A Strong Response to Paying Board Nominees

The stakes just got higher for shareholder activists.

Responding to hedge funds’ efforts to give incentives to nominees to company boards, the law firm Wachtell, Lipton, Rosen & Katz in essence came over the top on Thursday in a memo distributed to clients. Signed by the leading deal lawyer Martin Lipton and seven other Wachtell partners, the memo proposes that company boards consider adopting a bylaw prohibiting shareholder activists from compensating director nominees. Excluded from this prohibition are out-of-pocket expenses and payments for indemnification.

Wachtell’s proposal takes square aim at a topic I recently wrote about: the payment by hedge funds of large amounts of incentive compensation to director nominees. The issue has come to light because of two recent activist situations. Paul Singer’s Elliott Management has nominated five directors to the 14-member board of Hess while Barry Rosenstein’s Jana Partners recently lost a contest to elect five directors to Agrium’s 12-member board. In both cases, the hedge funds’ director nominees were provided with incentive compensation linked to the hedge funds’ investments that had the potential to pay them millions of dollars.

Since then a mini-debate has broken out online among law professors over whether these payments are legal or appropriate. Wachtell, which has done battle before with academics over their views in support of shareholders, is now citing two academics who are on its side.

The first is John C. Coffee Jr., the Columbia Law School professor, who stated that these “third-party bonuses create the wrong incentives, fragment the board and imply a shift toward both the short-term and higher risk.”

Meanwhile, Professor Stephen Bainbridge of the UCLA School of Law has written extensively on this subject and summed up his feelings by stating that “if this nonsense is not illegal, it ought to be.”

On the other side, several equally well-respected academics have signed off on these arrangements, even allowing themselves to be quoted in Elliot’s materials. In this corner we have Professor Randall Thomas of Vanderbilt Law School who said this approach made sense because it “lends itself to allowing these nominees, if elected, to focus on independent decision-making and fulfilling their fiduciary obligations on behalf of shareholders.” Another professor quoted in the materials is Larry Cunningham of George Washington University Law School who later argued that all of this “is intended to align the interests of those directors with those of the company’s shareholders.”

As you might suspect with all of this debate, many issues are being raised about whether these directors can be deemed independent, whether they have different incentives and whether this whole arrangement is even appropriate. Another law professor, Usha Rodrigues of the University of Georgia Law School, offers her own views on this while summarizing the state of play.

But as before and without wading into this feeding frenzy, I am a bit wary of these arrangements. I can see the need that hedge funds have to find director nominees and to attract the most qualified they need to be compensated. This compensation is all disclosed, so shareholders and other directors can monitor the situation and refuse to re-elect directors if the payment turns out to be inappropriate.

But I also have a “here we go again” view. Are we now going to do for director compensation what we did for chief executive compensation and spiral it all higher? The assumption that aligning incentives must be a good thing brings to mind that line from Whitney Houston that “the children are the future.” Of course they are the future, but it doesn’t really mean anything more than that. (Full disclosure: I am not only an academic, I have on occasion listened to Whitney Houston.) Another way to look at this is to examine what happened at Apple. Does anyone think that Apple would not have performed as well if it had paid Al Gore a couple of million dollars to be a director instead of tens of millions of dollars?

Still, though I am wary about incentive compensation for directors coming directly from hedge funds, I think that the issue is worth discussing and examining. And let’s be clear, in the case of Hess I believe the real issue is the company’s extremely poor relative performance over the years and which slate of directors is best situated to take the company forward.

But while making good points about the flaws of this compensation, Mr. Lipton and the lawyers at Wachtell aim to shut down the entire practice. This includes not only the potentially multimillion-dollar payments that Elliot and Jana agreed to, but the common practice of “tipping” hedge fund director nominees anywhere from $15,000 to $150,000 for just agreeing to be nominated. In fact, this type of tipping is really the more common practice than the most recent incentive compensation.

If Wachtell’s bylaw is adopted widely, and I suspect it will see some momentum, directors will have to agree to be nominated out of the goodness of their hearts. In other words, the bylaw not only strikes at the incentive compensation that is being the debated but the more common “tipping” arrangements that are not.

In fairness, Wachtell states in the memo that this bylaw will not stop directors from receiving compensation if they are elected or the hedge fund from paying them if they are not. But if you read the proposed bylaw, it is so broadly worded that any arrangements to compensate director nominees who do not get elected after the fact would be prohibited.
Moreover, the bylaw continues another worrying trend in corporate law. The use of bylaw amendments by boards to shut down, or severely inhibit, shareholder activism. Most recently, Commonwealth REIT successfully defended in a Maryland court the adoption of a bylaw requiring arbitration of shareholder disputes. The net effect was to halt for an indeterminate period a shareholder activist campaign by .

In this case, Wachtell’s bylaw could chill shareholder activist activity by making it harder to obtain qualified director nominees. Again, it may be that this compensation should be regulated or monitored, but wouldn’t it be better for this to be done in consultation with shareholders rather than unilaterally by the board. Institutional Shareholder Services, the large and influential proxy adviser, for example, has yet to take a position on the issue, which has just burst on the scene.

So while Wachtell is certainly raising the stakes in response to activists, and should be credited with raising good points that need to be addressed about this type of compensation, it still may be too much too early.