Activist investors commonly take their various fights to annual meeting, using the power of the proxy to get what they want. Another, less visible strategy, is to buy their way onto boards. So-called “golden leash” arrangements occur when activist shareholders—ypically hedge funds—pay a director or board nominee in connection with their service.
Calling this sort of third-party compensation “one area where investors may not have complete information,” the NASDAQ stock exchange has submitted a rule proposal to the Securities and Exchange Commission to require listed companies to publicly disclose these arrangements.
“These undisclosed compensation arrangements potentially raise several concerns, including that they may lead to conflicts of interest among directors and call into question their ability to satisfy their fiduciary duties,” the proposal says, adding that they may also “promote a focus on short-term results at the expense of long-term value creation.” The proposed rule applies to any compensation payments, or perks, including incentives for reaching share price timelines or health insurance premiums that are made in connection with a person’s candidacy or service as a director. The new Rule 5250(c) would require listed companies to publicly disclose these agreements on their website, proxy statement, Form 10-K, or Form 20-F.
The proposal, in the hands of the SEC and undergoing a public comment process, has renewed interest in what has been an ongoing battle between large, activist investors and those advocating for the interests of the broader shareholder community. Recent and controversial “golden leash” efforts have been a part of proxy fights at General Motors, Dow Chemical, Agrium, and Hess.
Proponents view the arrangements as a way to attract high-quality candidates aligned with the interests of shareholders. Critics rail against conflicts of interests, board disruptiveness, and a push for short-term value creation that can fit a hedge fund’s investment window at the expense of long-term strategy. The Council of Institutional Investors, a non-profit association of pension funds, endowments and foundations with combined assets that exceed $3 trillion, unsuccessfully petitioned the SEC in 2014 to review proxy rules with an eye toward demanding these disclosures.
How well are “golden leashes” currently disclosed? While many public companies do require that they be revealed, practices vary. “The disclosure that companies are charged with providing in their proxy statements regarding their own director compensation programs is far more comprehensive than that required by the 13D rules applicable to shareholders putting up their own director nominees,” says Lizanne Thomas, head of the law firm Jones Day’s corporate governance team. “Many companies have tried to fill this gap by instituting bylaw provisions that require shareholders to disclose any third-party compensation arrangements for its director nominees, but those disclosures often happen too late in the proxy season to be effective.”
“Keeping as much as possible at a full board level, not excluding the management directors, and keeping the company’s advisers in the game are all important for making sure that the activist directors are not taking over the boardroom."
Ethan Klingsberg, Partner, Cleary Gottlieb
Thomas—who serves on the boards of Krispy Kreme Doughnuts, Atlantic Capital Bancshares, and Popeye’s Louisiana Kitchen—agrees that the concerns fit within the larger debate over corporate short-termism. “The critical point to remember is that boards don't have the luxury of attending merely to short-term success, or, for that matter, solely to long-term value creation,” she says. “Boards must forever engage in the careful calculus of ensuring that their company and its management team build near-term credibility in order to achieve the best long-term results. Certainly, the task would be easier if boards were entitled to wear blinders regarding long-term value. They can't, and they shouldn't.”
Other concerns about the practice include a risk undermining boardroom stability and creating dissent. “The power that a board wields is as a unified decision-making group,” Thomas says. “If nominally independent directors are compensated by a third party, differently motivated than the remaining board members, and particularly when this compensation is not disclosed or disclosed only inadequately, how does a group charged with collective decision making work together in a spirit of candor and common fiduciary responsibilities? It defies reason, not to mention traditional notions of conflict of interest.”
Thomas says her inquiries to the NYSE indicate that it is monitoring reaction to NASDAQ’s proposed rule and “if there is a groundswell of support, it is likely to follow suit by proposing a sunshine rule.” In the absence of an outright prohibition, unlikely to come from the SEC, “sunshine can be a great disinfectant, and is consistent with the Commission's fundamental disclosure ethos anyway.”
PULLING BACK ON GOLDEN LEASHES
The following is from a Nasdaq rule proposal, submitted to the Securities and Excchange Commission, regarding so-called "golden leash" arrangemments.
Nasdaq is proposing to adopt Rule 5250(c) to require listed companies to publicly disclose on or through the companies’ website or proxy statement for the next annual meeting (or, if they do not file proxy statements, in Form 10-K or Form 20-F), all agreements and arrangements between any director or nominee and any person or entity (other than the company) that provide for compensation or other payment in connection with that person’s candidacy or service as a director.
The proposed rule is intended to be construed broadly and apply to both compensation and other forms of payment such has health insurance premiums that are made in connection with a person’s candidacy or service as a director. Further, at a minimum, the disclosure should identify the parties to and the material terms of the agreement or arrangement.
But in recognition of circumstances that do not raise the concerns noted above or where such disclosure may be duplicative, the proposed rule would not apply to agreements and arrangements that relate only to reimbursement of expenses incurred in connection with candidacy as a director or that existed before the nominee’s candidacy and have been otherwise publicly disclosed, for example, in a director’s biographical summary included in periodic reports filed with the Commission.
Thus, a company would not be required to disclose compensation or other payments from a third-party to a director candidate who had a pre-existing employment relationship with the third party and the compensation or other payments had been publicly disclosed.
Further, in recognition that a company, despite reasonable efforts, may not be able to identify all such agreements and arrangements, the proposed rule provides that a company shall not be deficient with the proposed requirement if it has undertaken reasonable efforts to identify all such agreements and arrangements, including by asking each director or nominee in a manner designed to allow timely disclosure, and promptly makes the required disclosure by filing a Form 8-K or 6-K, where required by SEC rules, or by issuing a press release.
In cases where a company is considered deficient, the company must provide a plan to regain compliance sufficient to satisfy Nasdaq staff that the company has adopted processes and procedures designed to identify and disclose relevant agreements and arrangements in the future.
The NASDAQ rule is in the spirit of what is already required by many company bylaws, says Ethan Klingsberg, a partner with law firm Cleary Gottlieb. Of greater interest is a hint at potential future rulemaking contained in a footnote to the proposal. It reads: “Separate from this proposed rule change, Nasdaq plans to publicly solicit comment from interested parties as to whether [it] should propose additional requirements surrounding directors and candidates that receive third-party payments, including whether such directors should be prohibited from being considered independent under Nasdaq rules or prohibited from serving on the board altogether.”
“If NASDAQ does anything that limits a director’s ability to qualify as ‘independent’ as a result of connections to hedge funds, it could be interesting,” Klingsberg says. “Hedge fund directors love to be on compensation committees and, as a non-independent, they would be barred from joining the compensation, nominating, or audit committee. I don't think such a limitation would stop the flow of activists getting their people on boards, but it would be an interesting move and one that is consistent with the message coming out of the Delaware courts to watch out for these directors who are principals at or otherwise attached to hedge funds because they are working for a constituency and not necessarily aligned with all the other shareholders."
The challenge amid all this is how a company can, and should, deal with activist investors who land on their board.
"You can't marginalize any director, that would be a violation of Delaware law [where many public companies are incorporated], but you also need to prevent improper domination of the process by a director whose interests are not aligned with the shareholders generally, especially those shareholders intending to hold for a longer period than the director’s ‘golden leash’ arrangement or hedge fund contemplates,” Klingsberg says “Even if hedge fund-affiliated directors are deemed not to be independent and barred from the compensation committee, the real issues are still going to be whether to sell the company, undertake a huge leveraged recapitalization, or take any of the other directions that are going to pump short-term value as an alternative to something more long-term oriented.”
“You need to ensure that the hedge fund director does not hijack the process for evaluating these issues by, for example, chairing a special committee appointed to handle these issues and hiring a separate set of advisers," he adds.
Klingsberg proposes that a “golden leash” director isn’t necessarily going to be a catalyst for board-wide dissent. “I've advised a number of boards with directors from activist hedge funds on them and, by and large, everything has worked out nicely, but you have to orchestrate it correctly,” he says. “You can't let the activist directors dominate and you can't marginalize them. There is a balance that has to be struck."
So, how do you strike that balance? “Keeping as much as possible at a full board level, not excluding the management directors, and keeping the company’s advisers in the game are all important for making sure that the activist directors are not taking over the boardroom," Klingsberg says.
Leverage the activists and turn them into your advocate by getting them information and explaining nuances and practicalities to them. “I've seen a number of times where they are loud mouths who were complaining and complaining before they get into the boardroom, but once they get in there they realize all of the dynamics and there is a meeting point much closer to where management started where they become aligned," he says.