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.