Proposals for performance-based pay for directors — potentially paying in the millions of dollars, as arose in two proxy proposals this year — should draw more attention to the compensation structure for corporate board members.
Directors face distinct challenges and conflicts in setting their own compensation.
Shareholders have directed their attention to the pay of CEOs and other top executives, focusing on eliminating excesses and aligning pay better with investor interest, particular by steering the compensation mix more toward performance-based pay and away from cash.
Directors increasingly have come under more pressure, from demands of the Dodd-Frank Wall Street Reform and Consumer Protection Act, to shareholder engagement and scrutiny. In addition, a corporate governance practice favored by many activist shareholders calls for corporations to scrap the model of one person being both chairman and CEO, leading both the corporate board and management. Instead, these shareholders call for an independent chairman to improve oversight and accountability of management. All these pressures put directors under more scrutiny, and expose them to more liability.
Shareholders should give more attention to addressing the compensation structure for board members, as they have for top executives. Shareholders view executive compensation structure as a primary tool for attracting and retaining top executive talent, a key to corporate performance. Likewise, the compensation structure for board members might serve in a similar manner to attract top talent to boards of directors. Shareholders also need to devote attention to the issue because some activist investors already have, and possibly others will follow, potentially with more refined, more acceptable compensation arrangements for directors.
The issue of performance-based pay for directors arose this year when hedge fund manager JANA Partners LLC put forth a lineup of five dissident nominees to the 12-member board of Agrium Inc., including Barry Rosenstein, managing partner of the hedge fund manager, and when Elliott Management Corp. put up a slate of five nominees to the 14-member board of Hess Corp.
Under the similar proposals, if their nominees won seats they would be eligible for pay that depended on the performance of the company's shares, but only the dissident directors would receive the incentive compensation.
In the case of Hess, each challenger director's compensation would be based on a sliding scale of incentives tied to the company outperformance of its peer group. Directors could receive up to $9 million per nominee if the company outperformed its peers by 300%. Plus, nominees were offered a $50,000 retainer above the pay they would receive as members of the board.
Compensation plans such as this could seed dissension and mistrust between the company-nominated directors and the dissidents, and fracture board decision-making on oversight. In addition, shareholders might become suspicious about the alignment of interests of the dissident directors, and question their independence and fiduciary loyalty as representatives of all shareholders.
In addition, the dissident director nominees might promote short-term performance in the interests of maximizing their incentive pay at the expense of what might be a more sustainable, more profitable objective that might take longer to realize. If the pay proposals were designed to attract shareholder support, they fell short. All of Agrium's incumbent directors were re-elected, while Elliott and Hess reached an agreement on board seats that included scrapping the extra pay.
The attempts by hedge fund investors to intervene in the director compensation debate raise other issues as well, such as how the performance of directors should be measured.
Measuring directors' performance has been a challenge for corporations. At J.P. Morgan Chase & Co.'s annual meeting May 21, James Dimon, chairman and CEO of the company was asked how the board knows it is doing a good job, and how to measure the value added by the board, including the independent directors.
According to a transcript, Mr. Dimon said: “I don't think you can isolate it. You're acting like you can take the independent board as a group and management as another group and try and ascribe some particular value to it. That's not the way we look at how we manage the company. We look at the totality of it and each group has a role in how that is done. And as a matter of fact if you try to separate it, you're going to destroy what is the relationship between the board and management.”
Directors are in a challenging position. In addition to setting executive compensation, they set their own pay structure. Currently director pay tends to be a combination of a cash retainer and some form of stock, noted Doug Fiske, Chicago-based global leader of executive compensation consulting at Towers Watson & Co., in an interview.
From the standpoint of performance-based pay, the stock directors get as part of their compensation serves as an incentive, Mr. Fiske said.
But there is no explicit performance benchmark, such as the type JANA and Elliott proposed.
To have directors set their own performance targets as well as their pay structure puts them in difficult position. The targets would have to conform to the hurdles set for management. Intervention by particular shareholders, such as JANA and Elliott, to set the targets and the pay for some directors, without full knowledge of the company, could misalign shareholder and director interests.
Some shareholders might have a perception that things other than compensation motivate director performance. But the increased workload of directors, and the need to attract talented overseers, will test that point of view.
Should shareholders have a say on pay for directors as they do now with a non-binding vote for top executives? They don't need it. Because unlike for the executives, shareholders vote directly on electing board members. So if shareholders are unhappy with director pay structure, they should vote the directors out.
But if director pay proposals become a trend, shareholders will have to pay greater attention to the nominees for directorships. As long as their terms are fully disclosed, shareholders should be left to decide whether the quality of the nominees warrants unorthodox pay arrangements.