Tej G. PatelFINC 418-010May 15 , 2014

Shareholder Value: The Evolution and

Future of Board Compensation

Fiduciary Duty

The well-established debate of whom the directors owe a fiduciary duty to has been the

center of attention for decades in American corporate law. The primary objective of the

corporation is to conduct business activities with a view of enhancing corporate profit and

shareholder gain (Forrester, 2012). Since the famous Dodge v Ford Motor Co. case, it has been

established that the only responsibility that a director should have is towards his or her

employers, which are in fact the shareholders. In the case, Henry Ford decided to give back to

the community (in favor of stakeholder theory) instead of pay dividends to investors, but the

Dodge brothers (who owned a significant amount of equity in Ford) wanted to collect the return

on their investment. This led to the dilemma that if shareholders were not receiving the proper

returns on their investment, and the company was allocating the profits elsewhere, then there

would be no more investors; if no one is willing to invest, then companies would not be able to

raise capital via equity. This can cause a huge breakdown in new and existing corporations, and

corporate America would take a sharp decline.

Since the early 20th century, when the Supreme Court ruled on the Ford case, it seems that

the general consensus is still in favor of the Friedman doctrine. Milton Friedman is the first

person that proposed the idea of the idea otherwise known as stakeholder theory. Friedman

believes that a company’s only responsibility is to increase its profits. In present times the

chairman of the audit committee of JPMorgan Chase & Co., Laban Jackson said “we work for

the shareholders, no one else” during a roundtable discussion at the Weinberg Center for

Corporate Governance (“Non-Profit Best Governance Practices”). The board has always been

under the duty of care and the duty of loyalty, these duties are put in place to protect the

shareholders. The fiduciary duty of the board of directors has thus always been primarily to

increase shareholder value; now the question that must be asked is, ‘how can one insure that the

board will act in the shareholders’ best interest’?

Purpose of Director Compensation

According to the National Association of Corporate Directors, “the purpose of director

compensation is twofold.”

The first reason for board compensation is to combine the interest of shareholders and

directors. Because the directors are hired as the shareholders’ agents, a compensation plan that is

correlated with shareholder value would be in the best interest of the investors. The second

reason for board compensation is to provide value to directors for received value. The job of a

director is no easy task; it takes great expertise in their field to be a competent director. Directors

are highly trained, valuable people who have alternative uses for their time and skill. “Over time

and in aggregate, exceptions aside, there is a good chance that you will get the board you pay

for”, meaning if you have an inferior compensation program for directors than you will more

than likely have inferior directors (NACD, 1995).

The top three highest paying corporations for board of directors as of May 2013 are

Fidelity National Information Services, News Corp. and Costco Wholesale Corp. These firms

realize that the board is just as valuable as the executives, the directors have generated awards of

a million dollars plus, while fidelity rewarded directors with a total of over 9 million dollars in

bonuses, these directors have had a hand in propelling their respective companies to the Fortune

500 level. Then there are cases where board compensation is very low, yet the company is doing

exceptionally well. One company that comes to mind is The Great Warren Buffett’s, Berkshire

Hathaway; the directors are not nearly as compensated, but at the same time the board consist of

billionaires, so an award of a million dollars would be fairly miniscule in perspective to their

personal finances (Green, 2013).

PAST: Salary-Based Compensation Structure

When the board first came into existence, the go to compensation package was to pay the

directors with a flat salary. In the past the only reason someone would want to become a director

was because they were large shareholders and they wished to protect their investment. Usually

those who were not shareholders did not care to be on the board. As we move on to present

times, being on a board is much more than it was before. Now people wish to be on boards even

if they do not own equity because it is catering to those wanting higher status, prestige,

professional development, it is considered community service and board compensation is pretty

high compared to other professions (Elson). This can cause the directors of our age to be more

aloof and unemotional about the company. The reason for this is because, yes, their name is out

there as someone who is giving back, but the board has no incentive to put forth the proper

oversight and monitoring of management; they are not focusing on increasing shareholder value.

The salary-based compensation structure essentially causes a board to be ineffective. An

ineffective board is detrimental to a corporation because

1. They lack objectivity and independence

2. They lack true authority over management

3. They lack a grasp of what is going on in the company

4. They simply do not work hard enough

Directors are generally experts in their own respective fields, or in the industry of the

company they are working for (Bacon, 1977). This means that, those that are chosen and

nominated to become a director of a board are more than likely financially well endowed.

Therefore, in order to even grab the attention of a potential director, the compensation (if strictly

salary-based), must be enough for them to accept the offer in the first place. The opportunity cost

associated with the hours must be equal or less than the compensation and value of the intangible

benefits. The reason salary-based compensation for directors worked in the past was because of

the large amount of equity the directors carried; whereas now directors (outside) usually don’t

own much or any equity upon being nominated for director. Once the salary-based compensation

package became obsolete, there needed to be a new way to compensate board members so that

the interest of the board was aligned with the interest of the shareholders.

In the case of Hewlett-Packard, the board was receiving an exorbitant amount of cash

retainers and fees. From 2011 till 2013, the Hewlett-Packard stock dropped from approximately

43 dollars a share down to about 15 dollars a share. While in 2012, three of the board members

were making upwards of one hundred thousand dollars in cash (not counting equity). Directors

tend to work 4-5 hours a week, for a total of 260 hours for the year; so some directors are making

over 500 dollars an hour.

As you can see since in the two years under the high salary base pay, the fortune 500 company

Hewlett-Packard’s stock value dropped over 64% (Yahoo! Finance, 2014). Clearly the high

salary compensation structure for boards is deemed obsolete in this case. Even with this sharp

decline over the past couple years, the board members were reelected on March 20th, 2013.

Hewlett-Packard is merely a single example of how high salary-based compensation structure

does not incentivize enough to increase shareholder value. There are many other cases in which

board members are just not performing at a high level, even though these board members are

experts in their respective fields. The strictly salary based compensation is deemed as irrelevant

for most corporations today (Hewlett-Packard, 2013).

PRESENT: Equity-based Compensation Structure

As we said earlier, in the past board members were just large shareholders that wanted to

protect their investment. The next compensation plan is to add stock or stock options as a part of

the director’s payment plan along with the salary. Adding equity to a director’s compensation

plan can be a little tricky, the reason being is because again, the directors are so financially well

off, how much equity will it take for them to care about the investment. Once the corporations

figure out the amount of equity that will make the director’s stomach turn if they lose it, they

align the interest of both shareholders and directors. As shareholder value increases via stock

price increases, the board will also make gains because of their stocks that they own as a result of

their compensation package. This method is much better than the salary method; because boards

are now comprised of people whose interest are aligned with shareholders.

This method of pay has worked very well in some cases. Biotech company, Celegene

Corp. was ranked number 10 in board compensation in 2012. The reason for this is because of

high shareholder gains. The share value of Celegene was at about 70 dollars a share in 2012, it

jumped over 100%, and it is now trading at 150 dollars a share. The majority of the directors

made over 400 thousand dollars, the bulk of their money came from stock options and restricted

stock unit awards. The incentive of equity has clearly paid off in this instance, and the directors

made the right calls and profited heavily because of it (Green, 2013).

However, just like the salary-based compensation structure there are possible problems

with this package. The problem with equity-based compensation is that if directors own enough

shares to make them fearful of a loss, then the board will become risk averse. Being risk averse is

not the absolute worst thing for a director, but being risk averse will cause the board to pass on

value-adding projects. Hypothetically, if Celegene Corp had not approved of value adding

projects (due to presented risks of loss), then the price of the stock would have remained at 75

dollars a share, or it could’ve even possibly dropped. Luckily for Celegene, the board did not act

cautiously, instead they were looking out for the best interest of the company and the

shareholders.

The board is there to maximize the corporation’s and the shareholders’ value, but if they

are risk averse they have a vested interest in maintaining the status quo. This means shareholders

will rarely over perform the S&P500, or whichever index is used as the benchmark. The

problem of cautious board members and underperforming could possibly even cause investors to

leave the company. The reason for this is because if the market is performing better than the

corporation, then the investors will put their money in the market or other corporations, in

contrast to investing in the corporation with cautious board members where they receive little or

no gain. The investors wish to see their investment grow, not stand still or decline, in order to

grow the businesses must accrue some risk for the potential benefit.

As time has passed, the compensation structure has changed slowly, but surely. As of

now, corporations have been invoking the equity-based compensation structure, but just as the

salary-based structure of compensation has phased out, the equity-based structure will also soon

become outdated and obsolete.

FUTURE: Dissident Director Pay for Performance Compensation Structure

In the past, the boards of directors were often in a passive role in governing the affairs of

the corporation. As the times have changed, the corporation have called for increased

effectiveness from the board in guiding corporate activities and in enhancing organizational

performance. As of now the equity-based structure is working pretty well, but soon enough the

payment structure will need to be revamped or changed. The new proposed payment plan

structure will be a pay for performance type compensation. The equity plan is technically a pay

for performance, because if the director performs well and the corporation performs well then the

underlying stocks the director is being paid with will also do well. The plan that is being

proposed is simply more direct with aligning financial gain to value (Iacobucci, 2013).

Some hedge funds have been adopting a new compensation structure for that of dissident

directors that enter a corporation via a proxy contest. “On top of paying their nominee directors

cash compensation for agreeing to participate in the proxy contest, and/or for succeeding in the

contest, hedge funds have on recent occasion promised to make payments to their nominees that

depend on how the stock price of the target company performs over some time horizon.”

(Iacobucci, 2013).

For example, Elliott Management who is the second largest owner of Hess Corporations

shares (with 4.5%) initiated a proxy contest to get seats on the board. They promised the

nominee a flat fee of 50 thousand dollars, in addition if the nominee were to be elected as a result

of the proxy contest then Hess would pay them a bonus after three years, provided Hess stocks

outperformed industry leaders. Due to the high amount of compensation for the dissident director

via Elliott Management, there was a lot of controversy; Elliott then cancelled the deal, as it

became a huge distraction. JANA Partners another hedge fund also tried to pay a dissident

nominee of Agrium Corporation, the deal for this nominee was that JANA would give a share of

the earnings to the said dissident. This also failed because it seemed as if a golden leash would

bind the director, meaning the director is essentially being paid to act in the interest of the major

shareholder, in this case JANA Partners (Iacobucci, 2013). .

This pay for performance compensation plan not only positively correlates the interest of

shareholders and board members but it also removes the risk-averse factor that comes with the

equity compensation plan. There are obviously going to be many arguments against the proposed

program before its inception. These arguments include but are not limited to:

1. Director will concentrate on short term gain (as a result of bonuses), rather than long

term shareholder value

2. Presence of a director with such outrageous incentives will divide the board causing

dissidents to be seen as a threat as opposed to a colleague

3. Can compromise the authority of the board and the independence of nominees

All of these problems can lead to a loss in shareholder value (Iacobucci, 2013). . If the director

concentrates on the short term than those that are in it for the long haul (primarily institutional

investors) could more than likely suffer long term losses. Also if there is a rift in the boardroom,

then the problem will be the same as it was in the past with dissident directors. Dissident

directors are finally now recommended within corporations, in the past they were treated like

pariahs and not included in any of the important activities or projects of the company. The same

will happen if dissident directors ‘hypothetically’ cause the board to become dysfunctional. If

this does occur then nothing will be agreed upon and there will essentially be a deadlock in the

boardroom causing missed opportunities and eventually shareholder loss. Finally the last

problem is that the dissident(s) on the board could possibly not share their own opinions. The

high amount of compensation from the hedge fund could quite possibly cause them to do what

the hedge fund would want. This can cause shareholder loss if the hedge fund is just flat out

wrong in what they are proposing. The dissident will probably stand by the hedge fund and

endorse the risky ventures which can lead to substantial loses for shareholders (including the

hedge fund).

The problems presented can definitely cause rejection of the proposed compensation

plan, however most of the problems are hypothetical and could go either way. For instance, as

far as the board being “Balkanized” due to high compensation, director pay has always varied

between each individual director within the board and it has not been an issue, this case should

be no different. The other problem that can be refuted is in regards to the loss of an independent

director (in this case the director will be dependent towards the Hedge Fund). One of the main

rebuttals is that hedge funds are filled with experts in finance; they have more than adequate

skills and resources to determine if ventures will be profitable. Also the hedge funds that initiate

these proxy contests usually carry a large quantity of shares of the company, if the stock price

decreases then the shareholders will suffer losses, and then the hedge fund will suffer losses at a

higher level due to the high amount of shares owned.

However, even with all the issues presented, there are always positives that could very

well increase shareholder value. Hypothetically, if a hedge fund were to offer such ridiculous

incentives to directors, then they clearly have confidence in the director’s ability to enhance

shareholder value. This can in turn effect the way the market perceives the underlying

corporation; it will signal investors to buy more shares, which will cause in increase in the share

price.

The tricky aspect of this compensation package is that the dissident will be inclined and

even incentivized to enhancing shareholder value (within three years). The reason this can be ill-

fated for the company and its shareholders is that it can cause the dissident to think more short

term (in this case three years), rather than focusing on long term shareholder value. The only

counter that is visible is that there is only going to be a couple dissidents on the board if that, this

is not enough to accept projects that could be a short term fix in nature.

FUTURE: My View – Hybrid Compensation Structure

I personally have another pay for performance type compensation plan in mind that could

possibly work better than all of the previously mentioned structures. The big difference between

the dissident pay and my view is that this compensation structure can be for all directors not just

the dissidents. It is very similar in the aspect that there is an added bonus for directors based off

of performance in comparison to industry peers. The difference is that with the potential bonus

for an increase in share value you add two other types of compensation structure, those being

equity and benefits. This will birth a hybrid structure comprised of bonuses, equity and benefits.

The major flaw in the pay per performance for dissidents is that there is too much

incentive on short-term gains and little incentive for long-term gain. Equity and benefits in

compensation packages has been known for keeping the directors on the board for greater

periods of time, longevity. With benefits and equity, the directors will be more inclined to stay

on the board for a longer period of time; hence the directors will focus on long-term gains of

shareholder value. Also since all the directors will be under the same compensation package that

is put together by the corporation, there will be very little chance of boardroom problems and

standoffs. Another problem that is resolved is the question of independence of the directors, all

of the directors will have this proposed payment scheme and the golden leashes of a larger

investor do not bind them.

This payment scheme is much better than the previous salary based scheme, considering

the salary compensation structure does not align shareholder value and director value. This

scheme is also better than the current compensation structure comprised of equity and salary

because the bonuses add an extra incentive ridding them of the cautious, risk averseness. This

payment structure will align the directors and shareholders value much better than the dissident

payment plan, and it will also get rid of a lot of the possible problems that caused it to fail during

the Elliot Management Group and JANA Partners proxy contests.

CONCLUSION

The fiduciary duty of a board as described by Milton Friedman and Laban Jackson is to

work in the best interest of the company and its shareholders. Through time there have been two

payment plans that seem to have been used the most; those plans being the salary based plan and

the other being the salary and equity plan. As the salary based compensation plan became less

useful, equity began to be added. Equity has now caused some directors to be risk averse because

of the fact that projects could possibly fail which would cause their share value to decrease. So as

directors stop taking risks, they miss out on opportunities that could be profitable for the

company and the shareholders. One of the future plans proposed by JANA Partners and Elliott

Management Groups is a pay for performance for dissident directors compensation plan. This

plan had multiple problems, and famed corporate lawyer Marty Lipton has even went as far to

question the legality of the plan. Then there is the hybrid plan that includes a pay for

performance aspect, equity aspect and a benefits package. This not only aligns the board with

shareholder value, but it also promotes longevity to combat the short sightedness that is prevalent

in the dissident pay for performance compensation plan. All in all, compensation plans are going

to evolve as markets, government regulation and governance structure evolves, sooner or later

these proposed future plans will become just a footnote in the world of corporate governance.

Works Cited

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Dodge vs. Ford Motor Co.. (n.d.). . Retrieved February 15, 2014, from http://www.casebriefs.com/blog/law/corporations/corporations-keyed-to-klein/the-nature-of-the-corporation/dodge-v-ford-motor-co/

Elson, C., Carey, D., & England, J. Directors & Boards. How should corporate directors be compensated?, 1-12.

Forrester, C., & Ferber, C. (2012). GENERAL OVERVIEW OF THE FIDUCIARY DUTIES OF DIRECTORS AND OFFICERS. Fiduciary Duties and other responsibilities of corporate directors and officers (5 ed., ). Chicago: .

Green, J., & Suzuki, H. (2013, May 30). Bloomberg - Business, Financial & Economic News, Stock Quotes. . Retrieved May 15, 2014, from http://www.bloomberg.com/

Hewlett-Packard. (2013). 2013 Annual Meeting of Stockholders. Palo Alto, California: (March 20th, 2013). Retrieved from http://media.corporate-ir.net/media_files/IROL/71/71087/AR-2013-t21sfr/index.html

Iacobucci, E. (2013, November). Special Compensation arrangements for dissident directors in proxy contests: A Policy Analysis.

(2014). Non-Profit Best Governance Practices United States: Weinberg Center for Corporate Governance .

Report of the NACD blue ribbon commission on director compensation. Purposes, Principles and Best Practices , 1-17.