Director Compensation and the "Best Interests of Shareholders"

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.

Comments

[Anonymous]

Perhaps this is explored further - and maybe even rebutted - elsewhere on this blog, but this post at least does not adequately support the assertion that "directors have an economic incentive to act in the best interests of management rather than shareholders." Your theory is that directors are highly paid so are incented to side with management. But you're ignoring the fact that most director compensation packages include a significant equity component. Depending on the design of the equity component, it may be the case - and I suspect it is frequently the case - that meaningful increases in company stock prices would result in gains in the value of directors' equity compensation that would easily exceed their annual cash compensation. And when directors receive stock options, declines in the company stock price would make that component of their compensation package worthless (regardless of the reporting of the "value" of the options as compensation received by the director). So at many companies, it's absolutely not true that the directors' economic interests are not aligned with shareholders.