Delaware, Executive Compensation, and Additional Federal Preemption: A Strategy for Preventing An Inevitability
Federal preemption of Delaware law has become almost ordinary. Nowhere has preemption been more apparent than with respect to executive compensation.
SOX took some tepid steps, particularly with respect to clawbacks of compensation. Dodd-Frank roared forward, giving the SEC the authority to regulate compensation committees of exchange traded companies, toughening the clawback requirements, mandating say on pay, increasing disclosure (particularly with respect to compensation ratios), and providing some substantive authority to regulate compensation practices that resulted in excessive risk. One might also argue that shareholder access was motivated at least in part by the concerns over executive compensation.
Is this going to stop? Almost certainly not. Delaware currently imposes no effective limits on executive compensation (waste is a theoretical limit but one, as In re Goldman shows, has little content). To the extent that compensation continues an inordinate path upward, pressure will continue to build for additional federal intrusion.
Preemption has significant and far reaching consequences, although they are only just beginning to be felt. The trends represent a fundamental transfer of authority that has, for over a century, been with states. Moreover, once it occurs, the shift will be almost impossible to reverse.
Even more profoundly, the shift from state to federal regulation will affect the dynamics of the corporate governance debate. As long as matters remained at the state level, the conversation over reform was mostly between shareholders and managers (actually in Delaware it was a conversation often with only the managers present). The preferred approach toward regulation was private ordering, an area where management had inherent advantages. See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.
Shifting the venue to the federal level resulted in an increased use of categorical rules. It also expanded the interest groups that could effectively participate in the debate. In those circumstances, resolution ceased to turn solely on the needs of shareholders and managers but on a broader set of interests.
Is there anything that can stop this trend? Is there anything that can keep these matters within the state law framework? There is one way but it is highly unlikely to ever happen. At the AALS conference, Vice Chancellor Laster noted a possibility. Here is how it was described by Gordon Smith.
Teasing the assembled law professors, Vice Chancellor Laster suggested that the Delaware courts could decide to review pay decisions with a form of enhanced scrutiny (because that standard of review applies to situations involving structural bias), but he rightly observed that such a move would be comparable to Smith v. Van Gorkom in 1985.
Enhanced scrutiny would mean greater judicial examination of compensation, perhaps requiring some review of substance rather than for the most part only process. The degree to which it would actually reform compensation would depend upon the level of "enhancement" applied by the courts. It probably wouldn't be very high but it would presumably be enough to scare boards into avoiding compensation packages on the margins that were widely seen by the public as abusive. With these packages vanquished, additional pressure for federal intervention would probably wane.
This isn't going to happen. As Gordon noted: "Plaintiffs lawyers should not get their hopes up, absent a big shift in the debate on executive compensation." In truth, a change in the compensation standard would provide other states with an opening for poaching some of the public companies currently incorporated in Delaware. If that happened, the abuses would continue only not in Delaware corporations. Delaware would lose business while the risk of preemption would remain.
In short, the race to the bottom, something that usually benefits Delaware, can also be a liability. Efforts to elevate the standards of corporate governance will flounder because of it. This is true even if, in the long term, states will benefit by holding onto their authority and preventing additional federal preemption.