Download - Board Compensation
Tej G. PatelFINC 418-010May 15 , 2014
Shareholder Value: The Evolution and
Future of Board Compensation
Fiduciary Duty
The well-established debate of whom the directors owe a fiduciary duty to has been the
center of attention for decades in American corporate law. The primary objective of the
corporation is to conduct business activities with a view of enhancing corporate profit and
shareholder gain (Forrester, 2012). Since the famous Dodge v Ford Motor Co. case, it has been
established that the only responsibility that a director should have is towards his or her
employers, which are in fact the shareholders. In the case, Henry Ford decided to give back to
the community (in favor of stakeholder theory) instead of pay dividends to investors, but the
Dodge brothers (who owned a significant amount of equity in Ford) wanted to collect the return
on their investment. This led to the dilemma that if shareholders were not receiving the proper
returns on their investment, and the company was allocating the profits elsewhere, then there
would be no more investors; if no one is willing to invest, then companies would not be able to
raise capital via equity. This can cause a huge breakdown in new and existing corporations, and
corporate America would take a sharp decline.
Since the early 20th century, when the Supreme Court ruled on the Ford case, it seems that
the general consensus is still in favor of the Friedman doctrine. Milton Friedman is the first
person that proposed the idea of the idea otherwise known as stakeholder theory. Friedman
believes that a company’s only responsibility is to increase its profits. In present times the
chairman of the audit committee of JPMorgan Chase & Co., Laban Jackson said “we work for
the shareholders, no one else” during a roundtable discussion at the Weinberg Center for
Corporate Governance (“Non-Profit Best Governance Practices”). The board has always been
under the duty of care and the duty of loyalty, these duties are put in place to protect the
shareholders. The fiduciary duty of the board of directors has thus always been primarily to
increase shareholder value; now the question that must be asked is, ‘how can one insure that the
board will act in the shareholders’ best interest’?
Purpose of Director Compensation
According to the National Association of Corporate Directors, “the purpose of director
compensation is twofold.”
The first reason for board compensation is to combine the interest of shareholders and
directors. Because the directors are hired as the shareholders’ agents, a compensation plan that is
correlated with shareholder value would be in the best interest of the investors. The second
reason for board compensation is to provide value to directors for received value. The job of a
director is no easy task; it takes great expertise in their field to be a competent director. Directors
are highly trained, valuable people who have alternative uses for their time and skill. “Over time
and in aggregate, exceptions aside, there is a good chance that you will get the board you pay
for”, meaning if you have an inferior compensation program for directors than you will more
than likely have inferior directors (NACD, 1995).
The top three highest paying corporations for board of directors as of May 2013 are
Fidelity National Information Services, News Corp. and Costco Wholesale Corp. These firms
realize that the board is just as valuable as the executives, the directors have generated awards of
a million dollars plus, while fidelity rewarded directors with a total of over 9 million dollars in
bonuses, these directors have had a hand in propelling their respective companies to the Fortune
500 level. Then there are cases where board compensation is very low, yet the company is doing
exceptionally well. One company that comes to mind is The Great Warren Buffett’s, Berkshire
Hathaway; the directors are not nearly as compensated, but at the same time the board consist of
billionaires, so an award of a million dollars would be fairly miniscule in perspective to their
personal finances (Green, 2013).
PAST: Salary-Based Compensation Structure
When the board first came into existence, the go to compensation package was to pay the
directors with a flat salary. In the past the only reason someone would want to become a director
was because they were large shareholders and they wished to protect their investment. Usually
those who were not shareholders did not care to be on the board. As we move on to present
times, being on a board is much more than it was before. Now people wish to be on boards even
if they do not own equity because it is catering to those wanting higher status, prestige,
professional development, it is considered community service and board compensation is pretty
high compared to other professions (Elson). This can cause the directors of our age to be more
aloof and unemotional about the company. The reason for this is because, yes, their name is out
there as someone who is giving back, but the board has no incentive to put forth the proper
oversight and monitoring of management; they are not focusing on increasing shareholder value.
The salary-based compensation structure essentially causes a board to be ineffective. An
ineffective board is detrimental to a corporation because
1. They lack objectivity and independence
2. They lack true authority over management
3. They lack a grasp of what is going on in the company
4. They simply do not work hard enough
Directors are generally experts in their own respective fields, or in the industry of the
company they are working for (Bacon, 1977). This means that, those that are chosen and
nominated to become a director of a board are more than likely financially well endowed.
Therefore, in order to even grab the attention of a potential director, the compensation (if strictly
salary-based), must be enough for them to accept the offer in the first place. The opportunity cost
associated with the hours must be equal or less than the compensation and value of the intangible
benefits. The reason salary-based compensation for directors worked in the past was because of
the large amount of equity the directors carried; whereas now directors (outside) usually don’t
own much or any equity upon being nominated for director. Once the salary-based compensation
package became obsolete, there needed to be a new way to compensate board members so that
the interest of the board was aligned with the interest of the shareholders.
In the case of Hewlett-Packard, the board was receiving an exorbitant amount of cash
retainers and fees. From 2011 till 2013, the Hewlett-Packard stock dropped from approximately
43 dollars a share down to about 15 dollars a share. While in 2012, three of the board members
were making upwards of one hundred thousand dollars in cash (not counting equity). Directors
tend to work 4-5 hours a week, for a total of 260 hours for the year; so some directors are making
over 500 dollars an hour.
As you can see since in the two years under the high salary base pay, the fortune 500 company
Hewlett-Packard’s stock value dropped over 64% (Yahoo! Finance, 2014). Clearly the high
salary compensation structure for boards is deemed obsolete in this case. Even with this sharp
decline over the past couple years, the board members were reelected on March 20th, 2013.
Hewlett-Packard is merely a single example of how high salary-based compensation structure
does not incentivize enough to increase shareholder value. There are many other cases in which
board members are just not performing at a high level, even though these board members are
experts in their respective fields. The strictly salary based compensation is deemed as irrelevant
for most corporations today (Hewlett-Packard, 2013).
PRESENT: Equity-based Compensation Structure
As we said earlier, in the past board members were just large shareholders that wanted to
protect their investment. The next compensation plan is to add stock or stock options as a part of
the director’s payment plan along with the salary. Adding equity to a director’s compensation
plan can be a little tricky, the reason being is because again, the directors are so financially well
off, how much equity will it take for them to care about the investment. Once the corporations
figure out the amount of equity that will make the director’s stomach turn if they lose it, they
align the interest of both shareholders and directors. As shareholder value increases via stock
price increases, the board will also make gains because of their stocks that they own as a result of
their compensation package. This method is much better than the salary method; because boards
are now comprised of people whose interest are aligned with shareholders.
This method of pay has worked very well in some cases. Biotech company, Celegene
Corp. was ranked number 10 in board compensation in 2012. The reason for this is because of
high shareholder gains. The share value of Celegene was at about 70 dollars a share in 2012, it
jumped over 100%, and it is now trading at 150 dollars a share. The majority of the directors
made over 400 thousand dollars, the bulk of their money came from stock options and restricted
stock unit awards. The incentive of equity has clearly paid off in this instance, and the directors
made the right calls and profited heavily because of it (Green, 2013).
However, just like the salary-based compensation structure there are possible problems
with this package. The problem with equity-based compensation is that if directors own enough
shares to make them fearful of a loss, then the board will become risk averse. Being risk averse is
not the absolute worst thing for a director, but being risk averse will cause the board to pass on
value-adding projects. Hypothetically, if Celegene Corp had not approved of value adding
projects (due to presented risks of loss), then the price of the stock would have remained at 75
dollars a share, or it could’ve even possibly dropped. Luckily for Celegene, the board did not act
cautiously, instead they were looking out for the best interest of the company and the
shareholders.
The board is there to maximize the corporation’s and the shareholders’ value, but if they
are risk averse they have a vested interest in maintaining the status quo. This means shareholders
will rarely over perform the S&P500, or whichever index is used as the benchmark. The
problem of cautious board members and underperforming could possibly even cause investors to
leave the company. The reason for this is because if the market is performing better than the
corporation, then the investors will put their money in the market or other corporations, in
contrast to investing in the corporation with cautious board members where they receive little or
no gain. The investors wish to see their investment grow, not stand still or decline, in order to
grow the businesses must accrue some risk for the potential benefit.
As time has passed, the compensation structure has changed slowly, but surely. As of
now, corporations have been invoking the equity-based compensation structure, but just as the
salary-based structure of compensation has phased out, the equity-based structure will also soon
become outdated and obsolete.
FUTURE: Dissident Director Pay for Performance Compensation Structure
In the past, the boards of directors were often in a passive role in governing the affairs of
the corporation. As the times have changed, the corporation have called for increased
effectiveness from the board in guiding corporate activities and in enhancing organizational
performance. As of now the equity-based structure is working pretty well, but soon enough the
payment structure will need to be revamped or changed. The new proposed payment plan
structure will be a pay for performance type compensation. The equity plan is technically a pay
for performance, because if the director performs well and the corporation performs well then the
underlying stocks the director is being paid with will also do well. The plan that is being
proposed is simply more direct with aligning financial gain to value (Iacobucci, 2013).
Some hedge funds have been adopting a new compensation structure for that of dissident
directors that enter a corporation via a proxy contest. “On top of paying their nominee directors
cash compensation for agreeing to participate in the proxy contest, and/or for succeeding in the
contest, hedge funds have on recent occasion promised to make payments to their nominees that
depend on how the stock price of the target company performs over some time horizon.”
(Iacobucci, 2013).
For example, Elliott Management who is the second largest owner of Hess Corporations
shares (with 4.5%) initiated a proxy contest to get seats on the board. They promised the
nominee a flat fee of 50 thousand dollars, in addition if the nominee were to be elected as a result
of the proxy contest then Hess would pay them a bonus after three years, provided Hess stocks
outperformed industry leaders. Due to the high amount of compensation for the dissident director
via Elliott Management, there was a lot of controversy; Elliott then cancelled the deal, as it
became a huge distraction. JANA Partners another hedge fund also tried to pay a dissident
nominee of Agrium Corporation, the deal for this nominee was that JANA would give a share of
the earnings to the said dissident. This also failed because it seemed as if a golden leash would
bind the director, meaning the director is essentially being paid to act in the interest of the major
shareholder, in this case JANA Partners (Iacobucci, 2013). .
This pay for performance compensation plan not only positively correlates the interest of
shareholders and board members but it also removes the risk-averse factor that comes with the
equity compensation plan. There are obviously going to be many arguments against the proposed
program before its inception. These arguments include but are not limited to:
1. Director will concentrate on short term gain (as a result of bonuses), rather than long
term shareholder value
2. Presence of a director with such outrageous incentives will divide the board causing
dissidents to be seen as a threat as opposed to a colleague
3. Can compromise the authority of the board and the independence of nominees
All of these problems can lead to a loss in shareholder value (Iacobucci, 2013). . If the director
concentrates on the short term than those that are in it for the long haul (primarily institutional
investors) could more than likely suffer long term losses. Also if there is a rift in the boardroom,
then the problem will be the same as it was in the past with dissident directors. Dissident
directors are finally now recommended within corporations, in the past they were treated like
pariahs and not included in any of the important activities or projects of the company. The same
will happen if dissident directors ‘hypothetically’ cause the board to become dysfunctional. If
this does occur then nothing will be agreed upon and there will essentially be a deadlock in the
boardroom causing missed opportunities and eventually shareholder loss. Finally the last
problem is that the dissident(s) on the board could possibly not share their own opinions. The
high amount of compensation from the hedge fund could quite possibly cause them to do what
the hedge fund would want. This can cause shareholder loss if the hedge fund is just flat out
wrong in what they are proposing. The dissident will probably stand by the hedge fund and
endorse the risky ventures which can lead to substantial loses for shareholders (including the
hedge fund).
The problems presented can definitely cause rejection of the proposed compensation
plan, however most of the problems are hypothetical and could go either way. For instance, as
far as the board being “Balkanized” due to high compensation, director pay has always varied
between each individual director within the board and it has not been an issue, this case should
be no different. The other problem that can be refuted is in regards to the loss of an independent
director (in this case the director will be dependent towards the Hedge Fund). One of the main
rebuttals is that hedge funds are filled with experts in finance; they have more than adequate
skills and resources to determine if ventures will be profitable. Also the hedge funds that initiate
these proxy contests usually carry a large quantity of shares of the company, if the stock price
decreases then the shareholders will suffer losses, and then the hedge fund will suffer losses at a
higher level due to the high amount of shares owned.
However, even with all the issues presented, there are always positives that could very
well increase shareholder value. Hypothetically, if a hedge fund were to offer such ridiculous
incentives to directors, then they clearly have confidence in the director’s ability to enhance
shareholder value. This can in turn effect the way the market perceives the underlying
corporation; it will signal investors to buy more shares, which will cause in increase in the share
price.
The tricky aspect of this compensation package is that the dissident will be inclined and
even incentivized to enhancing shareholder value (within three years). The reason this can be ill-
fated for the company and its shareholders is that it can cause the dissident to think more short
term (in this case three years), rather than focusing on long term shareholder value. The only
counter that is visible is that there is only going to be a couple dissidents on the board if that, this
is not enough to accept projects that could be a short term fix in nature.
FUTURE: My View – Hybrid Compensation Structure
I personally have another pay for performance type compensation plan in mind that could
possibly work better than all of the previously mentioned structures. The big difference between
the dissident pay and my view is that this compensation structure can be for all directors not just
the dissidents. It is very similar in the aspect that there is an added bonus for directors based off
of performance in comparison to industry peers. The difference is that with the potential bonus
for an increase in share value you add two other types of compensation structure, those being
equity and benefits. This will birth a hybrid structure comprised of bonuses, equity and benefits.
The major flaw in the pay per performance for dissidents is that there is too much
incentive on short-term gains and little incentive for long-term gain. Equity and benefits in
compensation packages has been known for keeping the directors on the board for greater
periods of time, longevity. With benefits and equity, the directors will be more inclined to stay
on the board for a longer period of time; hence the directors will focus on long-term gains of
shareholder value. Also since all the directors will be under the same compensation package that
is put together by the corporation, there will be very little chance of boardroom problems and
standoffs. Another problem that is resolved is the question of independence of the directors, all
of the directors will have this proposed payment scheme and the golden leashes of a larger
investor do not bind them.
This payment scheme is much better than the previous salary based scheme, considering
the salary compensation structure does not align shareholder value and director value. This
scheme is also better than the current compensation structure comprised of equity and salary
because the bonuses add an extra incentive ridding them of the cautious, risk averseness. This
payment structure will align the directors and shareholders value much better than the dissident
payment plan, and it will also get rid of a lot of the possible problems that caused it to fail during
the Elliot Management Group and JANA Partners proxy contests.
CONCLUSION
The fiduciary duty of a board as described by Milton Friedman and Laban Jackson is to
work in the best interest of the company and its shareholders. Through time there have been two
payment plans that seem to have been used the most; those plans being the salary based plan and
the other being the salary and equity plan. As the salary based compensation plan became less
useful, equity began to be added. Equity has now caused some directors to be risk averse because
of the fact that projects could possibly fail which would cause their share value to decrease. So as
directors stop taking risks, they miss out on opportunities that could be profitable for the
company and the shareholders. One of the future plans proposed by JANA Partners and Elliott
Management Groups is a pay for performance for dissident directors compensation plan. This
plan had multiple problems, and famed corporate lawyer Marty Lipton has even went as far to
question the legality of the plan. Then there is the hybrid plan that includes a pay for
performance aspect, equity aspect and a benefits package. This not only aligns the board with
shareholder value, but it also promotes longevity to combat the short sightedness that is prevalent
in the dissident pay for performance compensation plan. All in all, compensation plans are going
to evolve as markets, government regulation and governance structure evolves, sooner or later
these proposed future plans will become just a footnote in the world of corporate governance.
Works Cited
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Elson, C., Carey, D., & England, J. Directors & Boards. How should corporate directors be compensated?, 1-12.
Forrester, C., & Ferber, C. (2012). GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OF DIRECTORS AND OFFICERS. Fiduciary Duties and other responsibilities of corporate directors and officers (5 ed., ). Chicago: .
Green, J., & Suzuki, H. (2013, May 30). Bloomberg - Business, Financial & Economic News, Stock Quotes. . Retrieved May 15, 2014, from http://www.bloomberg.com/
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Iacobucci, E. (2013, November). Special Compensation arrangements for dissident directors in proxy contests: A Policy Analysis.
(2014). Non-Profit Best Governance Practices United States: Weinberg Center for Corporate Governance .
Report of the NACD blue ribbon commission on director compensation. Purposes, Principles and Best Practices , 1-17.