Executive Compensation in the Courts: Board Capture, Optimal Contracting, and Officers' Fiduciary Duties

Abstract

This Article proposes a new approach to monitoring executive compensation. While the public seems convinced that executives at public corporations are paid too much, so far attempts to rein in executive compensation have met with little success. Several approaches have been tried – requiring large pay packages to consist predominantly of incentive pay, new procedures for approving pay, mobilization of public outrage at giant compensation packages. None, however, has stemmed the growth of executive compensation, or convinced opponents of large pay packages that such pay is either fair or deserved.

Here we suggest a new approach, one that turns to an unlikely agency to oversee executive compensation: the courts. Foes of high executive compensation have generally dismissed the courts as ineffective allies in curbing executive compensation, reasoning that courts have never wished to become involved in pay decisions. We show, however, that at several points over the last century, courts have proven surprisingly willing to second-guess decisions on executive compensation. These courts ultimately retreated from activist approaches to executive compensation not because of complacency but because they did not wish to become entangled in setting pay.

Recent developments in corporate law point a way out of this impasse. Last year, in Gantler v. Stephens, Delaware’s Supreme Court resolved a major unanswered issue in corporation law when it held that a corporation’s officers owe the same fiduciary duty to the corporation and its shareholders as do its directors. Gantler opens the door for courts to monitor executive compensation by scrutinizing rigorously officers’ actions in negotiating their own compensation agreements. The Delaware Chancery Court has already taken up this invitation by holding that corporate officers are bound by their duty of loyalty to negotiate employment contracts in an arm’s-length, adversarial manner. If the officers do not do so, but instead try to manipulate the process, they will open themselves up to shareholder lawsuits and judicial scrutiny of compensation agreements via their negotiations. This approach should be welcomed by the courts, which will not be required to determine whether compensation packages are fair or merited, but will instead be asked to engage in a familiar task, examining whether proper procedures were followed in setting compensation.

This approach also promises to break an impasse between the two major academic approaches to executive compensation. Advocates of “Board Capture” theory have long argued that senior executives so dominate their boards that they can effectively set their own pay. “Optimal contracting” theorists doubt this, contending that, given legal and economic constraints, executive compensation agreements are likely to be pretty good and benefit shareholders. The approach advocated here should, surprisingly, please both camps. To Board Capture theorists, it offers to cast light on pay negotiations they believe are largely a sham; to Optimal Contracting theorists, it offers a way to improve the already adequate negotiating environment.

Keywords: executive compensation, board capture, courts, fiduciary duties, optimal contracting

JEL Classification: G3, K00, K2, K22