The Latest in Bylaws–No Director Third-Party Compensation

Every now and then a bylaw amendment gains favor in corporate America. A few brave companies act as early adopters. Then, if the concept has merit and nothing bad happens, other companies follow suit until it becomes mainstream. The latest iteration in this cycle may be the prohibition of director third-party compensation.

According to ISS, more than two dozen companies amended their bylaws in 2013 to disqualify from service any director who receives compensation or other payment from a third party in connection with that person’s candidacy or service as a director (regardless of whether the director discloses the compensation). This is a direct response to the increasing practice of institutional shareholders of compensating individuals for representing their interests on boards of directors, particularly where the company and shareholder have a less than cozy relationship. In such cases, director candidates are understandably reluctant to step into a dissident board/shareholder relationship without appropriate financial incentives to do so, especially in the context of a time-consuming proxy contest. Some (most?) companies, on the other hand, take a dim view of such “mercenary” arrangements, and a few now have amended their bylaws to preclude it.

Here’s how it works…

In most cases, the amendment can be adopted by the board without shareholder approval. It typically would be a simple addition to the bylaw article dealing with directors, often in a section addressing director qualifications. It is common to provide carve-outs from the otherwise absolute prohibition to allow things like third-party indemnification, expense reimbursement and pre-existing employment or consulting arrangements that are unrelated to the particular company or board seat in question.

Of course, the amendment is required to be filed on a Form 8-K (Item 5.03) within four business days of its adoption. A description will also appear in the governance section of the company’s next proxy statement.

ISS’s position…

Not surprisingly, ISS is unenthusiastic about this development. According to Jolene Dugan, ISS U.S. Research, it believes that such a provision could “deter legitimate efforts to seek board representation via proxy contest, particularly…[by]…candidates selected for their strong, relevant industry expertise, and who are generally recruited, but not directly employed, by the dissident shareholder.” ISS fears that such bylaw prohibitions could exclude “highly qualified” persons whose election might be “in the best interest of all shareholders…thereby acting as an entrenchment device” for the existing management and board.

Action steps…

This is the time of year when many boards of directors consider governance trends and developments in anticipation of proxy season. Consider adding this to the agenda of your next Nominating and Corporate Governance Committee meeting, or at least be prepared to discuss it if someone raises the issue.