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

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

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

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

“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

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 6 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 7 of 27

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

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

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

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

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 12 of 27 Stock options … 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 5. Companies pay employees with stock options in order to -- 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 13 of 27 Option backdating Grant date Vesting period Exercise price New exercise price Backdated grant date Expiration date

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 14 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 15 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 16 of 27 The numbers please Randall Thomas (Vanderbilt)

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

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

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 19 of 27 Delaware – evolving standards 1952 – Kerbs v. Calif Eastern Airways “sufficient consideration” 1960 – Beard v. Elster “good faith determination – prop benefit” 1979 – Michelson v. Duncan “existence of [any] consideration” 1997 – Lewis v. Vogelstein “classic waste standard”

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 20 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 longer- serving 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 21 of 27 Lewis v. Vogelstein (Del Ch 1997) Intermediate review: –sufficient consideration (reasonable relation between the value of the services and the value of the options) –Plan: conditions included to ensure that the consideration will pass to corporation. Waste standard: –Reviewable only if corporation received no consideration, the compensation was a gift, no person of ordinary prudence could possibly agree –Defer to shareholder ratification (in this age when institutional shareholders have grown strong) Apply? Chancellor Allen

Corporations: A Contemporary Approach Chapter 21 Executive Compensation Slide 22 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 23 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 non- exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith. CEO Michael Eisner with Michael Ovitz ($140 million “pay for failure”)

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