Will Courts' Reluctance to Address Executive Compensation Push Congress to Act? Joseph E. Bachelder III New York Law Journal August 28, 2008

Will Courts' Reluctance to Address Executive Compensation Push Congress to Act?

Joseph E. Bachelder III
New York Law Journal
August 28, 2008

http://www.law.com/jsp/ihc/PubArticleIHC.jsp?id=1202424104147

Courts do not like being arbiters of disputes over what is reasonable
compensation. The recent, abrupt conclusion of the state of New York's lawsuit against Richard A. Grasso is a case in point.



The lawsuit began on May 24, 2004 at the initiative of then-Attorney
General Eliot L. Spitzer, claiming that the payment of a lump-sum
amount of $139.5 million to Grasso was unreasonable compensation.[FOOTNOTE 1] The action was brought under the New York Not-For-Profit Corporation Law.



EARMARKS OF DUBIOUS BEHAVIOR



This case appeared to offer an ideal opportunity for New York courts to
address the issue of what is reasonable compensation. It had all the
earmarks of an egregious case of overpayment of compensation to an
executive together with evidence of dubious corporate behavior in the
setting of that compensation. Earmarks included:

1. The payment of $139.5 million, in a lump sum, to the CEO
of a relatively small not-for-profit trade organization and regulator
(albeit a well-known and very powerful one).



2. According to the complaint (and there is substantial publicly
available data to support this) the compensation and benefits for
Grasso expensed over the period of 2000-2002 equaled slightly less than
100 percent of the New York Stock Exchange's (NYSE) net income over
this same period. Complaint, para. 34. Over these three years, this
represented $130.3 million of compensation and benefits to Grasso
compared to $132.8 million of net income. Id.



3. Many of the directors of the NYSE (including members of the
Compensation Committee) were subject to regulation by Grasso himself,
as chairman and CEO of the NYSE. During the periods relevant to the
litigation, Grasso was authorized to appoint the members of the
Compensation Committee (subject to board approval) and to select one of
the members as the chairperson of the committee (the selection of the
committee chairperson did not require board approval). See, for
example, Charter: Human Resources and Compensation Committee, adopted
June 7, 2001; see also Complaint, paras. 5, 6 and 25.



4. For the Aug. 7, 2003 meeting of the board that approved Grasso's
2003 compensation arrangements, including the lump-sum payment of
$139.5 million, no advance notice (or virtually none) was given to
board members. Statement by the Director of Human Resources of the NYSE
(HRD Statement), Exhibit A to Exhibit 1 to Complaint, paras. 37-38.
Apparently due to this lack of notice neither of the outside
consultants who had been working on the matter was available to attend
the meeting. HRD Statement, Id. at para. 41. It would appear that, at
the Aug. 7, 2003 meeting, the board had very little time (and very
little information) before voting to approve Grasso's compensation
package including the lump-sum payment of $139.5 million.



5. The NYSE Compensation Committees that approved Grasso's compensation
arrangements over several years, including 2003, apparently were not
given accurate and complete information on Grasso's compensation. HRD
Statement, Id. at para. 50; see also Assurance of Discontinuance
Agreement with Consultant, Exhibit 2 to Complaint at pp. 1-2.[FOOTNOTE 2]

ATTORNEY GENERAL'S STANDING



Apart from the facts and alleged facts in this case, the attorney
general appeared to have standing to bring this action. The bases for
this conclusion were as follows:

1. The principle of parens patriae appeared to apply.
Parens patriae is the authority of the sovereign to protect the
well-being of its citizens, including the interest of important
segments of the public, such as the investing public, that are not able
to take action in a case like this. As stated by the New York Supreme
Court (Justice Charles E. Ramos) in this case:

[T]he Attorney General represents the investing community that lacks
the legal capacity to sue here, in order to redress the NYSE's failure
to act within the realm of its internal corporate governance or
regulatory frameworks. By granting Grasso's allegedly unreasonable
compensation, the NYSE Board failed to insure the integrity and
validity of the NYSE as an institution which, in turn, affects the
interests of the New York investing public. Accordingly, the Attorney
General has the authority to bring the challenged claims. People v. Grasso, 816 NYS2d 863, 874 (N.Y. Sup. Ct. 2006)

2. The attorney general was authorized to bring such an action under
specific sections of the N-PCL. For example, N-PCL §720(b) (Actions on
Behalf of the Corporation) provides that the attorney general may bring
certain actions such as one to set aside unlawful transfer of corporate
assets as well as relief in cases of breach of fiduciary duties by
officers and directors (which should include any wrongful payment by
the NYSE of unreasonable compensation of which an officer or director
was or should have been aware).



3. N-PCL §112 authorizes the attorney general to restrain persons from
exercising corporate rights "not granted to them by the law of the
state." (One example would seem to be an ultra vires act in a violation
of the N-PCL itself.) This implies the authority to recover a payment
that was beyond the authority of the corporation to make.



4. The attorney general does not appear to have lost standing following
the merger of the NYSE into a for-profit entity on March 7, 2006. See
N-PCL §§905(b) and 908(i). Supreme Court Justice Ramos in reaching this
same conclusion stated:

The integrity of the market mattered before the action was
initiated and it matters now. That interest has not changed with the
merger of the NYSE and Archipelago.



[T]he N-PCL clearly provides that where a New York not-for-profit
corporation merges with a foreign or domestic for-profit corporation,
any actions against the corporation or its directors or officers
continue 'as if the merger or consolidation had not occurred.' N-PCL
§905(b)(3). ... People v. Grasso, No. 401620/04, 2006 NYMisc. LEXIS 3023 at *11, *12 (N.Y. Sup. Ct. Oct. 18, 2006)

In October 2006, in a decision reached on motions before trial,  Ramos
concluded that the attorney general correctly brought the claims
pursuant to his authority under the N-PCL as well as in accordance with
the principles of parens patriae. The Supreme Court decision turned out
to be the only victory for Spitzer in this case. On appeal, the
Appellate Division, in a 3-2 decision, reversed Ramos.



SUDDEN DEATH



• Of the 'Grasso' Litigation. Between
June 25 and July 2, 2008, a little over one year after the Appellate
Division reversed the Supreme Court on most of the causes of action
against Grasso, the following occurred:

a. On June 25, the New York Court of Appeals affirmed the Appellate Division's dismissal of four of the six claims brought against Grasso.[FOOTNOTE 3]



b. Six days later, on July 1, the Appellate Division dismissed the two remaining claims against Grasso based on the March 2006 merger of the NYSE into a for-profit entity.[FOOTNOTE 4]



c. Just one day after the Appellate Division decision (July 2), current
Attorney General Andrew M. Cuomo announced the state would not appeal.
Thus ended the state's litigation against Grasso over his compensation.

APPELLATE COURTS' REASONING



In support of its conclusion that parens patriae did not give the
attorney general standing to sue Grasso in this case, the Appellate
Division cited numerous court decisions holding that the parens patriae
principle did not justify a sovereign, such as a state, bringing an
action in support of claims that are essentially the claims of private
parties (as distinguished from the well being of the public). (The
Court of Appeals explicitly did not address the parens patriae issue.)



Both the Appellate Division and the Court of Appeals held that the
attorney general had no standing under several of the N-PCL sections
cited by him in support of his position because his authority was not
explicitly stated in these sections. Other sections of the N-PCL
explicitly stated the attorney general's authority to bring action
under those sections. As stated by the Appellate Division in its 2007
decision, "expressio unius est exclusio alterius." People v. Grasso, 836 NYS2d 40, 46-47 (N.Y. App. Div. 2007)



As noted, the Appellate Division rendered the coup de grâce on July 1.
It held as to the two remaining causes of action against Grasso that
when the NYSE merged into a for-profit entity on March 7, 2006, any
standing the attorney general might have had to bring claims under the
N-PCL ended. As noted above, Ramos had addressed the merger and reached
the opposite conclusion. Until the July 1 decision of the Appellate
Division, neither of the appellate courts had mentioned the merger as
having a consequence to the standing of the attorney general.



Thus, the Appellate Division and the Court of Appeals did not even "get
close" to the issue of whether Grasso's compensation was reasonable or
reasonably determined. Some may say that behind the courts' decisions
may have been issues other than those suggested by their opinions as to
the attorney general's standing.



One explanation may lie in the March 2008 downfall of Spitzer, the
initiator of the litigation. His aggressive attacks on financial
service companies and executives employed by them, for example,
destroyed careers and cost some of those companies dearly. Spitzer's
personal downfall occurred in March 2008, while governor. No doubt, the
continuance of this litigation, in a very troubled economic environment
for the country, including financial centers like New York, must have
seemed an especially undesirable legal intervention at this particular
time.



A second reason for the abrupt dispatch of the Spitzer/Grasso
litigation certainly must have been the reluctance of courts to be the
arbiters of reasonable compensation. As said by the Court of Appeals at
the end of its decision on June 25:

[E]ach of the challenged causes of action against [Mr.]
Grasso seeks to ascribe liability based on the size of his compensation
package. The Legislature, however, enacted a statute requiring more.
The Attorney General may not circumvent that scheme, however
unreasonable that compensation may seem on its face. To do so would
tread on the Legislature's policy-making authority. People v. Grasso, No. 120, 2008 N.Y. LEXIS 1821, at *14 (N.Y. June 25, 2008).

Despite the deference to the New York Legislature, it
seems likely the Court of Appeals simply wanted out of this case, as
suggested by the first sentence of the quoted paragraph. That really
goes to the heart of this matter. Courts do not want to be involved in
disputes over the size of pay. They will explain at length why they are
unable to arbitrate such disputes based on principles such as those
imbedded in the business judgment rule or, as in the Grasso case,
based on their interpretation of a statute like the N-PCL. But after
all the interpretation and elaboration, the real point seems to be that
courts do not like deciding whether the size of executive pay in a
particular case is reasonable.



By a different route, and under the Delaware General Corporation Law,
the courts in Delaware ultimately held that directors of The Walt
Disney Co. did not violate their fiduciary duties in overseeing the
employment and subsequent severance arrangements of Michael Ovitz.
Ovitz, for 14 months, served as president and a director of Disney,
before being terminated without cause and leaving with approximately
$140 million in total value pursuant to severance provisions under his
employment agreement.[FOOTNOTE 5]
As stated by the Delaware Court of Chancery, "[N]ature does not sink a
ship merely because of its size, and neither do courts overrule a
board's decision to approve and later honor a severance package, merely
because of its size."[FOOTNOTE 6]



CONCLUSION



With the judiciaries of Delaware (Disney) and New York (Grasso) on the
sidelines, so to speak, on the subject of reasonable compensation,
Congress may consider, once again, legislation that would "put a lid"
on executive pay. There are significant constituencies pushing for
changes in the oversight of executive pay in this country. Many in
Congress, in the academic world and in the media have pushed for
legislative as well as other changes. All have expressed concern over
the levels of executive pay.



Legislative intervention has repeatedly proved unproductive in this
respect ... e.g., pay controls in the early 1970s (pay rose
significantly when controls ended several years after they were
installed); Internal Revenue Code §280G (the so-called parachute tax); Code §162(m) (the so-called $1 million cap on deductibility of non-performance-based senior officer pay); and, most recently, Code §409A,
an administrative nightmare for hundreds, probably thousands, of U.S.
corporations (imposing a 20 percent additional tax on certain forms of
deferred compensation that fail to meet legislative and regulatory
requirements under §409A).[FOOTNOTE 7]



It would be ironic if reservations of the judiciary over having an
interventionist role in the executive pay process lead to a much more
aggressive intervention by Congress. Draconian controls of executive
pay by Congress are not likely in the near future (at least the author
hopes they are not). But it is not beyond possibility that a reluctant
judiciary may be superseded by congressional legislation that could be
quite insensitive to the complexities involved in the process of
setting executive pay.



Joseph E. Bachelder III is a partner in the Law Offices of Joseph E. Bachelder.



:::::FOOTNOTES:::::



FN1 In addition to Grasso, the Complaint named two
other defendants: Kenneth G. Langone and the NYSE itself. The claim as
to Langone was dismissed by the Appellate Division in its July 1, 2008
decision. The claim against the NYSE was dismissed, to the extent it
sought injunctive relief (but not to the extent it sought a declaratory
judgment) by the Supreme Court's Oct. 18, 2006 decision, that dismissal
was affirmed by the Appellate Division in its July 1, 2008 decision. To
the extent that claim sought declaratory, rather than injunctive,
relief, it does not appear to have been dismissed.



The history of the Grasso litigation is as follows (the courts' handling of certain cross claims has been omitted):

• People v. Grasso, 816 NYS2d 863 (N.Y. Sup. Ct.
2006) (denied Grasso's motion to dismiss the nonstatutory causes of
action (constructive trust, money had and received, lack of proper
board approval, and unlawful loan)



• People v. Grasso, No. 410620/04, 2006 N.Y.Misc. LEXIS
3023 (N.Y. Sup. Ct. Oct. 18, 2006) (denied Grasso's motion to dismiss
the statutory claims against him (for unlawful conveyance and breach of
fiduciary duty); granted the attorney general summary judgment on
liability on the breach of fiduciary duty and unlawful loan claims
against Grasso; denied Langone's motion to dismiss the claim against
him; and granted Grasso's motion to dismiss the claim against the NYSE
to the extent it sought injunctive relief but denied it to the extent
the claim sought declaratory relief)



• People v. Grasso, 836 NYS2d 40 (N.Y. App. Div. 2007) (reversed the denial of the motion to dismiss the nonstatutory claims)



• People v. Grasso, No. 120, 2008 N.Y. LEXIS 1821 (N.Y. June 25, 2008) (affirmed the dismissal of the nonstatutory causes of action)



• People v. Grasso, No. 401620/04, 2008 N.Y. App. Div.
LEXIS 5853 (N.Y. App. Div. 2008) (reversed the granting of summary
judgment to the attorney general on liability and dismissed the
statutory claims against Grasso and Langone; and affirmed the denial of
the motion to dismiss the claim against the NYSE to the extent it
sought declaratory relief)

FN2 The HRD acknowledged that he did not advise the
Compensation Committee, over the several years involved, of the
supplemental retirement benefits that had been accruing to Grasso (in
the range of $40 million to $50 million by the beginning of 2003) ($45
million would be approximately one-third of the $139.5 million lump sum
payment to Grasso) and the HRD could not recall any occasion when it
was discussed with the committee. HRD Statement, Id. at paras. 13-15.
The HRD agreed to return $1.3 million in compensation received from the
NYSE, Assurance of Discontinuance Agreement with HRD, Exhibit 1 to
Complaint at p. 3; and one of the consulting firms advising the
Compensation Committee agreed to pay back $440,275 of its fees to the
NYSE, Assurance of Discontinuance Agreement with Consultant, Exhibit 2
to the Complaint, at p. 2. Presumably both the HRD and the consultant
repaid these amounts, at least in part, due to the mishandling of the
process by which Grasso's large amount of compensation had been
approved. Assurance of Discontinuance Agreement with HRD, Id. at pp.
1-2; see also Assurance of Discontinuance Agreement with Consultant,
Id. at pp. 1-2.



FN3 The June 28, 2008 Court of Appeals decision was
unanimous in upholding the Appellate Division dismissal of four of the
six claims. It agreed with the Appellate Division that the attorney
general did not have standing to sue on three of the four claims. These
three were:

• First Cause of Action: constructive trust and restitution (Complaint cites N-PCL §§202(a)(12) and 515(b))



• Fourth Cause of Action: Payment had and received (Complaint cites N-PCL §§202(a)(12) and 515(b))



• Fifth Cause of Action: Lack of Board approval (Complaint cites N-PCL
§715(f), which requires at least a majority vote of the entire board in
"[t]he fixing of salaries of officers, if not done in or pursuant to
the bylaws.") The claim was based on lack of complete and accurate
information furnished to the board, as brought out by documents outside
the complaint

Both the appellate courts took the position that the attorney general
could bring claims only pursuant to sections of the N-PCL that
specifically authorized the attorney general to bring action. None of
the sections cited by the attorney general contain specific
authorization of the attorney general to bring an action.



The fourth claim dismissed was as follows:

• Sixth Cause of Action: Unlawful loans (Complaint cites N-PCL §716).



The appellate courts held that while a violation of the loan
requirements of N-PCL §716 gave the attorney general authority to bring
an action, taking into account the provisions of N-PCL §§719 and
720(b), the attorney general did not cite the latter two sections (he
cited only N-PCL §716) and on this basis the appellate courts held the
claim failed for lack of proper pleading.



Despite the dismissal of the First, Fourth and Fifth causes of action,
it is noted that N-PCL §720(b) specifically authorizes the attorney
general to bring an action against an officer or director to compel the
officer or director to account for his conduct in the following
circumstances:

(A) The neglect of, or failure to perform, or other
violation of his duties in the management and disposition of corporate
assets committed to his charge.



(B) The acquisition by himself, transfer to others, loss or waste of
corporate assets due to any neglect of, or failure to perform, or other
violation of his duties.

In view of the appellate courts'
acknowledgement of the attorney general's authority to bring an action
in connection with the Second and Third causes of action, unlawful
conveyance (N-PCL §720(b)) and breach of fiduciary duty for accepting
unlawful (ultra vires) payments (N-PCL §§717 and 720(a) and (b)), it is
unclear on what basis the courts ignored the authorization of N-PCL
§720(b) as to the First, Fourth and Fifth causes of action. At the
heart of all three causes of action is Grasso's improper receipt of
corporate assets as to which N-PCL §720(b) seems to give specific
authorization to the attorney general to bring an action.



FN4 The two remaining claims against Grasso under the N-PCL were:

• Second Cause of Action: Unlawful conveyance (Complaint cites N-PCL §720(b))



• Third Cause of Action: Breach of fiduciary duty by accepting unlawful
(ultra vires) payments (Complaint cites N-PCL §§717 and 720(a) and (b))

The Appellate Division held that as a result of the merger
of the NYSE with Archipelago Holdings Inc. the NYSE was no longer a
Not-For-Profit Corporation and the state had no standing under the
N-PCL to sue, thus ending all claims against Grasso. As noted in the
text, notwithstanding the Appellate Division's dismissal, the
provisions of N-PCL §§905(b) and 908(i) would appear to have allowed
the attorney general's claims to survive the merger (as Supreme Court
Justice Ramos had concluded).



FN5 Following is a history of the Disney litigation:

• In Re The Walt Disney Company Derivative Litigation, 731
A.2d 342 (Del. Ch. 1998) (dismissed plaintiff shareholders' claims due
to their failure to make a demand on the Disney board and failure to
state a claim)



• Brehm v. Eisner 746 A2d 244 (Del. 2000) (affirmed lower
court's dismissal of shareholders' claims in part and reversed in part,
and remanded to allow the plaintiffs to replead)



• In Re The Walt Disney Company Derivative Litigation, 825
A2d 275 (Del. Ch. 2003) (denied the motion to dismiss and found the
facts as alleged to excuse demand because, if proved, those facts would
show conscious indifference on the part of the directors)



• In Re The Walt Disney Company Derivative Litigation, No.
15452, 2004 Del. Ch. LEXIS 132 (Del. Ch. Sept. 10, 2004) (granted
summary judgment to Ovitz on the claims of fiduciary duty alleged to
have occurred prior to Oct. 1, 1995; otherwise denied his motion for
summary judgment)



• In Re The Walt Disney Company Derivative Litigation, No.
15452, 2005 Del. Ch. LEXIS 113 (Del. Ch. Aug. 9, 2005) (found no bad
faith or breach of fiduciary duty on the part of the directors and
entered judgment in their favor)



• Brehm v. Eisner (In Re The Walt Disney Derivative Litigation), 906 A.2d 227 (Del. 2006) (affirmed the decision of the Court of Chancery)

FN6 In Re The Walt Disney Company Derivative Litigation, 731 A.2d 342, 350 (Del. Ch. 1998). (As noted in the litigation history of the Disney case,
supra note 5, this decision by the Delaware Court of Chancery was
reversed in part and remanded for further proceedings by the Delaware
Supreme Court; ultimately, a trial took place finding that no fiduciary
duties were violated and the Delaware Supreme Court affirmed.)



FN7 As stated by the Section of Taxation of the American Bar Association, in a letter to Congress on Code §409A,

Congress has created a federal regulatory system that is
largely unnecessary, will impose enormous administrative burdens on
taxpayers, their advisers, employers and others, as well as on the IRS
and Treasury, and is not a measured response to the underlying
problems.

Letter to Members of the House Committee on Ways and Means and Members of the Senate Committee on Finance (July 31, 2006).