Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

Corporate Governance

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What is the Practical Importance of Default Rules under Delaware LLC and LP Law?

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Mohsen Manesh*

Despite much academic debate, it is now well settled that in Delaware at least, corporate law differs from unincorporated alternative entity law in one fundamental respect. Under Delaware corporate law, fiduciary duties are mandatory. These duties, owed by the managers of a corporation to the shareholders of the firm, in general cannot be waived or modified by contract.[1] Under Delaware law governing limited liability companies (LLCs) and limited partnerships (LPs), however, fiduciary duties are merely default duties.[2] Although managers of these alternative entity firms owe fiduciary duties, these duties may be modified or even wholly eliminated by the terms of the alternative entity governing agreement.[3]

Recently however, the Chief Justice of the Delaware Supreme Court, Myron Steele, has sparked a new debate. In his article “Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies,” the Chief Justice makes the provocative assertion that fiduciary duties should not apply, even as a default, under Delaware alternative entity law.[4]

Despite the Chief Justice’s controversial claim, the Delaware Chancery Court, the state’s lower court and the nation’s premier venue for business litigation, has repeatedly held that absent a contractual agreement to the contrary, the managers of a Delaware LLC or LP owe fiduciary duties as a default.[5] But the Delaware Supreme Court has yet to expressly rule on this issue.[6] And the Chief Justice’s article, although written in his unofficial capacity, shows that at least one member of the state’s five-member high court disagrees with the Chancery Court’s rulings.

Thus, Chief Justice Steele’s article has renewed the debate over fiduciary duties, albeit in a new context. Rather than debating whether fiduciary duties should be subject to contractual limitations,[7] distinguished academics and practitioners now debate whether fiduciary duties should even apply as a legal default under unincorporated alternative entity law.[8]

On the surface, this new debate has significant implications for business planners and investors. In recent years, unincorporated alternative entities, and LLCs in particular, have become increasingly prominent in various aspects of the business world.[9] And, much like its dominant position in the world of corporate law, Delaware has quickly gained preeminence in the alternative entity context, due in large part to its apparent success in attracting LLCs and LPs to organize under Delaware law.[10]

In this essay, however, I argue that this new debate, although interesting as a theoretical matter, has limited practical importance. Sophisticated parties can and will contract to avoid undesirable default rules. And LLCs and LPs with passive investors have contractually created an almost de facto rule eliminating fiduciary duties. Thus, even if one believes Chief Justice Steele’s thesis is problematic, the problem it creates affects only a small portion of Delaware’s alternative entity universe.

Insignificance of Default Rules for Sophisticated Investors

Chief Justice Steele carefully limits his thesis to only those LLCs and LPs that are created from a “bargained for exchange” among “sophisticated” parties.[11] The Chief Justice argues that among sophisticated parties the application of default fiduciary duties makes little sense:

[I]t is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle.[12]

But it is among this very group—sophisticated parties who bargain for their rights and obligations—that the debate as to default rules is likely to have the least relevance. Regardless of the default rules that apply to LLCs and LPs, as long as Delaware law affords the maximum freedom of contract to deviate from such rules,[13] sophisticated parties can and will contract for their desired result. By hypothesis, sophisticated parties are aware of the default rules, understand they are not inescapably bound to such rules and will bargain for different rules if the default rules are undesirable.  If fiduciary duties apply as the default, sophisticated parties that want to eliminate or modify such duties can and will easily do so.[14] If, on the other hand, no fiduciary duties apply as the default, as Chief Justice Steele advocates, sophisticated parties can just as easily impose corporate-like fiduciary duties (or some subset of such duties) by simple reference to such duties in the terms of the LLC or LP governing agreement.[15]

To be sure, the Chief Justice would disagree with this analysis. He argues that it is easier (or, to use his jargon, it would reduce “contracting costs”) to contractually recreate fiduciary duties in a world where no fiduciary duties is the default (i.e., Chief Justice Steele’s preferred world) than to selectively eliminate limited aspects of fiduciary duties in a world where fiduciary duties are the default (i.e., the world in which we currently live).[16] But it is not clear that this is true.[17] In a world where fiduciary duties apply as the default, parties wishing to retain only a discrete aspect of the fiduciary duties (for example, a restriction on self-dealing transactions) may simply contractually eliminate all fiduciary duties (which Chief Justice Steele agrees may be achieved “at little cost”[18]) and then draft an explicit contractual provision prescribing the specific conduct that default fiduciary principles would otherwise normally prescribe (which Chief Justice Steele also suggests would be simple to draft[19]). Although the Chief Justice raises the concern that such provisions will “necessarily appear contradictory,”[20] LLC and LP agreements eliminating all fiduciary duties but also restricting self-dealing transactions are quite common, and there is little reason to believe the Delaware courts would have trouble interpreting such agreements.[21] Thus, it seems that regardless of the default rule, if the default rule is undesirable, sophisticated parties can and will readily contract to avoid it.

De Facto Rules for Passive Investors

In contrast to LLCs and LPs bargained for by sophisticated parties, Chief Justice Steele excludes from his analysis LLCs and LPs that involve passive (possibly unsophisticated) investors, who purchased or otherwise acquired their units and were not involved in the formation or negotiation of the firm’s governing agreement.[22] Perhaps because such firms bear closer resemblance to public corporations,[23] Chief Justice Steele would retain fiduciary duties as a default for such firms.

But even if default rules continue to apply fiduciary duties to LLCs and LPs that involve passive investors, such rules will be largely irrelevant. This is because LLCs and LPs with passive investors still retain the statutory freedom to contract out of the default rules,[24] and evidence suggests that almost all such entities actually do.[25] In a study forthcoming in the Journal of Corporation Law, I find that 88% of all publicly traded Delaware LLCs and LPs—firms that have sold units to disaggregated, largely passive public investors—have either entirely waived all fiduciary duties owed to investors or eliminated any liability arising from the breach of such duties.[26] This finding is perhaps unsurprising given that for publicly traded LLCs and LPs, the firm’s governing agreement is not the product of a give-and-take bargaining process between the firm and sophisticated investors sitting around a negotiating table, but rather drafted exclusively by the firm’s promoters and offered to public investors on a take-it-or-leave-it basis. And although my results are limited to the relatively few extant publicly traded Delaware LLCs and LPs, it is not unreasonable to believe that private LLCs and LPs with passive investors eliminate fiduciary duties with similar frequency.

Thus, even putting aside the problems of bifurcating default rules for sophisticated and unsophisticated parties that attorney Callison and Dean Vestal have noted,[27] the ultimate default rules in this context prove largely irrelevant. Given the statutory freedom of contract to deviate from default rules, LLCs and LPs with passive investors regularly eliminate fiduciary duties. In this sense, debating whether fiduciary duties should apply as a default in the context of LLCs and LPs with passive investors is like debating whether the fiduciary duty of care should apply as a default in the context of public corporations. The debate is largely academic: in practice, the de jure default rule applying such duties has been all but replaced with a de facto practice eliminating the same.[28]

Limited Practical Relevance for Delaware

So, for whom are Delaware’s default rules regarding fiduciary duties relevant? Perhaps it is those Delaware residents—those “mom and pop” businesses, as Professor Kleinberger describes them[29]—who may be legally unsophisticated but desire to use the LLC form to obtain limited liability and pass-through partnership tax treatment for their small business. Such “users” of Delaware LLC law may be unaware of Delaware’s default rules or lack the resources to competently tailor a governing agreement to contractually alter any undesirable aspects of the default rules. And, to the extent one believes that most of these unsophisticated business owners would prefer a regime in which fiduciary duties apply, adopting Chief Justice Steele’s interpretation of Delaware law could create undesired consequences.

But even if the Chief Justice’s preferred default rules would harm unsophisticated “mom and pop” businesses, as various practitioners and academics have suggested,[30] note that in Delaware, a state that is largely a haven for attracting out-of-state alternative entity charters,[31] where the ratio of LLCs to actual residents will soon approach one-to-one,[32] it is unlikely that a significant percentage of Delaware’s 550,238 LLCs fall into the unsophisticated “mom and pop” category.[33] Thus, if Chief Justice Steele’s interpretation of Delaware LLC and LP law is in fact problematic, the problem it creates affects only a narrow slice of the Delaware alternative entity universe. And it is this small population that the new debate as to fiduciary defaults is all about.

 

Preferred citation: Mohsen Manesh, What is the Practical Importance of Default Rules under Delaware LLC and LP Law?, 2 Harv. Bus. L. Rev. Online 121 (2012), https://www.hblr.org//?p=1828.

* Assistant Professor, University of Oregon School of Law. This essay is based on the author’s comments prepared for an online symposium entitled “Default Fiduciary Duties in LLCs and LPs” sponsored by The Institute of Delaware Corporate & Business Law, at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/.

[1] Under Delaware’s corporate statute, corporations may eliminate managerial liability arising from breaches of the fiduciary duty of care and carve out limited exceptions to the corporate opportunity doctrine. Del. Code Ann. tit. 8, §§ 102(b)(7), 122(17) (2011). Corporations, however, cannot eliminate the fiduciary duty of loyalty; cannot eliminate the corporate opportunity doctrine altogether; cannot insulate all interested transactions from exacting entire fairness review; cannot eliminate so-called Revlon duties; and cannot protect managerial decisions from judicial scrutiny under the intermediate Unocal standard of review. See, e.g., Del. Code Ann. tit. 8, §§ 102(b)(7) (prohibiting charter provisions that limit or eliminate the fiduciary duty of loyalty); Sutherland v. Sutherland, 2009 WL 857468, at *4 (Del. Ch. Mar. 23, 2009) (noting that “[w]hile such a provision [limiting the fiduciary duty of loyalty] is permissible under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, where freedom of contract is the guiding and overriding principle, it is expressly forbidden by the [Delaware corporate statute]”); In re Cox Commc’ns, Inc. S’holders Litig, 879 A.2d 604, 614-18 (Del. Ch. 2005) (explaining Delaware law requires entire fairness review of all cash-out mergers involving a controlling shareholder); Paramount Commc’ns, Inc. v. QVC Network, Inc. 637 A.2d 34, 51 (Del. 1994) (noting that a corporation may not contractually limit a corporate fiduciary’s Revlon duties).

[2] See, e.g., Paige Cap. Mang., LLC v. Lerner Master Fund, LLC, 2011 WL 3505355, *31 (Del. Ch. Aug. 8, 2011) (holding that “[a]s a matter of default law, [the] General Partner clearly owes fiduciary duties to the limited partners” unless the limited partnership agreement waives such duties); Kelly v. Blum, 2010 WL 629850, *10 (Del. Ch. Feb. 24, 2010) (noting that “default fiduciary duties apply” under Delaware LLC law “unless the LLC agreement . . . explicitly expands, restricts, or eliminates [such] duties); Bay Center v. Emery Bay PKI, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009) (“The Delaware LLC Act gives members of an LLC wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties.  But, in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional fiduciary duties . . . .”).

[3] Del. Code Ann. tit. 6, §§ 17­-1101(d) (2011) (applying to LPs); id. 18­-1101(c) (applying to LLCs).

[4] See generally Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009).

[5] See supra note 2.

[6] For example, in the recent case William Penn Partnership v. Saliba, 13 A.3d 749, 256 (Del. 2011), the Delaware Supreme Court, per Chief Justice Steele, applied default fiduciary duties in an LLC dispute but only after noting the litigants had stipulated that such duties apply. In a subsequent interview, the Chief Justice confirmed that his ruling in William Penn did not address the question of whether fiduciary duties would apply in the absence of the parties’ agreement that such duties apply and that that “unresolved issue [has] never been squarely decided by the Delaware Supreme Court.” See Practical Law the Journal, Q&A with Chief Justice Myron T. Steele of the Delaware Supreme Court, Dec. 1, 2011, at http://usld.practicallaw.com/3-515-1049.

[7] For a short summary of this debate, see Part I.B. of the forthcoming article Mohsen Manesh, Contractual Freedom under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs, 36 J. Corp. L. (forthcoming 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1939920.

[8] For example, in December 2011, the Institute of Delaware Corporate & Business Law sponsored an online symposium on this subject entitled “Default Fiduciary Duties in LLCs and LPs,” available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/.

[9] See generally Larry E. Ribstein, The Rise of the Uncorporation (2010); Mohsen Manesh, Legal Asymmetry and the End of Corporate Law, 34 Del. J. Corp. L. 465 (2009); Tom Lauricella & Carolyn Cui, Frenzy in Energy Partnerships, Investors Stick Billions of Dollars Into a Stock-Market Niche Known as MLPs, Wall St. J. (Aug. 10, 2010).

[10] See Bruce Kobayashi & Larry E. Ribstein, Delaware for Small Fry: Jurisdictional Competition for Limited Liability Companies, 2011 U. Ill. L. Rev. 91, 116 (finding that among closely held LLCs with 50 or more employees that form outside of their home state, more than 61% are formed under Delaware law); Jens Dammann & Matthias Schundeln, Where are Limited Liability Companies Formed? An Empirical Analysis (June 28, 2010) p.3, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1633472 (finding that among closely held LLCs with 5,000 or more employees that form outside of their home state, more than 95% are formed under Delaware law); see also Mohsen Manesh, Delaware and the Market for LLC Law: A Theory of Contractibility and Legal Indeterminacy, 52 B.C. L. Rev. 189, 201-02 (2011) (finding that every LLC filing for or completing an initial public offering during a recent 6 year period was organized under Delaware law); Manesh, Legal Asymmetry, supra note 9, at 476 (finding that every LLC and LP filing for or completing an initial public offering during a recent three-plus year period was organized under Delaware law); Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7, at Appendix A (noting that every publicly traded LLC and LP organized under domestic law, save one, is organized in Delaware).

[11] See Steele, supra note 4, at 225, 241 n.71.

[12] Likewise, elsewhere in the article, the Chief Justice argues that

In determining which default duties should apply, courts seeking to adopt economically sensible default duties might begin by considering whether the parties to an LLC would provide for fiduciary duties if they had bargained over all of the risk. . . . To help answer this question, it is important to note that sophisticated parties bargain for the obligations and duties provided in an LLC agreement. The choice of the LLC form was an intentional form, chosen by sophisticated parties because that form provides the contracting parties with the maximum ability to customize their relationship. Understanding this key difference between LLCs and corporations points us away from adopting default corporate-like fiduciary duties and, instead, applying only Delaware’s default contractual duties. . . .

Id. at 237.

[13] See Del. Code Ann. tit. 6, § 17­-1101(c) (governing LPs) (2011); id. § 18­-1101(b) (governing LLCs).

[14] For examples of LLC agreement provisions eliminating all fiduciary duties see Fisk Ventures, LLC, 2008 WL 1961156, *11 (Del. Ch. May 7, 2008), aff’d, 984 A.2d 124 (Del. 2009) (interpreting the following provision to eliminate all fiduciary duties of LLC members: “No Member shall have any duty to any Member of the Company except as expressly set forth herein or in other written agreements.”); In re Atlas Energy Resources LLC, 2010 WL 4273122, *12 (Del. Ch. Oct. 28. 2010) (interpreting the following provision to eliminate all fiduciary duties of officers and directors in a manager-managed LLC: “Except as expressly set forth in this Agreement or required by law, none of the Directors, nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Company or any Member.”).

[15] See Steele, supra note 4, at 240 (“[I]f we proceed from a baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved—without much cost.”). For an example of a LLC agreement provision that creates corporate-like fiduciary duties by reference, see Och-Ziff Capital Management Group LLC, Second Amended and Restated Limited liability Company Agreement, in Annual Report (Form 10­K), exhibit 3.2, § 5.23 (Nov. 13, 2007), available at http://www.sec.gov/Archives/edgar/data/1403256/000119312508064885/dex32.htm (“Except as otherwise expressly set forth in this Agreement or required by the Delaware Act, (i) the duties and obligations owed to the Company by the Officers and Directors shall be the same as the duties and obligations owed to a corporation organized under DGCL by its officers and directors, respectively, and (ii) the duties and obligations owed to the Members by the Officers and Directors shall be the same as the duties and obligations owed to the shareholders of a corporation under the DGCL by its officers and directors, respectively.”).

[16] See Steele, supra note 4, at 240-41.

[17] Attorney Callison and Dean Vestal make a similar claim to support their view that fiduciary duties should apply as a default. See J. William Callison & Allan W. Vestal, “Triple Error: Chief Justice Steele and Default,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/j-william-callison-and-allan-w-vestal-triple-error-chief-justice-steele-and-default/ (“[B]ased on our experience, we do not think it is apparent that starting with a panoply of default duties and then contracting for modification or elimination of those duties is more difficult th[a]n starting with a blank slate and drafting a full set of duties.”).

[18] See Steele, supra note 4, at 240 (“I agree that a wholesale elimination of duties in an LLC agreement comes at little cost. . . .”).

[19] Id. (“If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft. . . .”).

[20] Id.

[21] For example, in In re Atlas Energy Resources LLC, 2010 WL 4273122 (Del. Ch. Oct. 28. 2010), Vice Chancellor Noble held that the LLC agreement at issue eliminated all common law fiduciary duties of the LLC’s officers and directors, but replaced such duties with a contractually defined fiduciary duty of good faith. Id. at *12. In dismissing the complaint against the defendant officers and directors, the Vice Chancellor noted that “[a]lthough Plaintiffs accuse certain defendants of conduct that might constitute breach of traditional fiduciary duties, they do not allege that the Individual Defendants engaged in conduct [violating the contractually defined duty of good faith].” Id. at *15.

[22] See Steele, supra note 4, at 241 n. 71.

[23] See Manesh, Legal Asymmetry, supra note 9, at 483-488 (describing the ways in which publicly traded LLCs and LPs are indistinguishable from their corporate counterparts).

[24] See Del. Code Ann. tit. 6, § 17­-1101(c) (governing LPs) (2011); id. § 18­-1101(b) (governing LLCs).

[25] See generally Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7.

[26] Id. at Part III.A.

[27] See Callison & Vestal, supra note 17; see also Lyman Johnson, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/lyman-johnson/.

[28] Compare Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7 (finding that 88% of all publicly traded Delaware LPs and LLCs have either eliminated all fiduciary duties or eliminated any liability arising from the breach of any fiduciary duties) with J. Robert Brown, Jr. & Sandeep Gopalan, Opting Only In: Contractarians, Waver of Liability Provision, and the Race to the Bottom, 42 Ind. L. Rev. 285 (2009) (finding that all but one corporation in the Fortune 100 have provisions eliminating liability for breaches of the fiduciary duty of care).

[29] Daniel S. Kleinberger, “Why Justice Cardozo Was Right, and Chief Justice Steele Is Wrong,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/?page_id=335&preview=true. Note, it is unlikely that unsophisticated out-of-state mom-and-pop business would reach to Delaware LLC law—rather than the law of their home state—to organize a small business.

[30] See Callison & Vestal, supra note 17 (“In our view, it is unlikely that 112,000 new [Delaware] LLCs involved sophisticated parties with the resources to enter customized governance structures, just as it is unlikely that the LLC form was chosen because it provides parties with the maximum ability to customize their relationship.”); Kleinberger, supra note 29 (“Presumably, Delaware LLCs are the vehicle of choice not only for the sophisticated venturers from throughout the world but also myriad local (Delaware-based) ‘mom and pop’ entrepreneurs … many of [whom] are outside the Chief Justice’s assumptions.”); John Cunningham, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/john-cunningham-dec-9-2011/ (“It seems clear that the Chief Justice meant the article to apply to what, in practice, is only a minute percentage of actual Delaware LLCs.”).

[31] See supra note 10.

[32] As of 2010, the population of natural persons in Delaware was 897,934, up from 783,600 in 2000, See U.S. Census Bureau, Delaware QuickFacts (2010), available at http://quickfacts.census.gov/qfd/states/10000.html. At the same time, at the end of 2010, Delaware was home to 550,238 LLCs, with 82,027 new LLCs formed during 2010 alone. See A. Gilchrist Sparks, “Legislative Developments in Delaware’s “Alternative Entities”, Harvard Law School Forum on Corporate Governance and Financial Regulation, at http://blogs.law.harvard.edu/corpgov/2011/09/08/legislative-developments-in-delaware%E2%80%99s-%E2%80%9Calternative-entities%E2%80%9D/.

[33] See Robert B. Thompson, Allocating the Roles for Contracts and Judges in the Closely Held Firm, 33 W. New Eng. L. Rev. 369, 401 (2011) (pointing to anecdotal data that suggests Delaware law attracts a specific subset of the LLC marketplace, namely sophisticated parties who are willing and able to contract around statutory defaults).

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Dodd-Frank, Compensation Ratios, and the Expanding Role of Shareholders in the Governance Process

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J. Robert Brown, Jr.*

I. Introduction

Congress, in adopting the Dodd-Frank Act,[1] sought to correct some of the abuses believed to have contributed to the financial crisis of 2008-2009.  Executive compensation was one of them.  Formulas used to determine compensation were thought to promote a short-term perspective that encouraged excessive risk taking.[2]  As a result, financial regulators were given the authority to review compensation practices for risk.[3]  Likewise, the Act sought to strengthen the integrity of the compensation approval process[4] and to increase clawbacks of performance-based compensation following certain restatements.[5]

Not all compensation provisions, however, were designed to address risk.  Some were inserted in an effort to expand the role of shareholders in the governance process.  Addressed primarily under the rubric of fairness,[6] the Act gave shareholders an advisory vote on executive compensation.[7] At the same time, Dodd-Frank expanded the information available to shareholders making the determination.  Specifically, Section 953(b) required disclosure of a ratio that compared CEO and employee compensation.[8]  Although hardly noticed at the time of adoption, the provision eventually generated considerable controversy and engendered serious calls for repeal within Congress.

This article will do several things.  First, it will examine the role of compensation ratios in the debate over executive compensation.  Second, the article will discuss Section 953(b), including the broad regulatory authority retained by the Securities and Exchange Commission (“SEC” or “Commission”) in implementing the provision.  Finally, the article will analyze the current controversy surrounding the provision.

II. Compensation and Ratios

Ratios have long been part of the debate over executive compensation.  They typically rely on average CEO compensation as the numerator and average employee compensation as the denominator.  In general, they have been used to show the relative increase of CEO compensation over time.[9]

Ratios, however, have not been a particularly useful metric for shareholders.  For one thing, they are not computed on a company-specific basis.  For another, they are not determined in a consistent fashion.  While average CEO compensation can, for the most part, be computed on a uniform basis,[10] there is considerable variance with respect to employee compensation.  Ratios may rely on the amount paid to the “average production worker”[11] or “private sector” employee.[12]  Some look to the minimum wage.[13]  They can exclude particular sub-categories of employees[14] or resort to medians rather than means.[15]

The lack of consistency and the absence of firm specific data minimize the ability to use the metric to assess CEO compensation within a particular company.  Thus, while they can demonstrate broad trends in compensation, they have not been particularly helpful in providing shareholders with a tool for assessing the reasonableness of compensation in their own company.

III. Dodd Frank and Compensation Ratios

Sponsored by Senator Menendez of New Jersey and originally part of separate legislation,[16] the requirement to disclose compensation ratios was inserted into the Senate version of Dodd-Frank during committee deliberations.  Apparently a late addition, the provision generated no meaningful legislative history.[17]

The requirement addressed many of the concerns that limited the value of compensation ratios to shareholders.  Section 953(b) of Dodd-Frank imposed a mandatory formula for calculating the statistic.[18]  Moreover, it provided for the determination of ratios on a company-specific basis and mandated the use of medians rather than averages.[19]  Implementation was, however, accomplished in a highly complicated fashion.  Rather than simply require disclosure of the ratios, the provision in three instances cross-referenced or incorporated portions of existing regulations.  The result was substantial discretion on the part of the SEC in implementing the requirement.

Specifically, Section 953(b) provided that ratio disclosure must appear in Item 402 of Regulation S-K (or its successor),[20] the SEC provision defining executive compensation.[21]  In effect, Congress opted to write a portion of Item 402, transforming a regulation into a statute.[22]  As a consequence, the Commission could amend or rewrite Item 402 with respect to most compensation matters but, once implemented, could not eliminate ratio disclosure.

Congress also referred to SEC regulations in defining the breadth of the disclosure requirement.  Section 953(b) provided that ratio disclosure was to appear “in any filing of the issuer described in section 229.10(a).”[23]  Because Item 10(a) referred to periodic reports, the reference suggested that the ratios were to be disclosed on a quarterly if not more frequent basis.[24]  Congress, however, left the Commission with the discretion to reduce the frequency through amendments to Item 10.[25]  Deletion of the words “or other” after “annual report” in Item 10 would eliminate the ratios from all periodic reports except the Form 10-K, effectively requiring only annual disclosure of the information.[26]

Finally, Section 953(b) prescribed the method for calculating employee compensation by referencing Item 402(c)(2)(x), the subsection that defined the CEO’s total compensation.[27]  Congress specifically limited the SEC’s authority to change the formula by requiring application of the standard “in effect on the day before the date of enactment of this Act.”[28]  The SEC nonetheless retained considerable discretion over the formula.  The reference to Item 402 specified the categories of compensation that were to be considered[29] but did not prescribe the method of calculating the categories.  That was left to the administrative discretion of the SEC.[30]

The provision, therefore, provided a broad role for the SEC in developing and applying ratio disclosure.  The SEC retained the authority to determine the frequency of ratio disclosure and the method used to calculate employee compensation.

IV. The Ongoing Debate

The imposition of ratio disclosure caused little controversy during the debate over Dodd-Frank.  As implementation approached, however, vigorous opposition developed over the merits of the provision.[31]  Critics asserted that calculation of median compensation for employees would be costly[32] and logistically difficult. [33] In addition, they challenged the value of the information, asserting in part that the ratios did not provide a meaningful basis for comparison.[34]

The concerns attracted attention in Congress.  The Burdensome Data Collection Relief Act called for the repeal of Section 953(b) in its entirety.[35]  On June 22, 2011, the House Financial Services Committee approved the legislation by a vote of 33-21.  The accompanying report reiterated the concerns about the immateriality of the information and the burdensome nature of the calculation.[36] Attempts in the committee to rewrite Section 953(b) to simplify the formula and limit the frequency of disclosure were defeated.  While the matter has not yet passed the House, opposition in the Senate has surfaced.[37]

V. Compensation Ratios Going Forward

Most of the concerns expressed over ratio disclosure can be fixed in the rulemaking process,[38] something that the SEC has indicated will occur before the end of 2011.[39]  As discussed, the SEC has considerable flexibility to limit the frequency of disclosure.[40]  Likewise, while Congress prescribed the categories used in determining employee compensation, the SEC retains broad discretion to determine how these categories are calculated.[41]  As for the treatment of part-time and overseas workers, there may be little administrative discretion over the issue.[42]

With respect to the materiality of the information, ratios have particular importance in the era of “say on pay.”  An advisory vote on compensation gives shareholders an opportunity to comment on the reasonableness of CEO pay.  Reasonableness, however, requires context.  Metrics that allow for a comparison of pay practices among public companies can assist in providing the requisite context.[43]  Moreover, the ratios provide a mechanism for the first time for assessing the reasonableness of the compensation within each particular company.[44]

Variations in the ratio that arise from differences in business models or geographic reach can be addressed through accompanying  disclosure.  Companies can explain the relevant differences through the use of narrative and additional ratios.  Moreover, such information will likely have the benefit of providing shareholders with additional insight into the calculation of CEO compensation and the company’s employment practices.[45]

The most significant impact of the ratio may, however, be on the board of directors.  The disclosure requirement effectively increases the information available to boards when setting executive pay.  Some boards already take ratios into account when determining compensation.[46]  Because a bad ratio may be embarrassing,[47] the board has an incentive to alter compensation in order to avoid adverse disclosure.[48]  Disclosure of the ratio may, therefore, impact the amount of compensation paid to employees and the CEO.[49]

VI. Conclusion

Ratio disclosure raises some legitimate logistical concerns over the method of computation and the frequency of disclosure.  Most can be addressed and resolved by the SEC during the authority process.  The addition of ratio disclosure, when coupled with say on pay, provides shareholders with a more meaningful ability to participate in the compensation process.

 

Preferred citation: J. Robert Brown, Jr., Dodd-Frank, Compensation Ratios, and the Expanding Role of Shareholders in the Governance Process, 2 Harv. Bus. L. Rev. Online 91 (2011), https://www.hblr.org//?p=1751.
* J. Robert Brown, Jr. is a Professor of Law and Director of the Corporate-Commercial Law Program at the University of Denver Sturm College of Law.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (“Dodd-Frank” or “the Act”).
[2] S. Rep. No. 111-176 (2010), available at http://thomas.loc.gov/cgi-bin/cpquery/?&item=&&sid=cp111FTCKo&&refer=&&r_n=sr176.111&&dbname=cp111&&sid=cp111FTCKo&&sel=TOC_446491&&sid=cp111FTCKo&r_n=sr176.111&dbname=cp111& (noting that legislation addresses “executive compensation practices that promoted excessive risk-taking”).
[3] See Dodd-Frank Act § 956.  Even before the adoption of Dodd-Frank, the SEC required disclosure by public companies of relationship between compensation policies and risk.  See Regulation S-K, 17 C.F.R. § 229.402(s) (2011). The provision was adopted in 2009.  See Proxy Disclosure Enhancements, Exchange Act Release No. 61175 (Dec. 16, 2009).
[4] Dodd-Frank Act § 952.  The SEC has proposed implementing rules with respect to these requirements.  See Listing Standards for Compensation Committees, Exchange Act Release No. 64149 (March 30, 2011).
[5] Dodd-Frank Act § 954.
[6] S. Rep. No. 111-176, supra note 3 (“Congress is empowering shareholders in a public company to have a greater voice on executive compensation and to have more fairness in compensation affairs.”).
[7] Dodd-Frank Act § 951.
[8] Dodd-Frank Act § 953.
[9] Indeed, for the most part, ratios have shown a substantial growth in CEO compensation compared to employees.  See Joel Seligman, Rethinking Private Securities Litigation, 73 U. Cin. L. Rev. 95, 114 (2004) (“These decisions coincided with a dramatic increase in the ratio of the compensation of the corporate CEO to that of the average corporate blue collar employee.  In 1980, this ratio was 42 to 1; by 1990, it had grown to at least 120 to 1; by 2000, it was estimated to be at least 475 to 1.”).  See also Jeffrey N. Gordon, Essay: “Say on Pay”: Cautionary Notes on the UK Experience and the Case for Shareholder Opt-In, 46 Harv. J. on Legis. 323 (2009) (“By the mid-2000s the changing ratio in the compensation level of CEO versus line-worker–from 20-1 in the 1950s to a purported approximate of 350-1 today–created controversy in the political realm as well as the boardroom.”).  For an example of ratios used to show increasing CEO compensation outside the United States, see The High Pay Commission, Interim Report: More for Less: What Has Happened to Pay at the Top and Does It Matter? (2011), available at http://highpaycommission.co.uk/wp-content/uploads/sites/18/2011/09/HPC-IR.pdf.
[10] Companies must disclose total compensation for the CEO using a common formula.  See Regulation S-K, 17 C.F.R. § 229.402 (2011).  Nonetheless, variations exist.  Ratios used an average of CEO compensation, something that could vary depending upon the group selected.  See Sarah Anderson, Eric Benjamin, John Cavanagh, & Chuck Collins, Institute for Policy Studies, Executive Excess 2006: Defense and Oil Executives Cash in on Conflict, available at http://www.faireconomy.org/files/ExecutiveExcess2006.pdf (average CEO compensation for 350 companies with revenues above $1 billion).  Likewise, administrative changes to the formula used for calculating CEO compensation could alter ratios over time.  See Executing Compensation and Related Person Disclosure, Exchange Act Release No. 54302A (August 26, 2006).
[11] See Economic Policy Institute, More Compensation Heading to the Very Top, http://www.stateofworkingamerica.org/files/images/orig/8-Wages_ceo_pay.png (last visited Oct. 6, 2011).
[12] See Anderson, et al., supra note 11 (average pay for private sector workers in 2005 as determined by U.S. Department of Labor, with average including part-time employees).  Others have referred to the compensation paid to the “average” worker.  See Lawrence Mishel, CEO-to-Worker Pay Imbalance Grows, Economic Policy Institute (June 21, 2006), available at http://www.epi.org/economic_snapshots/entry/webfeatures_snapshots_20060621/.
[13] See Heritage Institute, Spotlight on CEO Compensation, available at http://www.heritageinstitute.com/governance/compensation.htm#The_Ratio_of_Average_CEO_and_Worker (last visited Oct. 6, 2011).
[14] Larry Bumgardner, High CEO Pay Could Draw Renewed Attention in Election Year, 11 Graziadio Bus. Rev. (2008), available at http://gbr.pepperdine.edu/2010/08/high-ceo-pay-could-draw-renewed-attention-in-election-year (“One could plausibly argue that the ratio is likely overstated somewhat by including only 350 large companies for CEO pay, and by considering part-time employees in the average worker calculation.”).
[15] Frederic W. Cook, The Business Roundtable, Research on CEO Compensation for Business Roundtable (2006), available at http://www.shrm.org/hrdisciplines/compensation/Documents/20060705002ExecutiveCompensationResearch_FWC_62906.pdf (noting that with respect to an average, “outliers pull the averages up above the median” and that “[m]edian statistics are more representative of the practices of a large group”).  While most compensation ratios used averages, at least one study relied upon the median and produced a substantially lower ratio.  See Bumgardner, supra note 15 (“By contrast, a separate study released in 2006 by a CEO group, the Business Roundtable, concluded that the ratio was starkly lower-179 to 1.”).
[16] The legislation was the Committee on Banking, Housing, and Urban Affairs.
[17] The only mention of the provision in the Senate Report accompanying the legislation was a brief reference by the minority.  See S. Rep. No. 111-176, supra note 3 (“Although provisions like this appeal to popular notions that chief executive officer salaries are too high, they do not provide material information to investors who are trying to make a reasoned assessment of how executive compensation levels are set. Existing SEC disclosures already do this.”).  See also 156 Cong. Rec. S4075 (daily ed. May 20, 2010)  (statement of Sen. Shelby) (“The grab bag includes puzzling items, like a . . . provision that requires disclosure of the ratio of the median employee’s compensation to the chief executive officer’s compensation.  It looks to me like the way is being paved to achieve so-called ‘social justice’ in income distribution.  This is another disturbing example of the government getting its nose under the private sector’s tent.”).
[18] Dodd-Frank Act § 953(b).
[19] Id. (“[T]he median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer”).  Interestingly, calculation of the median cannot include CEO compensation.  The elimination of a single person from the determination of the median is not likely to have any meaningful effect on the calculation.  The same would not be true had employee compensation been computed based upon averages.
[20] See id. (“The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer to disclose in any filing of the issuer described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)”).
[21] 17 C.F.R. § 229.402.
[22] Regulations affirmed in legislation are elevated to the status of law.  Smith v. Whitney, 116 U.S. 167, 181 (1885) (“This legislative recognition of the Navy Regulations of 1870 ‘must,’ as was said by Chief Justice Marshall of a similar recognition of the Army Regulations in the act of April 24, 1816, ch. 69, § 9, 3 Stat. 298, ‘be understood as giving to these regulations the sanction of the law.’”).
[23] 17 C.F.R. § 229.10(a).
[24] Disclosure in multiple filings does not necessarily require multiple calculations.  The SEC could require a single calculation but mandate that the same calculation appear in an assortment of filings (perhaps through incorporation by reference).
[25] Where Congress did not intend for the SEC to have the authority to amend the applicable language, it said so.  See infra note 31.
[26] See 17 C.F.R. § 229.10(a)(2) (applying Regulation S-K to “annual or other reports under sections 13 and 15(d)”).  The savings clause contained in Item 10(a) would prevent the amendment from having any effect on the applicability of Regulation S-K to quarterly and current reports.  See 17 C.F.R. § 229.10(a) (providing that Regulation S-K applied to “any other document required to be filed under the Exchange Act, to the extent provided in the forms and rules under that Act.”).  So long as the forms for quarterly and current reports provide for the applicability of Regulation S-K, it would apply even if unmentioned in Item 10(a).
[27] The statute specifically requires application of Item 402(c)(2)(x) of Regulation S-K.  17 C.F.R. § 229.402(c)(2)(x).
[28] Dodd-Frank Act § 953(b) (“For purposes of this subsection, the total compensation of an employee of an issuer shall be determined in accordance with section 229.402(c)(2)(x) of title 17, Code of Federal Regulations, as in effect on the day before the date of enactment of this Act.”).  The Commission could, therefore, amend the provision and change the method used to calculate total compensation for top executive officers.  The amendment would not, however, apply to the calculation of the median compensation paid to employees.
[29] See 17 C.F.R. § 229.402(c)(2)(x).  The seven categories are salary, bonus, stock awards, stock options (with both stock awards and stock options measured by their value on the award date), other incentive pay, changes in pension value and other deferred compensation, and all other compensation.
[30] Thus, for example, 17 C.F.R. § 229.402(c)(2)(ix) provides that perquisites are included in CEO compensation only if they exceed $10,000.  The SEC could impose similar thresholds throughout the other categories, effectively limiting employee compensation to the amounts paid in cash.
[31] Although not proposing rules to implement ratio disclosure, the SEC did invite comments.  See http://www.sec.gov/comments/df-title-ix/executive-compensation/executive-compensation.shtml.
[32] See Center on Executive Compensation, The Dodd-Frank Pay Ratio Is Unduly Burdensome and Contrary to Sound Disclosure Policy, Hearing on Legislative Proposals to Promote Job Creation, Capital Formation, and Market Certainty Subcommittee on Capital Markets and Government Sponsored Enterprises House Committee on Financial Services (March 16, 2011), available at http://www.hrpolicy.org/downloads/2011/c11-34%20House%20Fin%20Svcs%20Cmt%20Testimony%20March%2016%202011%20FINAL.pdf.
[33] See Letter from Retail Industry Leaders Association (Oct. 27, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-43.pdf; Letter from Center on Executive Compensation (Sept. 1, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-10.pdf.  One solution might be the use of sampling.  See Letter from Center on Executive Compensation (Aug. 11, 2011), available at http://aflcio.org/corporatewatch/capital/upload/AFL-CIO-Comment-Letter-on-Dodd-Frank-Section-953-b.pdf
[34] Letter from Center on Executive Compensation, supra note 34.  See also Brett Harsen, Matt Ward, & Ted Buyniski, Dodd-Frank Act: The Importance of Putting CEO Pay Multiples into Context 1 (Radford), available at http://www.globalequity.org/geo/sites/default/files/Radford_Whitepaper_DoddFrank_CEO_Pay_Multiples.pdf (“A company involved only in semiconductor chip design will have a much lower CEO pay multiple than a similar entity that designs and fabricates the chips because the latter has a large workforce of lower-paid manufacturing workers. A company that has moved a segment of its workforce to lower cost countries will have a higher CEO pay multiple than one whose workforce is based solely in the United States.”).  Some have described the ratio as “overly simplistic.” Id.
[35] Burdensome Data Collection Relief Act, H.R. 1062, 112th Cong. (2011).
[36] See H.R. Rep. No. 112-142 (2011), available at http://financialservices.house.gov/UploadedFiles/HR1062hreport.pdf.  An amendment designed to fix the major concerns over the calculation of the ratio was defeated by a 27-25 vote.  Id. at 4.
[37] U.S. Senators Robert Menendez (D-NJ), Tom Harkin (D-IA), Sherrod Brown (D-OH), and Carl Levin (D-MI) sent a letter to Charles G. Tharp, CEO of Center on Executive Compensation, urging the organization to reconsider its position and to “stop shielding your member companies from revealing this basic information.”  Letter to Charles G. Tharp (Jul. 6, 2011), available at http://menendez.senate.gov/download/?id=c374a0b8-8413-4bab-a4a7-dd54ce712aff.
[38] At least one company has already disclosed a compensation ratio.  See MBIA Inc., Proxy Statement (Form DEF 14A) (filed March 18, 2011) (“The average and median salary for all employees other than the NEOs (385 employees) were $151,700 and $130,000, respectively. The average and median salary and bonus for all employees were $223,000 and $165,000, respectively. These compare to Mr. Brown’s salary of $500,000 (3.3 times average and 3.9 times median) and salary and bonus of $2,300,000 (10.3 times average and 14.0 times median) for 2010.”), available at  http://www.sec.gov/Archives/edgar/data/814585/000119312511070813/ddef14a.htm.
[39] See Implementing Dodd-Frank Wall Street Reform and Consumer Protection Act — Upcoming Activity, www.sec.gov, http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml (last visited Oct. 11, 2011).
[40] See supra text accompanying notes 24-27.
[41] See supra text accompanying notes 29-33.  Others have suggested the use of sampling techniques.  See Letter from Meridian Compensation Partners (Oct. 19, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-49.pdf . See also Letter from Davis Polk (Nov. 16, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-51.pdf.
[42] See Letter from Senator Menendez (Jan. 19, 2011), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-59.pdf (“Specifically, I want to clarify that when I wrote ‘all’ employees of the issuer, I really did mean all employees of the issuer.  I intended that to mean both full-time and part-time employees, not just full-time employees.  I also intended that to mean all foreign employees of the company, not just U.S. employees.”).  The inclusion of part time workers and foreign workers in low wage countries will likely lower the median compensation paid to employees and increase the ratio.  See supra note 15.
[43] Shareholders can make comparisons based upon the total compensation paid to the CEO.  The utility of this statistic, however, is limited at least in part by the “Lake Wobegon” effect.  See Letter from Americans for Financial Reform to Elizabeth M. Murphy (Mar. 23, 2011), available at http://ourfinancialsecurity.org/blogs/wp-content/ourfinancialsecurity.org/uploads/sites/18/2011/03/AFR-SEC-953b-3-23-11.pdf (“Existing requirements mandate disclosure of top executive compensation only, encouraging companies to focus unduly on peer to peer comparisons when setting CEO pay. These comparisons help lead to ever increasing levels of CEO pay by virtue of a ‘Lake Wobegon’ effect, where nearly all CEOs claim to be above the average CEO quality level.”).
[44] By making shareholders better informed at the time they vote on compensation, they are in a position to give the board better “advice.”  See Shareholder Approval of Executive Compensation and Golden Parachute Compensation, Exchange Act Release No. 63768 n. 175 (Apr. 4, 2011) (“Even though each of the shareholder advisory votes required by Section 14A is non-binding pursuant to the rule of construction in Section 14A(c), . . . we believe these votes could play a role in an issuer’s executive compensation decisions.”).  Calls for the use of similar ratios have arisen overseas.  See Will Hutton, Hutton Review of  Fair Pay in the Public Sector: Final Report 8 (March 2011) (“The Government should not cap pay across public services, but should require that from 2011-12 all public service organisations publish their top to median pay multiples each year to allow the public to hold them to account.”), available at http://cdn.hm-treasury.gov.uk/hutton_fairpay_review.pdf.
[45] See Letter from Calvert Investment Management (May 27, 2011) (“Investors could use data on median pay to understand U.S. and global compensation trends, and to better understand issuer decisions to move certain operations and jobs overseas.”), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-75.pdf.
[46] See Whole Foods Market, Annual Report 7 (Form 10-K) (2011) (“We also have a salary cap that limits the total cash compensation paid to any team member in a calendar year to 19 times the average annual wage of all team members. In addition, our co-founder and co-chief executive officer, John Mackey, has voluntarily set his annual salary at $1 and receives no cash bonuses or stock option awards.”), available at http://www.sec.gov/Archives/edgar/data/865436/000110465910059917/a10-19737_110k.htm;  El Paso Corporation, Proxy Statement (Form DEF 14A) (2011) (“We also believe that our executive compensation program must be internally consistent in order to motivate our employees as a whole to create stockholder value. We are committed to internal pay equity and our Compensation Committee monitors, on an annual basis, the relationship between the compensation of our named executive officers and the compensation of our non-managerial employees.”), available at  http://www.sec.gov/Archives/edgar/data/1066107/000095012311030217/h80859ddef14a.htm.  See also James A. Cotton, Toward Fairness in Compensation of Management and Labor: Compensation Ratios, A Proposal for Disclosure, 18 N. Ill. U. L. Rev. 157, 183 (1997) (“At Ben & Jerry’s Homemade, Inc., in Waterbury, Vt., for example, top people get no more than seven times what the lowest-paid full-time person earns.”).
[47] Cotton, supra note 46, at 182 (ratio disclosure “[t]o a large extent . . . will embarrass [directors] into trying to do the right thing rather than face questions at the stockholders meeting or at a meeting of financial analysts. Embarrassment is a rather large factor among a group that considers itself to be as special as this one does.”).
[48] Menendez, supra note 38 (noting that disclosure will encourage “firms to take a harder look at the rising pay discrepancies between CEOs and their workers”).  The rules of the SEC are often designed to affect substantive behavior inside the boardroom.  See J. Robert Brown, Jr., Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure, 57 Cath. U. L. Rev. 45 (2008).
[49] The ratio can be reduced either by raising the median compensation paid to employees or lowering the total compensation paid to the CEO.