May 04, 2013
More on Hedge Funds' Director Bonuses
Posted by Usha Rodrigues

Last month I blogged about DealProf Steven Davidoff's piece on a few cases of hedge funds paying bonuses to their successful board candidates.  Controversy has since swirled in the law prof blogosphere. Lawrence Cunningham of ConOp summarizes the action thusly:

A hot debate rages among corporate law professors amid one of the largest proxy battles in a decade: Hess Corp., the $20 billion oil giant, is the focus of a contest between its longstanding incumbent management and the activist shareholder Elliott Associates.   Ahead of Hess’s annual meeting on May 16, where 1/3 of the seats on Hess’s staggered board are up, antagonists offer dueling business visions.  They battle bitterly over such fundamentals as sectors to pursue, degrees of integration to have and cash dividend policy.

The professorial debate, more civil, is about a novel pay plan Elliott proposes for its director nominees, which Hess’s incumbents condemn and Elliott defends as suited to shareholders. On one side, all quoted inElliott’s investor materials circulated April 16, are meLarry Hammermesh (Widener), Todd Henderson (Chicago), Yair Listoken (Yale) and Randall Thomas (Vanderbilt); on the other  Steve Bainbridge (UCLA), Jack Coffee (Columbia) and Usha Rodriques (Georgia), all of whom have blogged since the matter was first reported by Steven Davidoff (Ohio State) in the New York Times April 2 (for which he connected with me for comment).

As in all such cases, Elliott proposes to pay nominees a flat fee of $50,000 each for their troubles and to indemnify them for legal liability.  The novelty is that Elliott will provide incentive compensation to the group: if any Elliott nominee is elected as a result of this year’s  contest, all nominees receive a bonus at the end of three years if Hess’s stock performs better than a group of industry peers. Elliott, not Hess, pays all bonuses.

Steve has since offered a response to Lawrence.  My original post was pretty cursory, and given the subsequent debate, I've been thinking more about the issues.  I have two points that are really more questions than answers:  

First, Lawrence argues that  the bonuses are "surgically tailored to tie the payoff to Hess’s stock price performance compared to competitors." But directors are supposed to act "in the best interests of the firm."  Doesn't Elliott's scheme predispose the directors in question to a certain version of "the best interests of the firm" in an impermissible way?  I.e., even if (and it is an "if" in some circles, at least) we're all agreed shareholder wealth maximization is the goal, these schemes enshrine one particular version for these directors.  That may not be kosher.

Second, Jack Coffee suggested that, if successful, these directors should not be considered independent: 

In the new world of hedge fund activism, we need to look to whether individual directors are tied too closely by special compensation to those sponsoring and nominating them. Once we recognize that compensation can give rise to a conflict of interest that induces a director to subordinate his or her own judgment to that of the institution paying the director, our definition of independence needs to be updated.  Although not all directors must be independent, only independent directors may today serve on the audit, nominating, or compensation committees.  

Director independence has interested me for a long time. In the Fetishization of Independence I distinguished between Delaware's situational notion of independence and securities law's static conception of independence meaning independence from management.  SOX 301, unlike the exchanges, takes into account bare share ownership when assessing independence, since affiliates of the issuer are not independent. The question whether successful Elliott directors would be deemed affiliates would turn on the extent of Elliott's control of Hess.  Coffee suggests that, even if Elliott is not an affiliate, its bonus program should be enough to render its nominees nonindependent.  

This notion has intuitive appeal for me, but I'm having some trouble squaring it with how the logic of independent committees.  Take compensation.  It's clear why we want compensation committee members to be independent of management--managers have a conflict of interest when setting their own pay.  But it's not clear that the Elliott nominated directors, even with their juiced incentives, have any particular disqualifying bias when it comes to setting executive compensation.  Or maybe the concern is that they could wield their comp-setting powers in order to extort private benefits from management?  

Currently under Dodd-Frank factors to consider in evaluating independence of comp committee members include the sources of the director's compensation and whether the director is affiliated with the issuer.  So I have a hunch we're at the start of a long conversation about director compensation and independence.

Update: for even more from Steve and Lawrence, see here (including the comments).

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