Corporate Governance and the Problem of Executive Compensation: The Source of the Problem and the Consequences (Part 1)
Boards are the front line of the executive compensation issue. They have the authority to determine compensation and to adopt standards that minimize abuse.
Compensation decisions are, like all matters, tested under the board's fiduciary obligations. The duties are broadly divided into a duty of care and a duty of loyalty. The duty of care is a process standard. If the process is done correctly, the substance of the decision, for the most part, is irrelevant. The duty of loyalty on the other hand imposes on the board the burden of showing that the transaction was fair. In these circumstances, substance matters.
With respect to CEO compensation, the default standard is the duty of loyalty. In the US, the CEO sits on the board. As a result, the board is determining compensation for someone inside the board room. This creates an obvious conflict of interest and, to protect shareholders, directors must show that the compensation was fair.
Were fairness to be the applicable standard, boards would have greater difficulty showing that personal use of the aircraft or total compensation measured in nine or more figures was fair. Moreover, since directors are personally liable for breaches of their fiduciary obligations, they would likely take a rigorous approach to fairness. The benefit of applying a fairness standard can be seen in few cases where it has been applied. For a discussion of cases applying this standard, see Returning Fairness to Executive Compensation.
Yet for the most part, fairness and substance are not part of any review of CEO compensation. The Delaware courts have interpreted fiduciary duties in a manner that results in the application of the duty of care rather than duty of loyalty to CEO compensation. The courts have done so by finding that the duty of care applies where the board is informed and consists of a majority of independent directors (a requirement for all listed companies).
In those circumstances, the "taint" of any conflict (the presence of the CEO inside the boardroom) is deemed to have been expunged. It doesn't matter for the most part that the CEO is present when the decision is made or participates in the discussion. For more on this, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.
What is a recent example of this approach? In re Goldman Sachs, a case we will address in the next post.