chapter 21 executive compensation

Corporations:A Contemporary Approach

Chapter 16Public Shareholder Activism

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Seb Farrington, “Crankenstein” (2014)


Chapter 21Executive Compensation

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• Compensation puzzle– Relation to corporate governance– Types of pay: salary, bonuses, stock grants,

stock options– Special issues with stock options

• Standard of review– Vogelstein case– Waste standard over time

• Delaware approach in Disney– Disney I - reject complaint / demand futile– Disney II - accept “good faith” claim– Disney III - no finding of bad faith / affirmed– Analysis:

• heightened review?• political economy of case?

Module VII – Fiduciary Duties

Citizen of world

Citizen of world

Law profession

Law profession

Corporate practice

Corporate practice

Bar examBar

exam



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Fiduciary duties(directors)

OversightDecision-making

Bestinterests

Business Judgment RuleShlensky v Wrigley

Inattention Conflictinterest Remillard

Grossnegl

Van Gorkom

WasteVogelstein

Corpopp

Farber

IllegalityMiller v AT&T

Malfeasance(bad faith)

Francis

IllegalityCaremark Bad faith

Disney

Disinterestedindependent

Benihana

102(b)(7)

102(b)(7)



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Plato“5x”

Friedman“market - 400x”

“CEO to average worker” Ratio(Dodd-Frank reports)

• 250 largest companies in S&P 500 index – 331 to 1

• Highest and lowest? – 1,795 to 1 (J.C. Penney’s Ron Johnson)– 173 to 1 (Agilent Technologies’ William Sullivan)

• Pay for performance? – Agilent shares: plus 49% last year– J.C. Penney’s shares: minus 73%.



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In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren’t encouraging.

Warren Buffett, letter to shareholders of

Berkshire Hathaway, Feb. 2004



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Joe (team manager)

Hal and Hank(team owners)

Public Shareholders

CEO

Board ofDirectors



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Executive pay

Types of pay

• Salary (cash)• Bonuses• Plan-based

– Stock awards– Option grants– Non-equity incentives

• Deferred compensation – Pension plan– Nonqualified deferred

comp• Other

– Executive loans (SOX!)– Fringe benefits

Tax deductibility• Cap of $1,000,000 (CEO and top 4

officers), unless --– performance-based pay – set by compensation committee

(outside directors) – approved by shareholders

Proxy disclosure• 1992 SEC amendments

– Tabular form (CEO + top 5)– Pay committee processes

• 2006 SEC amendments • 2011 “Say on Pay”• 2012 CEO to average worker ratio

Judicial review• Waste: no relation to services• Care: board grossly uninformed• Loyalty: fraud or conflict



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Stock options …

1. What is a stock option?A.The right to buy stock in the futureB.The duty to buy stock in the future

2. You have a stock option that vests in 2 years?

A.You can exercise the option any time for next 2 years

B.You must wait 2 years before exercising option

3. Your stock option has a strike price of $25. Market price is $20

A.You should exercise the optionB.You should hold on to the option – it has

value though “out of the money”

4. Market price is $30. Your option (strike = $25) expires in 5 years

A.You can wait for prices to go higher – and defer taxes

B.You should exercise it immediately

5. Companies pay employees with stock options in order to --

A.Create an incentive for employees to increase stock prices

B.To hide compensation from financial statements

6. Stock options are impossible to valueA.True. There’s no way to know what will

happen to stock pricesB.False. Option value depends on past price

volatility and interest rates

7. Can you buy an option in General Electric stock?

A.Yes. Options for many public companies’ stock are bought and sold

B.No. Only employees can acquire stock options

8. If you thought GE stock would stay steadyA.You can make money by selling a “call option” B.You can make money by buying a “put option”

1-A / 2-B / 3-B / 4-A / 5-A / 6-B / 7-A / 8-A



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Option backdating

Grantdate

Vesting period

Exercise price

New exercise price

Backdatedgrant date

Expirationdate



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Judicial review

Review standards - over timeMeaning of “waste” - safety valveDisney case - duty of “good faith”



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Traditional review – “waste”

Applicable standard: “If a business payment has no relation to the value of the services for which it is given, it is in reality a gift.”

Rogers v. Hill (US 1933)

Applicable attitude: “Nothing is so divergent and contentious and inexplicable as values. Courts are ill-equipped to solve or even to grapple with these entangled economic problems.”

Heller v. Boylan (NY Sup Ct 1941)



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The numbers please

Randall Thomas(Vanderbilt)



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Thomas & Martin – Plaintiff success rates(124 reported exec pay cases)

52%53%50%CHC(at least one theory)

32%30%34%PHC(at least one theory)

35%39%28%Loyalty

30%33%27%Care

40%46%29%Waste

TotalNon-DelawareDelaware

(35 cases) (27 cases)

(8 cases) (47 cases)



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Evolving judicial review

in Delaware …



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Delaware – evolving standards19

52 –

Ker

bs v

. Cal

if Eas

tern

Airw

ays

“suf

ficie

nt c

onsid

erat

ion”

1960

– B

eard

v. E

lster

“goo

d fa

ith d

eter

min

atio

n –

prop

ben

efit”

1979

– M

ichel

son

v. D

unca

n

“exis

tenc

e of

[any

] con

sider

atio

n”

1997

– L

ewis

v. V

ogel

stei

n

“cla

ssic

waste

sta

ndar

d”



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Lewis v. Vogelstein (Del Ch 1997)

Mattel shareholders challenge board's stock option compensation plan for themselves (ratified by shareholders).

Under the plan directors received: (1)15,000 one-time options (exercise

price = market price on date granted / exercisable for up to 10 years)

(2)5,000 (or 10,000 for longer-serving directors) annual options (vest over a 4-year period / exercise price = market price when granted / and exercisable for up to ten years

What’s the standard of review?



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Lewis v. Vogelstein (Del Ch 1997)

Intermediate review:

–sufficient consideration (reasonable relation between the value of the services and the value of the options)

–Plan: conditions included to ensure that the consideration will pass to corporation.

Waste standard:

– Reviewable only if corporation received no consideration, the compensation was a gift, no person of ordinary prudence could possibly agree

– Defer to shareholder ratification (in this age when institutional shareholders have grown strong)

Apply?

Chancellor Allen



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Duty of care Board approval of executive pay

Disney I - complaint

Disney II - amended complaint

Disney III - trial



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Disney III (Del 2006)

Third category of fiduciary conduct, between (1) subjective bad intent and (2) gross negligence.

This third category – intentional dereliction of duty, a conscious disregard for one's responsibilities – is non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith.

CEO Michael Eisner withMichael Ovitz ($140

million “pay for failure”)



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The end

chapter 21 executive compensation

Documents

executive compensationslide

executive compensationceo

contemporary approachchapter

compensation committee

stock grants

pay2012 ceo

performancebased pay

stock optionsspecial