Hedge Funds

A debate over paying board nominees of activist funds

David Gelles
A Hess gas station in Brooklyn, N.Y.
Craig Warga | Bloomberg | Getty Images

When executives serve on a company's board, they are often handsomely compensated.

But as activist hedge funds continue to get more of their preferred candidates on the boards of companies, some of the hedge funds are angling for certain directors to be paid twice: once by the company, and once by the hedge funds that supported their candidacy.

In two efforts earlier this year, dissident candidates up for election at the Hess Corporation and the Canadian fertilizer company Agrium—two companies targeted by activists—were offered large bonuses by the hedge funds that nominated them.

At Hess, Elliott Management nominated five candidates to the oil company's 14-member board, saying current management had underperformed. And at Agrium, Jana Partners nominated five directors to a 12-person board. In both cases, the directors nominated by the hedge funds would have received their bonuses only if the companies' stock rose sharply.

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None of the activist directors joined the boards with such arrangements in place. The dissident slate at Agrium was rejected, and while some new directors joined the board at Hess, they did so without the extra compensation.

Nonetheless, the prospect of such incentives upset the stuffy world of corporate governance. And the simmering dispute around director compensation from third parties is the latest front in the growing war of influence being waged between activist hedge funds and corporate boards.

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Hedge funds want to compensate director nominees who commit their time and risk a public fight by standing for election to a company board. But companies say that it is not clear who the activist director is really working for—its shareholders, or the hedge fund.

On Tuesday the issue will come into focus again as shareholders of Provident Financial Holdings, a small bank holding company, will decide whether to re-elect three members of the board who unilaterally passed a provision barring the practice earlier this year.

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The Provident bylaw states that no director of the company can be compensated by a third party in connection with his or her election to or service on the board.

"It's problematic that you're forcing them to focus on the short term, rather than follow a long-term strategy which might be better for the company," said John C. Coffee Jr., a professor at Columbia Law School.

Provident did not return requests for comment.

Provident is not the first company to wrestle with the shifting landscape of director compensation. But the type of bylaw adopted by Provident and at least 25 other companies goes further than similar ones at other companies, which state only that directors getting compensated by third parties must disclose it.

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Though Provident is a small company, several multinational companies including Halliburton, Marathon Oil, Eastman Chemical and Wynn Resorts have adopted a version of the bylaw.

The provision is modeled on a proposal put forth by Wachtell, Lipton, Rosen & Katz, the esteemed Wall Street law firm known for its work defending corporate clients.

But in recent days, Institutional Shareholder Services, the influential proxy advisory service, recommended that Provident shareholders vote against the directors who passed the bylaw because they did not take the vote to shareholders.

"Investors may find the new bylaw provision concerning because it could deter legitimate efforts to seek board representation via a proxy contest, particularly those efforts that include independent board candidates selected for their strong, relevant industry expertise, and who are generally recruited, but not directly employed, by the dissident shareholder," wrote Jolene Dugan of I.S.S.

"Such nominees often receive a reasonable fee for agreeing to stand for election, to compensate them for the considerable time commitments incurred in proxy contests," she said.

In response, Wachtell Lipton struck back, arguing for Provident's right to adopt such bylaws even though the company was not a client.

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"To the extent this I.S.S. recommendation is a harbinger of a new, and previously unannounced, one-size-fits-all policy, however, it may discourage companies from protecting themselves against inappropriate director conflict and enrichment schemes, and encourage activists to offer them," the founding partner Martin Lipton wrote in a memo.

"In our view, this would be a most unfortunate development, because I.S.S. would be unwittingly promoting fragmented and dysfunctional boards, conflicted and self-interested directors and short-termist behavior," he continued.

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Wachtell Lipton is also concerned that the opposition could discourage boards from adopting bylaws without a shareholder vote, a common practice that I.S.S. singled out as unfair to investors.

Despite Wachtell Lipton's protestations, the debate is likely to have a chilling effect on such bylaws. I.S.S.'s recommendations carry weight with institutional investors, and given its opposition, many boards may not take the risk. And while no director has been nominated to a board with a lucrative third-party compensation plan in place, industry watchers are betting that it is only a matter of time before such arrangements are in effect.

"After last summer, a lot of investors wanted to talk to us about the issue to better understand it," said Charles Penner, a partner at Jana. "Almost every investor we've spoken to understands that some compensation is often necessary to get the best candidates possible and that having actual skin in the game is a good thing."

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Directors compensated by third parties may face a unique legal conundrum because they may not be protected by the business judgment rule, according to Mr. Coffee. That law shields public company directors from legal action as long as they are trying to act in the best interest of shareholders.

Mr. Coffee is advocating for a middle ground. He says he believes that boards should have the ability to adopt such bylaws on their own in the short term, but that any long-term changes to a company's rules should be subject to a shareholder vote.

And he would like directors nominated by hedge funds to be compensated for certain expenses related to their campaign, but is wary of the opportunity for huge windfalls.

"I believe that there is something to board cohesion and having directors subject to the same basic compensation," Mr. Coffee said. "When boards disagree, it's better that they not think it's being done because certain directors are being bribed."

—By David Gelles of The New York Times