Tuesday, September 28, 2010

Director Incentives

Recent developments in the previously discussed offer by XING to acquire Stock Idea QXM illustrates a major flaw in current corporate governance standards.

XING is offering $200 million to pick up more than $265 million in liquid assets (mostly in the form of cash). But the Special Committee of the Board of Directors has so far offered no opinion on this offer. Why? Because these directors own no shares in the target company. As such, they have no incentive to force an increase in the share price offered. Instead, these directors are incentivized to befriend the acquirer so that they can continue to land lucrative director fees in the future.

Companies listed on the NYSE are required to have a number of independent directors. But these directors are not acting in the company's best interests if their financial incentives are not aligned with those of shareholders. In the case of QXM, the independent directors own no shares, while the rest of the directors own 60% of QXM.

But the minority shareholders are fighting back. The Special Committee has "received...communications from several institutional shareholders of QXM in which such shareholders have indicated that they did not believe the Proposed Offer was sufficient and that they did not support the Proposed Offer, noting among other things that as of June 30, 2010 both the net asset value per share, and the cash value per share, of QXM was substantially in excess of the value per share of QXM represented by the Proposed Offer."

Nevertheless, the acquiror is pushing forward to force the transaction through. Had the directors had the financial incentive they should have, they may have demanded (publicly or otherwise) a higher offer price. Instead, shareholders may get ripped off.

Warren Buffett has often spoken of the need to correctly incentivize directors. These paragraphs are from Berkshire's 2002 letter to shareholders:

"[W]e will add a test that we believe is important, but far from determinative, in fostering
independence: We will select directors who have huge and true ownership interests...expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees.

"That gets to an often-overlooked point about directors’ compensation, which at public companies
averages perhaps $50,000 annually. It baffles me how the many directors who look to these dollars for perhaps 20% or more of their annual income can be considered independent when Ron Olson, for example, who is on our board, may be deemed not independent because he receives a tiny percentage of his very large income from Berkshire legal fees. As the investment company saga suggests, a director whose moderate income is heavily dependent on directors’ fees – and who hopes mightily to be invited to join other boards in order to earn more fees – is highly unlikely to offend a CEO or fellow directors, who in a major way will determine his reputation in corporate circles. If regulators believe that “significant” money taints independence (and it certainly can), they have overlooked a massive class of possible offenders.

"At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance.
Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don’t provide them with officers’ and directors’ liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years).

"Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family’s net worth, not by their compensation. That’s the equation for Charlie and me as managers, and we think it’s the right one for Berkshire directors as well.

"To find new directors, we will look through our shareholders list for people who directly, or in their family, have had large Berkshire holdings – in the millions of dollars – for a long time."


Paul said...


How do you find out about the liability insurance for directors? That's something that I don't believe I've ever heard of before.

Saj Karsan said...

Hi Paul,

I believe you can find this info in the DEF 14A under director compensation. For example, page 62 of the latest DEF 14A for Best Buy notes:

"[A]ll directors are covered under a directors' and officers' indemnity insurance policy."

Paul said...


You're awesome as always. Thanks for that!