Chapter 21 Executive Compensation

1. Module VII – Fiduciary Duties Chapter 21Executive Compensation Bar exam Corporate practice Law profession 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? Citizen of world Chapter 21 Executive Compensation

2. Fiduciary duties(directors) Bestinterests Decision-making Oversight Business Judgment RuleShlensky v Wrigley Inattention CorpoppFarber WasteVogelstein GrossneglVan Gorkom ConflictinterestRemillard IllegalityMiller v AT&T 102(b)(7) 102(b)(7) IllegalityCaremark Malfeasance(bad faith)Francis DisinterestedindependentBenihana Bad faithDisney Chapter 21 Executive Compensation

3. Plato “5x” Friedman “market - 400x” Chapter 21 Executive Compensation

4. 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 Chapter 21 Executive Compensation

5. Hal and Hank(team owners) Joe (team manager) Public Shareholders Board of Directors CEO Chapter 21 Executive Compensation

6. 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” Judicial review Waste: no relation to services Care: board grossly uninformed Loyalty: fraud or conflict Executive pay Chapter 21 Executive Compensation

7. Chapter 21 Executive Compensation

8. Chapter 21 Executive Compensation

9. Stock options … • 5. Companies pay employees with stock options in order to -- • Create an incentive for employees to increase stock prices • To hide compensation from financial statements • 6. Stock options are impossible to value • True. There’s no way to know what will happen to stock prices • False. Option value depends on past price volatility and interest rates • 7. Can you buy an option in General Electric stock? • Yes. Options for many public companies’ stock are bought and sold • No. Only employees can acquire stock options • 8. If you thought GE stock would stay steady • You can make money by selling a “call option” • You can make money by buying a “put option” 1. What is a stock option? • The right to buy stock in the future • The duty to buy stock in the future 2. You have a stock option that vests in 2 years? • You can exercise the option any time for next 2 years • You must wait 2 years before exercising option 3. Your stock option has a strike price of $25. Market price is $20 • You should exercise the option • 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 • You can wait for prices to go higher – and defer taxes • You should exercise it immediately 1-A / 2-B / 3-B / 4-A / 5-A / 6-B / 7-A / 8-A Chapter 21 Executive Compensation

10. Option backdating Expiration date Vesting period Exercise price Grant date New exercise price Backdated grant date Chapter 21 Executive Compensation

11. Judicial review Review standards - over time Meaning of “waste” - safety valve Disney case - duty of “good faith” Chapter 21 Executive Compensation

12. 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) Chapter 21 Executive Compensation

13. The numbers please Randall Thomas (Vanderbilt) Chapter 21 Executive Compensation

14. 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 (at least one theory) 34% 30% 32% (35 cases) (27 cases) CHC (at least one theory) 50% 53% 52% (8 cases) (47 cases) Chapter 21 Executive Compensation

15. Evolving judicial review in Delaware … Chapter 21 Executive Compensation

16. 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” Chapter 21 Executive Compensation

17. 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:  • 15,000 one-time options (exercise price = market price on date granted / exercisable for up to 10 years) • 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? Chapter 21 Executive Compensation

18. 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? Lewis v. Vogelstein (Del Ch 1997) Chancellor Allen Chapter 21 Executive Compensation

19. Duty of care Board approval of executive pay Disney I - complaint Disney II - amended complaint Disney III - trial Chapter 21 Executive Compensation

20. 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. Chapter 21 Executive Compensation

21. The end Chapter 21 Executive Compensation

22. Review of fiduciary duties …(directors) Chapter 21 Executive Compensation

23. Fiduciary duties(directors) Bestinterests Decision-making Oversight Business Judgment RuleShlensky v Wrigley Inattention CorpoppFarber WasteVogelstein GrossneglVan Gorkom ConflictinterestRemillard IllegalityMiller v AT&T 102(b)(7) 102(b)(7) IllegalityCaremark Malfeasance(bad faith)Francis DisinterestedindependentBenihana Bad faithDisney Chapter 21 Executive Compensation

24. GE Proxy Statement – 2005 What was Jeff Immelt (CEO) paid? Cash, bonus, perks PSUs Stock options How did Comp Committee explain itself? Executive pay Chapter 21 Executive Compensation

25. Our decisions regarding senior executive officer compensation are primarily based upon our assessment of each senior executive officer’s leadership performance and potential to enhance long-term shareowner value. We rely upon our judgment about each individual—and not on rigid guidelines or formulas, or short-term changes in business performance—in determining the amount and mix of compensation elements for each senior executive officer. Key factors affecting our judgments include: the executive’s performance compared to the goals and objectives established for the executive at the beginning of the year; the nature, scope and level of the executive’s responsibilities; the executive’s contribution to the company’s financial results; the executive’s effectiveness in leading our initiatives to increase customer value, productivity, cash flow and revenue growth; the executive’s contribution to the company’s commitment to corporate responsibility, including the executive’s success in creating a culture of unyielding integrity and compliance with applicable law and our ethics policies; and the executive’s commitment to community leadership and diversity. We also consider the compensation levels and performances of the 30 companies in the Dow Jones Industrial Index, as these companies are most likely to compete with us for the services of our executives; however, we do not tie our compensation decisions to any particular range or level of total compensation paid to executives at these companies. GE Compensation Committee Chapter 21 Executive Compensation

26. Evaluation - Exec Comp • “Rethinking Today’s CEO Pay Practices” • “Have Stock Options Run Their Course?” • “Compensation Committees That Work” • “How Compensation Gets Manhandled” Chapter 21 Executive Compensation

27. Fiduciary duties(directors) Bestinterests Decision-making Oversight Business Judgment Rule Inattention Corpopp Waste Grossnegl Conflictinterest Illegality 102(b)(7) 102(b)(7) Illegality(bad faith) Malfeasance(bad faith) Bad faith Disinterested,independent Chapter 21 Executive Compensation

28. Lewis v. Vogelstein (Del Ch 1997) Shareholders of Mattel challenged the board's stock option compensation plan for directors, which had been ratified by shareholders.  Under the plan directors received:  • 15,000 one-time options with an exercise price equal to market price on the date granted, and exercisable for up to ten years, • 5,000 (or 10,000 for longer-serving directors) annual options that vest over a four-year period, with an exercise price equal to market price when granted, and exercisable for up to ten years.  What’s the standard of review? Chapter 21 Executive Compensation