In connection with the upcoming annual meeting of Provident Financial Holdings, Inc., the Proxy Advisory Services arm of Institutional Shareholder Services has recommended that Provident Financial’s stockholders withhold their votes for the director candidates of the company who are members of its nominating and governance committee, citing a “material governance failure” arising from the board’s recent adoption of a bylaw disqualifying as a nominee for election to the board anyone who receives compensation for that candidacy from a third party. Companies which have, or are considering the adoption of, a bylaw governing this area should carefully consider its scope to avoid triggering undesired consequences.

Provident’s bylaws did not violate a specific guideline issued by ISS. Instead, ISS’ position was taken under the aegis of its more general policy that under extraordinary circumstances a withhold recommendation will be issued “for materialfailures of governance, stewardship, risk oversight, or fiduciary responsibilities.”

The relevant portion of Provident Financial’s bylaws follows:

“[N]o person shall qualify for service as a director of the Corporation if he or she is a party to any compensatory, payment or other financial agreement, arrangement or understanding with any person or entity other than the Corporation, or has received any such compensation or other payment from any person or entity other than the Corporation, in each case in connection with candidacy or service as a director of the Corporation; provided that agreements providing only for indemnification and/or reimbursement of out-of-pocket expenses in connection with candidacy as a director (but not, for the avoidance of doubt, in connection with service as a director) and any pre-existing employment agreement a candidate has with his or her employer (not entered into in contemplation of the employer’s investment in the Corporation or such employee’s candidacy as a director), shall not be disqualifying under this section.”

ISS noted that it was aware of at least 26 companies which have adopted such bylaw provisions since May 2013, following the controversial proxy contests at Agrium Inc. and Hess Corp., where incentive awards were proposed to be paid to dissident director candidates by certain stockholders if such candidates were successfully elected. These incentive arrangements have been criticized by many companies and other observers, citing the potential distortion in board focus on strategic objectives and appropriate time frames, conflicts of interest and the duty of loyalty to stockholders generally, and internal boardroom divisiveness that such arrangements could engender.

ISS noted that in Provident Financial’s case the bylaw provisions were adopted after an investor group had filed two Schedule 13Ds reporting additional members of the stockholder group which collectively owned 7.4% of the company’s stock. ISS noted the “absence of transparency”, failure to disclose the rationale for the bylaw adoption, and lack of stockholder input.          

In its Provident Financial recommendation, ISS made it clear that it has no objections to bylaws making candidates for the board ineligible if they fail to disclose third party compensation arrangements. What clearly appears to be objectionable to ISS is the prohibition in the Provident bylaws of third party compensation for serving as a candidate for election to the board. It is ISS’ view that this provision will restrict the availability of qualified candidates who would not be prepared to devote the time and effort necessary to run, absent third party compensation. ISS believes that the ultimate determination of the appropriateness of such compensation arrangements should be made at the stockholder ballot box. 

The Provident Financial bylaw restriction covered third party compensation payments for both director candidacy and director service on the board. Because the ISS recommendation only addressed the restriction on compensation arrangements pertaining to candidacy, it would appear that bylaw disqualification provisions pertaining to third party compensation for board service may be acceptable to ISS.

Inasmuch as the proxy season will heat up soon and many companies have, or are contemplating the adoption of, third party director compensation disqualification bylaws, ISS and the other proxy advisory services can be expected to provide clearer guidance on their positions, both with respect to the contours and scope of such bylaws generally and any facts and circumstances which could distinguish or differentiate a company’s adoption of such bylaws in particular.