Delaware's Top Five Worst Shareholder Decisions for 2011 (#2: In re Goldman)

More than any case this year, the decision in In re Goldman explains the inexorable shift of compensation decisions from state to federal law. 

Goldman involved a challenge to the compensation practices used by the investment bank and approved by the board.  Shareholders essentially argued that the board approved a compensation scheme that was not designed to benefit shareholders.  By assigning a percentage of net earnings to compensation, the board, according the shareholders, provided employees with an incentive to take risks that maximized short term earnings.  If the risks succeeded, their compensation went up.  If the risks failed, it was shareholders who suffered the consequences.  In other words, the compensation created a "divergence of interest between Goldman’s management and its stockholders."  Shareholders also argued that the amount of compensation was waste since it was significantly higher than that paid by other investment banks.

The case provided the Delaware courts with an opportunity to set some standards with respect to the approval of compensation.  In effect, the court could have required the board to engage in a more exacting review of compensation.  Instead, however, the court dismissed the suit at the pleading stage. 

In doing so, the court first found that the Goldman board was independent.  In an analysis reminiscent of Disney, the court found that numerous connection between the directors and Goldman (or Goldman's foundation) were not sufficient to create reasonable doubt (at the pleading stage) about director independence.  Thus, for example, one director, Rajat Gupta, had connections to three nonprofits, a business school in India, a school of economics and management in China, and a commission for the UN.  Moreover, plaintiff asserted that "a member of these boards and commission, it is part of Gupta’s job to raise money.”  In fact, the Goldman Foundation had given the three organizations a total of $6.7 million since 2002. 

In considering whether these payments raised "reasonable doubt" about Gupta's independence, the court concluded that they did not.

• The Plaintiffs do not mention the materiality of the donations to the charities or any solicitation on the part of Gupta. The Plaintiffs do not state how Gupta’s decision-making was altered by the donations. Without such particularized allegations, the Plaintiffs fail to raise a reasonable doubt that Gupta was independent.

In other words, the court discounted entirely the possibility that a director could lose his or her objectivity through significant payments by the company (or its foundation) to nonprofits and charities supported by the director.  Instead, shareholders had to show that the payments were subjectively important to the particular director, the type of information not likely to be in the public domain. 

In considering whether directors are "independent," Delaware law already does not adequately account for friendship, former positions with the company, or material income streams in the form of fees.  Moreover, these categories of "independent" directors are well represented on Boards.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity.  Goldman effectively adds another category, those affiliated with nonprofits, even where the company (or its foundation) makes substantial contributions.  

Given the independence of the board, plaintiffs were stuck with a claim for waste.  In asserting the claim, they alleged that Goldman, when compared to other large investment banks, "consistently allocated and distributed anywhere from two to six times the amounts that its peers distributed to each employee".  In other words, the amount of compensation was excessive.  Rather than at least shift the burden back to Goldman to justify the discrepency, the court dismissed the claim out of hand.

• A broad assertion that Goldman’s board devoted more resources to compensation than did other firms, standing alone, is not a particularized factual allegation creating a reasonable doubt that Goldman’s compensation levels were the product of a valid business judgment.

Yet in this case, "more resources" included allegations that Goldman paid a multiple of two to six times what was paid by other investment banks.  A showing of disproportionate payments, therefore, is not enough to get a shareholder past a motion to dismiss.

Delaware law relies on "independent" directors to protect the interests of shareholders.  Goldman, however, raises concern over the definition employed by the Delaware courts.  The approach likely explains why, in Dodd-Frank, Congress gave to the SEC for the first time the authority to tamper with the definition of director independence by defining the factors that need to be considered by the board.  The SEC also received authority to regulate the compensation committee of the board.  These transfers reflect congressional concern over the integrity of the compensation process, a concern that was not allayed by the analysis in Goldman. 

As for the assertion that Goldman paid compensation equal to a multiple of its rivals, it shows that courts in Delaware are not inclined to let cases go forward where the challenge to compensation is based on some type of argument that the amount is excessive.  This is consistent with the view that state law does not adequately ensure that the amounts paid are not excessive.  Initiatives designed to ensure that executive compensation is not excessive will, therefore, have to come from the federal level.