What lies ahead for the 2010 proxy season and annual meeting, and why should you care? Simply stated, public companies will face the greatest challenges that most have experienced in recent memory.
The Securities and Exchange Commission’s recent approval of a rule to eliminate broker discretionary voting in director elections presents the most significant challenge to many corporations. Under the old rule, if brokers had not received instructions from their retail clients by 10 days before the conclusion of proxy voting, they were allowed to vote their clients’ shares as they saw fit. These votes were largely cast in favor of management.
Kenneth Altman, president of the Altman Group, a proxy solicitation firm, believes the amended rule will hurt smaller companies the most. He warns that small-cap businesses, particularly those with stock prices below $5 per share and large portions of shares held by retail investors, will find fewer broker votes in favor of the board’s nominees. Moreover, he says, investors with “narrow, short-term interests” will seek to take advantage of the changed playing field.
Conventional wisdom suggests that these activist investors include certain pension funds and hedge funds using “withheld” votes for directors to carry out their agendas for change. Companies that have majority-voting thresholds for directors, could be particularly at risk, since it will be easier for activists to rack up a majority of “withheld” votes against unwanted directors. Most companies with majority-vote requirements also have a policy that directors who fail to win a majority submit their resignation from the board. Some still leave the board discretion not to accept the resignation but, obviously, anyone who fails to achieve a majority and then remains on the board will not be as effective as others.
The broker-voting change isn’t likely to be a significant problem for large-cap companies, particularly those mostly held by institutional investors, absent some concerted withhold-vote campaign. But for small and mid-cap companies, many of which are listed on the NASDAQ OMX exchange, the effect could be much more pronounced, particularly those whose shares trade for less than $5.
Given that many institutions may not invest in companies trading below $5, this can result in a higher percentage of retail shareholders. But very few retail shareholders vote their proxies. With this year’s implementation of notice-and-access for proxy materials, Broadridge found that from July 1, 2008, to June 30, 2009, only 4 percent of retail shareholders who received a notice voted their proxies. The overall percentage of retail investors who voted was just under 13 percent.
The combination of a low retail shareholder vote and the elimination of the broker voting rule will pose a real challenge for smaller companies with a relatively large retail investor base to reach a quorum for the annual meeting. To deal with this possibility, these companies will endure the added expense of hiring a proxy solicitation firm to get out the vote.
NOBO/OBO Problems
To deal with the low retail shareholder vote, one might suggest that companies urge their individual investors to vote their proxies. The problem under the current NOBO/OBO system (Non-Objecting Beneficial Owner/Objecting Beneficial Owner), is more than 70 percent of retail investors are considered OBOs; companies don’t know who they are or how to reach them directly. Ironically, a 2006 NYSE survey found that most OBOs didn’t know companies could not communicate with them, and they wanted direct communication.
How did this situation ever arise? When the SEC adopted the NOBO/OBO designation under the Shareholder Communications Act of 1985, people expected only a small percentage of investors who held their shares in brokerage accounts would ask to be designated as OBOs. Since then it has suspected that brokers have been checking the OBO box for their retail shareholders rather than the individual doing so; that would explain why such a high percentage of OBOs don’t even know that their identity was shielded from the companies in which they were invested.
Numerous shareholder communication groups have lobbied the SEC to change the NOBO/OBO system to remove the communication barriers between companies and their individual investors. Altman, in a recent submission to the SEC, “Practical Solutions to Improve the Proxy Voting System,” recommends the agency adopt an “ABO” (All Beneficial Owners) system in lieu of the current NOBO/OBO designation, but only for use at annual and special meetings and a limited number of special circumstances. This would allow companies to communicate directly with all of their retail shareholders and engage them in the proxy voting process. These communications must be limited to proxy issues and not be used for marketing purposes.
Clearly, the upcoming annual meeting and proxy season are posing challenges unlike what companies have dealt with in the past.
Altman believes that an ABO system would provide regulators with greater transparency and disclosure as well as greater retail shareholder participation in the proxy voting process.
‘Empty Voting’ and ‘Over Voting’
Another peril that lies ahead for the annual meeting is the growing practice of share lending, otherwise known as “empty voting.” Some pension funds and brokerage firms loan shares (for a fee, of course) to activist investors who then use the voting rights of these shares to influence the outcome of director elections or other proxy issues. They have no economic interest in the shares, just the power of the voting rights.
The problem from the retail side is that brokerage firms aren’t telling their retail investors that their shares have been loaned for their voting rights. This can result in over-voting, when individuals vote their proxies at the same time that their loaned shares are voted by the borrower. This conflict is not determined until the votes are being counted for the annual meeting.
This problem could be solved if the SEC were to require full disclosure of the loaning transaction both on the part of the lender and the borrower. Such a disclosure requirement, however, would surely be resisted by both parties.
Proxy Access
While many were anticipating that the SEC would pass some form of shareholder proxy access (Rule 14a-11) for director nominations in time for the 2010 proxy season, the large volume of comment letters on the SEC’s proposal will likely delay the vote until next spring. This postponement will allow Congress to act on pending legislation authorizing the SEC to adopt proxy access and avoid the legal challenges that inevitably would have followed had the SEC acted on its own. Proxy access would allow activist investors to place director candidates on a company’s proxy at the company’s expense. While corporations may breathe a sigh of relief for dealing with this in 2010, it is likely to be temporary relief. Be prepared for 2011.
Say-on-Pay
While a few companies have voluntarily adopted shareholder advisory votes on executive compensation, most haven’t and are awaiting congressional action to require say-on-pay. The House of Representatives approved the Corporate and Financial Institution Compensation Fairness Act in July and the Senate is expected to approve the legislation as well, but not in time for implementation in 2010. Meanwhile, companies can anticipate an increasing number of shareholder proposals next year calling for adoption of say-on-pay.
Corporate counsel and corporate secretaries must inform their boards of how these issues are likely to affect their companies’ annual meetings. Even though companies can’t communicate directly with their OBOs, they can use their Website to communicate with all investors on the companies’ positions on proxy issues and encourage the retail investors to vote their proxies.
Lastly, the corporate secretary or general counsel should meet directly, as soon as possible, with those who vote the proxies among their major investors—particularly those who have their own proxy voting guidelines and are not inextricably tied to the advice of proxy advisory firms, as is the case of many of the smaller institutional investors. Few companies are doing this and more need to do so.
Clearly, the upcoming annual meeting and proxy season are posing challenges unlike what companies have dealt with in the past. And for many their effect is likely to be very significant.
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