ISS Questions Director Compensation Bylaw
- Board-adopted bylaw prohibited directors from accepting compensation from third parties during candidacy or board service.
- ISS recommended votes against the reelection of the governance committee members, characterizing the bylaw as a "material failure of governance."
- Separate compensation paid by special interest third parties can be divisive and subvert traditional director fiduciary duties to all shareholders; general ISS support of those arrangements would be baffling, and we believe that ISS's actual views on these bylaws may be more nuanced.
Earlier this month, ISS recommended "withhold" votes for the election of the members of a company's nominating committee because its board adopted—without shareholder approval—a corporate bylaw that barred director nominees from accepting compensation from anyone other than the company during their candidacy or service as a board member. These director compensation bylaws, which have been adopted by about 30 companies to date, arose as a result of controversial incentive compensation arrangements offered by insurgent shareholders to their director nominees in two recent high-profile proxy contests. Those arrangements were designed to reward the dissident directors, if elected, for increases in shareholder value or the insurgent shareholder's profits, and in some cases could have resulted in multimillion-dollar payouts.
ISS indicated that the director compensation bylaw recently adopted by Provident Financial Holdings restricts its shareholders' ability to nominate and elect directors in a proxy contest, and thus infringes on the shareholder franchise. ISS characterized the Provident Financial board's adoption of the bylaw without a shareholder vote as a "material failure of governance" and noted that if the board did not address the issue, ISS may consider recommending withhold votes against the full board in the future.
In our view, director compensation bylaws do not preclude proxy contests, nor are they intended to exclude legitimate board candidates. Instead, they are designed to prevent conflicts of interest on the board and to ensure that directors are focused on the long-term interests of shareholders as a whole. A director's acceptance of incentive compensation from a third party with special interests necessarily fosters continuing allegiances between the director and the sponsoring party, and it may cause the director to focus on those special interests at the expense of long-term corporate goals. Ultimately, the prohibition on third-party director compensation is intended to ensure that individuals who serve as directors are paid as directors, and not as the agent of an outsider with its own agenda and deep pockets. Further, it is well within a board's power to adopt corporate bylaws that set forth qualifications for directors, particularly qualifications that are designed to prevent conflicts of interest in the boardroom. A bylaw that requires directors to be paid by the company only for their service as a director nominee or board member serves precisely that purpose.
ISS's research report for Provident Financial indicated that these types of prohibitions on director compensation could deter a shareholder's legitimate efforts to seek board representation via a proxy contest because they bar a director candidate from receiving "a reasonable fee for agreeing to stand for election" designed to compensate the nominees "for the considerable time commitments incurred in proxy contests." We assume that ISS is referring to the one-time retention fees—normally in the range of $50,000 to $75,000—that are typically paid by an insurgent shareholder to a director nominee in exchange for the nominee's agreement to be named as a candidate. Based on discussions in other contexts, we have reason to believe that ISS's views on director compensation bylaws may be more nuanced than was originally believed to be the case when the Provident Financial recommendation was published. While we will not know ISS's official stance on this issue until early 2014, we expect that it may leave room for bylaws that allow typical one-time retainers in proxy contests but prohibit significant post-election compensatory arrangements not made available to all directors. We will keep you apprised as we learn more about developments relating to this issue and ISS’s position as more information becomes available.