Would you pay a director tens of millions for fantastic performance Welcome to the newest trend in activist investing: hedge funds paying their nominees to a company’s board as if they were chief executives.
The latest examples can be found in two prominent proxy fights. In the first, Paul Singer’s Elliott Management has acquired about $800 million in stock of the Hess Corporation, the integrated oil company. The hedge fund has nominated five directors to the 14-member Hess board and is agitating for change, arguing that the company has substantially underperformed its peers by 460 percent over the last 17 years.
In the second, Barry Rosenstein’s Jana Partners is storming the ramparts of Agrium, acquiring about 7.5 percent of the company, an agriculture supply retailer and wholesaler based in Calgary, Alberta. Jana, which contends Agrium has underperformed its peers by 160 percent over the last five years, has nominated five directors to the company’s 12-member board.
Agitating for changes and waging proxy fights are familiar pages from the activist investor playbook. What’s different here is that each hedge fund is promising to pay its director candidates what are essentially bonuses that could run into millions of dollars, if not more.
In Elliott’s case, its five nominees will be paid a $50,000 retainer, a mere tip. The kicker is that any of its nominees who win a seat on the Hess board and serve for a year will be paid an aggregate $30,000 for each percentage point the stock price of Hess outperforms a peer group of stocks over three years from January 2013, when the stock was trading at about $58 a share (it’s at $70 now). The total potential payment tops out at $9 million for each director â€" or 300 percent outperformance, an admittedly fantastic return for everyone if it occurs.
Jana is paying its nominees in a more direct and potentially more lucrative manner. Jana’s nominees also get $50,000 each, but they will receive 2.6 percent of Jana’s net profit from the price of Agrium shares as of Sept. 27, 2012, if they are elected (Agrium’s stock then was $102.99 in New York, and is currently trading a few dollars below that). If they are not elected, they will still receive 1.8 percent of Jana’s net profit. The hedge fund’s investment is about $1 billion, so we are talking about potential millions, if not tens of millions, of dollars.
Any way you slice it, Jana and Elliott are raising the ante for director compensation. A study of 1,500 companies found that the average director made $134,000 in annual cash and incentive compensation from 2006 to 2010. And this week, Susanne Craig of The New York Times reported that some Goldman Sachs directors made more than $500,000 a year. That’s a nice sum, but these hedge fund-nominated directors stand to make much more.
Not surprisingly, both Agrium and Hess are up in arms about the hedge funds’ plans to pay their nominees. They make two basic arguments.
The first is that the hedge fund directors are not independent. Because the directors are being paid by the hedge fund, they will be loyal to the hedge fund, rather than the company.
The second is that by paying these directors large sums over three years, the hedge fund nominees will aim for short-term performance and not care what happens to the company in the longer term.
The counterargument has been put forth most forcefully by Jana. The hedge fund argues that the compensation system is hard-wired. Jana (and Elliott, for that matter) have already agreed to pay these amounts and can’t renege, so the directors are no longer beholden to the hedge fund, if they ever were.
Jana also contends that its compensation arrangement is better than other kinds of director pay, since it better aligns the company’s performance with the directors’.
Elliott echoed this, saying in a statement: “There is no link to any plan, there is no discretion by Elliott, and the term is longer than any compensation offered by Hess. In other words, there is complete alignment with long-term shareholders’ interests.â€
So who is right
First, as long as the arrangement is disclosed and the hedge funds don’t exert any future control over the nominees, it is unlikely that this violates any state or federal law. Here, director compensation falls into the same basket as executive compensation.
The examples of hedge funds paying directors are all over the place.
Some funds, like Pershing Square Capital Management, do not directly compensate nominees. Other funds pay just a flat fee of $50,000 to $150,000. And then there are arrangements like the one Carl C. Icahn had with Frank J. Biondi Jr., the former chief executive Viacom, during Mr. Icahn’s battle with Time Warner in 2006. In that case, Mr. Icahn’s fund agreed to pay Mr. Biondi $6 million to $10 million depeding on whether he was elected or not (he was not).
It’s clear that if you need good people to run for these positions and clean up the company, it is going to cost money. Most of the people the hedge funds have nominated have better things to do than walk around with a bull’s-eye on their backs.
But it’s hard to know. There is no doubt that this kind of pay arrangement sets up two classes of directors doing the same job but being paid very different amounts. It could not only create resentment, but disagreement over the path of the company. And it also has the potential to begin a second arms race in director compensation, something probably best avoided.
There is a bigger problem here. Directors are looked on as caretakers. In exchange for a wide release from liability, they get a decent salary for not a lot of work. In most instances, they are not going to become staggeringly rich.
Relatively modest compensation may ensure that directors act more prudently and serve as a counterweight to chief executives, who are more willing to shoot for the moon because their upside is so high. By paying directors as if they were chief executives, they may become all the more willing to take on more risk.
This may be particularly true where there is no downside, which is not typical for directors who receive stock in the company. In fairness, Jana’s directors have bought $14 million in Agrium stock, so they do have downside. Some of Elliott’s nominees have also purchased Hess shares.
In the end, it is hard to see either of these contests as a referendum on director compensation. Shareholders will get full disclosure of the arrangements, but in this case it is hard to say that it matters. They are going to vote for who they think is the better for the company and probably not pay much attention to the compensation issue, like “say on pay†votes, which regularly pass. I can’t really argue with this. Let’s face it, the performance and assessment of these companies is the most pressing point.
The influential proxy adviser Institutional Shareholder Services looked at the director compensation issue in the case of Agrium, but didn’t take a position on it. (It is recommending two of Jana’s nominees, while a competitor, Glass Lewis, has recommended all of Agrium’s nominees.)
Whatever the outcome in both contests, perhaps it is time to take a hard look at director compensation. For this could all end in tears. The last decade hasn’t exactly inspired confidence that incentive compensation works as the theorists say it should in terms of aligning directors, executives and shareholders. Compensating directors more like chief executives may change the entire risk profile of companies. It may be for the better, but it also can be for the worse. We just don’t know.
