Corporate Governance

Director Compensation and the "Best Interests of Shareholders"

By J. Robert Brown

We return to an issue that we have raised a number of times on this Blog. 

Directors of public companies make hefty fees.  This is born out by data from larger samplings.  In one study of 300 companies, directors saw their compensation increase by 4.7%, with a median of $182,102.  In some cases, directors receive total compensation (as set out in the proxy statement) in the vicinity of $700,000.  In other words, they are well paid. 

There is nothing wrong with this.  The position is likely becoming more complicated and, despite the resolute refusal of Delaware courts to impose meaningful obligations on directors, increased federal regulation (SOX for one) and the financial crisis are likely causing them to work harder.

The issue concerns director independence. Despite these hefty sums, both the stock exchanges and the Delaware courts consider fees essentially irrelevant in the determination of whether or not a director is considered independent (fees arguably are relevant under the listing standards of the NYSE but the Exchange does not appear to enforce the relevant requirement).  Thus, investors are led to believe that stock exchange companies really consist of a majority of independent directors.  Under Delaware law, boards treated as independent get extra deference when their decisions are litigated.  (This is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).

It is as if their fees are so irrelevant they do not and cannot influence directors in making their decisions, a conclusion that defies common sense.  Moreover, if directors want to keep their fees, they must be renominated to the board (election is a foregone conclusion).  Since in most cases the only directors nominated are those submitted by management, the best way to assure renomination (and retention of the fees) is to make management happy.  In other words, directors have an economic incentive to act in the best interests of management rather than shareholders. 

This isn't a challenge to directors fees.  Directors, as we noted, are increasingly having to work harder and supervise more.  They should be paid adequately for their services.  It is more a comment on their characterization as "independent."  This is a strange term to use to describe directors with obvious economic incentives that can influence their decision making process.

It is this type of reasoning that leads to the ineluctable conclusion that the only way to truly ensure independence is to create the risk that directors who side excessively with management can be voted out of office.  That in turn will only occur when shareholders get access to the company's proxy statement for their nominees.  That, however, is a reform that is coming.

Full post as published by The Race to the Bottom on June 12, 2009 (boomark / email).