A New Legal Theory to Test Executive Pay: Contractual Unconscionability

58 Pages Posted: 16 Feb 2011

See all articles by Lawrence A. Cunningham

Lawrence A. Cunningham

George Washington University; Quality Shareholders Group; Mayer Brown

Date Written: 2011

Abstract

Lucrative pay to corporate managers remains controversial yet continues to evade judicial scrutiny for legitimacy. Although many arrangements likely would pass the most rigorous scrutiny, it seems equally clear that some would not. Some agreements are not the product of arm’s-length bargaining, can rivet managers on short-term stock prices at the destruction of long-term business value, and can misalign manager-shareholder interests. Yet even such objectionable arrangements are immune from serious legal oversight. In theory, they are open to judicial review under corporate law, but shareholders challenging pay contracts face formidable procedural hurdles in derivative litigation and substantive obstacles from corporation law’s business judgment rule and the anemic doctrine of waste. A new legal theory would be useful to check board excesses in the population of clearly objectionable cases.

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

Keywords: Executive Compensation, Corporate Waste, Optimal Contracting, Efficient Markets, Incentive Alignmnet, Stock Options, Retention, Incentives, Unconscionability, Internal Affairs, Choice Of Law, Derivative Litigation, Walt Disney, Warren Buffett, Citigroup, New York Stock Exchange, Dodd-Frank Act

JEL Classification: G1, G2, G3, G30, G34, J33, J30, J33, J38, J41, K1, K2, K4, K12, K19, K20, K22, K41

Suggested Citation

Cunningham, Lawrence A., A New Legal Theory to Test Executive Pay: Contractual Unconscionability (2011). Iowa Law Review, Vol. 96, 2011, GWU Legal Studies Research Paper No. 524, GWU Law School Public Law Research Paper No. 524, Available at SSRN: https://ssrn.com/abstract=1762123

Lawrence A. Cunningham (Contact Author)

George Washington University ( email )

Quality Shareholders Group ( email )

HOME PAGE: http://https://qualityshareholdersgroup.com/

Mayer Brown ( email )

HOME PAGE: http://mayerbrown.com

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