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 also serve as trustee for certain family trusts holding large numbers of company shares, and some of his family members may be pushing the trust (and the board) to increase the dividends that they live on, while other family members may be supporting greater company investment in research and development. The point is that the personal positions of all of these people will inevitably create different interests and priorities – but these competing interests and priorities do not disqualify them from board service. Rather, such disparate situations are part of the normal reality of board membership and have, since the creation of the corporation as a business form, been dealt with at the board level through time-tested processes, such as, among other things, board members abstaining from voting in certain circumstances, satisfaction of fiduciary obligations and transparency in the election process. No one is suggesting (nor should they) that these very real differences among board members should disqualify anyone from board membership. Similarly, the particular circumstances of a nominee who has agreed to receive additional compensation from a shareholder create no novel issues that justify a “solution” as draconian as the Director Disqualification Bylaw. Clearly, the Director Disqualification Bylaw is, in actuality, simply another entrenchment device purposely designed to separate management from owner (i.e. shareholder) influence and limit the ability of an activist shareholder to build a slate of highly-qualified nominees to challenge incumbent directors and the status quo.
Compensation by Activist Shareholders – Aligning the Interests of Nominees and Shareholders
Apologists for incumbent boards also ignore the most obvious facts about the compensation paid to shareholder nominees for board membership. Compensation arrangements between activist shareholders and their nominees have historically come in two forms: (i) fees in recognition of the time commitment and effort inherent in participating in a contentious proxy fight, and (ii) incentive compensation tied to the performance of the company. The fees paid to nominees in recognition of the time commitment involved in participating in a contentious proxy fight are paid prior to becoming a director. In fact, in many cases these fees are not payable at all if the nominee is ultimately elected or appointed to the board of directors (in which case the nominee will instead receive customary director compensation from the company). But of vastly more significance is the fact that compensation arrangements based on the performance of the company, such as those that were at issue in last year’s contested proxy fights at Hess Corp. and Agrium, Inc., only reward directors when a company is succeeding. In other words, even when a director will receive compensation from an activist shareholder, the amount of which will be determined based on the performance of the company, the interests of that director remain fully aligned with those of shareholders – it is in their economic interest to see the value of the company increase.
Under our federal securities laws, shareholders are required to be informed of all facts material to electing directors, which includes full disclosure of any compensation arrangement between a nominee and an activist shareholder. It is then up to those shareholders to determine, with full knowledge of the facts, including the precise terms of any compensation arrangement, whether to elect an activist’s nominee or some golfing buddy of the current CEO. Therefore, in considering the Director Disqualification Bylaw and the issue of nominee compensation by activists, we pose the following questions: If fully informed shareholders wish to elect a nominee who has agreed to be compensated by an activist to the board of directors of the company they own, who then are the incumbent board members to say that they cannot do so? And why should any bylaw prohibit or infringe on this choice? This is the most obviously objectionable characteristic of the Director Disqualification Bylaw – the fact that it undermines the most basic right of shareholders – the right to decide, through an election, who shall serve on the board of directors of a company owned by those very shareholders.
The Importance of Activists as a Market Force
The value of activist shareholder interventions is demonstrable and significant. For example, from November 15, 2008 to November 15, 2013 (a five year period), Icahn nominees joined the boards of directors of 20 public companies. A person that invested in each company on the date that the Icahn nominee joined the board and sold on the date that the Icahn nominee left the board (or continued to hold through November 15, 2013, if the nominee did not leave the board) would have obtained an annualized return of 28%. Similarly, Professor Lucian Bebchuk of Harvard Law School and his colleagues Alon Brav of Duke University’s Fuqua School of Business and Wei Jiang of Columbia Business School, studied about 2,000 activist interventions from 1994 to 2007 and found that activist interventions are typically followed by a five-year period of improved operating performance. This kind of success has inspired a generation of activist investors, and as a movement I believe that we are empowering shareholders. Nevertheless, despite such tremendous success at enhancing shareholder value and improving operating performance, companies and their highly-paid “advisors” continue to erect obstacles to prevent activists from seeking direct shareholder representation on boards of directors. The Director Disqualification Bylaw is just the latest device developed by self-interested, entrenched powers that threatens to deprive shareholders of the increase in value and improved operating performance that often comes when an activist shareholder campaigns (at its own expense) for change at an underperforming company.
In summary, the perquisites doled out by companies to directors, such as access to private planes, come at the sole cost of shareholders while providing benefits only to entrenched directors and management[iii] and creating an environment where board members are more loyal to current management than they are to shareholders. Compensation arrangements between a nominee to a board of directors and an activist shareholder, on the other hand, come at the sole cost of the activist shareholder, create no novel conflicts of interest among directors and provide benefits to all shareholders. That is why I encourage all shareholders to oppose any directors who seek to insulate themselves from competition by unilaterally adopting a Director Disqualification Bylaw and to oppose any proposal by incumbent board members to adopt a Director Disqualification Bylaw at their company.
DO NOT LET INCUMBENT DIRECTORS LIMIT YOUR MOST VITAL RIGHT AS A SHAREHOLDER – THE RIGHT TO ELECT DIRECTORS OF YOUR CHOICE.
[i] It is important to note that the law provides incumbent board members with unlimited license to spend shareholder capital in a proxy fight. Thus, the Director Disqualification Bylaw essentially amounts to authorizing an incumbent mayor, already authorized to use unlimited taxpayer dollars to wage his re-election campaign, to also be able to select his own opponent! That is why we call the Director Disqualification Bylaw “particularly pernicious.”
[ii] It is not surprising that 14 of the 33 companies that have embraced the Director Disqualification Bylaw also have staggered boards, compared to less than 11% of companies in the S&P 500 index.
[iii] ISS describes companies that unilaterally adopt a Director Disqualification Bylaw as “effectively creat[ing] a powerful entrenchment device without providing shareholders any offsetting benefits” (emphasis added).