  3. Lawrence Cunningham says:

    I don’t recognize the line between direct and derivative shareholder suits as being as stark as ohwilleke suggests, though I appreciate the comment and A.J.’s good question. There may be polar cases easily classified but they are not the two ohwelleke gives and most, like those, are complex and contestable. The ultimate issue is whether an alleged harm to be remedied is better conceived of as individual to a shareholder or to the corporation as a whole.

    Not all breach of duty cases are classified as direct. Disney was a breach of duty case, including a waste claim, and was classified as derivative. That is because directors owe duties to the corporation and its shareholders, not to the shareholders alone.

    Factors inform the analysis and classification decision, not scientific algorithms or natural law truths. An important factor is the remedy sought. A shareholder complaint seeking money damages is more likely classified as derivative than direct; one seeking injunctive, declaratory, prospective or equitable relief is more likely classified as direct than derivative. The primary remedy I envision when challenging obnoxious stock option pay contracts is rescission.

    Another is the theory of liability. Asserted violations of statutes granting shareholders inspection rights suggest a direct action. Violations of duty are less readily classified. The liability theory of a contract unconscionability claim is that the contract is unenforceable as a matter of law, an assertion that the corporation lacked authority to enter into it in the first place.

    A third is the identity of the defendants. Assertions against the board of directors can be either direct or derivative, of course. A claim against an executive officer may likewise be either. As AJ wonders, of the three factors my post notes, this is the one least likely to support classifying the action as direct. But the other two cannot be ignored and would not inevitably outweigh this one.

    Note also that it is not strictly necessary to classify the case as direct for the non-Delaware contract law theory to prevail. Disney, classified as a derivative case, got to the merits, only no corporate law waste was found; even as a derivative case, on the merits, contractual unconscionability would have been more likely found.

    While there’s no space here (or even my paper) for a dissertation on the distinction between direct and derivative classifications of shareholder lawsuits, here is a sampling, from my Corporations casebook, of how various categories of claims have been classified.

    The following were classified as direct: dividend policy, inspection rights, preemptive rights, voting rights, minority oppression, cash-out mergers, and entrenchment for board resistance to hostile takeovers.

    The following were treated as derivative: breaches of the duty of care for internal control or statutory violations; breaches of the duty of loyalty for self-dealing or exploitation of corporate opportunities; recovery of greenmail paid when board resisted hostile takeover.

    The conceptual divide between harm to the shareholder separate from harm to the corporation drives the inquiry but the inherent difficulty with that conception requires looking at other factors, especially the theories of liability and remedy.

  4. Andrew Lund says:

    Just on the necessity of labelling the claim a direct one, it’s pretty hard to see how the claims surrounding Ovitz’ contract, for instance, could today be formulated so that demand would be deemed futile. After Lyondell, you’d need an utter or complete failure to fulfill board duties in order to show anything more than exculpated lack of care, right? (This assumes no traditional loyalty claim, but if such a claim were a live one, then derivative suits aren’t so difficult for shareholders.) If so, labelling the claim “direct” will be crucial, though I gather from your comment that this may be possible on the right facts.


  5. Lawrence Cunningham says:

    Andrew: Thanks for the good point. Maybe so. But Lyondell could be read more narrowly. Substantively, it found that directors in that case didn’t consciously disregard a known duty when selling control because Revlon doesn’t particularize duties. Procedurally, it decided the case, a class action, on the merits, rather than at the demand futility stage in a derivative action. In an exact replay of the Disney case, the trial court decision excusing demand could be written again, even with the rhetoric appearing in Lyondell (copied from both Disney and Ritter v. Stone). But I appreciate your point very much and will incorporate it!