Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis that arcane debate to public scrutiny.
Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.
I come down in the middle. There are problems in at least an important number of cases, and current proposals to redress them unlikely to work. So I seek a new approach—contract unconscionability—to police extreme cases. Before detailing this approach, which must surmount some hurdles but isn’t as radical as it sounds.
A good way to summarize the debate highlights a three-pronged theory that promotes and supports much of prevailing executive compensation, especially stock-based components, and contrasting it with views of critics who point out limits on each prong.
First: in optimal contracting theory, boards design manager contracts to minimize agency costs. But when managers dominate the process, the managerial power thesis suggests this ideal may not be met.
Second: with efficient stock markets, stock price is a good proxy for the shareholder interest and a mirror of managerial performance. But stock price can differ from business value for sustained periods, fogging both.
Third: stock-based pay could align managerial incentives with shareholder interests if designed right and markets work well. But otherwise they create perverse effects.
From the viewpoint of critics, one problem with corporate pay is relatively little legal oversight. Even well-intended boards can fail; yet corporate law defers to them; and federal securities and tax law encourage stock-based pay, without regard to perverse effects.
Reforms debate expanding shareholder power to motivate boards, led by Lucian Bebchuk and Jess Fried. Others, like David Walker, prescribe tax changes or better disclosure. Still others, others, like Randall Thomas and Harwell Wells, look to enhanced corporate law oversight, invoking officer fiduciary duties, recently explicated in Gantler v. Stephens, to police renewals of employment contracts. Throughout debate, and most of the reforms, there is much talk of redesigning pay contracts to focus managers on long term value, not short term price, by scholars as diverse as Bebchuk/Fried to Roberta Romano. Many of these are careful and useful. What’s still missing is a way to implement them, and I suggest using private litigation and contract law.
So I invent a new way to provide legal oversight to regulate associated risk: a contract law doctrine that has much in common with corporate waste, but is slightly more capacious. Pay has been evaluated under corporate law. But its business judgment rule and deference to independent committees and process means the only possible way to prevail is under corporate law’s waste doctrine. But it bans only gifts, or dumping cash into the river, so massive salaries and stock-based pay with perverse incentives are outside it.
Unconscionability has some kinship to waste. It is used sparingly, reflecting freedom of contract. It looks at procedural aspects of a transaction. But unlike waste, which varies little with context, contract law’s propensity to use unconscionability intensifies according to a coherent logic. It becomes increasingly skeptical of lop-sided bargains as it goes beyond arm’s-length deals, into those plagued by procedural irregularities, heard by courts in equity, and involving fiduciaries.
So my basic theory is simple. These are contracts and when unconscionable should be rescinded—whether or not they amount to corporate waste, or are approved by boards or shareholders. Several hurdles appear, meaning few cases succeed, catching only the most odious.
The first is the internal affairs doctrine that could make pay contracts governed by the corporate law of the state of incorporation, not the contract law of another. This doctrine protects corporate participants in relations with each other against inconsistent laws. Compared to the home state, others have weak interests in internal affairs, like shareholder voting, director elections, and mergers.
Employment agreements could be internal affairs. They are authorized by the board with officers as the counter-party. They regulate the corporation-officer relation. The internal affairs case is strengthened by seeing stock-based pay as a way to align manager-shareholder interests. But they are not inevitably internal affairs. That is clearest when formed with a newly-recruited manager—an outsider. Their primary function is to get labor in exchange for pay. They are increasingly justified as recruiting and retention tools, not alignment devices. From these viewpoints, they are merely contracts.
Analogies may help. Suppose a contract most states would see as an illegal bargain. Say the board of a Delaware corporation running casinos in New Jersey approves a contract with the casino manager, paying bonuses for staging dog fights, or with an oppressive non-compete clause. Enforceability is not merely a question of Delaware corporate law but of New Jersey contract law.
Another hurdle could arise if managers put favorable choice of law clauses in their contracts. That’s a nice gambit but faces three limits.
First, choice-of-law clauses are not dispositive. Standard conflicts of law principles apply, asking what state has greatest interest. Second, an unconscionability claim can render the entire contract unenforceable, determined before applying any contract terms, including a choice of law. Third, even a Delaware choice of law clause would mean Delaware contract law not corporate law applies, which is a bit tougher.
The next hurdle involves whether a claim is direct or derivative. If derivative, shareholders face corporate law hurdles. Most seriously, shareholders must demand that boards act or show why that’s futile and special board committees can take control of the case and even decide to dismiss it. The line between the two can be blurry. The issue is whether a harm to be remedied is better conceived as individual to a shareholder or runs to the corporation as a whole.
The conceptual difficulty makes classification turn on factors, not bright line rules. These include the theory of liability and remedy. Cases tend to classify as derivative—claims for breach of duty and seeking money damages. Cases and statutes tend to classify as direct, claims asserting lack of corporate authority (called ultra vires), and/or seeking equitable relief. Shareholder challenges to pay contracts will more likely be seen as direct by asserting that their unconscionable character puts them beyond the corporation’s authority, and the primary remedy is rescission. Even derivative cases can get to the merits, of course, as Disney did, and the unconscionability claim has other procedural advantages in terms of excusing shareholder demand and limiting board control.
But these hurdles are serious and many judges would be averse to overcoming them—out of comity—or because contracts may be so complex that judges hesitate to assume competency to evaluate them. Enforcement incentives are another practical issue. It is certainly beyond the SEC’s power and probably beyond that of many states or the interests of their attorney’s general. That leaves the private bar, whose incentives may be limited. A pure case of rescission would produce no payment and even a claim accompanied by a judgment in restitution may be comparatively small. But there may be sufficient incentives for the most high-profile case that could yield instrumental and reputational value.
Still, the hurdles are formidable, though incrementally lower than under corporate law. On balance, that is desirable. There is no risk of any floodgate effect. And a few egregious cases would be enough to deter excesses.
Turning to the merits, contract analysis is slightly broader than corporate law’s. Procedural aspects are not confined to corporate law’s focus on board independence or information. Courts consider the bargaining process, probing whether it was more consistent with optimal contracting or managerial power. Substantive unconscionability analysis is contextual, so stating broad principles difficult. But some tests can be suggested. One would compare the contract’s terms with academic models appearing in the literature (whether by Bebchuk/Fried or by Romano). Conforming contracts would be presumptively valid, but those wildly out of line suspect.
Another would compare dollar amounts, though that often will be difficult, and doubts resolved in favor of upholding the agreement. But when that ratio can be measured with reasonable certainty, and does shock the judicial conscience, the contract can be declared unconscionable and rescinded.
Consider Disney. Disney is a Delaware corporation based in California. Its board approved an employment contract with a new top recruit. It was made, performed and terminated in California. The executive worked 14 months, when the board fired him, triggering a $140 million payout, with features that may have induced the executive to perform poorly—but not terribly—for short-term personal gain.
Shareholders lost a derivative suit, under corporate law, in Delaware. At first the trial court dismissed the complaint. Notably, it said the contract was like a board decision to lend or borrow money—supporting the view that employment agreements are not internal affairs. The first appellate opinion reversed, saying: the case was troubling; any bargaining was casual, sloppy and perfunctory; the pay was exceedingly lucrative and luxurious, and so on. Despite these excoriations, they had no effect as a matter of corporate law, not even to excuse shareholder demand on the board. They only justified leave to amend the complaint.
The second trial court excused demand because shareholders raised doubt that the pay or procedure were protected by the business judgment rule. On the corporate law merits after trial, the trial court and final appellate opinions both upheld the contract. Though both lamented the breathtaking payout and sloppy board process, neither violated Delaware corporate law.
But suppose shareholders sued the corporation and executive in California, asserting unconscionability and seeking rescission. California contract law applies because the contract was made, performed, and terminated there—as Delaware’s first trial court opinion in Disney suggests.
Classification as direct or derivative may be a closer call, especially because payments had been made that would be recovered. But, under Delaware statutes, that does not prevent classifying the case as direct and, in any event, the actual Delaware Disney cases excused demand, so that would be no bar.
On the merits, the bargaining process, even in the Delaware court’s views, looked more like exercise of managerial power than optimal contracting. In substance, even if $140 million in the dreamland of Hollywood or Disney is a trifle, it shocked even the Delaware courts.
Their only real difficulty was comparing it to the value of recruiting the executive. And though Delaware courts rejected that the contract’s terms skewed the executive’s incentives, the argument was certainly credible. In short, while not a slam dunk, the case would be considerably stronger under contract law than corporate law. And that offers a new legal theory to test executive pay.