Servants of Two Masters? The Feigned Hysteria Over Activist-Paid Directors

Yaron Nili is a fellow at the Harvard Law School Program on Corporate Governance. This post is based on Mr. Nili’s recent article, Servants of Two Masters? The Feigned Hysteria over Activist-Paid Directors, forthcoming in the Penn Journal of Business Law. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

Director compensation in the U.S. has garnered much less attention than the compensation of executives. Directors are most often elected without challenge, based on the company’s recommendation. They serve, at least in theory, all shareholders and owe their duties to the corporation. In each company, directors are compensated equally regardless of their affiliation, credentials or tenure. This parity has been lauded as a crucial element in promoting board “cohesiveness,” to the benefit of all shareholders.

Recently, however, activist investors have asked shareholders to elect director-candidates who receive a lucrative compensation package from the activist in addition to their compensation arrangement with the company. Incumbent managers and their defenders, such as Wachtell Lipton, have sharply condemned this practice, terming it a “Golden Leash” that subjects the nominated director to the activist’s control. They argue that the payment of incentive compensation by a sponsoring shareholder establishes a two-tiered compensation structure for the board, creates dissension and lack of cohesion in the boardroom, and fosters continuing allegiances between the director and the activist shareholder following the election therefore calling into question the independence of the director. Further, they argue that these arrangements could cause the firm to be too “short-term” oriented. Activists, however, claim that these arrangements help recruit talent that would otherwise not serve on a board for regular director pay, particularly in the case of a contested election and that structuring it as performance-based pay serves a number of useful functions that may not be achieved by fixed compensation.

In recent weeks, Nasdaq has joined the debate. On January 28, 2016, NASDAQ filed a proposed rule with the Securities and Exchange Commission requiring disclosure of any compensation arrangements with individuals who serve as dissident director candidates. In addition, the exchange is expected to solicit comment on other matters related to third party compensation arrangements, including whether such payments impair directors’ independence and could affect boards’ committee structure.

In my article, Servants of Two Masters? The Feigned Hysteria over Activist-Paid Directors (forthcoming, Penn Journal of Business Law (2016)), I critically present and evaluate the arguments against such side payments, explaining why these opponents of supplemental-pay are mistaken. In fact, I argue, activist-paid directors can be expected to improve corporate performance at poorly performing firms, and the cost of such arrangements, if any, is likely to be much lower than that of similar arrangements that are already widely used throughout corporate America and are welcomed by these opponents. I further assert that even if such arguments are taken at face‌ value a strong case can be made for allowing such payments under certain conditions.

Specifically, I argue that current boards have already been suffering from many of the issues that those opposing supplemental pay are invoking as potential concerns arising from side payments, that activist-paid directors are not expected to change this landscape dramatically, and that given the benefits that supplemental pay provides to shareholders and boards themselves this categorical opposition to supplemental pay is unmerited.

First, addressing the concern of damaging board cohesiveness, I argue that in many cases it is more likely to be that the board is too “cohesive,” preventing it from being effective and from taking the hard steps necessary to improve the firm performance. More importantly, the argument that paid activist-nominees will reduce board cohesiveness assumes that such cohesiveness already exists on companies’ boards, and that the cohesiveness is dependent on the directors being elected as part of one slate and with similar financial incentives. In reality, however, these assumptions are far from an accurate representation of how boards are comprised. Finally, supplemental pay may actually serve as a way to even out the financial interests between the incoming directors and the more tenured directors already serving on the board.

Second, addressing the concerns regarding the independence of activist-paid directors, I argue that activist-paid director are (i) independent of the activists, and (ii) even if they were dependent on the activists, they would be no more dependent on a particular shareholder than directors in other settings. Finally, I argue that no harm would flow if these activist non-affiliated directors were in fact dependent on the activists.

Third, addressing the “short-termism” concerns raised by opponents of supplemental pay, I argue that there are several bases that should alleviate the concern regarding corporate short-termism. Since boards have directors with far worse short term incentives, for instance directors who are about to retire, activist-paid nominees might actually be an improvement as far as short-termism is concerned. Further, since activist-paid directors can only act if they convince other directors, as most often these nominees only account for a small fraction of the board, any action taken by the board reflects more than just the opinion and wish of the activist nominees. Finally, a question exists regarding the merits and validity of the short-termism concern in the context of activist campaigns.

Taking the benefits that activist-paid nominees may provide to companies, I suggest that instead of reacting with unfounded hysteria to these pay structures, a more nuanced approach is warranted. Such an approach would balance between the benefits these marquee directors could provide to companies and the valid concerns that some pay arrangements may present. In laying out this approach, I present key factors that each board and shareholder base should evaluate when an activist hedge fund seeks to appoint a director with a supplemental pay arrangement.

The full article is available for download here.

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