Corporate Governance

The Dodd-Frank Wall Street Reform Act and the Preemption of Delaware Law (Compensation Committee Reform, Part 1)

By J Robert Brown Jr.

We are examining the preemption of Delaware law in the Dodd-Frank Wall Street Reform Act.  One place where there has been an obvious preemptive effect is the process used in determining executive compensation. 

Delaware law extends to the board the authority to determine CEO compensation.  Because the CEO invariably sits on the board, there is a conflict of interest in the decision making process.  Ordinarily, this would require application of the duty of loyalty.  The duty of loyalty in turn places on the board the obligation to show that the transaction (in this case the CEO's compensation) was fair.  Fairness in turn requires that the compensation be typical of the industry, typical of what has been paid in the past, or justified by unique circumstances.  It is not a particularly tough standard (a standard that is discussed here). 

Yet even that relatively mild standard has been eviscerated by the Delaware courts.  They have replaced substantive fairness with process.  So long as the CEO's compensation is approved by a board with a majority of independent directors, it will be reviewed not under the duty of loyalty but the far more impenetrable duty of care.  Moreover, under the demand standard, a case challenging CEO compensation will generally be dismissed if the board has a majority of independent directors.

The approach ignores the fact that the interested influence is still in the board room (Delaware courts do not require that the CEO be uninvolved in the process).  It also is based upon a definition of director independence that does not ensure that in fact directors are independent.   The definition largely ignores fees, despite their often prodigious amount, friendship, and most outside business relationships among officers and directors.  Moreover, high pleading standards essentially prevent shareholders from obtaining discovery on the issue of independence, even when facts suggest that directors do not meet applicapble standards. 

As a result, there is no guarantee that the approval process has sufficient integrity to ensure the fairness of compensation.  Indeed, Delaware courts, in rare cases when they have allowed compensation matters to get to discovery, have uncovered serious problems with the process employed by the board. 

Unsurprisingly, therefore, Congress has intervened and largely preempted much of the process to be used in connection with executive compensation.  The DFA has sought to regulate director independence on the Compensation Committee, assigned specific responsibilities to the committee, and more or less required independent advisors.  We will discuss these requirements in the next post. 

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.

Full post as published by The Race to the Bottom on July 19, 2010 (boomark / email).