Say on Pay and the Business Judgment Rule


By: Jordan F.

Last week the Delaware Chancery Court dismissed a derivative suit filed against Goldman Sachs. The suit alleged that the company’s compensation system wrongfully rewarded employees for taking risks that harmed the firm’s stock price. The suit was filed in the wake of the most recent mortgage crisis. The plaintiffs lawyers argued that the firm’s board of directors breached their fiduciary duties by establishing a compensation structure that improperly encouraged highly “risky trading practices and over-leveraging of the company’s assets” which led to illegal business practices.

Goldman Sachs employees received billions of dollars in pay and bonuses last year, while at the same time the firm was settling United States Securities and Exchange Commission allegations that executives misled investors in collateralized debt obligations related to subprime mortgages. Consequently, Goldman Sachs paid $550 million and promised to reform the business practices that misled investors. “Half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC…a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

In this lawsuit, Goldman Sachs moved to dismiss the complaint under Delaware Court of Chancery Rule 23.1 (which is notably stronger than Rule 12(b)(6)) for failure to state a claim). The 67 page decision reads like a law school corporation’s text book explaining the fiduciary duties of directors and officers. The decision hinges on the concept of the business judgment rule. The court explained that Delaware law “provides corporate directors and officers with broad discretion to act as they find appropriate in the conduct of corporate affairs” and “in the exercise of their business judgment on behalf of the corporation.”

In reality, the facts of the case do not establish that the work done by tens of thousands of Goldman employees was deficient enough for a reasonable person on the board to deny awarding high levels of compensation. However, should the board of directors not be held accountable for overseeing the compensation system for employee’s wrongful conduct and the corresponding decline of Goldman’s stock price? And why should the shareholders burden the loss? In effect, if the illegal practices turned profitable, Goldman’s employees would have received even more of a windfall; however losses fell on the stockholders.

In May 2011, pay awards to Goldman Sachs executives were approved by 73 percent of the stockholders in a say on pay advisory vote. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires a shareholder advisory vote for most publicly traded companies on the approval of compensation paid to the company’s executive officers for the past fiscal year. Dodd-Frank was not addressed in this case because the claim arose from 2007 through 2009, and Dodd-Frank was passed in 2010. However, Goldman Sachs and all companies subjected to the rule should keep their eye on the compensation concerns of their shareholders.

If a “say on pay” vote is negative, it could lead to say on pay litigation. With a declining stock market and high levels of volatility, the business judgment rule may not provide as much protection at the pleading stage for the compensation decisions made by directors subject to derivative lawsuits. While Dodd-Frank states the say on pay vote is nonbinding, and does not alter the fiduciary duties of officers or directors, the judicial reality is that elevated shareholder scrutiny on compensation means directors must take heed and caution to the decisions they make regarding executive compensation. Perhaps this shareholder challenge will come to Goldman Sachs sooner rather than later, as they just reported a quarterly loss for the second time ever.

At least for now, the Delaware Court of Chancery has determined a conventional business judgment rule analysis should apply to such “oversight” business risk claims. Alas, stockholders who are unhappy can always exit by selling their shares or unrealistically seek to replace board directors in an election.


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Fordham Journal of Corporate & Financial Law