Activist Investing: New NASDAQ Rule on Director Comp Disclosure
Last week, the NASDAQ approved a new rule about disclosure of what investors pay to directors of portfolio companies. It came as a bit of an under-the-radar move, seeing as it garnered relatively little publicity and the SEC (which approves all such rules) received a mere eight comment letters on the subject.
A brief refresher: while not (yet) common, investors have started to compensate individuals that serve on a BoD of a portfolio company. This can occur in two ways:
❖a PM serves on the BoD, and of course earns salary, bonus, and benefits from the fund that employe him or her
❖an individual serves on the BoD at the behest of the shareholder, who then pays the director.
Often that pay depends on the company’s performance, say based on TSR or some other similar share price metric. In both instances, the investor pays the director in addition to whatever the company pays the director. We favor these arrangements.
Now, NASDAQ mandates disclosure of these deals as a condition of maintaining a listing. The disclosure rules are fairly straightforward, if vague and not without loopholes. The details of that disclosure will affect investors that pay directors in this way, and the PMs and others that serve on BoDs pursuant to these arrangements.
What to and Not to Disclose
The operative terms are:
A Company shall disclose ... in the proxy ... for the next shareholders’ meeting at which directors are elected ... the material terms of all agreements and arrangements between any director or nominee for director, and any person or entity other than the Company ... relating to compensation or other payment in connection with such person’s candidacy or service as a director of the Company.
NASDAQ interprets this further:
The terms “compensation” and “other payment” ... are not limited to cash payments and are intended to be construed broadly.
Compensation can thus include:
❖cash (salary, fees) for serving on the BoD
❖bonuses, in cash, company shares, fund units, or other currency, based on company performance
❖fringe benefits, such as health insurance, associated with BoD service
A company need not disclose two items
Expense reimbursement: the rule exempts “expenses in connection with candidacy as a director”, without defining “expenses” or “connection”. Aggressive investors will interpret expenses broadly, to include club memberships, car allowances, and other perks.
Pre-existing arrangements: such as comp packages for PMs that pre-date the BoD service. This could probably include pre-existing consulting relationships with independent directors, too. The director and the investor need to have disclosed the existence of the employment or consulting relationship. Within an existing relationship, the investor and director need to disclose any material increase in comp from accepting a BoD position. For instance, if a PM accepts a BoD seat at a portfolio company, and receives a raise and bonus for doing so, they disclose the amount of the raise and bonus, if material.
The disclosure follows an annual cycle. The company does not need to disclose comp arrangements at the time the investor and the director agree to them, but only for the next annual meeting.
The rule isn’t especially well-drafted. We aren’t intimate with most of the listing rules at the exchanges, and we found a number of gaps through which a clever shareholder could drive at least a mid-sized sedan.
The rule seeks disclosure of “material” terms, without defining material. What is material to an individual director, say in terms of the amount of compensation, is probably less material to a shareholder. Directors and investors can probably interpret this concept liberally.
The rule exempts expenses. Just as companies do with CEOs, investors could pay directors lavishly and find a way to call it “expenses”.
The rule also exempts pre-existing arrangements, as noted earlier. Suppose that within such an arrangement, a PM or independent nominee accepts a BoD position, and the shareholder increases the comp package accordingly. The company would need to disclose this, but only the amount of the increase, and then only if material. Similar to how CEOs think about basic financial accounting disclosures, materiality affords further latitude in deciding whether the exception applies.
The annual disclosure allows more room. A shareholder and director could agree to a disclose-able comp package a day after an annual meeting, and would disclose it a year later.
Perhaps the biggest loophole pertains to shareholder-nominated BoD candidates in contested elections. The rules apply only to companies, not to shareholders. The company can ask incumbent directors to disclose these arrangements as a condition of renomination, or new directors as a condition of nomination. NASDAQ can delist companies that don’t comply, although there are intermediate remedies (like, disclose the undisclosed information) that will surely take effect before delisting. It lacks similar jurisdiction over shareholders.
We expect companies to use the annual D&O questionnaire to learn about these arrangements. Yet, a company can’t require a D&O questionnaire from a dissident director candidate.
A company could make this disclosure a condition of a nomination notice, like other terms in advance-notice bylaws. Some have started down this path, while a few went farther, using bylaws to preclude any such compensation deals. Bylaws that sought to disqualify directors who receive BoD comp from anyone other than the company, rather than merely disclose the terms, were quickly discredited. Those few companies that adopted that kind of restrictive bylaw retreated quickly.
It seems slightly curious that this rule takes the form of an exchange listing requirement. Perhaps the SEC would have never allowed it as a change in the proxy solicitation rules, given its backlog of other stuff. Or, maybe it found it easier to assent to this by delegating the hard work to NASDAQ.
Some companies have already worked this disclosure into advance-notice terms in bylaws. That becomes a slogging, company-by-company effort. A NASDAQ rule extends it more universally, at least to the companies that list there.
At a minimum, this means the rule applies only to NASDAQ companies, not NYSE. No word about whether NYSE plans to do this, too.
Things to consider
For NASDAQ companies, directors with investor comp deals can expect questions in the D&O questionnaire in advance of the next annual meeting.
Consistent with the materiality standard, investors and directors can probably disclose the structure of a comp deal, without disclosing the size. Stating how comp depends on company performance, and the form of comp (cash, shares, etc.) probably matters more than the size of the deal.
Some investors prefer to recruit directors and compensate them directly, rather than having the PM join the BoD. These investors can structure a consulting relationship with directors in advance of nominating them to a portfolio company BoD. In this way the relationship falls under the pre-existing arrangement exemption from these new rules.
There probably is little need, though, to conceal these arrangements from other shareholders. A PM that goes as far as compensating a director based on company performance probably goes farther than the company itself. Instead of hiding it, letting other investors know this investment matters enough to do this is worth the effort.