The Advisors' Blog

Despite the contention of pay critics that Delaware’s “business judgment rule” all but requires compensation committees to hire an “independent” compensation consultant, at least one esteemed jurist thinks otherwise. As part of a recent ruling in the ongoing Northwest Airlines bankruptcy case, U.S. Bankruptcy Court Judge Alan L. Gropper provided his views on whether use of a compensation consultant providing other services to management would be grounds for rejecting the company’s compensation plan for key executives. His views should be considered by compensation committees in conjunction with the study Broc cited in his post last week, which concludes that full-service firm consultants do not have clients who provide higher pay.

As background, section 1129(a)(3) of the Bankruptcy Code, sets forth the requirement that a plan be “proposed in good faith and not by any means forbidden by law.” This standard is similar to that under Delaware law that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.” In re Walt Disney Derivative Litigation, Case No. 411, 2005 (Del. June 8, 2006) at 39. Under Delaware law, directors are protected by the “business judgment rule” absent a showing they had either breached their duty of care or had not acted in good faith.” In re Walt Disney Derivative Litigation at 39.

In considering whether the Northwest Board acted in good faith in their creation of a management equity plan (MEP) to retain key executives through the Bankruptcy proceedings, Judge Gropper observed:

“The objectors contend the consultants were not entirely independent because the firm, [name omitted] has worked for the debtors on unrelated pension matters. There is no evidence or indication that [name omitted] advice was colored in any way by its other work, and no citation has been provided to any rule of law or ethics that was violated.” (In re Northwest Airlines Corp., Case No. 05-17930 (ALG) (Bankr. S.D.N.Y. May 18, 2007).

This case demonstrates two important points that make it premature to conclude Delaware law requires boards to hire a consultant that performs no other services for a company.

First, the only standard to be met in making a decision to hire a consultant – as the Delaware court also opined in Disney – is for that person to have the requisite expertise in their field. Judge Gropper stated, “As a matter of process, there is no evidence that [name omitted] could not be relied on as experts in their field, or that they did not do an adequate job.” at p. 522.

Second, not only did the use of this consultant not cause the adoption of the MEP plan to fail to meet the good-faith requirement of section 1129(a)(3) of the Bankruptcy Code, the court also found “[T]he board’s procedures and decision easily satisfy the business judgment rule, assuming that it was required by applicable law.” at p. 529.

As consultants who work for a full-service firm, it is our humble reading of this case, and our view of Delaware law, that the key question boards and compensation committees ought to focus on in hiring a consultant is: “What is their expertise in advising companies of similar size, in a similar industry and in similar circumstances?”

We also would advise committees to document their reasoning in hiring their consultant, and cite directly to these factors in that document. We also recommend to committees to annually review the work of their consultant, and to document how the consultant rated in their review. We believe that it is far more likely the issue of expertise would be raised in future litigation than would the question of perceived conflicts of interest.

Many thanks to Peter Friedman of Cadwalader, Wickersham & Taft, who co-authored a fine article on “Management Equity Plans in Bankruptcies,” for alerting us to this case.

– Steve Seelig and Ira Kay, Watson Wyatt