Mutually assured destruction

The satirical English poet Alexander Pope once wrote that ‘a little learning is a dangerous thing’. The same can be said for a little power, and there is no denying that shareholders have, in recent times, gained more than a little power. With this power comes activism.

Much to the dismay of US public corporations, shareholder activism is increasingly becoming akin to military campaigns. The activists view themselves as revolutionaries, and the companies as entrenched and often corrupt governments. They have been campaigning for years to gain more power and promote their own agenda, and now, for the first time, they have been given the tools to overturn those in power.

With so much change taking place, there are concerns about what the shift in the balance of power will mean. Some of the country’s leading academics, business people and regulators feel that with investors being newly empowered there is a distinct possibility they might misuse that power and cause more problems than they solve. There is already a great deal of statistical evidence to suggest that greater investor democracy and activism do not really improve shareholder value – and may, in fact, damage it.

The arguments surrounding the pros and cons of increased activism are many and varied, and nearly all focus on the concept of proxy access. With the SEC promising to rule on proxy access during the fall, the discussion could not be more timely. Investor advocates suggest the rule would simply even the scales and allow shareholders to nominate their own slate of directors on the proxy statement. It is argued that such a democratic process will improve overall governance and management of companies. Not everyone agrees, however.

Risk-averse

Peter Atkins, a partner at Skadden Arps Slate Meagher & Flom, warns that implementing Rule 14a-11, otherwise known as proxy access, could undermine the structure of capitalism. ‘The very essence of capitalism is that it fosters risk taking,’ he explains. He stresses that ‘mistakes’ are a natural and necessary part of risk taking, and trying to prevent or curtail the process will get in the way of innovation and profit making.

He also asserts that a board’s real function is to determine precisely which risks are ‘systematically unacceptable’, and feels that granting investors direct access and forcing directors to fight campaigns will grossly interfere with the oversight process, thus defeating the very purpose of the board.

Another, often overlooked element is that of expertise: just because you own a car doesn’t mean you have any idea how it was made, and while most people eat in restaurants, it doesn’t mean we all know how to cook. It follows, therefore, that just because an investor owns a stock, it does not mean he or she has even a basic idea of how the company should be run or what skill sets directors and managers might need.

Companies are concerned that greater shareholder involvement may result in a politicization of the process that allows investor groups with limited knowledge – or, even worse, vested interests that are not business-focused – to exert undue influence over corporate boards and management teams.

One thing investors fail to understand is that business was never designed to be a democracy – far from it. Democracies may be ‘fair’, but they are incredibly inefficient. Look at politicians and judges: most spend more time campaigning for reelection than doing what they are supposed to be doing.

Done deal

But is all this talk really important? Most people believe proxy access is a foregone conclusion. The SEC has strongly indicated its support for the concept, and while it may not pass in time for proxy season 2010 it seems likely that some form of access will happen. This leaves companies in a position where they need to figure out how to implement it.

What many investors don’t realize is that, at a time when companies are struggling with the most challenging financial situation in a generation, the push for proxy access is diverting attention from the fundamental activity of running the business and finding a way through the current malaise. Even companies with significant resources like Pfizer and Johnson & Johnson are spending ‘more hours than the day has’ on dealing with proxy access.

Apart from the considerable time expense companies are incurring, there is the actual fiscal cost proxy campaigns will produce. Firms can little afford to spend funds on expensive proxy campaigns, and although this should not be a reason to allow under-performing boards a free pass, it is an important consideration.

James McRitchie, editor of CorpGov.net, recognizes this problem and suggests it is exactly why improved governance tools are needed. He says all-out fights should be avoided unless absolutely necessary. ‘The cost to either party would be too great,’ he explains. ‘Proxy battles are unnecessarily expensive. Too often they occur only after a company has suffered years of decline. The market is often too slow to respond to entrenched managers and boards. Proxy access, majority voting and other tools give shareowners the power to shift boards, without the cost of a bloody war or revolution.’

First steps

But if SEC adoption of proxy access is almost a fait accompli, is all this talk and debate just empty rhetoric? Not exactly. Regardless of what the SEC does, proxy access took a big step toward becoming a reality earlier this year when the state of Delaware updated its General Corporation Law and expressly included language allowing for proxy access.

As John Grossbauer, a partner at Potter Anderson & Corroon who was directly involved in the formation of the new Delaware rules, points out: ‘The state really wanted to get out in front of the whole proxy access discussion and allow companies the opportunity to implement it with or without the SEC.’

The reason the debate surrounding proxy access remains important is that, regardless of what the SEC does, implementation will require a change to corporate bylaws, which, in most cases, requires a shareholder vote. Not all shareholders are supportive of all-out proxy access, so it is important to communicate potential problems to ‘friendly’ shareholders.

In addition, as Grossbauer pointed out at the Corporate Secretary East Coast Think Tank in June, ‘the Delaware law specifically allows for the company to stipulate limitations to proxy access.’ These limits typically focus on share ownership. One commonly touted benchmark is that only shareholders with a minimum of 5 percent of company stock will be allowed to nominate directors on the proxy. According to Grossbauer, however, ‘a company is free to set whatever ownership limits it wants’ when writing the bylaws. Bear in mind that the bylaw change will require shareholder approval, so if limits are set too high, companies could be setting themselves up for a negative result.

In addition to ownership limits, a number of companies are considering stipulating a minimum holding period. For example, only investors with at least 5 percent of stock for a continuous period of 12 months prior to the record date for voting will be permitted to nominate directors.

The Delaware State Bar Association (DSBA) currently does not support SEC-mandated proxy access. It bases its opposition on the long-standing idea of state rights, asserting in a recent comment letter to the commission that ‘the rule would unnecessarily deprive Delaware corporations of the flexibility state law confers to deal effectively with myriad different circumstances that legislators and rule makers cannot anticipate, and would thereby undermine a key element of the state system of corporate governance that has been largely successful for decades.’

In its letter, the DSBA cites comments from earlier access proposals to support the suggestion that shareowners want high ownership thresholds and restrictions on who can propose board nominees. ‘Proposed Rule 14a-11 would prohibit stockholders from exercising their state law right to adopt a bylaw incorporating more demanding eligibility requirements,’ the letter states.

The better part of valor?

Stephen Bainbridge, William D Warren professor at UCLA School of Law and author of the paper ‘Shareholder activism in the Obama era’, believes shareholder action against directors should be a tool of last resort. ‘Shareowners should wait until performance is sufficiently degraded,’ he says. Only under this circumstance would ‘a takeover fight be worth waging.’

Bainbridge points to some studies that prove shareholder activism does not add value. His argument is that most shareholders, including institutions, lack the necessary in-depth corporate knowledge and invest too little time to really make a difference once they gain a board seat. This was certainly true in the late 1990s, but it could be argued that investors have become far more sophisticated in recent years.

As companies prepare themselves for proxy access, they should closely monitor arguments put forward by proponents and also those against the idea. Perhaps the most influential voice against proxy access is that of Joe Grundfest, a former SEC commissioner and a William A Franke professor of law and business at Stanford Law School.

Grundfest’s arguments are similar to those put forward by the DSBA: he wants shareholders and companies to be able to develop their own models. If shareowners were ‘sufficiently intelligent and responsible to nominate and elect directors,’ he asks, why would the SEC ‘prohibit the identical shareholder majority from establishing a proxy access regime, or from amending the proposed rules to establish more stringent access standards?’ Access advocates such as McRitchie say the SEC proposal ‘does not replicate the annual meeting process where access could be relaxed or strengthened.’

Grundfest does suggest some changes that will improve the proposal and make it more beneficial, in his opinion, for both companies and shareholders in the long term: relax the rules governing communication among shareholders seeking to organize precatory ‘just vote no’ campaigns; impose additional disclosure and communication requirements on registrants with directors who have a majority of votes withheld, regardless of whether the corporation has a majority vote policy; and impose additional disclosure and communication requirements on registrants who fail to satisfy specified majority voting standards.

Rallying support

Grundfest believes that, as it is currently written, the SEC proposal will not gain support from a majority of shareholders. He urges the commission to conduct more intensive surveys and conversations with major institutional shareholders – not just the vocal activist groups – to determine a structure that would meet with broad acceptance. ‘These surveys might indicate that different categories of corporations have shareholder bodies with different preferences regarding the design of proxy access regimes,’ he says. ‘To respect that natural variation in shareholder preferences, the SEC could adopt a set of proxy access criteria that would seek to synthesize the default rules shareholders would prefer if the matter were put to a vote. The family of default rules could then be further subject to an opt-out rule allowing a majority of shareholders to strengthen or relax proxy access standards at individual corporations in a manner consistent with the legislative mandate.’

Access increase

Whatever form the final SEC rules take, companies can expect to see a surge in access proposals from investor groups in 2010. Pat McGurn, special counsel for RiskMetrics, explains that his company is expecting access to pass ‘in some form or another’ but admits that it may well not happen in time for 2010. ‘With the changes in Delaware and growing acceptance at the SEC,’ however, RiskMetrics is preparing a ‘significant number’ of access proposals in addition to others involving board structure and executive compensation.

The upcoming proxy season will be extremely active. Companies are going to need a well-defined plan for how they deal with proxy access, should it be mandated, and will have to consider whether there is any advantage to be gained through getting in front of the situation by working with selected shareholders to make bylaw changes under the Delaware model.

Either way, communication with investors will be essential to determining what level of support these proposals will get and assessing the likelihood of alternative slates being proposed. 

Delaware State Bar association’s concerns over SEC proxy access proposal

• Stockholders would lose their state law right to adopt a proxy access bylaw that prevents a stockholder or group from making a director nomination for consecutive years if the stockholder’s or group’s previously sponsored nominee was not elected or did not receive a minimum number of votes.
• Rational stockholders may prefer limitations the SEC previously proposed to require between nominator and nominees, such as prohibiting the nominee from being a member of the immediate family, or an employee, of the nominating shareholder or group.
• Proxy access may be precluded where a ‘traditional’ election contest is underway.
• Preventing stockholders from exercising their state law rights to adopt alternative governance rules they deem appropriate, wherein the DSBA lists a number of potential costs to corporations and indirectly to shareowners. Under Delaware law, stockholders and boards of directors have the right to decide that these potential costs of a mandatory proxy access procedure outweigh the potential benefits to that particular corporation.
• Whereas the access proposal invokes ‘the importance of facilitating shareholders’ ability to exercise their rights to determine their own additional shareholder nomination proxy disclosure and related procedures’, it actually prohibits exercise of their rights, ‘including bylaws that impose more stringent requirements for proxy access than proposed Rule 14a-11.’
• Delaware has a better dispute resolution, as no-action letters would likely be appealed to federal courts, which take a great deal more time to render decisions.

Source: DSBA comment letter