A Role for the Judiciary in Reforming Executive Compensation: The Implications of Securities and Exchange Commission v. Bank of America Corp.

Mathew Farrell

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I. Introduction

Few areas of corporate governance have received as much attention as executive compensation. In the nineteenth century, robber barons were criticized and mocked, and in the early twentieth century, newspapers frequently disparaged top executives. These criticisms have continued into the twenty-first century, and they have intensified as politicians, activists, and filmmakers have explored various aspects of executive compensation. At the core of executive compensation is a conflict between ownership and management, as managers have a natural urge to pursue their interests at the expense of the owners, whom the managers theoretically serve. To address this central conflict, the federal government, states (most importantly Delaware), the SEC and other government agencies, and self-regulatory organizations (such as the National Association of Securities Dealers) have promulgated rules regulating corporate governance and disclosures.1 Politicians have also recently introduced bills, such as the Shareholder Bill of Rights Act, that seek to further regulate executive compensation. I argue, however, that the judiciary has a central role in enforcing existing executive-compensation rules, and SEC v. Bank of America2 presents an example of how courts can accomplish this task.

II. Corporate Governance

American companies resemble representative democracies, in that shareholders generally do not actively participate in managing or overseeing the management of a company. Instead, shareholders elect the board of directors, and these directors are responsible for running the company. The directors of a company are responsible for crafting an executive-compensation plan and, although slight differences among boards exists, most boards develop these plans through similar procedures. Usually, a specialized compensation committee of a board makes decisions regarding executive compensation. The compensation committee relies on hired consultants and experts to provide it with information on common practices and data that allow the committee to craft an executive-compensation plan. After the compensation committee develops a compensation plan, the entire board of directors reviews the plan and officially decides how to compensate the company’s executives.

The compensation packages that boards ultimately implement, although varying in detail, tend to have numerous similarities. Executive compensation usually includes a fixed base salary, a bonus scheme (usually consisting of stock options and other incentive plans), perquisites (including pension plans, company cars, use of company aircraft, and other “perks”), and conditional promises of severance payments. Executive-compensation packages are usually quite large, with the chief executive officers (CEO) of many companies earning more than one hundred times the earnings of the average company employees. The compensation that top executives earn has also increased relative to other company employees.  In 1991, the CEO of a large company earned, on average, 140 times what the average employee earned; by 2003 an average CEO at a large company earned 500 times what the average employee earned.3 This increase in compensation is so large that neither increases in firm size, nor improvements in company performance, nor changes in industry practice explain it.

III. The “Problems” with Executive Compensation

Despite the increases in total and relative compensation that executives receive, significant debate exists over whether an executive compensation “problem” exists. Some scholars argue that the American executive-compensation model is immoral, rewards greedy executives for company performance that is unrelated to an executive’s performance, allows executives to essentially set their own compensation and to enrich themselves at the expense of shareholders, and causes significant economic harm. Others argue that American executive-compensation practices are efficient, reward talented individuals who compete in an extremely competitive market, and have contributed to economic growth. One common critique of executive compensation is the “populist” critique, which focuses on outcomes and has a common refrain that “anyone who makes that kind of money must be doing something either illegal or immoral.”4 Nevertheless, paying an executive a large amount of money may be completely rational.  For example, if hiring a hypothetical executive would increase the value of a hypothetical company by $10 billion, then paying this executive $1 billion, which seems excessive and “unfair,” makes sense and may even constitute underpayment from the executive’s perspective, as he or she is not receiving the entire value that he or she created. Therefore, because of the limitations of the populist critique, a preferable approach is to focus on the flaws of the executive-compensation process (rather than its outcomes) and evaluate the seriousness of the problems in terms of unrecognized shareholder benefits.

I conclude that a problem exists with executive-compensation practices, even though some argue that no problem exists or the problem is insignificant. The most important reason for this conclusion is that empirical studies of the correlation between executive compensation and performance do not find a strong and persistent relationship between executive compensation and company performance. Additionally, if companies are able to “camouflage” their executive-compensation practices, then shareholders and the general public will be unable to take action. This notion of camouflage helps to explain why improving disclosures is the key to improving executive-compensation practices. If companies are forced to disclose all pertinent information related to executive compensation in a concise and understandable form, the ability of executives to obtain undeserved compensation will be constrained.

IV. Addressing Executive-Compensation Problems

In 2006, the SEC passed new rules requiring that companies disclose the compensation that CEOs, chief financial officers (CFOs), and the three other highest-paid officers at a company received during the fiscal year. The goal of these rules was to increase transparency by providing investors with a more complete and clearer image of the compensation for certain executives; the goal was not to dictate levels of compensation. Rather than list the information that a company must disclose, the SEC disclosure rules are “principles based,” meaning that a company must report all forms of compensation unless the rules specifically exempt it. In brief, a company must explain how much compensation its top executives received and why.

I argue that the SEC rules are sufficient to address the existing problems of executive compensation, but this requires that the SEC enforce the rules in a manner consistent with the goals of the rules. This, in turn, requires that judges not completely defer to the SEC’s determination of what action is in the public interest. When the SEC settles a case involving executive-compensation disclosures, it generally settles with the company rather than with board members, executives, or consultants. Thus, the settlement payment comes from the corporation, which belongs to the shareholders, with the underlying rationale being that shareholders will be more vigilant and can take appropriate action. As Judge Jed Rakoff notes in SEC v. Bank of America Corp., these settlements are frequently “neither fair, nor reasonable, nor adequate.”5 Rakoff noted that the practice of forcing a company that violates securities laws to pay a penalty essentially means that the victims of the violation pay an additional penalty, which seems inappropriate.6 Additionally, because the company was responsible for the penalty, its payment would not deter those truly responsible for misleading the shareholders.7.

The ramifications of SEC v. Bank of America Corp. have the potential to be especially significant.  In SEC v. Bank of America Corp., the SEC did not prosecute Bank of America because it paid bonuses to former Merrill Lynch employees; rather, the SEC alleged that Bank of America failed to disclose the bonus arrangements to its shareholders.

The 2006 SEC disclosure rules, however, broadly establish the principle that a corporation must disclose all executive-compensation information, with a few specific exemptions. Accordingly, imagining future SEC enforcement actions that resemble the situation in SEC v. Bank of America Corp. is not difficult. To be sure, the SEC must be willing to challenge the sufficiency of executive-compensation disclosures, which is admittedly uncertain, but nothing indicates that the SEC will be reluctant to enforce its new rules, particularly as executive compensation receives significant attention. If courts adopt Rakoff’s approach and, instead of approving whatever action the SEC takes, require that the SEC focus on those responsible for disclosure failures and crafting camouflaged compensation regimes, shareholders will be better protected and many executive-compensation problems will be significantly reduced or eliminated.


Matthew Farrell is a 2011 J.D. Candidate at Cornell Law School.

This Legal Workshop Editorial is based on Mr. Farrell’s Note:  Matthew Farrell, Note, A Role for the Judiciary in Reforming Executive Compensation: The Implications of Securities and Exchange Commission v. Bank of America Corp., 96 CORNELL L. REV. __ (forthcoming 2010).

Copyright © 2010 Cornell Law Review.

  1. Shareholder Bill of Rights Act of 2009, S. 1074, 111th Cong. (2009).
  2. 653 F. Supp. 2d 507 (S.D.N.Y. 2009) (denying proposed consent judgment).
  4. Mark A. Salky, Comment, The Regulatory Regimes for Controlling Excessive Executive Compensation: Are Both, Either, or Neither Necessary?, 49 U. Miami L. Rev. 795, 797 (1995) (quoting Andrew R. Brownstein & Morris J. Panner, Who Should Set CEO Pay?  The Press?  Congress?  Shareholders?, Harv. Bus. Rev., May–June 1992, at 28, 29).
  5. SEC v. Bank of Am. Corp., 653 F. Supp. 2d 507, 508 (S.D.N.Y. 2009).
  6. Id. at 508, 512.
  7. Id. at 512

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