How corporate governance is made: the case of the golden leash.

• Author: Cain, Matthew D.
• Position: Introduction through II. The Case of the Golden Leash, p. 649-678

This Article presents a case study of a corporate governance innovation: the incentive compensation arrangement for activist-nominated director candidates colloquially known as the "golden leash." Golden leash compensation arrangements are a potentially valuable tool for activist shareholders in election contests. In response to their use, a number of issuers adopted bylaw provisions banning incentive compensation arrangements. Investors, in turn, viewed director adoption of golden leash bylaws as problematic and successfully pressured issuers to repeal them.

This study demonstrates how corporate governance provisions are developed and deployed, the sequential responses of issuers and investors, and the central role played by governance intermediaries--activist investors, institutional advisors, and corporate law firms.

The golden leash also presents an opportunity to test the response of share prices to governance innovation. We conducted two cross-sectional event studies around key dates that affected the availability of the golden leash. Our core finding is that share prices of firms facing activist intervention reacted positively to events that make golden leashes more available and negatively to events that make golden leashes less available. Moreover, we found that this governance innovation did not affect every firm in an identical manner. Only the share prices of those firms most likely to be subject to activist attention experienced statistically significant share price reactions.

Our research contributes to the debate over how corporate governance is made and its economic significance. Although we found that corporate governance provisions may be priced, at least in some circumstances, our study also suggests that corporate governance is a complex story involving the actions and reactions not merely of the firm and its shareholders but of a variety of intermediaries and interest groups that have agendas of their own.

INTRODUCTION I. THE MAKING OF CORPORATE GOVERNANCE A. Which Governance Terms Are Adopted? B. How Does Corporate Governance Change? II. THE CASE OF THE GOLDEN LEASH A. Background B. An Activist Innovation--The Golden Leash C. The Advisors Strike Back III. EMPIRICAL ANALYSIS A. Data Description B. Analysis--Adopters and Repealers C. Price Effects D. Companies Subject to Shareholder Activism IV. IMPLICATIONS A. Governance Intermediaries and the Differential Pricing of Governance Terms B. Price Discrimination in the Market for Governance Terms C. Activism CONCLUSION APPENDIX--MATCHED PAIR ANALYSIS INTRODUCTION

How is corporate governance made? In one telling, corporate governance is endogenous and closely tailored to firm-specific needs. (1) Companies adopt those governance provisions that are designed to create the greatest value given the firm's particular situation. (2) Alternatively, governance mechanisms may be adopted by or imposed upon firms without regard to firm value in order to insulate self-interested executives or directors, or to respond to interest group pressures. (3) Between these two poles lies a spectrum of other tales about corporate governance and its impact on firm value. And yet, in spite of the persistent disagreement surrounding these accounts, there is an increasing emphasis on adherence to the "right" governance principles espoused by activist hedge funds and institutional investors, even though these principles are often unproven and difficult to evaluate empirically. (4)

We use a case study of a corporate governance innovation--the golden leash--to shed light on how corporate governance originates and how it is valued. Activist hedge funds invented the golden leash as a tool for attracting and incentivizing director candidates in a proxy contest. Under the terms of the golden leash, these hedge funds agreed to pay their director nominees millions of dollars if the nominees were successful both in winning board seats and achieving the hedge fund's desired objectives.

The golden leash burst onto the scene in 2012 (5) when JANA Partners, LLC (JANA) offered to pay its nominees to the board of Agrium, Inc. (Agrium) an additional $50,000 each, if elected, plus a collective total of 2.6% of JANA's net gain on the investments Around the same time, Elliott Management (Elliott) agreed to pay its dissident nominees to the Hess Corp. (Hess) board an additional $30,000, if elected, for each percentage point by which Hess outperformed its peers over a three-year period. (7) These pay arrangements offered potential compensation in the millions to be paid directly by the activists to their nominees. As such, the arrangements had the potential to tie the interests of the nominees, once elected, to the activists that had nominated them. Accordingly, opponents of the arrangements dubbed them "golden leashes." (8)

The golden leash was immediately controversial. JANA and Elliott justified the golden leash by the need, first, to get the right people onto their slates and, second, to incentivize those people, once elected, to push the company to outperform. (9) According to this account, golden leashes empower shareholders by providing directors committed to unlocking hidden value and increasing market returns. Critics of the golden leash, however, derided these arrangements as pernicious innovations that merely emboldened those who would "jeopardize a company's ability to generate sustainable long-term returns" and "destroy jobs." (10)

Opponents of activist shareholders soon responded with an innovation of their own. On May 10, 2013, Martin Lipton of Wachtell, Lipton, Rosen & Katz (Wachtell), a prominent law firm known for defending firms against activist interventions and hostile takeovers, issued a public memorandum recommending that corporations adopt bylaws prohibiting golden leash compensation arrangements (the "Wachtell Bylaw"). (11) In relatively short order, more than thirty public companies adopted the Wachtell Bylaw. (12) Moreover, because it could be adopted by any company virtually overnight, the Wachtell Bylaw had a market-wide effect. (13)

The Wachtell Bylaw was challenged, but not in any court of law. (14) Instead, it provoked the wrath of a prominent proxy advisory firm, Institutional Shareholder Services (ISS). On November 12, 2013, ISS recommended that shareholders withhold their votes from directors at Provident Financial Holdings, Inc. (Provident) because the bank had adopted the Wachtell Bylaw. (15) At the subsequent annual meeting, Provident's director nominees received a substantial number of withhold votes, and ISS threatened more withhold recommendations, publishing a list of other firms that had adopted the Wachtell Bylaw. (16)

Corporate America got the message. By May 20, 2014, twenty-eight of the thirty-two companies known to have adopted the Wachtell Bylaw prior to the Provident meeting had removed it in whole or in part. (17) The golden leash, in contrast, is far from dead: it has been used in several recent activist attacks, notably those involving Dow Chemical (Dow) and General Motors. (18) In November 2014, Dow agreed to seat two Third Point, LLC (Third Point) nominees who became the first directors to be compensated pursuant to a golden leash. (19)

The back and forth on the golden leash and the Wachtell Bylaw provides a case study of how corporate governance originates and is tested by the marketplace. The golden leash shows that corporate governance in many cases is a product of "governance intermediaries," each with its own agenda and interests. (20) Activist hedge funds may have invented the golden leash, but the shape of the governance arrangements that ultimately emerged has as much to do with the counseling of a corporate law firm and the advocacy of an institutional proxy advisor as it does with the activists themselves. The success or failure of a governance innovation may often depend upon the position taken by such intermediaries.

While intermediaries may introduce these provisions, the question remains whether they are beneficial to the companies adopting them. With respect to the golden leash, this can be studied empirically. We did so by first examining each company and the circumstances of its adoption and repeal of the golden leash bylaw. We found that while some firms were reacting directly to activist threats, others had no apparent rationale for adopting the Wachtell Bylaw. (21) Second, if the golden leash is economically good or bad, one would expect to see stock price reactions--either positive or negative--in response to firms' adoption and repeal of the Wachtell Bylaw. We therefore ran a time series analysis to determine how the market reacted to firms' adoption and repeal of the new corporate governance terms. We found no statistically significant share price effect for those companies that adopted--and subsequently repealed--the Wachtell Bylaw. (22)

We then looked further. Because a golden leash bylaw can be adopted unilaterally at any time by the board of directors, we posited that what matters is not the actual adoption of the bylaw but rather the bylaw's availability for adoption if and when the board decides that it is needed. Additionally, we reasoned that the availability of a golden leash may not matter for all companies, but only for those that face the imminent prospect of a proxy contest or other activist intervention.

We examined this possibility by looking at the companies that experienced shareholder activism during the period from one year prior to the Wachtell Memorandum to one year after the Provident annual meeting. We assumed market discrimination in pricing corporate governance terms and hypothesized that we would find a share price reaction to the Wachtell Memorandum in...