Home > Compensation, Conflictos de Interés y Transparencia > Should third parties be allowed to reward directors at all?

Should third parties be allowed to reward directors at all?

There has recently been a lot of debate and regulation about Compensation to Directors by firms. Discussions include Non executive directors fixed or variable pay, equity compensation, long versus short-term compensation, the connection between pay and independence, and many other things, such as disclosure and  binding or not binding “say on pay” by shareholders.

But, what about the possibility that outsiders, shareholders or not, might reward directors, some or all of them? The debate has arisen after two hedge funds, (Elliot Management in Hess Corp. and Jana Partners in Agrium), bought respective stakes in the companies, arguing for change after years of underperformance versus peers. Both proposed a partial slate of directors, and also offered them if elected, (and if certain objective conditions were met), big rewards, (fixed amounts per percentage point of stock appreciation or percentages of the fund`s return).

The first answer by the affected firms against the proposed practice referred to the loss of independence by those directors, and the short-termism in which they would decide on company matters, (more linked to the long-term). Hedge funds opposed alignment increases, and also that they would be offering those packages to their nominees, not being able to withdraw the offer, so that directors` independence would be preserved.

There has been a public debate after these disclosures among academics and practitioners, and we will deploy the main arguments in what follows, both against and in favor of this practice. Some of those arguing against even recommend that a particular bylaw feature be introduced by companies that would veto the practice, and we will also comment that possibility.

Arguments in favor:

  1. Alignment, as rewards would be connected to stock price appreciation.. This is very relevant when, as in most companies attacked by shareholder activists, previous performance has been deceiving.
  2. It generates a certain value to the rest of shareholders, for which they would not be paying, as the reward is due by a particular shareholder.
  3. Independence: it should not be legally considered lost, as nominees still would remain independent from management. Even if there is a close tie to those sponsoring them, there is no reason to believe they lose their independence to act as such where it is legally required, (Compensation committees for example, and even in Audit Committees). The subject kept aside, independence would be lost if the sponsor could at a certain point decide to withdraw the compensation proposal, so as to execute a pressure in favor of certain decisions, but this is not the case.
  4. Those payment arrangements are needed if companies are to attract the most qualified directors.

Arguments against the practice:

  1. Loss of independence, as a third-party interest would be served, (shareholder or not). Some (Bainbdridge, for instance), strongly assert it would be a danger to introduce this self-interest feature between directors and their duty of loyalty to the corporation and all shareholders.
  2. It introduces short-termism in the boardroom.
  3. It creates a different class of directors, with much higher pay levels, which might generate unnecessary controversies in the boardroom for an external factor, and even entail a spiral of director pay.
  4. Those highly paid directors would presumably assume much more risk that those only paid normal fees, (the highest paid to NED`s near 500.000 USD), and would not act as a barrier to excessive risk-taking by executives.
  5. Some (Prof Coffee) state that, given late developments in capital markets, (ownership concentration, higher institutional investors power, removal of poison pill and other defenses), the additional ability of bribing directors should not be allowed to hedge funds or other institutional investors.

What should be done, as suggested by those against the practice?

  1. Prof. Coffee recommends that the law evolves so a director, , can only be said to be independent, it they are independent from management (current regulation) but also from those who sponsored or nominated them.
  2. The law firm Watchell, Lipton, Rosen & Katz propose that companies modify their bylaws so as to prohibit shareholder activists -or any agent other than the company- to compensate directors, (in all forms and size).

Should the Watchell-Lipton bylaw be adopted by companies? A general view is that W-L tries -as in many proposals by this firm- to disturb shareholder activism and help entrenched boards and management. A second argument is this bylaw would make it difficult to attract the best director candidates. Thirdly, W-L appears to consider directors brought by activists as more likely to breach their fiduciary duties than incumbents and management.

An additional topic to he considered is that in fact, there could be a wide variety of third parties interested in paying incentives to directors. M&A firms, or any other third-party could have an interest that could be (truly or not) dressed with the robe of the long-term shareholders` interests.

The Council of Institutional Investors in the US has rejected third-party bonuses or performance payments for directors.

In any case, it is very probable that this debate will continue, and many different realities might well contribute to its effervescence.

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