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The Grasso Lawsuit’s Demise: Why Don’t Courts Decide Compensation?

Joseph Bachelder offers a detailed and insightful analysis of why Eliot Spitzer’s much ballyhooed excess compensation lawsuit against former NYSE CEO Richard Grasso fizzled in the NY courts. One of his theories takes a deeply Legal Realist approach:

One explanation may lie in the March 2008 downfall of Mr. Spitzer, the initiator of the litigation. His aggressive attacks on financial service companies and executives employed by them, for example, destroyed careers and cost some of those companies dearly. Mr. Spitzer’s personal downfall occurred in March 2008, while governor. No doubt, the continuance of this litigation, in a very troubled economic environment for the country, including financial centers like New York, must have seemed an especially undesirable legal intervention at this particular time.

Another is consistent with judicial review of corporate governance generally:

A second reason for the abrupt dispatch of the Spitzer/Grasso litigation certainly must have been the reluctance of courts to be the arbiters of reasonable compensation. ... Courts do not want to be involved in disputes over the size of pay. They will explain at length why they are unable to arbitrate such disputes based on principles such as those imbedded in the business judgment rule or, as in the Grasso case, based on their interpretation of a statute like the N-PCL. But after all the interpretation and elaboration, the real point seems to be that courts do not like deciding whether the size of executive pay in a particular case is reasonable.

The analogy he draws to the Disney litigation is apt.

Judicial reluctance to review executive pay makes perfect sense. Justice Jackson famously observed of the Supreme Court: “We are not final because we are infallible, but we are infallible only because we are final.” Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?

Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints are provided by a competition in a number of markets.  The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers.  Granted, only the most naïve would assume that these markets perfectly constrain director decisionmaking.  It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges.  As such, rational shareholders will prefer the risk of director error to that of judicial error. Hence, shareholders will want judges to abstain from reviewing board decisions.

Judicial review also threatens to deter boards from engaging in optimal risk taking. In theory, if judicial decisionmaking could flawlessly sort out sound decisions with unfortunate outcomes from poor decisions, and directors were confident that there was no risk of hindsight-based liability, the case for the business judgment rule would be substantially weaker.  As long as there is some non-zero probability of erroneous second-guessing by judges, however, the threat of liability will skew director decisionmaking away from optimal risk-taking.

The Grasso suit died because it never should have been brought in the first place.