With the financial sector meltdown in 2008, the resulting recession, and the recent “Occupy” movements springing up across the country, many have begun to closely scrutinize the practices and procedures of the financial organizations involved in the financial fiasco. Reports of near 10% unemployment contrasted with those of financial institutions paying hefty salaries and accruing large profits have further fueled public and congressional outrage at what appears to be a “broken” financial system.
A recent Delaware court decision, however, seems to fly in the face of this perceived public outrage. In a suit filed in January, 2010, the Southeastern Pennsylvania Transportation Authority (SEPTA), a shareholder of Goldman Sachs, sued Goldman Sachs, claiming that its failure to reign in an excessive executive compensation system led to unreasonably risky business decisions that ultimately hurt shareholders financially.
Goldman’s compensation system features a “pay for profit” component where executives’ compensation is based on the amount of profit Goldman makes in a given year. SEPTA argued that this compensation strategy incentivizes executives to pursue unreasonably risky opportunities. If the opportunity is successful, executives reap most of the profits while shareholders only receive a marginal amount. If the opportunity fails, however, most of the burden is borne by the shareholders whose assets decrease in value. As a result, some view Goldman’s compensation plan as a positive feedback loop where employees reap the benefits but the stockholders bear the losses.
Although SEPTA’s claims appeared to be reasonable, the Court ruled in Goldman’s favor. It found that SEPTA failed to state a claim for which relief could be sought. In its decision, the Court gave deference to Delaware’s Business Judgment Rule which differentiates between one who makes a poor business decision, and one who conducts business in a reckless manner. A poor business decision simply reflects an error or a mistake. Conducting business in a reckless manner involves taking unreasonable risks without appropriate regard for the financial well-being of shareholders. In arguing its case, SEPTA did not appear to provide the requisite evidence that would transform a series of poor business decisions into a pattern of reckless business conduct. Many will likely see this as an unwarranted defense of a pay system that the public already views as unfair. This is not the case.
The Court only finds that simply having such a pay system in place does not constitute reckless behavior per se. In reality, the Court does not specifically justify Goldman Sachs’ pay structure. Rather, it stresses that without direct evidence linking the pay structure to an intentional or reckless pursuit of unreasonably risky financial ventures, any financial loss that shareholders may incur from a corporation’s actions must be assumed to be, at the worst, the result of a poor business decision pursued in good faith. The fiduciary duty between the corporation and its shareholders has not been broken unless additional evidence can prove otherwise. This does not prohibit any further challenges to an executive pay structure similar to that of Goldman Sachs, but it establishes a high requisite burden of proof that a plaintiff would need to meet to succeed in such a challenge.
The role of corporate fiduciaries is to balance the financial risk of investments with a good faith attempt to increase stockholder wealth and improve the corporation’s overall well-being. A decision for the plaintiffs in this case could have created a slippery slope of sorts with regard to corporate fiduciary management. It would open the door for corporate fiduciaries to be held liable for any investment decision, reasonable or not, which would incur a loss to shareholders. Financial institutions might become too risk averse and the result could possibly hurt shareholders even more in the long run. This is not to say that a compensation system similar to what Goldman Sachs employs does not or cannot lead to an unreasonable assumption of risk. Some have pointed out possible short-term risk issues which could result in a divergence of corporate and shareholder interests.
Additionally, certain provisions of the recently passed Dodd-Frank Act may affect similar cases in the future. Section 951 of the Act contains a “Say on Pay” provision. It essentially states that once every one to three years a corporation is required to disclose its compensation information to shareholders as well as conduct shareholder vote to approve executive compensation. Although a shareholder vote regarding compensation is not binding on the corporation, it still may serve a purpose. Suppose that in addition to the facts above, the majority of Goldman shareholders had voted against the executive pay scale at an annual meeting. Despite this vote though, Goldman had refused to modify it. SEPTA could then use such information at trial as evidence of recklessness and stand a better chance of prevailing in its claim against Goldman Sachs.
Though Section 951 appears to be an initial attempt to reign in excessive executive compensation, its nonbinding nature leaves much to be desired. In light of the current economic climate as well as both public and political concerns, some reform of this system seems to be in order. The exact manner in which this reform should or could take place, however, remains to be seen.