Governance Perspectives: Director Compensation Bylaws
In two recent high-profile proxy contests, shareholders entered into incentive compensation arrangements with their director nominees that were intended to reward their particular nominees for increases in shareholder value or the activist’s profits. Elliott Management agreed to pay its nominees for election to Hess’s board an additional $30,000 for each percentage point Hess’s stock outperformed its peers, with a maximum potential payment of $9 million for each director. JANA Partners offered to pay four of its nominees to Agrium’s board a percentage of any profits that JANA earned on its Agrium shares within a three-year period.
Incentivizing directors to achieve corporate goals is not a new idea, of course—most public companies grant equity awards to their directors to align directors and shareholder interests. It can be argued, however, that the payment of incentive compensation by a particular shareholder creates a two-tiered compensation structure for the board, creates confusion as to who is the director’s true master, and fosters continuing allegiances between the director and the shareholder.
The issues raised by third-party payments may be exacerbated when that third party is a stockholder with a short-term investment horizon. Some shareholders, particularly those who engage in proxy contests, focus on short-term value creation through a special dividend, a spin-off, the divestiture of non-strategic assets, or other strategies. Incentive compensation tied to the completion of those goals may motivate those shareholders’ nominee directors to focus on short-term objectives at the expense of long-term value maximization. In addition, third-party incentive payments may also fuel the nominees’ appetite for high-risk strategies, divide the board, and cause discord in the boardroom.
The debate over director compensation bylaws will almost certainly continue in the 2014 proxy season, and it is possible that insurgent shareholders will develop modified compensation arrangements that seek to address some of the concerns. Curiously, the principal proxy rating firms have, to date, largely ignored these arrangements, in sharp contrast of course to their fixation on management compensation. Even if proxy advisory firms decide that these compensation arrangements raise meaningful governance issues, that determination may not affect their support for an insurgent’s nominees in a proxy contest. For example, Glass Lewis questioned the compensation arrangements that Elliott proposed for its nominees to Hess’s board, stating that they “introduce a troubling and, in our view, wholly unnecessary potential for boardroom conflict.” Despite this, Glass Lewis endorsed Elliott’s entire slate of nominees (ultimately, the nominees waived their rights to the special compensation before the contest was settled).
As evidenced by the 2013 proxy season, the current era of investor activism is enduring, and activists are increasingly targeting larger companies. Permitting these types of third-party incentive payments may aggravate the issues presented when an activist-sponsored director joins a board, and may intensify the director’s sense of obligation to the sponsoring stockholder. Companies can, however, preclude these types of compensation arrangements by adopting corporate bylaws that expressly prohibit payments to directors by a third party for board service other than the typical retainer, expense reimbursement, and indemnification offered by a proxy contestant to its nominees. While the 2014 proxy season may seem a long way off, this is a good time to review this and other possible measures (such as providing for flexibility in advance notice bylaws).