Monday, October 3, 2011
It has been nearly 15 years since the Walt Disney Company offered Michael Ovitz a non-fault termination and the estimated $140 million severance package which came as a reward for 14 1/2 months of turbulent and ineffective leadership at the company. We summarized the basic facts here and commented briefly on one of the many rulings in the case here.
James Stewart, author of a great account of the Walt Disney Company during the Eisner years, knows a thing or two about executive compensation and he shares his thoughts in this article from Saturday's New York Times. Basically, very little has changed. Last week, the Times' Eric Dash reported on seven executives who had received lavish severance pay after "failed tenures." Stewart's account focuses on one of the seven, Leo Apotheker (pictured), who received $13 million in severance benefits after less than a year as CEO at Hewlett-Packard (HP). One might say that this is progress. After all Apotheker's severance is an order of magnitude less than was Ovitz's. But Stewart points out that the perverse incentives that were at the heart of the Disney litigation remain. According to Stewart, CEOs like Apotheker make more if they can get a quicky non-fault termination than they make if they stay on the job. And since "non-fault" is a term of art, encompassing everything other than committing a felony or not showing up to work at all, CEOs can rely on non-fault terminations.
Stewart refutes the usual defense of such severance payments. Executive compensation experts often argue that such "downside protection" is necessary to lure talent away from their old jobs at which they have an assured income. That argument might have made some sense with respect to Michael Ovitz, who left his partnership at which he was earning $20-25 million/year to join Disney. But Stewart points out that there is no empirical support for this claim. Moreover, the notion that executives are entitled to downside proection is at odds with the capitalist ideal that one should always have a motivation to strive for success and that failure should never be rewarded. In the case of Mr. Apotheker, the theory clearly could not have applied, since he had been fired from his last position and so was not giving up anything in order to come to HP.
Stewart suggests that the solution is to stop treating "non-fault" as a term of art. If a CEO is fired because he is incompetent, ineffective or simply fails to provide the leadership that a company needs, the company should be able to fire him for cause and without lucrative benefits. The solution seems simple, but I don't see how it would make any difference. Boards don't want to fire CEOs for cause, because that would suggest that they made an incompetent decision in hiring the CEO in the first place. Regardless of the definition, I think boards would continue to call terminations "non-fault," and courts would defer to that determination under the business judgment rule. And even if the courts refused to uphold the business judgment of the board, there would likely be no remedy, since board members cannot be personally liable for breaches of the duty of care. A suit to recover the money from the departing CEO would be difficult, I would think, as she would certainly be entitled to argue that she relied on the authority of the board in entering into the employment agreement in the first place.
We offer an equally implausible alternative solution: courts should adopt the structural bias thesis in reviewing challenges to executive compensation decisions. There is ample evidence that corporate boards provide generous compensation packages to executives because board members are themselves corporate executives and value their own contributions at levels that are not determined by any sort of market test. The breach of fiduciary duty at issue then is no longer the duty of care but the duty of loyalty, as all board members may be presumed to have a personal interest in setting executive compensation absurdly high. Once we switch from care to loyalty, we no longer have to worry about the business judgment rule or those pesky statutes that immunize board members from liability for anything short of fraud or illegality.
More implausibly still, I argued a few years ago in an article that appeared in the Tulane Law Review that the business judgment rule should not apply to executive compensation agreements. Tulane has not (yet) adopted the increasingly popular practice of putting back issues up online. Therefore, the easist place to find the article, in its pre-edited format, is on SSRN.
My reasoning is as follows:
1. None of the justifications for the business judgment rule make sense -- it's not true that judges are not business experts; it's no longer true that board members need the business judgment rule to protect them from liability for risky decisions; and corporate democracy is not sufficiently robust to effect the sort of delegation of decision-making authority from shareholders to directors that the business judgment rule assumes to have occurred.
2. But the business judgment rule is justified in situations where the costs of disclosure of prospective business plans or strategies associated with litigation outweigh any potential benefit to the corporation from litigating the alleged breach of the board's duty of care.
3. Executive compensation is not determined with reference to any prospective business plans.
4. Therefore, there is no need to accord board business judgment rule protections with respect to executive compensation plans.