Monday, May 6, 2013

Shareholder Activism Enters the Boardroom

Over the last month or so, an interesting debate has surfaced that takes shareholder activism to the next level. As the Deal Professor column notes, two hedge funds have initiated proposals whereby they have promised to pay their nominees, if elected to the board of the investee company, director compensation linked to the profitability of the company as if they were executives. The promised compensation has two parts: one, a fixed retainer/fee; another, a bonus depending upon the financial performance of the company that could extend to a few million dollars. This has the effect of treating institutional shareholder nominees on par with executives for the purpose of compensation. This development raises a number of legal issues pertaining to corporate law and corporate governance. Although the details regarding the issue are only beginning to get fleshed out, a post on the Conglomerate Blog helpfully provides links to the key debates.

Although shareholder activism has taken off quite strongly in India (as noted here and here), it might be some time away before the issue of institutional investor nominees takes such a deep grounding in the Indian context. Nevertheless, it is useful to consider some of the key conceptual issues that this gives rise to:

1.         The first issue relates to who pays the compensation to the institutional nominee directors. The current trend seems to suggest that the compensation is paid by the nominator/investor rather than the company itself, which would minimise the effect of the usual issues pertaining to executive compensation if it were to be paid by the company itself.

2.         These appointments could create factions on the board, i.e. between the inside directors (executives) and the so-called outsiders (nominees), thereby possibly curbing efficient (if not effective) decision-making. A contrarian approach to this would suggest that such differing views and perspectives may actually be beneficial to the overall well-being of the company and the interest of the shareholders.

3.         There could be questions regarding the effectiveness of the nominee directors. For example, given that they are non-executive directors, they may have difficulties in accessing information regarding the business of the company or to other officers in the same way as an executive director can.

4.         It is unclear if the nominee directors may be willing to take on the risk of facing liability because they may have responsibilities without the accompanying power or control within the company.

5.         As these directors are nominated by the institutional investors (who may have a significant holding in the company), it is unlikely that these directors would be treated as independent directors. Their appointment on the board may tilt the balance of independent and non-independent directors which may make it difficult to comply with the requisite board independence requirements under the corporate governance norms without appointing more independent directors maintain the appropriate balance.

6.         Since the nominee directors would owe fiduciary duties to the company, they are in an unenviable position whereby they may have to prefer the interests of the company over those of their nominating investor in case of a conflict between those interests.

These are only some initial thoughts, but a number of other issues and concerns on both sides of the debate are contained in the links provided above.

Update – May 14, 2013: A memo from Wachtell Lipton provides a strong response to the proposal for offer of incentive compensation to investor nominees, and a column by the Deal Professor advocates caution in adopting the incentive compensation approach.

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