Officers and directors breach their fiduciary duties to the corporations by paying themselves excessive compensation.
The Rule Against Excessive Compensation
Corporate directors may also serve as officers, and there is an element of self-dealing if a director votes to set his own compensation as an officer. Prior to the enactment of section 21.418 of the Business Organizations Code (and its predecessors), the rule in Texas was that the compensation agreement was voidable by the corporation if the director voted to set his own compensation and his vote was necessary to authorize the contract. If the agreement was voided, then the officer was entitled to recover reasonable compensation for his services. Section 21.418 now specifically provides that a contract between a director and the corporation which is fair or has been authorized in the prescribed manner shall not be voidable solely because the director's vote was counted in authorizing the contract. To the extend that the prior case law conflicts with the statute, it is overruled.
An officer or director who diverted a corporate fund earmarked for court-ordered payment to a trust account to pay his own salary may be guilty of self-dealing. A corporate manager may also be deemed to be guilty of self-dealing if he uses corporate assets for his own benefit without explicit authorization. In Thywissen v. Cron, a corporate officer who derived personal benefit from dealing with corporate assets was deemed to have been engaged in self-dealing. The corporate officer thus breached his fiduciary duty to deal fairly in the disposition of the profits resulting from his exercise of a right of first refusal.
Example of Excessive Compensation Case
In Carbona v. CH Medical, Inc., the Dallas Court of Appeals dealt with an excessive compensation claim. The defendant executive was the former chief executive officer of C.H. Medical, and a director of CH Industrial, Inc. He was sued by the two corporations for breach of contract and breach of fiduciary duties relating to his calculation of his exit bonus at the time of termination. C.H. Medical was a wholly-owned subsidiary of CH Industrial, Inc., which was itself entirely owned by a single shareholder who was actively involved in management and had hired the defendant. At the time the defendant was hired, he signed an employment agreement that provided for a schedule of bonuses. When the opportunity arose to sell the subsidiary, which would necessarily involve the termination of the defendant, the bonus arrangement in the employment agreement was replaced with a new bonus agreement providing for the calculation of an exit bonus based on the net sales price of the subsidiary. Ultimately, the subsidiary was sold, the defendant was terminated, and the defendant calculated and was paid an exit bonus under the terms of the bonus agreement.
However, the shareholder of the parent corporation became concerned over the size of the bonus, which he believed was inflated by the exclusion of a $7 million intercompany payable from the calculation. The trial court held that the bonus agreement was ambiguous and submitted the interpretation of the agreement to the jury. A jury found that the intent of the parties was to include the intercompany payable and found that the defendant had failed to comply with the contract in calculating his bonus. The jury also found that the defendant committed breach of fiduciary duties and fraud in failing to disclose the fact that the intercompany payable was not explicitly included in the bonus calculation. The trial court granted a motion to disregard the jury findings on fraud and breach of fiduciary duties, but entered a judgment in favor of the corporations for breach of contract in an amount of more than $2 million.
The Court of Appeals reversed a breach of contract judgment. The Court of Appeals held that the terms of the bonus agreement were explicit and unambiguous and that as a matter of law the contract did not include the intercompany payable in the bonus calculation. While the express terms of the bonus agreement contemplated the inclusion of accounts payable to reduce the amount of the bonus in the calculation, each of the accounts payable was separately listed, and the intercompany payable was not on the list. The Court of Appeals affirmed the trial court's refusal to render a judgment on the fraud and breach of fiduciary duty findings, holding that there was not sufficient evidence of a misrepresentation or nondisclosure. The companies contended that the defendant had failed to disclose the fact that the intercompany payable was not included in the formula for calculating the bonus, and the jury apparently agreed.
The Court of Appeals held that there was no failure to disclose because the non-inclusion of the intercompany payable was patently obvious on the face of the written agreement.What is interesting about this case is that the Court of Appeals' analysis pays absolutely no attention to the fact that the defendant, as an officer and director, was subject to fiduciary duties to the corporations with respect to the negotiation and performance of the new bonus agreement. The Court of Appeals' analysis treats the contract as if it were an ordinary, arms-length transaction. It is likely that the original employment agreement was an arms-length transaction and was not subject to fiduciary duties, but the new bonus of agreement that replaced the original contract was most certainly negotiated, executed, and performed while the defendant owed fiduciary duties to both corporations. Based on the Court's statement of the facts in the record, the result is not necessarily wrong, but the analysis most certainly is wrong. In order for an officer and director to seek compensation, even under a written contract with the corporation, the transaction must be fair to the corporation and executed in good faith. Even if the terms of the contract were not ambiguous, the defendant would still have had the burden of proving that the agreement was signed with full disclosure, in good faith, and was fair to the corporation in all respects. There must be some question as to whether the defendant could have satisfied this burden given that (1) the exclusion of the intercompany payable was, according to the jury, not intended by the parties and (2) all of the accounts payable were included in the calculation to reduce the size of the bonus, except for the single largest payable which was larger than the other payables by a factor of ten. Even if the transaction was not fair for corporations, the shareholder of each corporation could certainly agree to the transaction or ratify the transaction with full knowledge of the unfairness and a conscious decision to disregard the unfairness, but the defendant would have to prove that the shareholder was made aware of the exclusion and consciously intended to approve that exclusion. Even if the shareholder should have figured out that the written contract did not accurately reflect the intent of the parties, a fiduciary is not permitted to knowingly take advantage of a mental lapse by the shareholder, and the defendant surely could not have signed the agreement in good faith knowing that the terms of the contract did not reflect the intent of the parties, unless the defendant could demonstrate that it was reasonable for him to assume that the shareholder had changed his mind about the intent of the agreement. Such an assumption by the defendant, however, could hardly be reasonable without full, explicit disclosure of the change or some form of communication of approval of the change by the shareholder.
Excessive Compensation Standards
Unfortunately, a claim for excessive compensation is extremely difficult to prove. Compensation decisions are inherently subjective. Courts are extremely deferential to compensation decisions. The factors include: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities
of the business; (4) a comparison of salaries paid with gross income and net income; (5) the prevailing general economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the corporation as to all employees; and (9) in the case of small corporations with a limited number of officers, the amount of compensation paid to a particular employee in previous years.