Since 2007, executive compensation practices of public companies have been at the forefront of activist shareholders’ and shareholder rights groups’ agendas. Mandatory say-on-pay proposals, enhanced executive compensation disclosure, compensation committee and compensation consultant independence rules are just a few of the recent significant changes to the laws and regulations applicable to public companies in the U.S. Moreover, as we reported in prior blogs, some countries have gone as far as making say-on-pay proposals binding on public companies. In fact, just this year, Switzerland amended its constitution to require binding shareholder say-on-pay votes and other executive compensation limitations for its public companies (also check out Broc Romanek’s blog for a collection of articles related to this topic). However, while public company executives have been in the crosshairs, little attention, if any, has been given to compensation of public company directors.
But that may change as a result of certain director pay practices highlighted by a recent NY Times Deal Book article by Steven Davidoff. The article focuses on two current proxy fights involving hedge funds attempting to get their proposed nominees elected to the boards of Hess Corporation and Agrium Inc. In the first case, the nominating hedge fund is proposing to pay a $30,000 bonus to any of its nominees who ultimately win a seat on the Hess board. Additionally, each such nominee would be eligible to earn a performance bonus based on share performance relative to its peer group. Based on the performance award formula, the maximum potential payout could be as much as $9 million if Hess outperforms its peer group by 300% over a three-year measuring period.
The second case is potentially even more lucrative for the director nominees. In addition to a $50,000 bonus each nominee would receive if elected, they would also receive 2.6% of Jana Partners’ net profit based on the stock closing price on September 27, 2012. Director nominees not elected would still receive 1.8% of the net profit during that same period. Considering Jana’s total investment in Agrium is over $1 billion, the earning potential could be significant. However, based on the results of the Agrium annual meeting held on April 9, it appears that none of these Jana nominees were elected to the Agrium board this time around.
These arrangements pose some interesting questions from a corporate governance standpoint. Historically, directors have been paid relatively modest director fees to encourage more prudent business judgment to counterbalance company executives who are typically less risk averse due to the structure of their compensation packages. By compensating directors in a manner similar to executives, directors may likewise be willing to accept more risks which could be detrimental to shareholders if such risk-taking was excessive.
The two hedge funds in this case are rationalizing this practice by saying that this type of compensation arrangement helps align board interests with those of the shareholders and incentivizes long-term shareholder returns. On the other hand, however, these pay practices could call into question the ability of such directors to fully carry out their fiduciary duties to the companies they serve and their ability to exercise independent business judgment in carrying out such duties.
As Professor Stephen Bainbridge points out in a recent blog post, while directors are not agents of the corporation, they do share many of the same fiduciary duties. One of the basic tenants of the law of agency is the prohibition of agents using their position as such for personal gain without the principal’s consent. Arguably, the election of any of these nominees by shareholders with full disclosure of the compensation arrangements could function as consent but it may not be completely clear whether this would cure the potential conflicts of interest. Moreover, Delaware courts have taken a similar stance and have applied these principals to directors and officers of corporations in what seems to be even a stricter manner. The Delaware Court of Chancery has described these obligations and duties to be similar to those imposed upon trustees:
Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. While technically not trustees, they stand in a fiduciary relation to the corporation and its stockholders. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty …. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. [Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. Ch. 1939)]
Thus, it would seem that this type of compensation arrangement could potentially be problematic from a state law perspective (at least in Delaware). Clearly these arrangements affect, to some degree, the directors’ abilities to carry out fiduciary duties to the companies they serve and their respective shareholders. Moreover, as Davidoff argues in his article, because the measuring period for the determination of payments to these hedge fund directors is three years, “the hedge fund nominees will aim for short-term performance and not care what happens to the company in the longer term.” This practice would likely also create a strange dynamic in the boardroom where one group of directors would be receiving their nominal director fees and another group having the potential to earn significantly more based on performance. Not only would this likely be a divisive force among the board members, but could lead to a significant escalation of director compensation, similarly to what we have seen with executive compensation over the past decade.
The question remains whether director compensation will now or in the near future come under the microscope? Only time will tell but I am sure plaintiff firms hope this to be the case as it could be one more arrow in their quiver to attack corporations and their boards in cases alleging breaches of fiduciary duties or conflict of interest transactions.