by Cydney Posner
At the end of January, Nasdaq filed with the SEC a rule proposal related to third-party compensation of directors in connection with their candidacy for and/or service on company boards, often referred to as “golden leash” arrangements. Golden leash arrangements are most common in connection with board nominations (either through negotiation or proxy contest) by hedge fund activists. Shortly after submitting the proposal, however, Nasdaq’s Rule Filing Status Report indicated that the proposal had been “rejected.” Now, two reliable sources, Broc’s Blog on thecorporatecounsel.net and Joe Mont at ComplianceWeek, have confirmed that the proposal was rejected for technical reasons only and that Nasdaq plans to resubmit it. As a result, the proposal merits some discussion. (Update as of 3/17/16: the rule proposal has been resubmitted.)
The proposal arises out of Nasdaq’s concern that third-party compensation of directors may not always be publicly disclosed. While there is no set format for these arrangements, they may include compensation conditioned on achievement of specified benchmarks such as an increase in share price. Nasdaq fears that these arrangements “may lead to conflicts of interest among directors[,] call into question their ability to satisfy their fiduciary duties [and] tend to promote a focus on short-term results at the expense of long-term value creation. Nasdaq believes that enhancing transparency around third-party board compensation would help address these concerns and would benefit investors by making available information potentially relevant to investment and voting decisions.”
Nasdaq’s proposal would require listed companies to publicly disclose third-party compensation of directors on or through the companies’ websites or proxy statements under proposed new Rule 5250(c). Nasdaq advises that the proposed rule is “intended to be construed broadly” to all forms of compensation, including health insurance premiums, and would require, minimally, identification of the parties to and the material terms of the arrangement. However, the proposed rule would not apply to “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.” Companies would be required to undertake “reasonable efforts” to identify all arrangements. As noted in Broc’s blog, this type of disclosure may already be required by SEC rules in some, but not necessarily all, circumstances. For example, S-K 402 requires “disclosure of all plan and non-plan compensation awarded to, earned by, or paid to …. directors covered by paragraph (k) of this Item, by any person for all services rendered in all capacities to the registrant and its subsidiaries….” [emphasis added] Similarly, in the event of appointment of a new director (not elected by the shareholders), Item 5.02 of Form 8-K requires disclosure of any arrangement or understanding between the new director and any other persons pursuant to which the director was selected as a director, as well as any material arrangements, grants or awards in connection with the election. And, in the event of a proxy contest, Item 5 of Schedule 14A requires disclosure regarding any interests that participants have in the matter to be acted on.
But the most interesting part of the proposal is something that’s not really part of the proposal at all. In footnote 5, Nasdaq indicates that, “[s]eparate from this proposed rule change, Nasdaq plans to publicly solicit comment from interested parties as to whether Nasdaq 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. Nasdaq has made no decision about whether to propose additional rules.” [Link added.] The implication of footnote 5 is that transparency alone may not suffice to resolve the potential problems created by golden leash arrangements: director conflicts of interest, compromises of director independence, motivation of directors to focus on their own short-term interests to the detriment of the company and its shareholders as a whole and development of fragmented and dysfunctional boards.
Notably, current efforts to eliminate these troubling effects by reining in golden leash arrangements have been challenged by the major proxy advisory firms — both ISS and Glass Lewis view the board’s unilateral adoption of a bylaw that disqualifies a director nominee who receives third-party compensation as a problematic governance practice, potentially leading to a recommendation against directors.
Even in the narrower context of proxy access bylaws, ISS, the Council of Institutional Investors and some proxy access proponents view restrictions on third-party compensation of directors and nominees as problematic, apparently taking the position that transparency alone is enough to address the conflicts and other challenges that golden leash arrangements can create. In its new FAQs, ISS indicates that, in evaluating the adequacy of companies’ implementation of successful proxy access proposals, among the restrictions on proxy access that ISS views as potentially problematic are restrictions on third-party compensation of proxy access nominees, although requirements for disclosure of these arrangements are not necessarily disfavored. Similarly, CII policies oppose proxy access restrictions (other than mere disclosure) based on compensation arrangements with parties other than the corporation.
SideBar: Interestingly, although CII opposes restrictions on third-party compensation arrangements for proxy access nominees, its own corporate governance policies appear to recognize the potential for conflict inherent in many golden leash arrangements: “While the Council is a strong advocate of performance-based concepts in executive compensation, we do not support performance measures in director compensation. Performance-based compensation for directors creates potential conflicts with the director’s primary role as an independent representative of shareowners.”
Moreover, some companies that have adopted proxy access bylaws that include restrictions on golden leashes have received “curative” proxy access proposals from a prolific proxy access proponent that are generally consistent with the CII positions on various issues, including provisions that expressly eliminate restrictions that would prohibit compensation arrangements between shareholder nominees and parties other than the corporation. See, for example, the proxy access shareholder proposal in the 2016 Whole Foods proxy statement.
SoapBox: Given these positions and practices, it comes as no surprise that most companies have been reluctant to include restrictions on golden leash arrangements in their proxy access provisions, even if they might otherwise view them as salutary. Nasdaq’s proposal, if it comes to fruition, could go a long way toward eliminating this dilemma.