When AIG executives received their annual bonuses even after the struggling firm took $700 million in federal bailout funds, a storm of public criticism erupted. AIG justified its decision to pay the bonuses by claiming it was contractually obliged to do so.

New research from Leigh Anenson, associate professor of business law, with co-author Donald Mayer, University of Denver, says that corporate boards already have the tools they need to stop such payments. Under a long-standing equitable doctrine known as "clean hands,” directors can refuse to reward an executive who asks for contractually agreed compensation after risking the company’s future for present personal gain. In assessing the efficacy of the “clean hands” defense in the executive pay context, their research integrates and extends research in the fields of business, ethics, and law.

“Our analysis suggests that the use of the ‘clean hands’ doctrine to check compensation abuses is a legitimate and effective role for courts in the reform process,” says Anenson. “Ultimately, it fortifies the legal arsenal of the board in combating excessive executive pay, to provide greater protection to the company and guarantee fairness to shareholders and other stakeholders.”

Centuries ago in England, the idea of equity arose to prevent abuse of the law and legal process by the politically and economically powerful. The equitable defense of “clean hands” protected courts from those seeking to profit by their own wrong-doing. Conduct did not have to be illegal for courts to consider the defense. Behavior that did not conform to minimum ethical standards in business would suffice.

Anenson’s research demonstrates the continuing value of equity and ethics in corporate law and governance. Where the hunt for bonuses encourages excessive risk-taking, the doctrine of “clean hands” empowers boards to take defensive and remedial action. “Corporate boards often consider financial equity as a means of raising capital for the good of the firm. But in the ongoing financial crisis, raising legal equity may be their best strategy,” says Anenson.

If directors think in terms of “clean hands” rather than contractual compliance, they could withhold excessive bonuses, severance packages, and other payments. Boards could also seek to rescind payments that have already been made. This doctrine gives directors the right to question out-sized pay and use courts rather than the typical situation of directors being questioned in court by shareholders.

The application of unclean hands in cases of excessive compensation, Anenson says, supplements and supports federal legislation regulating executive compensation in public companies. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates compensation committee independence, shareholder “say on pay,” and compensation clawbacks. Ensuring that independent directors negotiate executive employment contracts and giving shareholders a nonbinding vote on their corporation’s executive pay plan generally occurs ex ante to the contract, Anenson comments, whereas unclean hands operates to protect shareholders ex post.

Compensation clawbacks already exist under limited circumstances in the Sarbanes-Oxley Act and the Troubled Asset Relief Program. The new requirement that public companies adopt a policy to recover excess incentive-based compensation paid to executive officers is restricted to situations where the company must prepare an accounting restatement for material noncompliance with any financial reporting requirement under the securities laws. Recovery is mandated regardless of whether the restatement resulted from the misconduct by the company or its employees. Recoupment under unclean hands would be available without a restatement, Anenson says, but only where fraud or other unethical conduct involving excessive risk-taking was detrimental to the company.

Like shareholder advisory votes on pay, many companies have clawback policies, some of which are more stringent than federal law. Anenson remarks on the risk that the statutory standard may become a “moral minimum.” If that occurs, she says, “unclean hands would be available to fill the gap.” According to Anenson, one of the advantages of the “clean hands” doctrine is that it relies on the expertise of the Board, rather than regulators. “The beauty of judge-made law like equity is that it can operate regardless of political will and without the need for a one-size-fits-all regulatory policy.”

“‘Clean Hands’ and the CEO: Equity as an Antidote for Excessive Compensation,” is forthcoming as the lead article in the University of Pennsylvania Journal of Business Law. The paper was recognized as the Distinguished Paper at the 2010 Annual Conference of the Pacific Southwest Academy of Legal Studies in Business.