Voting systems in focus as activism returns

What do 35 corporate secretaries, a couple of Chicago lawyers, an insurance expert, a communications professional and a proxy solicitor have in common? Well, they all came together for the fourth Corporate Secretary Midwest Think Tank in Chicago in late September – and they are all passionately interested in regulatory reform and proxy mechanics.

When you bring this many corporate lawyers and other experts together you can never be quite sure what they will want to talk about, but one thing is certain: there will be no shortage of opinions and spirited debate. This event was no exception.
Pressing issues

Hosted at the downtown offices of Foley & Lardner, the day started with a topic that, while not new, is of great importance: proxy mechanics. Shareholder activism has been on the rise in recent years, and while hostile activity may have taken an unexpected vacation in this year’s proxy season, the trend of increased engagement and activism from shareholders is likely to continue. That makes the system for submitting and monitoring votes of vital import.

The problem, according to most people at the think tank, is that the system as it stands is broken, wrought with inaccuracies and inconsistencies. Making the problem worse is a general lack of transparency, which results in a misunderstanding of the underlying process.

Historically, inaccuracies in the corporate proxy voting system were not readily identifiable; nor were they really a problem thanks to plurality voting standards, staggered boards and other structures that rendered voting a formality. But the adoption of majority voting and the recent raft of regulatory changes have made votes both harder to get and more important.

The problem, according to Pat McGurn, panelist for the opening session, is that the system has not kept up with these changes. McGurn, who is special counsel for ISS and a well-known figure in the proxy advisory world, explained that regulation is in many ways one-sided. Proxy statements and other financial filings are highly legalistic and heavily regulated by the SEC, which has explicit rules for what must be in them, where they need to be and how they should be presented. McGurn pointed out that, once the proxies are in the hands of the investor, the regulatory body completely backs off and a group of largely unregulated private businesses manage (or mismanage) the process of submitting, collating and validating the votes.

David Drake, president of Georgeson, echoed McGurn’s sentiment and explained that the SEC concept release on proxy voting is, for the first time, ‘trying to bring end-to-end accountability and transparency to the process.’ This is important because, as Drake explained, errors occur in the voting process far more often than most people realize. Activities like share lending and other processes that can separate voting rights from economic rights, plus an inability or unwillingness on the part of some intermediaries to ensure each share is voted by the rightful person only (and voted once only), can lead to vote outcomes being manipulated.
And sometimes, of course, the results are just plain wrong. Votes may be counted incorrectly; often, thousands or millions of votes are not counted at all. While there is no evidence to prove that this type of error has resulted in a director not being elected, it is not unreasonable to think it has happened. Unfortunately, there is no way for companies to know, because they do not have access to the shareholder list, and at present the intermediaries are not really accountable to anyone.

So what are the solutions? ‘There are so many intermediaries in the voting process that the chance for error is very high,’ observed McGurn. ‘Broadridge is the biggest player in this market, and it is in charge of the part of the process that is the most unclear, which leads to a lack of transparency. There is no clear opinion on the value of addressing this lack of transparency, however, because enhanced transparency through voting confirmation or other mechanisms leads to higher costs. There are many divergent views on whether enhanced transparency is worth the extra cost.’

Judging by some of the comments from the gathered group of corporate issuers, many would be happy to bear the extra cost if it provided greater transparency and a more accurate vote, not to mention direct access to the shareholder list. It is possible, however, that by opening up the system and introducing more competition, prices would come down. Several large firms are waiting on the sidelines to step into the fulfillment space if and when the rules change.

Access all areas
Following on from this theme, the second panel of the day, supported by Aon, looked at some of the finer points of the Dodd-Frank legislation and what it will mean for corporate secretaries and in-house counsel. The initial conversation centered on the new proxy access rules and the implications for voting season in 2011 and beyond. Two important points became clear almost immediately: the rules are unlikely to be in place for next year’s proxy season, and most companies believe the 3 percent ownership threshold will insulate them from the majority of activists.

This second assumption – that a high ownership standard is ample protection – is a dangerous one. It was explained that, while very few institutions currently hold that level of ownership at the largest companies, many mid-cap and smaller firms are definitely exposed. In addition, the rules for investors working in concert to achieve the 3 percent threshold have been relaxed, and there are several investors that are regular allies that could band together that level of stock. For example, CalPERS, CalSTRS and Relational Investors all often work together and could achieve the necessary holding level.

It is important to understand the rules. Dissidents cannot use access to launch a bid for control of the company, they may not nominate directors to more than 25 percent of the board, and the statements to be included on the proxy must be 500 words or less.

Despite all the changes, the odds are still in favor of the board and company. The key, as with many forms of potential conflict, is communication. As McGurn pointed out, a company is bound by law as to what it can say on a proxy, so it must reach beyond the annual 10K filing to connect with shareholders on a meaningful basis throughout the year.

Executive stress
Judging by the comments from attendees, it is clear that compensation is the issue of greatest concern. Say on pay continues to challenge many issuers, although it seems a large number of companies are coming to terms with it. The major issues are the so-called pay disparity law requiring comparison of CEO pay to that of the average employee, golden parachutes and the clawback provision for executive compensation.

The rules, as Pat Daugherty, a partner at Foley & Lardner, pointed out, require the company to recover any bonus compensation paid to executives in the event of a financial restatement. The problem is that the law is unclear on the position of former directors who have signed a release, and on whether there are limits on what can be claimed. What is clear, though, is that every company must establish a policy – and soon.

All this greatly increases the risk faced by board members, and some companies are seeing an impact. Attendees noted the difficulty of mounting an investor relations campaign; one speaker agreed that executive officers and board members can be reluctant to go on the road to meet with shareholder groups, and those same officers and directors are often later surprised to find shareholder votes delivering adverse outcomes to management.

The speaker also noted that it may be difficult to find directors willing to sit on a compensation committee with all the new requirements and potential liabilities Dodd-Frank has established for that committee. At least one attendee concurred, citing the early departure from her corporation of a director who felt the pressure of sitting on the committee was overwhelming.
One way to mitigate these risks is, of course, through insurance, but as the regulatory framework shifts, the insurance market becomes more complicated. No one knows yet how much of these new liabilities a director can be indemnified against, but it is probably worth reviewing the existing policies, in particular those covering former directors and executives. 


Thoughts on proxy mechanics

• SEC should create a uniform system of dealing with the situation when there is an over-vote or under-vote.
• It is questionable whether this is an issue for regulatory authorities or courts to decide, but something needs to be done to increase transparency and accountability.
• General counsel need to start working more closely with investor relations teams and compensation officers to speak directly with institutions about voting.
• Proxies will turn into sales documents where pretty graphs and pictures accompany the disclosure ‘check boxes’ in place of good qualitative disclosures.
• Proxy advisory firms are not responsive and do not provide issuers with opportunities for input. The fact that so many institutions rely on advisory groups that don’t listen and frequently have errors in their issued information makes issuers nervous.

Top five challenges from Dodd-Frank

• New proxy access requirements
• Shareholder say-on-pay votes
• Shareholder votes on executive golden parachute arrangements
• Requirements for clawback of compensation in the event of a financial restatement
• Proxy disclosures of executive compensation and links to performance