U.S. Supreme Court to Hear Case on Executive Compensation

Earlier this year, the U.S. Supreme Court agreed to hear an appeal of Jones v. Harris Associates L.P., 527 F.3d 627 (7th Cir. 2008). Perhaps the most notable aspect of the Seventh Circuit's decision/opinion in Harris Associates was Judge Posner's dissent from the Courts denial of rehearing en banc. Most of you know Judge Posner as an ardent supporter of free markets. However, in his dissenting opinion, he seemed to suggest support for the approach taken by the Second Circuit Court of Appeals in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.3d 923 (2d Cir. 1982).

The Harris Associates case involves payment to investment fund managers, which is not entirely analogous to executive compensation from corporations. However, Posner's withering dissent is particularly notable (ominous?) for the following two statements:

Gartenberg permits a court to consider, as a factor, in determining such a breach, whether the fee is "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."

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The panel based its rejection of Gartenberg mainly on an economic analysis that is ripe for reexamination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. . . . Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO. Compensation consulting firms, which provide cover for generous compensation packages voted by boards of directors, have a conflict of interest because they are paid not only for their compensation advice, but for other services to the firm—services for which they are hired by the officers whose compensation they advised on.

Again, this latter statement is particularly noteworthy, coming from the leading proponent of free markets in the judiciary.

At the risk of stating the obvious, let me be crystal clear about the potential importance of this case: The entire system of board responsibility and liability for executive compensation decisions, based on the business judgment rule as it now is, could be upended based on the Supreme Court's decision in this case. The Supreme Court has scheduled oral arguments in this case for November 2, 2009. Rest assured that this Blog will keep you apprised of developments in this case and analyze the Supreme Court's decision as soon as it is published.