ISS targets new bylaw regarding director qualifications

A provision disqualifying board nominees who receive third-party compensation from standing for election could serve to entrench existing directors, ISS says

In what could be seen as the opening salvo of proxy season 2014, ISS has recommended that Provident Financial Holdings shareholders withhold their votes for three directors for a material governance failure regarding an amendment to the company’s bylaws that significantly impacts shareholders’ rights.

What’s raised the proxy advisory firm’s hackles is a new provision concerning director qualifications that Provident’s board adopted unilaterally in July. The provision disqualifies any person who receives compensation from a third party from standing as a nominee for the board or serving on the board if elected. Consequently, ISS has advised shareholders to not re-elect Joseph Barr, Bruce Bennett or Debbi Guthrie, all whom are members of the nominating and governance committee. 

Technically, ISS’ recommendation comes on the tail end of the 2013 proxy season, as it concerns the election of directors scheduled for Provident’s annual shareholders meeting on November 26. But given there are 25 other companies that ISS said it is aware of that have adopted this ‘new flavor of bylaw’ since May 2013, companies should anticipate ISS will make similar recommendations for other firms that have adopted this bylaw as the upcoming proxy season gets underway.

As ISS said in its Provident recommendation, released November 12, the new provision has been prompted by arrangements proposed during proxy contests at Agrium and Hess earlier this year that would have provided financial incentives to dissident nominees not employed by the dissident shareholder if they had been elected to the respective boards. Those proposals sparked controversy due to worries that companies might end up with directors with different compensation systems, which could result in conflicts of interests, according to ISS.

As its recommendation makes clear, ISS doesn’t object to bylaws that say nominees who receive any third-party compensation are ineligible for board service if they don’t disclose such payments. But Provident’s provision is troublesome because it seeks to bar particular people from boards merely because they are paid for their time and effort spent as a candidate during a proxy contest.

‘The provision could deter legitimate efforts to seek board representation via a proxy contest, particularly those efforts which include independent board candidates selected for their strong, relevant industry expertise, and who are characteristically recruited, but not directly employed, by the dissident shareholder,’ the ISS report states.

By potentially excluding highly qualified individuals whose election might be in all shareholders’ best interests, the provision may serve as ‘an entrenchment device by restricting investors’ right to select the individuals they deem suitable for board service,’ ISS states. ‘The proper forum for assessing an individual’s suitability for board service is the election process. If investors are concerned with a candidate’s compensation arrangements, they are free to express their concerns at the ballot box.’

Matteo Tonello, a managing director at The Conference Board, didn’t exactly agree with ISS’s assessment. ‘The rationale for ISS’s objection to the type of bylaws introduced by Provident Financial seems to be that the bylaws would introduce an unfair and possibly insurmountable obstacle to proxy solicitation in director elections,’ he says.

William Lawlor, a partner at Dechert LLP who handles M&A deals and heads Dechert’s corporate governance practice, says at least 26 companies have adopted such bylaws out of concern that nominees’ sidecar deals with dissident shareholders, such as in the Agrium and Hess proxy contests, create potential conflicts of interest, divisiveness and distortions concerning the board’s strategic decisions.

‘It’s still a novel concept in general. Corporate lawyers for those companies are looking hard at these issues, and if companies don’t have these provisions, they’re thinking about [adopting them],’ he says. ‘That’s why the ISS position has created quite a bit of notoriety over the past several days.’ Companies have to consider the ISS position on such bylaws because of how much influence ISS wields, he adds.

The Council of Institutional Investors’ policy on compensation is silent on payments to nominees to the board. ‘We recognize that’s a fairly common practice,’ says Amy Borrus, deputy director of CII. ‘Our policies start with service on the board, but we do have policies on director pay and see the compensation committee as the sole arbiter of compensation.’

CII supports director compensation consisting only of cash and equity shares, but opposes performance-based pay because ‘it creates potential conflicts with directors’ primary role as an independent representative of shareowners,’ says Borrus. For example, a director who is paid in shares that vest based on the stock reaching certain price thresholds over a three-year period may be unwilling to support a strategic business decision that could be costly in the near term, but profitable beyond three years, she adds.

Lawlor says he doubts ISS will decide to extend its negative recommendation to companies whose bylaws prohibit directors from serving on boards if they receive third-party compensation while a board member, as opposed to being compensated for being a candidate. But, he warns, ‘he who makes up the rules interprets the rules. So we have to see how this plays out as companies that have these bylaw provisions hold their annual meetings and ISS has to make its recommendations.’

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