DealBook Columns Discussing Incentive Pay to Directors and Proposed Preclusive Bylaw
By Cydney Posner
In this article, The New York Time's DealBook column discusses a recent practice of hedge funds' "paying their nominees to a company's board as if they were chief executives."
In the most recent instances, shareholder-hedge funds, believing a company's stock to be underperforming, agitate for change through proxy fights. Seems like fairly standard activist behavior? "What's different here is that each hedge fund is promising to pay its director candidates what are essentially bonuses that could run into millions of dollars, if not more." In one case, the hedge fund's nominees will be paid a $50,000 retainer as a kind of "tip" for their service, apparently, a fairly common practice. But, if any of the fund's nominees wins a seat on the board and serves for a year, he or she will be paid $30,000 for each percentage point the stock price outperforms its peer group, up to a potential $9 million for each director. In another case, the fund is again paying each of its nominees a $50,000 tip, plus 2.6% of the fund's net profit from the company's stock price increase (fund's investment: approximately $1B) if the director is elected and 1.8% even if not elected -- quite a chunk of change.
The companies involved contend that the hedge fund directors would not be independent, but rather loyal to the hedge fund, and that the hedge fund nominees would aim for short-term performance to achieve their compensation goals without regard to the long term. The funds argue, in turn, that they have no future control over the nominees and that the special pay aligns the nominees' interests with company performance.
The column's author suggests that this kind of pay arrangement undoubtedly "sets up two classes of directors doing the same job but being paid very different amounts. It could not only create resentment, but disagreement over the path of the company. And it also has the potential to begin a second arms race in director compensation, something probably best avoided. There is a bigger problem here. Directors are looked on as caretakers. In exchange for a wide release from liability, they get a decent salary for not a lot of work. In most instances, they are not going to become staggeringly rich. Relatively modest compensation may ensure that directors act more prudently and serve as a counterweight to chief executives, who are more willing to shoot for the moon because their upside is so high. By paying directors as if they were chief executives, they may become all the more willing to take on more risk. This may be particularly true where there is no downside, which is not typical for directors who receive stock in the company. " Interestingly, in one case, ISS took no position on the director compensation issue and recommended two of five of the fund's nominees, while Glass Lewis recommended all of the nominees.
In this follow-up DealBook column, the author discusses the response proposed by Marty Lipton to the recent trend of hedge funds' incentive payments to board nominees: adopt a bylaw prohibiting shareholder activists from compensating director nominees. More specifically, the bylaw proposal is framed as a form of director qualification that prevents anyone from serving on the board if he or she is a party to a compensatory arrangement, except with the company, in connection with board candidacy or service, other than indemnification and reimbursement for out-of-pocket expenses or as part of any pre-existing employment agreement a candidate has with his or her employer. http://www.scribd.com/doc/140691513/Shareholder-Activism-Update-Bylaw-Protection-Against-Dissident-Director-Conflict-Enrichment-Schemes-pdf
Note that the bylaw would prohibit not only the more generous "special" payments by hedge funds, but also the more common practice of "tipping," although customary compensation to nominees for their failed efforts would be allowed if they are not elected.
Since the original DealBook column, the author notes, legal academics have debated the propriety and legality of these special payments. According to Columbia professor John C. Coffee Jr., "these ‘third-party bonuses create the wrong incentives, fragment the board and imply a shift toward both the short-term and higher risk.'" Others have similarly argued that "‘if this nonsense is not illegal, it ought to be.' On the other side, several equally well-respected academics have signed off on these arrangements, [including a Vanderbilt professor] who said this approach made sense because it ‘lends itself to allowing these nominees, if elected, to focus on independent decision-making and fulfilling their fiduciary obligations on behalf of shareholders.'" Another professor argued that the payments are "'intended to align the interests of those directors with those of the company's shareholders.'"
While recognizing that hedge funds may need to compensate director nominees and that the compensation is disclosed so shareholders can vote and monitor results, the author complained of a gnawing "here we go again" feeling: "Are we now going to do for director compensation what we did for chief executive compensation and spiral it all higher? The assumption that aligning incentives must be a good thing brings to mind that line from Whitney Houston that ‘the children are the future.' Of course they are the future, but it doesn't really mean anything more than that." In other words, does paying a director tens of millions of dollars really affect company performance?
Nevertheless, the author concludes that, while he is wary of the trend, "the issue is worth discussing and examining." By precluding even the common practice of tipping, the proposed "bylaw could chill shareholder activist activity by making it harder to obtain qualified director nominees. Again, it may be that this compensation should be regulated or monitored, but wouldn't it be better for this to be done in consultation with shareholders rather than unilaterally by the board." Moreover, the author contends, "the bylaw continues another worrying trend in corporate law. The use of bylaw amendments by boards to shut down, or severely inhibit, shareholder activism [such as] a bylaw requiring arbitration of shareholder disputes." It remains to be seen whether the proposed bylaw gains general acceptance.