Corporate Governance Failures: Codes Of Conduct That Require Automatic Pay Reductions

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Ties that Bind: Codes of Conduct that Require Automatic Reductions to the Pay of Directors, Officers, and Their Advisors for Failures of Corporate Governance

Greg Michael Zipes

Attorney, New York City

January 7, 2015

15 J. Bus. & Sec. L. 105 (2015)


Executives and directors at large corporations rarely face personal liability for failing to impose effective controls on subordinates or outside suppliers, even when this failure results in significant financial or reputational damage to the corporation. My proposal for binding codes of conduct seeks to change the dynamics of corporate governance. These executives and directors would agree to meet certain standards and further agree to automatic reductions in compensation if these standards are not met, regardless of whether there is an actual violation of the law.

Certain consumers and investors already send business to perceived “ethical” companies or companies that are known for having strong and effective management. Some executives and directors will therefore seek further business by agreeing to my proposed binding codes of conduct. Others will not adopt the codes. Consumers and investors will decide whether they care. My proposal is completely market-based, and requires no government intervention or changes to the law.

Ties that Bind: Codes of Conduct that Require Automatic Reductions to the Pay of Directors, Officers, and Their Advisors for Failures of Corporate Governance – Introduction

Executives and directors of large corporations often keep their jobs and their generous compensation packages even when their incompetence or lack of effective oversight of employees or suppliers leads to reputational damage, massive losses for a company, or even systemic harm to the national economy. This seems patently unfair, when a minimum wage employee would likely face immediate termination for lack of attentiveness or negligence.

The Caremark case, decided nearly 20 years ago, is illustrative. Caremark’s problems arose when it allegedly violated a law generally prohibiting kickbacks for referrals of Medicare or Medicaid business. In 1995, Caremark pleaded guilty to a single felony count of mail fraud and agreed to make various payments totaling approximately $250 million.

While Caremark paid a price, Caremark’s directors and officers emerged unscathed. A derivative action against Caremark’s directors for insufficient oversight was settled using corporate funds to pay the plaintiff shareholders’ legal fees.8 No directors had to pay out of their pockets. The Delaware Chancery Court reluctantly accepted the settlement, but not because the settlement paid too little, or did not target individual directors or officers. Instead, the court labeled the plaintiffs’ case against Caremark’s directors as “weak”9 and opined that “[i]f the directors did not know the specifics of the activities that lead to the indictments, they cannot be faulted.”

As will be described below, the law provides strong protections to directors and officers of large corporations in instances of lax oversight. Directors and executives typically must know about specific misconduct; having mere supervisory control when even massive criminal conduct occurs on their watch is not sufficient to impose personal liability.

Because of this reality, potential civil adversaries are often unwilling to take chances in litigating cases against directors and officers to their conclusion. When a corporation offers a large settlement to resolve shareholder litigation, plaintiffs are unlikely to quibble that the source of the settlement funds is from the corporation itself, or from an insurance carrier and not from the pockets of officers or directors.

Binding codes of conduct would change the current dynamics by holding chief executive officers and other senior corporate agents personally accountable for inadequate supervision and bad corporate governance, regardless of whether they would be found liable under the law.

Some consumers and investors would send business to corporations with executives and directors willing to risk a portion of their compensation to show that they can meet minimal standards such as ensuring, most basically, that their companies do not engage in criminal conduct. 14 My proposal for binding codes of conduct is therefore a market-based approach to the problem of a lack of personal accountability for these senior executives and directors.

Codes of conduct are already common. Corporations, law firms, and financial firms in the United States adopt codes on a routine basis to foster good will with their clients and the public. Codes may state that executives and employees must act ethically and, for example, report improper behavior. Importantly, codes rarely provide for specific remedies when they are breached. Moreover, corporations often disavow their own seemingly applicable codes of conduct to avoid lawsuits from what they perceive as an overly aggressive plaintiff’s bar.

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