CEO pay meets its match: plaintiffs lawyers
By Geoffrey Colvin

(FORTUNE Magazine) – I'm sick and tired of the eternal handwringing over CEO pay. Yes, it's out of control; we all know it, and that's as far as we ever get. A year ago the conventional view held that CEO pay was next on the reformers' hit list, and it got a lot of predictable attention this past proxy season. But when I recently asked Ira Millstein, America's preeminent corporate-governance lawyer, what had substantively changed in CEO pay, he gave a one-word answer: "Nothing."

Now, just maybe, change is in the works. Good news? Not so fast. It pains me to report that it's coming at the hands of our old friends, the plaintiffs bar.

Let me be clear: I think too many plaintiffs lawyers are leeches, shakedown artists, legal Mafiosi who target business success and squeeze it for themselves. But the hard truth is, if they've finally found an opening into suing corporations over executive pay, then it's only because corporate directors have created that opening through incredible laxity and cluelessness.

Here's what's happening. No matter how outrageous a CEO's pay may seem, it has been virtually impossible for shareholders to sue over it because of the well-known "business judgment" rule. Setting the boss's pay is a business judgment, and as long as the directors exercised care in making it, you can't sue them just because their judgment may have been lousy.

But the Delaware Court of Chancery--America's most important business court, since most companies are incorporated in Delaware--changed the game last year. The case involved a suit against Disney over the pay of Michael Ovitz, who served as Disney's president for just over a year in the mid-1990s and left with some $140 million in pay. Surprisingly, the court refused to throw out the suit. Why? Because the plaintiffs allege not that Disney's directors exercised poor judgment but that they exercised no judgment at all. Specifically, the plaintiffs say the directors approved Ovitz's pay agreement without having seen even a draft of it, with no analyses of how much the deal might cost Disney and no analyses of how much the termination provisions could cost.

The court expressed no opinion about the truth of the charges, and I certainly have none. But the court said that if the charges were true, then the directors' behavior went way beyond poor judgment. It was "not in good faith" or "intentional misconduct," two ominous phrases in Delaware corporation law.

Directors can absolutely be sued on that basis, but that's not the worst part. The worst part is that when a court finds that a director failed to act in good faith, then director's and officer's insurance does not cover the damages. Delaware law forbids it.

So if a court were to find that a board had handed a CEO a mammoth contract without even checking to see how expensive it could be, then those directors could be personally liable for major damages. As the Corporate Counsel newsletter concludes, "this could mean that each director would have to pay out of his or her own pocket ... several million dollars each!"

An alarming prospect, but can directors really be so oblivious that they'd get themselves into that kind of pickle? Apparently they can. In fact, such a scenario seems far more plausible today than it did just a year or two ago.

That's because the corporate scandals of the past three years have spurred regulators, prosecutors, and journalists to delve deeper into CEO pay, and they've hit what you might call pay dirt. Many CEOs have accumulated gigantic, Grasso-style deferred pay accounts compounding at above-market interest rates, the total eventual payout undisclosed to shareholders (which is within SEC rules) and perhaps unknown even to the directors. SERPs, supplemental executive retirement plans, are another form of stealth pay that directors may know little about. Many companies have become extraordinarily clever at contriving CEO perks in such a way that the costs seemingly fall below SEC reporting thresholds--but the true costs may be Kozlowski-scale and unknown to the directors.

It's crazy that the threat of multimillion-dollar personal penalties should be required to make directors finally add up what they're really paying the CEO, but at some companies it may be. I stress that we haven't seen any cases reach that point yet. But if someday soon you read that one of the plaintiffs lawyers you love to hate has won such a settlement--just be careful whom you blame.

GEOFFREY COLVIN, senior editor at large of FORTUNE, can be reached at gcolvin@fortunemail.com. Watch him on Wall $treet Week With FORTUNE, Friday evenings on PBS.