To Challenge Executive Compensation, Shareholders Must Prove Waste

The total CEO compensation of the five largest banks in 1990–Citibank, Bank of America, Chase Manhattan, Morgan Guaranty Trust Company of New York, and Wells Fargo–was 98x the salary of the median bank employee at those firms. By 2015, the total CEO compensation of the five largest American banks–Wells Fargo, JP Morgan, Bank of America, Citigroup, and Goldman Sachs–was almost 500x the salary of the median bank employee.

This is an individualized snapshot of a trend that is well known among the general public: The compensation of America’s top executives has increased at a much quicker rate than that of a rank-and-file employee. There have been some short hurdles that have been put in place to slow this trend down–the New York Stock Exchange and Nasdaq have independence requirements for a publicly held corporation’s compensation committee that must be met in order for the company to be listed on the exchange. There are also advisory executive compensation requirements under the Dodd-Frank piece of regulation, but it is still very much a work-in-progress to determine how these shareholder votes should actually affect executive compensation (at the present time, these regulations are not binding upon themselves, although a corporation is free to make the shareholder votes binding according to their own bylaws).

The fun for corporate executives received its blessing from the U.S. Supreme Court in the 1933 case of Rogers v. Hill in which the Supreme Court deferred to the by-laws of American Tobacco that had been approved at the March 13, 1912 annual meeting. The 1912 shareholders, acting at the recommendation of American Tobacco’s management, approved By-Law XII which provided that 10% of the firm’s “excess profits” would be directed to six people–the President of American Tobacco would collect 2.5% of the excess profits, and five Vice Presidents would each collect 1.5%. The By-Law defined “excess profit” as annual profit growth–e.g. American Tobacco earned $8.2 million in profits during 1910, and the Board would tally up the amount of profits earned in excess of $8.2 million during 1911, and then give 10% of that to six officers during the annual shareholders meeting in March 1912.

Richard Reid Rogers and Evan Shelby, two New York residents, got their hands on 600 shares of American Tobacco stock in 1916 and then challenged the executive compensation agreement of By-Law XII as “per se unreasonable.”

It worked its way up to the Supreme Court–remember, this case was 1933 so it was before the 1938 case of Erie Railroad v. Tompkins stated that federal courts cannot make federal common law out of state court claims that emerge under diversity jurisdiction–and the Supreme Court held that much weight would be given to a corporation’s duly adopted by-laws. Absent fraud, the Supreme Court held that it could only overturn executive compensation in two situations: (1) when executive compensation comes “so large as in substance and effect to amount to spoliation or waste of corporate property”; or (2) the payment to a corporate manager offers “no relation to value of services” so as to constitute “a gift.”

The “waste standard” defined as such a spoil of corporate assets to constitute a gift, hasn’t changed much over time. There has been an additional “grossly uninformed” prong that shareholders can use as a line of attack against the Board’s decisions, but in practice the American courts remain exceptionally deferential to compensation arrangements that arise in good faith from a compensation committee or the Board itself.

The business judgment rule, the hallmark of Delaware corporate law and much-copied elsewhere, is a strong presumption that any action taken by the Board of Directors was in the best interest of the corporation. This applies to the recommendations of compensation committees and the pay packages approved by the Board itself.

Where did this rule come from? In 1959, the Delaware Supreme Court decided the case of Lieberman v. Becker permitted executive compensation so long as “there must be some element which, within reason, can be expected to the desired end.” The next year, the court held in Beard v. Elster that it would be “precluded from substituting [its] uninformed opinion for that of experienced business managers of a corporation who have no personal interest in the outcome, and whose sole interest is the furtherance of the corporate enterprise. At most, therefore, we find ourselves in the twilight zone where reasonable businessmen, fully informed, might differ.”

The case of Beard v. Elster was important in defining the hands-off attitude of courts towards second-guessing the payment plans of corporate executives. It created a Delaware common law tradition that a Board wasn’t even required to view a present value spreadsheet tabulating the present value of options to remain compliant with fiduciary obligations.

This is the kind of reason why 52% of publicly held corporations in the United States are incorporated in Delaware. There is an amazing amount of discretion given to directors and officers. When you have good executives, this permits intelligent risk-taking without the fear of a court later second-guessing decisions. But the state of Delaware’s common law tradition does not do much to protect minority shareholders from the decisions of compensation committee that strike the sensibilities of most as excessive. That isn’t the test–a shareholder challenging a Delaware corporation’s agreed-upon compensation must show that the Board was “grossly uninformed” or constituting “waste”, effectively making a gift of corporate assets. The standard is high, as the corporation is only required to show “relation” between the compensation package and the desired ends of the corporation.

The business judgment rule is alive and well, especially in Delaware. This is good for the entrepreneurial spirit and the creative dynamism of the American Republic. But it is not a rule without drawbacks, especially if you are in the position of a passive shareholder watching executive compensation climb faster than the growth of your holdings. By Delaware statutory and common law design, there is little you can do to stop it.

Notice: This article, which I believe may be of interest to readers, is for general information only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal advice.

Sources Consulted:

Rogers v. Hill, 289 U.S. 582, 585 (1933).

Lieberman v. Becker, 155 A.2d 596 (Del. 1959).

Beard v. Elster, 160 A.2d 731 (Del. 1960).