The Golden Leash and the Fiduciary Duty of Loyalty

Gregory H. Shill is an Associate Professor of Law at the University of Iowa College of Law. This post is based on an article recently published in the UCLA Law Review and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Servants of Two Masters? The Feigned Hysteria Over Activist-Paid Directors, by Yaron Nili (discussed on the Forum here).

Traditionally, activist hedge funds identify a company ripe for improvement, acquire a toehold position in the company’s stock, and then launch a campaign to convince shareholders to dump incumbent directors in favor of candidates nominated by the fund. In recent years, some funds have begun experimenting with a variation on this practice by offering incentive pay in the form of bonuses to directors they nominate, over and above the compensation all directors receive from the company for their service on the board. These bonuses, known as “golden leashes,” have further polarized the debate over shareholder activism and short-termism. I examine the phenomenon more critically in a recent article, The Golden Leash and the Fiduciary Duty of Loyalty, recently published in the UCLA Law Review.

The case for golden leashes to date has invoked traditional shareholder rights arguments: golden leashes provide opportunities to enhance shareholder wealth and reduce agency costs by creating incentives to drive needed change. The reaction of Delaware judges has been skeptical (as the article details at Part III). In particular, Vice Chancellor Travis Laster suggested in a recent transcript ruling that golden leash arrangements might constitute conflicts of interest per se. See In re PLX Technology Inc. Stockholders Litig., C.A. No. 9880-VCL, at 30 (Del. Ch. Sept. 3, 2015). Some leading corporate law scholars have gone further, likening golden leashes to bribery and urging that they be banned.

This binary framing, which tracks shareholder activism debates more generally, obscures some of the golden leash’s most promising qualities. Chief among these is the structure’s landmark innovation: the golden leash enlarges the universe of those who can earn outsize sums as director candidates beyond hedge fund managers to include outsiders to the fund.

Making the Economics of Activism Available to Director Candidates Who Are Not Partners in the Fund

Proponents of the leash to date claim that it encourages directors to improve the performance of a company’s stock by granting them a percentage of the stock’s upside, to be paid by the fund. In a typical activist engagement, no golden leash-type bonus is necessary to align the economic interests of hedge fund nominees and shareholders: by virtue of their partnership stake, nominees who are hedge fund partners are personally heavily invested in the target company already. What the golden leash structure does is give the economics of activism to outsiders. For example, in the recent leash (and the only one put in place thus far), by Third Point at Dow Chemical, the nominees received stock appreciation rights in Dow shares from the fund.

The Golden Leash’s Impact on the Composition of the Activist Director Labor Pool

The golden leash’s proponents trumpet its potential as a curb on agency costs, and its detractors worry about short-termism, i.e., that the fund will prioritize short-term results over the long-term health of the company. These understandings are too narrow. True, the compensation provided by the nominating fund transforms the nominees into major shareholders, thus shrinking the gap between their interests as directors and their interests as shareholders. But that’s not new; conventional shareholder activism already achieves that result (and attracts the same worries regarding investment horizon).

The authentic innovation of the golden leash is its effect on the director labor pool. Historically, activist nominees—usually ex-bankers cum hedge fund partners—have focused primarily on driving changes to the company’s capital structure: initiating stock buybacks, adding leverage, and engaging in other forms of what might be described as financial engineering. The golden leash provides funds with a way to recruit individuals who have years or decades of experience in the target company’s industry and who are well positioned to drive fundamental changes in corporate strategy and leadership.

And indeed, the limited experience of the golden leash to date confirms this view. In the first known attempt to put one in place, in 2008 JANA Partners nominated technology executives to the board of CNET, the technology website, pursuant to a golden leash. In 2012, JANA tried again: to the board of Agrium, a Canadian agribusiness, it nominated a former Canadian Minister of Agriculture. The following year, Elliot Management nominated a former CEO of American Express and a former senior executive of BP to the board at Hess, the oil company. These efforts failed or became moot for various reasons (discussed at Part II.B of the article). In 2015, Third Point’s nominees—Raymond J. Milchovich and Robert S. Miller, both former CEOs in the industrials space—won seats on the board of Dow Chemical pursuant to a golden leash. While activists have had success enticing other outsiders to serve as nominees without supplemental compensation, like their golden leash forebears the Third Point candidates were unusually well-qualified for their future board positions.

Delaware Is Well-Equipped to Manage Challenges Presented by the Golden Leash

The final point I make in the article is that, while new and associated specifically with shareholder activists, the golden leash should be understood to belong to a larger class of well-established, mainstream legal structures that increase expertise at individual firms by, paradoxically, tying directors to multiple firms. These structures include corporate governance innovations in two other areas of the capital markets: the venture capital ecosystem and the practice of corporate directors sharing information with outside entities (both discussed at Part IV of the article). Like the golden leash, both of these models create overlapping obligations for directors. Yet these other arrangements are welcomed by scholars, courts, and firms on the grounds that they improve enterprise value and corporate governance by quietly blending loyalties, notwithstanding the fact that they almost certainly make conflicts of interest more likely. The golden leash thus follows in a coherent, if unheralded, tradition of structures that forge ultraclose bonds between directors and outside shareholders. Supplemented by enhanced disclosures (which I sketch in Part V), existing legal doctrine and market discipline in these areas will enable courts and markets to manage the risks of the golden leash relating to conflicts of interest.

Conclusion

Properly designed and disclosed, the golden leash has great promise. To the labor pool of dynamic director candidates, it adds industry experts who likely have a background in mainstream corporate America (not Wall Street), lack a preexisting relationship to the fund, and must be persuaded by the fund to push their case. There is arguably some tension between this argument and the traditional case for shareholder activism, which may explain why it has never been made explicitly.

The golden leash thus activates a recruitment process that is likely to bring the activist’s objectives, tactics, message, and culture closer to the realm of core corporate strategy and further from the financial engineering for which activist funds have historically been criticized. A well-executed golden leash can therefore promote not only superior returns but consensus-building, dialogue, and other values important to sound corporate governance.

The complete article is available here.

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