Directors could be forgiven for feeling a bit insecure these days.

The move toward majority voting in uncontested elections of directors has picked up so much steam that even Wachtell Lipton, diehard defenders of corporate management, acknowledged earlier this year that it is likely to become universal. Meanwhile, the New York Stock Exchange has decided to eliminate the broker vote in uncontested elections, depriving companies of a block vote typically in favor of management nominees.

To Amy Borrus, deputy director of the Council of Institutional Investors, the changes are all good. “Getting rid of broker voting will put more punch into majority voting and probably make directors a little more accountable to shareholders,” she says.

Brokers may vote at the annual meeting on behalf of shareholders who have not given instructions on proposals the NYSE deems “routine.” The theory is that if shareholders were unhappy presumably they would vote, so brokers assume non-voters are content to follow management recommendations. In uncontested director elections, that skews the vote in favor of the nominees.

Starting in 2008, however, the NYSE wants to remove uncontested elections from the “routine” category. Campaigns to withhold votes from director nominees in a plurality vote or to vote against nominees at companies that adopt majority voting no longer will have the deck stacked against them.

Foran

How much difference will it make? For Pfizer—the target of a withhold vote drive in 2005—the broker vote boosted support for director nominees by about 6 percent, according to Peggy Foran, head of corporate governance at Pfizer and chair of the American Bar Association Committee on Corporate Governance.

Without broker votes, the outcome of resolutions suddenly could become much more close. Suppose institutions own 80 percent of the shares, and half of them withhold their vote but all retail investors support management. With the broker vote, 60 percent of votes cast would be in favor; without a broker vote for 75 percent of retail holdings, the favorable vote drops to 45/85, or 53 percent.

That new math will increase the influence of proxy-voting advisers like Institutional Shareholder Services and Glass, Lewis & Co.; a prospect Foran finds “a little scary.” These services may account for up to 30 percent of the vote, depending on the shareholder base. Some institutions—mutual fund managers in particular—follow third-party recommendations to resolve potential conflicts if they manage money for benefit plans at companies where controversial proposals come to a vote. Companies, Foran says, now “have to go out and talk to your investors and make sure they are not deferring to the sound bite or on autopilot.”

Although the NYSE has never considered shareholder proposals routine, the new rule will increase pressure on boards to act on proposals that attract a majority vote. At present, ISS automatically recommends a withhold vote on the entire board if an advisory resolution receives a majority of votes two years in a row (one year if it receives a majority of shares outstanding). In a plurality vote, no harm occurs even if the majority of votes cast are withheld: the directors are still elected. “It is a protest vote,” says Patrick McGurn, executive vice president and special counsel at ISS. “It is a communicative process, not an accountability process.”

Under majority voting, investors don’t get a free pass, however. Theoretically, a failed election could leave a company with no directors elected to the board. In practice, however, every state has holdover provisions that leave incumbent directors in place until they are replaced. In addition, companies that have adopted director-resignation policies (Pfizer among them) always leave the final decision of whether to accept the resignation to the board. For example, if the only financial expert qualified to chair the audit committee failed to get a majority of votes cast, the director must tender his or her resignation—but the board could refuse it, at least until another qualified candidate had been tapped. “Worst case scenarios that have been raised by opponents of majority voting simply don’t hold much water,” McGurn says.

WITHHOLD VOTES

Year

Directors

With >15%

Withheld

Number Of Companies

2004

474

261

2005

445

228

2006 (through 10/31)

385

189

Source: Georgeson Shareholder

Nonetheless, ISS is considering whether to modify its policy for companies that have majority voting. Feedback to date indicates that ISS clients are reluctant to see any change until the broker vote goes, McGurn says. “Clients don’t want to pull back on withhold votes as long as companies are able to stuff the ballot box with votes in favor of the incumbent directors or any new management nominees.”

Despite increasing shareholder activism, withhold votes have become less common over the past three years, according to David Drake, senior managing director of Georgeson Shareholder. ISS has recommended a withhold vote against only 15 percent of director nominees in 2006, down from 25 percent in 2004. Georgeson confirmed the trend when it tallied the number of directors who received a withhold vote of 15 percent or higher among companies in the Standard & Poor’s 1,500 index (see box at above, left).

Spelling Out Voting Standards

ISS believes that the investment and corporate communities need to debate what “rules of engagement” are appropriate for director elections at companies that adopt majority voting. In a survey, clients were evenly split (37 percent each way) over whether ISS should consider the consequences of “withhold” or “against” recommendations at companies that have adopted a majority voting bylaw like Intel’s. For a Pfizer-style director-resignation procedure that preserves a plurality vote, however, respondents favored maintaining the current policy by a wide margin (50 percent to 19 percent). “The adoption of a majority voting rule is the key mile marker you have to get beyond, even to consider bifurcation or discretion coming into the process,” McGurn says.

SURVEY

An excerpt follows from the ISS’ website discussing changes to director elections and its 2006 survey.

III) Under Consideration for 2007

-Majority voting shareholder proposals

Given the continued strong support for majority voting shareholder proposals, along with the movement towards increased accountability through director resignation policies, ISS is considering modifications to its majority voting proposal policy to reflect the progress made in this reform. Intel and many other companies advanced the director election standard debate by adopting both a majority voting standard and a director resignation policy earlier in the year. Many now consider that dual structure the gold standard in director election reforms.

For 2007, we are considering general support for proposals asking for boards to change their standard to a majority of votes cast. Given the movement that many companies have made toward majority voting, ISS is considering removing the “meaningful alternative” evaluation as articulated in our 2006 policy.

- Director withholds

In addition, ISS is considering different election standards when evaluating directors in uncontested elections. A question in our 2006 Policy Survey asked our institutional clients whether shareholders should apply withhold votes less often at companies that have adopted a majority voting standard (defined as an affirmative vote of a majority of votes cast to be elected). Responses were evenly split, with 37% saying that shareholders should apply withhold votes less often, and 37% believing that shareholders should not apply withhold votes less often for majority standard companies. (The remainder of the respondents were in the categories of Don’t know/ No opinion/ It depends.)

A second question in our 2006 Policy Survey asked whether or not shareholders should apply withhold votes less often at companies with a director resignation policy and a plurality standard. Of the respondents, 50% said no, they would not apply withhold votes less often when a director resignation policy is in place. 19 % said they would apply withholds less often in that case. The response rate indicates that investors are less willing to “forgive” potential withhold votes for companies with director resignation policies than for companies with majority voting standards.

Therefore, recommendations on withhold votes under three standards are under consideration – withholds under a majority voting standard (with or without an additional director resignation policy), withholds under a plurality standard with a director resignation policy, and withholds under a plurality standard with no additional policy. A key question is whether or not the different types of voting standards warrant different withhold recommendations, all other things being equal. In almost all cases, the final decision on director removal still rests with the board. (New nominees at a majority voting company, for example, would be an exception because the holdover status would not apply.) Even in a situation with over 50% withholds against directors at a company with a majority voting standard, the board makes the final determination. As indicated earlier, ISS has advocated for modification of the “Holdover Rule” to give full effect to shareholders’ votes while ensuring that boards can continue to operate. Absent a Holdover Rule modification, withholding votes in an uncontested election continues to be a signaling device, albeit a powerful one, for shareholders to signal discontent with board members.

IV) Intent & Impact

The intent of modifying our majority voting proposal policy is to recognize the forward momentum in the marketplace. We have generally supported most proposals already. Our policy under consideration would call for general support unless the proposal had been substantially implemented or the proposal language is flawed in some way.

The discussion and debate on director elections has focused on those directors receiving significant “no” votes, but the reality is that the population of directors in question is extremely small. Over the last several years, negative votes in director elections have decreased. While 25% of board nominees received withhold recommendations from ISS in 2003, 15% of board nominees have received withhold recommendations in 2006. Only eight companies within the S&P 500 have directors who garnered in excess of 40 % withhold votes, and none have received over 50% withhold votes in election results so far this year.

In considering companies that have adopted a majority voting standard, the universe is also still extremely small. Approximately 70 companies have adopted a majority voting standard. In addition, more than 140 companies have adopted some form of a director resignation policy. While the changes at these companies represent progress in reforming director elections, they continue to be in the vast minority of publicly traded companies, the majority of whom still have a plurality election system.

Source

Director Election Reforms (Institutional Shareholder Services)

McGurn

In some states, including Massachusetts and Ohio, directors do not have the power to alter the voting requirement because it is either enshrined in the charter or in a bylaw that cannot be changed without a shareholder vote. McGurn sees activist investors trying to enlist issuers’ help to get state laws changed; where that fails, they may press the company to reincorporate in a jurisdiction like Delaware where the board can adopt majority voting.

If directors cannot act on their own, companies may seek shareholder approval to implement majority voting anyway. Earlier this month, General Electric, a New York corporation, announced it will put forth a proposal at its 2007 annual meeting to amend the certificate of incorporation and adopt majority voting; if the resolution passes, the board also will adopt a bylaw requiring directors who don’t meet the threshold to tender their resignation.

Drake

GE may be an exception, however. Georgeson’s Drake expects most companies to opt for Pfizer-style director-resignation policies that retain plurality voting. He believes that the prospective elimination of the broker vote and the resuscitation of proxy access (which would allow shareholders in certain circumstances to nominate one or more directors in the management proxy statement) will make companies shy away from true majority voting. “There may be some reluctance now that companies see more changes on the way,” Drake says.

Companies that adopt majority voting do face the risk that a director nominee not already on the board at the time of an annual meeting could fail to be elected, leaving a vacancy. Even in that case, the board would be able to cope, according to Robert Messineo, a partner at the law firm Weil, Gotshal & Manges. The directors typically have the power to fill a vacant seat (although they probably wouldn’t appoint the failed nominee) and the existing board should already be in compliance with listing requirements.

Messineo

In extreme circumstances—the untimely death of the only financial expert, for example—the board could be in trouble if the nominated successor were not elected, but Messineo doesn’t believe the company would lose its listing right away. “As a practical matter the exchanges would give people an opportunity to cure,” he says. He points out that companies can, and usually do, appoint a new director to the board before the annual meeting; if the election fails, the holdover provisions kick in because the nominee is then an incumbent.

The probability of failed director elections depends on how the shares are counted, too. If the threshold for election is a majority of shares present at the meeting, broker-controlled shares that cannot vote for directors will nevertheless be counted in the total voting pool. “It’s important that any sort of majority approach be based on votes cast, as opposed to a majority of the shares present,” says Messineo.

Activist shareholders—including hedge funds, Taft-Hartley plans, and socially responsible funds—will wield more power in a majority-voting environment without the broker vote. Campaigns against directors will draw a higher percentage of the vote, but CII’s Borrus doesn’t believe that special interests will be able to hijack elections because they still will need to attract the support of other constituencies to command a majority.

She also points out that while the new rules do improve the odds for activists, they started out with all cards stacked against them. “We have been living until now in what is for all intents and purposes a Stalinist system of director elections,” says Borrus. Now, the revolution is looming.

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