How Much Latitude Do Directors Have In Setting Executive Compensation?

Executive compensation decisions are core functions of a board of directors and, absent unusual circumstances, are protected by the business judgment rule.  As Delaware courts have repeatedly recognized, the size and structure of executive compensation are inherently matters of business judgment, and so, appropriately, directors have broad discretion in their executive compensation decisions.  In light of the broad deference given to directors’ executive compensation decisions, courts rarely second-guess those decisions.  That is particularly so when the board or committee setting executive compensation retains and relies on the advice of an independent compensation consultant.

Nevertheless, despite the high hurdle to challenging compensation packages, shareholder plaintiffs continue to aggressively challenge executive compensation decisions, in particular at companies that have performed poorly and received negative or low say-on-pay advisory votes.

As we’ve discussed on previous occasions, Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires most public companies to include a resolution in their proxy statements asking shareholders to approve the compensation of their executive officers, in a non-binding, “say-on-pay” shareholder vote.  Despite the fact that Dodd-Frank explicitly provides that say-on-pay votes “may not be construed” as altering the fiduciary duties of boards or imposing any additional fiduciary duties, dozens of companies throughout the country have been the subject of shareholder derivative lawsuits following a negative say-on-pay vote.  These lawsuits generally allege that the directors breached their fiduciary duties by failing to alter an executive compensation plan in response to its rejection by the shareholders.  Notably, even though most of these lawsuits target Delaware corporations, none have been filed in Delaware.

In any event, most courts have rejected say-on-pay cases challenging executive compensation disapproved by shareholders, the most recent being the California Court of Appeal in Charter Township of Clinton Police and Fire Retirement System v. Martin.  The complaint in that case alleged that the board of Jacobs Engineering Group, a Delaware corporation, breached its fiduciary duties by, among other things, adopting a compensation plan in the face of poor performance by the company, and failing to amend the plan after its rejection by a majority of Jacob’s shareholders.  The court dismissed the complaint, recognizing that matters of executive compensation are generally “left to the wide discretion of the directors.”  As the court held, under Delaware law, allegations that the directors “supported the [compensation] plan during the shareholder vote, and stuck with it after the negative vote, do not begin to approach the level of pleading necessary to overcome the presumption of the business judgment rule,” since the “goal of retaining key executives during poor economic circumstances is entirely reasonable in order to attempt to minimize the effects of a major economic downturn on a company.”

This case, along with other cases that have rejected similar “say-on-pay” claims, reinforce the principle of U.S. corporate law that directors, not shareholders, manage the business and affairs of the company.  Absent extraordinary circumstances, directors of public companies have the power and discretion to decide what the level of executive compensation should be, taking into account a variety of factors other than financial performance and shareholder sentiment.