There are many good, independent boards of directors at public companies in the United States. Unfortunately, there are also many ineffectual boards composed of cronies of CEOs and management teams, and such boards routinely use corporate capital to hire high-priced “advisors” to design defense mechanisms, such as the staggered board and poison pill, that serve to insulate them from criticism. Recently, these advisors have created a particularly pernicious new mechanism to protect their deep-pocketed clients – a bylaw amendment (which we call the “Director Disqualification Bylaw”) that disqualifies certain people from seeking to replace incumbent members of a board of directors. Under a Director Disqualification Bylaw, a person is not be eligible for election to the board of directors if he is nominated by a shareholder and the shareholder has agreed to pay the nominee a fee, such as a cash payment to compensate the nominee for taking the time and effort to seek election in a proxy fight, or compensation that is tied to performance of the company.[i]
We believe that the Director Disqualification Bylaw is totally misguided. It is absolutely offensive for an incumbent board to unilaterally adopt a Director Disqualification Bylaw without shareholder approval, and shareholders should also reject a Director Disqualification Bylaw if their incumbent board puts one up for a vote in the future. For the reasons explained below, we believe it is more appropriate for shareholders to continue, as they have in the past, to evaluate candidates individually based on their merits, including their experience, relationships and interests, all of which is required to be fully disclosed in a proxy statement.
As of November 30, 2013, thirty-three (33) public companies had unilaterally (i.e. without shareholder approval) amended their bylaws to include a Director Disqualification Bylaw.[ii] In response, on January 13, 2014, Institutional Shareholder Services (“ISS”) stated that it may recommend a vote against or withhold from directors that adopt a Director Disqualification Bylaw without shareholder approval. In adopting this new policy position, ISS noted, as we do below, that “the ability to elect directors is a fundamental shareholder right” and that Director Disqualification Bylaws “unnecessarily infringe on this core franchise right.”
The law firm of Wachtell, Lipton Rosen & Katz LLP (“Wachtell Lipton”), which has long history of advising corporations in responding to activists, has accused ISS of “establishing a governance standard without offering evidence that it will improve corporate governance or corporate performance” and ignoring the “serious risks that [outside director compensation] arrangements pose to fiduciary decision-making and board functioning.” In reality, it is those promoting Director Disqualification Bylaws who fail to provide evidence that outside director compensation arrangements (which, in a typical PR-savvy distortion of the facts, they have dubbed “golden leashes”) actually pose “serious risks…to fiduciary decision-making and board functioning,” and that is because in truth the risks that they focus on – “conflicted directors, fragmented and dysfunctional boards and short-termist behavior” – are just as likely (if not even more likely) to arise if directors can unilaterally disqualify potential candidates without consequence. Further, the recent Wachtell Lipton posting to The Harvard Law School Forum on Corporate Governance and Financial Regulation advises boards of directors regarding the adoption of variants of the Director Disqualification Bylaw, thereby ensuring that this issue remains a continuing controversy (and lucrative source of fees for advisors).
Perquisites for Incumbent Directors – Creating a Real Conflict of Interest
For decades, perquisites have been lavished on so called “independent” directors of public companies, even in times of declining profitability at the companies they supposedly oversee. Boards have routinely teamed up with management to establish mutually beneficial “arrangements” (a cynic may call them “bribes”) to make available to one another such perks as access to private planes, box seats at premier sporting events, country club memberships, re-pricing of underwater stock options, tax gross-ups and, of course, massive cash payments, all at the cost of shareholders and to the benefit of directors, management and other entrenched powers. One particularly good example occurred at Chesapeake Energy Corp. before we took a position in the company. During fiscal year 2011, under company policy, non-employee directors were permitted forty (40) hours of personal use of the company’s fractionally owned aircrafts, while the company’s CEO received, with board approval, total compensation of almost $18 million. Unfortunately for Chesapeake shareholders, the stock price did not fare nearly as well in fiscal 2011 as incumbent directors and management did – as of the end of the year the company’s share price had declined over 37% from its 52-week high. It is that kind of mutual profiteering at the expense of shareholders that has resulted in a market in which CEOs of failing companies make 1000 times the wages of the average worker and then, when they are finally shown the door, exit with multi-million dollar “golden parachutes.”
Nevertheless, the propriety and legality of perquisites for incumbent directors is viewed as “business as usual.” It is therefore particularly irksome that apologists for incumbent boards are now cynically raising questions about whether activist shareholders should be permitted to compensate their nominees for board membership. One supposed justification for the Director Disqualification Bylaw is that compensation arrangements between activist shareholders and their nominees create a conflict of interest. But these cynics conveniently turn a blind eye when management and directors at Service Corporation International, one of the 33 companies that adopted a Director Disqualification Bylaw, allow themselves personal use of private airplanes at the expense of shareholders. Similarly, they are not bothered that most of the outside directors of International Game Technology (“IGT”), another one of the 33 companies that has adopted a Director Disqualification Bylaw, received total compensation of over $300,000 last year. Perhaps the apologists think that is fair compensation since IGT’s stock has only underperformed its peers by approximately 60% over the last three years. Regardless of the reason, those defending the Director Disqualification Bylaw, ignore the fact that corporate perks and inflated director compensation at the expense of shareholders create an environment where board members are more loyal to current management than they are to the shareholders, which is the real conflict of interest we should all be concerned about.
Disparate Positions of Board Members – The Inherent Norm
Those promoting the Director Disqualification Bylaw claim that it is necessary to prevent conflicts of interest among directors. But, in reality, disparity among board members has always existed in the past and will always exist in the future. For example, one director may have been on a board for many years, be highly dependent on board compensation to pay his expenses and have accumulated a large position in company stock due to his years of service. Another board member may be newly elected – perhaps he is an independently wealthy former executive of a large supplier of materials to the company, holding only a small number of shares of company stock but a large number of shares of stock in his former employer. A third could be a grandson of the founder of the company. He may