Corporations A Contemporary Approach Chapter 16 Public Shareholder

Corporations: A Contemporary Approach Chapter 16 Public Shareholder Activism Slide 1 of 65 Seb Farrington, “Crankenstein” (2014)

Module VII – Fiduciary Duties Chapter 21 Executive Compensation • Compensation puzzle Bar exam – Relation to corporate governance – Types of pay: salary, bonuses, stock grants, stock options – Special issues with stock options Corporate practice • Standard of review Law profession • Delaware approach in Disney Citizen of world – Vogelstein case – Waste standard over time – – 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? Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 2 of 27

Fiduciary duties (directors) Oversight Best interests Decision-making Business Judgment Rule Shlensky v Wrigley Inattention 102(b)(7) Waste Vogelstein Illegality Malfeasance Caremark (bad faith) Francis Corporations: A Contemporary Approach Gross negl Conflict interest Illegality Miller v AT&T Van Gorkom Remillard Corp opp Farber 102(b)(7) Bad faith Disney Disinterested independent Benihana Chapter 21 Executive Compensation Slide 3 of 27

Plato “ 5 x” Corporations: A Contemporary Approach Friedman “market - 400 x” Chapter 21 Executive Compensation Slide 4 of 27

“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%. Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 5 of 27

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 Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 6 of 27

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 7 of 27

Hal and Hank (team owners) Public Shareholders Joe (team manager) Board of Directors CEO Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 8 of 27

Executive pay • Cap of $1, 000 (CEO and top 4 officers), unless -– performance-based pay – set by compensation committee (outside directors) – approved by shareholders Types of pay • Salary (cash) • Bonuses • Plan-based Proxy disclosure – Stock awards – Option grants – Non-equity incentives • 1992 SEC amendments • Deferred compensation – Pension plan – Nonqualified deferred comp • Other – Executive loans (SOX!) – Fringe benefits Corporations: A Contemporary Approach Tax deductibility – 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 Chapter 21 Executive Compensation Slide 9 of 27

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 10 of 27

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 11 of 27

Stock options … 5. Companies pay employees with stock options in order to -- 1. What is a stock option? A. The right to buy stock in the future B. 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 option B. 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 A. Create an incentive for employees to increase stock prices B. To hide compensation from financial statements 6. Stock options are impossible to value A. True. There’s no way to know what will happen to stock prices B. 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 steady A. 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 Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 12 of 27

Option backdating Expiration date Vesting period Exercise price Grant date New exercise price Backdated grant date Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 13 of 27

Judicial review Review standards - over time Meaning of “waste” - safety valve Disney case - duty of “good faith” Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 14 of 27

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) Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 15 of 27

The numbers please Randall Thomas (Vanderbilt) Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 16 of 27

Thomas & Martin – Plaintiff success rates (124 reported exec pay cases) Delaware Non-Delaware Total Waste 29% 46% 40% Care 27% 33% 30% Loyalty 28% 39% 35% PHC 34% (35 cases) 30% (27 cases) 32% 50% 53% 52% (8 cases) (47 cases) (at least one theory) CHC (at least one theory) Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 17 of 27

Evolving judicial review in Delaware … Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 18 of 27

– K “s erb uf s fic v. ie C nt al co if ns Eas id te er rn “g at oo io Air d n” w fa 196 ay ith 0 s d – et er Be m ar in d at v. io E n ls – te pr r “e 197 op xis 9 b – te en M nc ef ich e it” of el [a so ny n ] c v. on Du sid nc er an 19 at 97 io “c – n” la L ss e ic wis wa v ste. V st oge an ls da tei rd n ” 52 19 Delaware – evolving standards Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 19 of 27

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 longerserving 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? Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 20 of 27

Lewis v. Vogelstein (Del Ch 1997) Intermediate review: Waste standard: – sufficient consideration (reasonable relation between the value of the services and the value of the options) – Reviewable only if corporation received no consideration, the compensation was a gift, no person of ordinary prudence could possibly agree – Plan: conditions included to ensure that the consideration will pass to corporation. Chancellor Allen – Defer to shareholder ratification (in this age when institutional shareholders have grown strong) Apply? Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 21 of 27

Duty of care Board approval of executive pay Disney I - complaint Disney II - amended complaint Disney III - trial Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 22 of 27

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 nonexculpable, non-indemnifiable violation of the fiduciary duty to act in good faith. Corporations: A Contemporary Approach Chapter 21 Executive Compensation CEO Michael Eisner with Michael Ovitz ($140 million “pay for failure”) Slide 23 of 27

The end Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 24 of 27