The following post comes to us from Brandon S. Gold, a fellow in the Harvard Law School Program on Corporate Governance. Beginning in the Fall, Brandon will be an associate with Schulte Roth & Zabel LLP.
In a recent memorandum to clients shared on this blog, Wachtell, Lipton, Rosen & Katz urged companies to adopt a bylaw that would effectively prevent hedge funds and other shareholders from offering their director nominees compensation arrangements such as “pay-for-performance” plans. In an effort to weaken shareholder activists, Wachtell has ignored arguments it has been making for decades and has treated the mere existence of special compensation arrangements—in a total of two proxy fights this year—as a sign of the apocalypse. The proposed bylaw (the “Wachtell Bylaw”), in pertinent part, prevents any person from qualifying “for service as director if he or she is a party to any . . . 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.” Rather than prematurely adopt an overly broad bylaw that prohibits these arrangements, boards should take a more cautious approach and evaluate any shareholder compensation arrangements on a case-by-case basis. This post also discusses why such bylaws may be legally invalid under Blasius.
I. Why the Wachtell Bylaw is Overbroad
In a previous post, Professor John C. Coffee Jr. briefly summarized these shareholder compensation arrangements:
This year, two activist investors—Elliott Management Corp. and Jana Partners—have run minority slates of directors for the boards of Hess Corp and Agrium, Inc., respectively, and each has offered to pay special bonuses to its nominees (and no one else). Elliott will pay bonuses [of up to $9 million] to its five nominees measured by each 1 percent that Hess shares outperform the total rate of return over the next three years on a control group of large oil industry firms. . . . In the case of the Agrium proxy fight, which Jana narrowly just lost, Jana offered to pay its four nominees a percentage of any profits that the hedge fund, itself, earned within a three year period on its Agrium shares.
Wachtell asserts that these “egregious” schemes pose a number of threats, including: undermining Board prerogatives to set director compensation, creating a multi-tiered dysfunctional board with “poisonous” conflicts resulting from differences in compensation for subsets of directors, and “creating economic incentives to take the corporation in the specified direction, and within the timeframe, that would trigger outsized compensation . . .” Boards should certainly take the time to understand the potential negative consequences of shareholder compensation arrangements raised by the Wachtell memo and Professor Coffee’s post. However, it is a mistake to exaggerate the potential risks while simultaneously ignoring the corresponding benefits. These dissident compensation schemes are not always bad and should not be universally prohibited.
It is necessary to understand why shareholders have introduced these compensation arrangements in the first place. Their simple purpose is to get the most qualified individuals to serve as director nominees. In fact, before publishing the client memo that overlooks the value of these arrangements in helping to attract top quality candidates, Mr. Lipton and Wachtell have repeatedly argued that the principal criterion for directors should be competence. JANA and Elliot were able to leverage these compensation arrangements to attract just the type of talented and highly qualified directors that Wachtell had called for.
It well known that recruiting highly qualified directors is a challenge. In past publications, Wachtell has noted some of these obstacles, which apply equally to incumbent boards and shareholders. Shareholders, however, face more hurdles than incumbent boards to attract top director candidates. According to JANA Partners, relying on its own experience, “[u]nlike directors who are appointed or nominated by the board itself, directors who are nominated by shareholders run the risk of coming under substantial attack by the company (e.g., being publicly and falsely accused of riding in on a Trojan Horse or wearing a golden leash or being a pain). In addition, they are less likely to be asked to join other corporate boards and are generally signing on for a potentially long and often difficult process.” Shareholder-initiated compensation arrangements simply provide qualified individuals an additional incentive to overcome these hurdles. In the words of Wachtell, directors must not lose sight of the underlying goal of compensation: “to attract, retain and incentivize highly qualified individuals.”
Moreover, there is reason to doubt the claim that any special compensation arrangement will necessarily lead directors to put their own personal economic interests over the interests of the corporation and its shareholders. The shareholder compensation schemes in the Hess and Agrium proxy fights may arguably do more to align their directors’ interests with the interests of the corporations and shareholders than the incumbent schemes. But this conclusion is open for debate and should turn on the specifics of the arrangement. Therefore, instead of adopting a bylaw that prohibits any type of shareholder compensation arrangement, boards should simply evaluate the actual arrangement at issue. If they believe the arrangement misaligns the interests of the shareholder nominees, they should make that argument to their shareholders before the contested vote. Indeed, the Hess board took their argument against Elliot’s director compensation arrangement to the airwaves and successfully raised enough questions to compel Elliot’s nominees to waive the arrangements. While the prospect of waiver may hinder Elliot’s use of these arrangements in the future, it does not negate the fact that these incentives were a helpful recruiting tool in the first place (when the nominees did not know that they would be waived).
In any event, Wachtell now sees threats they have previously disclaimed in other contexts. For example, the memo suggests that monetary incentives will cause directors to take the corporation in a specified direction or will pressure directors to sell the corporation when it is not in shareholders’ interests to do so. This threat only has credence if one believes that directors will ignore their fiduciary legal duty to act in the best interests of the corporation. However, there is no reason to assume that shareholder nominees are any more likely than incumbent directors to disregard their fiduciary duties. Indeed, Mr. Lipton has aptly noted, “although directors and managers may be motivated by financial gain, they are equally motivated by reputation and satisfaction in the success of the corporations they run. Regardless of the compensation package, no director or manager wants to see the corporation he or she runs fail to succeed and thrive.” It would be unreasonable to argue that this statement applies to all incumbent directors and no shareholder directors.
II. Why the Wachtell Bylaw May Fail Blasius Scrutiny
Furthermore, even though boards are authorized to adopt bylaws prescribing qualifications for directors, Wachtell’s proposed bylaw may pose serious problems under Blasius. In Blasius Industries, Inc. v. Atlas Corp., Chancellor Allen found that board action taken for the sole or primary purpose of interfering with or impeding the effective exercise of the shareholder franchise requires a “compelling justification.” A board’s “good faith effort to protect its incumbency, not selfishly, but in order to thwart implementation of [a corporate policy] that it feared, reasonably, would cause great injury to the Company” might nonetheless violate the duty of loyalty if it interferes with the shareholder franchise. The shareholder franchise encompasses not just shareholder voting rights, but also shareholders’ rights to run competing slates of candidates in director elections. In Harrah’s Entertainment Inc., Chancellor Strine explained why courts are reluctant to approve measures that impede these rights, noting, “[a]s the nominating process circumscribes the range of choice to be made, it is a fundamental and outcome-determinative step in the election of officeholders. To allow for voting while maintaining a closed selection process thus renders the former an empty exercise.”
A court engaged in Blasius scrutiny is likely to find that a board that adopted (or refused to waive) the Wachtell Bylaw had an improper purpose. In Chesapeake Corp. v. Shore, Chancellor Strine noted, “the most important evidence of what a board intended to do is often what effects its actions have.” And the sole effect of the Wachtell Bylaw is the preclusion of shareholders’ use of a recruiting tool for proxy contests. It undoubtedly acts as an impediment to the exercise of the shareholder franchise by removing shareholders’ ability to offer compensation and other incentives in order to recruit highly qualified director nominees. In short, it thwarts the shareholders’ free will. The fact that shareholders can theoretically avoid the adverse effects of the Wachtell Bylaw does not render it proper.
It is also worth noting that the Wachtell Bylaw works exclusively against shareholders and tips the playing field in the favor of the incumbent board. Courts have noted that “[t]he corporate election process, if it is to have any validity, must be conducted with scrupulous fairness and without any advantage being conferred or denied to any candidate or slate of candidates.” While the Wachtell Bylaw operates against shareholders by forbidding them from offering nominee compensation arrangements, it leaves the incumbent board with free reign to recruit directors through whatever compensation scheme it wants, provided that the corporation pays for it. Because the bylaw’s primary effect is the impediment of the shareholder franchise, a court will likely find an improper purpose.
Even if a court finds an improper purpose under Blasius, board action may be upheld if there is a “compelling justification.” However, the theoretical threats posed by shareholder compensation arrangements are unlikely to satisfy this standard. “The words “compelling justification” echo the almost impossible to satisfy standards used under the First and Fourteenth Amendments to address restrictions on political speech and governmental classifications based on race.” As previously mentioned, Wachtell alleged that these compensation arrangements pose numerous overlapping threats, including the possibilities that they would:
- creat[e] economic incentives to take the corporation in the specified direction . . . whether or not doing so would be in the best interests of all shareholders, . . .
- open a schism between the personal interests of directors who stand to benefit in the short-term from the special compensation scheme and the interests of shareholders with a longer-term investment horizon.
However, courts have already rejected these justifications. In Steel Partners II, the defendant company sought to postpone its annual meeting by arguing that the plaintiff shareholders’ directors, if elected, will be conflicted, will seek to steer the company in a specific direction that might not be in the best interests of all shareholders, and will have personal interests adverse to the majority of the defendant’s shareholders. Chancellor Chandler refused to find that these justifications provided a sufficient basis to impinge the shareholder franchise. Instead, the Chancellor held that the proper recourse was for the company to communicate its concerns directly to its shareholders, who can “decide to stay the course with the Company’s current management or else elect a new slate of directors.”
Wachtell’s underlying argument is that the prospect of losing an election to shareholder nominees subject to such arrangements is a threat that justifies the adoption of the Wachtell Bylaw. But courts have found that the prospect of losing an election does not constitute a legitimate threat to corporate interests. Chancellor Allen explained why a board’s good faith beliefs on the merits of the opposing slate is not a valid justification for an action that impedes the shareholder franchise in Blasius:
The only justification that can be offered for the action taken is that the board knows better than do the shareholders what is in the corporation’s best interest. While that premise is no doubt true for any number of matters, it is irrelevant (except insofar as the shareholders wish to be guided by the board’s recommendation) when the question is who should comprise the board. . . . It may be that the [shareholder’s proposal] was or is unrealistic and would lead to injury to the corporation and its shareholders if pursued. . . . The board certainly viewed it in that way, and that view, held in good faith, entitled the board to take certain steps to evade the risk it perceived. It could, for example, expend corporate funds to inform shareholders and seek to bring them to a similar point of view.
Thus incumbent directors in a proxy fight involving shareholder compensation arrangements should take their arguments to the airwaves. Wachtell’s approach, on the other hand, could be seen as an improper use of the corporate machinery.
Assuming that the Wachtell Bylaw is permissible, however, boards should nonetheless decline to adopt it. Companies should permit new tools such as these compensation arrangements to develop through experimentation, trial, and error. Boards and their legal advisors should not prematurely adopt bylaws that outlaw this new instrument. In the rare event that a shareholder launches a proxy fight and utilizes a director compensation arrangement, boards are in a position to evaluate the specific details of such arrangements on a case-by-case basis and to publicize their findings so that shareholders can weigh their arguments. Dissident shareholders may even amend their compensation arrangements in order to address boards’ concerns or withdraw them altogether, as Elliot did. Companies and shareholders would be better served if we allow experimentation and make individual judgments rather than jumping to conclusions that inhibit innovation.
 Martin Lipton et al., Bylaw Protection against Dissident Director Conflict/Enrichment Schemes, CLS Blue Sky Blog, May 10, 2013, https://clsbluesky.files.wordpress.com/2013/05/shareholder-activism-update-bylaw-protection-against-dissident-director-conflict-enrichment-schemes-1.pdf.
 Wachtell suggests boards adopt the following bylaw:
“No 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 bylaw.”
 John C. Coffee, Jr., Shareholder Activism and Ethics: Are Shareholder Bonuses Incentives or Bribes, CLS Blue Sky Blog, Apr. 29, 2013, https://clsbluesky.law.columbia.edu/2013/04/29/shareholder-activism-and-ethics-are-shareholder-bonuses-incentives-or-bribes/.
 See id.
 E.g., Martin Lipton, Some Thoughts for Boards of Directors in 2008, 11(7) Briefly… 19 (2008), available at http://www.aei.org/files/2008/01/01/20080403_Briefly_somethoughtsfor.pdf. Martin Lipton et al., Some Thoughts for Boards of Directors in 2011, 3(1) Director Notes 4 (Jan. 2011), available at http://www.conference-board.org/retrievefile.cfm?filename=TCB%20DN-V3N1-111.pdf (“The most important factors in determining the effectiveness of boards are the people who serve as directors and the expertise, business sense, judgment, integrity, diverse perspectives, commitment, energy and objectivity that they bring to the boardroom.”).
 Whereas incumbent management usually attacks the dissident’s nominees as “unqualified” in most proxy fights, Agrium was never in a position to attack the qualifications and experience of JANA’s director nominees. Cf. AOL, Press Release, AOL Comments on ISS Report that Rejects Starboard’s Full Slate of Nominees, Jun. 2, 2012, http://corp.aol.com/2012/06/02/aol-comments-on-iss-report-that-rejects-starboard-s-full-slate-o/ (“We believe that ISS’s recommendation to dismiss Starboard’s full slate is further evidence that Starboard’s nominees are unqualified to lead AOL.”).
 Martin Lipton et al., Some Thoughts for Boards of Directors in 2012 (2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2020413 (“The challenges of recruiting and retaining world-class directors are complicated by the significant workload and time commitment required for board service today. The 2011 Public Company Governance Survey of the National Association of Corporate Directors (NACD) suggests that public company directors spent an average of over 227 hours performing board-related activities in 2011. In addition, the reputational risks of withhold-the-vote campaigns, majority voting standards, criticism of executive compensation policies and significant product failure or other risk management crises has increased the reluctance of qualified individuals to serve on public company boards.”).
 JANA Partners, Supplemental Presentation To Proxy Advisors (Powerpoint presentation, Mar. 21, 2013).
 Lipton, supra note 8.
 William Alden, Hedge Fund Rejects Proposal by Hess to End Proxy Fight, N.Y. Times DealBook, May 13, 2013, http://dealbook.nytimes.com/2013/05/13/elliott-rejects-a-proposal-by-hess-to-end-proxy-fight/. The Elliot nominees agreed to waive the compensation arrangement because it was causing an “ongoing distraction” in the proxy fight.
 Lipton, supra note 1 (threats include “creating poisonous conflicts in the boardroom by creating a subclass of directors who have a significant monetary incentive to sell the corporation or manage it to attain the highest possible stock price in the short-run”).
 Martin Lipton & Steven A. Rosenblum, Election Contests In the Company’s Proxy: An Idea Whose Time Has Not Come, 59 Bus. Law. 67, 79 (2003).
 Section 141(b) of the Delaware General Corporate Law expressly authorizes qualifications for directors. Del. Code. Ann. tit. 8, §141(b) (West 2013). The drafters of this section noted that qualifications must not be unreasonably or inequitably imposed. Del. Gen. Corp. Law Comm., Commentary on Legislative Proposals, 127th 2d Sess., at 2. (1974). In other words, a bylaw that is inconsistent with any rule of common law is void and “bylaws must be reasonable in their application.” Frants Mfg. Co. v. EAC Indus., 501 A.2d 401, 407 (Del. 1985) (citing Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (1971)).
 It is worth noting that there is a series of cases in which the Delaware Supreme Court found that a qualification bylaw did not trigger the Blasius standard. However, this was because the company already had a majority shareholder and therefore there could be no interference with the shareholder franchise with respect to the election of directors. Stroud v. Grace, 606 A.2d 75, 91–92 (Del. 1992). Additionally, the amendments at issue in Stroud were ratified by a fully informed majority of the shareholders. Id.
 564 A.2d 651 (Del. Ch. 1988).
 Blasius, 564 A.2d at 657 (cited approvingly by the Delaware Supreme Court in MM v. Liquid Audio, Inc., 813 A.2d 1118, 1128–29 (Del. 2003)).
 Harrah’s Entertainment Inc. v. JCC Holding Co., 802 A.2d 294, 310 (Del. Ch. 2002).
 Id. at 311. See also CA Inc. v. AFCSME Employees Pension Plan, 953 A.2d 277, 237 (Del. 2008) (“The shareholders of a Delaware corporation have the right “to participate in selecting the contestants” for election to the board.”); Linton v. Everett, 1997 Del. Ch. LEXIS 117, 29 (Del. Ch. July 31, 1997) (“The right of shareholders to participate in the voting process includes the right to nominate an opposing slate.”); Hubbard v. Hollywood Park Realty Enterprises, Inc., 1991 Del. Ch. LEXIS 9, 18 (Del. Ch. Jan. 14, 1991) (same).
 Chesapeake Corp. v. Shore, 771 A.2d 293, 320 (Del. Ch. 2000).
 Cf. Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 817 (Del. Ch. 2007) (“Being required to wait a month or so before making a final decision hardly subjects stockholders to a loss of free will.”). Conversely, forbidding shareholders from using compensation arrangements to recruit nominees represents a significant loss of free will.
 “Even if in theory the plaintiffs could have avoided the adverse effects of the advance notice provision . . . that ‘cannot serve to excuse the conduct of management . . . that . . . was both inequitable (in the sense of being unnecessary under the circumstances) and [that] had the accompanying dual effect of thwarting shareholder opposition and perpetuating management in office.'” Linton v. Everett, 1997 Del.Ch. LEXIS 117, 32 (Del. Ch. July 31, 1997) (citing Lerman v. Diagnostic Data, Inc., 421 A.2 906, 913–14 (Del. Ch. 1980)).
 Sherwood v. Chan Tze Ngon, 2011 Del.Ch. LEXIS 202, 53 (Del.Ch. Dec. 20, 2011) (quoting Aprahamian v. HBO & Co., 531 A.2d 1204, 1206–07 (Del. Ch. 1987)).
 Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 806 (Del. Ch. 2007).
 Lipton et al., supra note 1.
 Steel Partners II, L.P. v. Point Blank Solutions, Inc., 2008 Del. Ch. LEXIS 107 (Del.Ch. Aug. 12, 2008).
 Id. at *3–5.
 E.g., Stahl v. Apple Bancorp, Inc., 579 A.2d 1115, 1124 (Del. Ch. 1990) (“Threats to legitimate interests may arise in a proxy contest setting, of course, . . . but the prospect of losing a validly conducted shareholder vote cannot, in my opinion, constitute a legitimate threat to a corporate interest, at least if one accepts the traditional model of the nature of the corporation that sees shareholders as “owners.”).
 564 A.2d at 663 (emphasis added). The Delaware Supreme Court subsequently relied this rationale in Liquid Audio. MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118, 1128–29 (Del. 2003).
 See id. at 69.