‘Golden Leash’ Payments Fuel Debate; Shareholders and Advisers Are Choosing Sides Over Activists Paying Bonuses to Board Members

‘Golden Leash’ Payments Fuel Debate

Shareholders and Advisers Are Choosing Sides Over Activists Paying Bonuses to Board Members

DAVID BENOIT and JOANN S. LUBLIN

Updated Nov. 25, 2013 6:36 p.m. ET

A shareholder vote Tuesday in California for board members of a small, local bank is emerging as a test case for one of the hottest topics in corporate governance: whether activist investors should be able to pay bonuses to their picks for board seats. After approving a new corporate bylaw that would bar such investor-paid bonuses, three directors at Provident Financial Holdings Inc. PROV +0.28% have found themselves in the middle of the debate and are facing a call for them be voted out. Activists say the payments reward directors for helping increase shares’ value, which benefits all company investors. Critics have dubbed the issue the “golden leash,” referring to some activists’ aim to offer bonus payments over time to board members they help install at a company. Lawyers for companies have argued that such deals can compromise directors’ independence by tying them to specific shareholders, when they have a duty to all stockholders.So far, attempts by activist investors including Jana Partners LLC and Elliott Management Corp. to pay bonuses to certain board members have met resistance. But they are pressing ahead, trying to convince large institutional shareholders that such payments can be good governance.

As the industry wrestles with the topic, TIAA-CREF, the giant pension manager, is co-hosting a gathering Dec. 5 at its New York headquarters to help it formulate a view on the issue, a spokesman said. The idea “is to just start a dialogue…between the hedge funds and the institutional-investor community.”

The activists’ adversaries are making their case against such payments. Wachtell, Lipton, Rosen & Katz LLP—a law firm long noted for its work defending companies against activists—this year urged companies to adopt bylaws that would bar from a board any candidate who has been paid for board candidacy or service by an outsider. A Wachtell memo warned about “poisonous conflicts” arising from “creating a subclass of directors.”

Since May, at least 26 companies have adopted bylaws that resemble Wachtell’s recommendation, including the small California bank, Provident, according to proxy-advisory firm Institutional Shareholder Services Inc.

Provident, a Riverside, Calif., bank-holding company with less than $1 billion in deposits, is the first of these companies to hold an annual meeting, slated for Tuesday.

It is facing a potential backlash, as ISS, the biggest U.S. proxy adviser, has urged Provident investors to oppose the re-election of the three directors who make up its governance committee because they approved the bylaw change, which matched Wachtell’s memo almost word for word. The directors declined to comment, as did a Provident representative.

In making its recommendation, ISS pointed to what it called the “broad scope” of the Provident bylaw, which by its reading would not only bar activist performance payments for directors but also payments for being willing to stand for election.

Those types of awards are common and typically disclosed, activists and lawyers say.

Glenview Capital Partners LP agreed to pay $100,000 each to the eight nominees it put up for the board of hospital operator Health Management Associates Inc., according to a proxy filing. Starboard Value LP agreed to compensate its three nominees for the Office DepotInc. ODP +0.76% board $20,000 in cash that was to be used to buy shares in Office Depot, according to a filing. Representatives for Glenview and Starboard declined to comment. Wachtell says its bylaws don’t prevent such “customary compensation” and that the rules allow board nominees to get certain sums, such as out-of-pocket expenses.

More broadly, ISS said in a Nov. 15 newsletter, the Provident bylaw and the broad restrictions on compensation could lead to the exclusion of high-quality individuals from the board. ISS also took issue with the fact that Provident put the bylaw in without a shareholder vote and because of the “lack of a compelling explanation from the board,” said Patrick McGurn, ISS’s special counsel, in an interview.

Wachtell responded in a Nov. 20 memo that shareholders could challenge a bylaw after its adoption and that the ISS recommendation may “discourage companies from protecting themselves against inappropriate director conflict.”

ISS’s Provident report didn’t explicitly speak to incentive payments for directors paid by activist investors after the board members are seated, which ISS will likely address in coming months, Mr. McGurn added.

Supporters of the activist investors’ argument took the Provident recommendation as a good sign.

“The recent attempts to eliminate all compensation wholesale was entirely overreaching, and the companies and their counsel knew exactly what they were doing,” said lawyer Steve Wolosky, who represents activist investors.

The activists argue incentive payments are good corporate governance, because they can link director pay to performance, which they say can benefit all stockholders. Charles Penner, a partner at Jana, says that if directors are paid based on share gains, they may be more—not less—inclined to reject activist arguments they think could harm shares. Activist investors also say payments will help attract better candidates. Jana proposed paying their nominees for Agrium Inc.’s board, but the candidates lost. Elliott had planned to pay its Hess Corp. HES -0.84% director nominees but later dropped the idea.

Governance gurus say they can see a common ground being worked out.

The Council of Institutional Investors, which represents about 125 pension funds with more than $3 trillion in assets, has generally opposed special incentive pay for directors from an outsider. But in late September, it began reviewing postelection pay incentives, a council representative said.

Robert Jackson, an associate professor and governance expert at Columbia Law School who is expected to give a presentation at the TIAA-CREF meeting, says he is consulting with investors on the topic and is recommending basing a director’s incentive on the company’s results, not the hedge funds’ returns.

“After the initial shock…the truth is somewhere in the middle,” Mr. Jackson said of the debate.