Will Shareholder Proposals Benefit or Destroy?

The resentment and anger over recent corporate performance, especially in the financial services sector, has gone from bubbling up to boiling over.

Individual and institutional investors seeing share prices plummet as their companies have been brought to their knees and watching the ensuing credit squeeze and economic recession want to see changes in how companies are governed. Add to the equation an escalating outcry over executive compensation—with managers’ and shareholders’ wealth going in opposite directions—along with increasing clarity around failures by both boards of directors and government regulators, and we have much support for dramatic action.

And make no mistake: Change indeed is coming. Politicians, regulators, and shareholder activists are on the train, which already has left the station.

What’s Coming Down the Track

Let’s look at a core issue: who gets to elect directors to serve on corporate boards. Yes, shareholders always have elected the directors, but with only one slate on the ballot there’s certainly little democracy in that process. The Securities and Exchange Commission has resurrected an initiative to let shareholders propose board candidates without having to go through the arduous and expensive process of a proxy fight. And the SEC’s new initiative looks little like its former ones, except to say the new one is on steroids.

Basically, the proposal allows shareholders owning as little as 1 percent of a company’s shares, held for more than one year, to nominate up to 25 percent of the board’s directors. A bill put forth by Sen. Charles Schumer (D-N.Y.) would amend the Securities Exchange Act to confirm explicitly the SEC’s authority to establish rules in this area. Additionally, forthcoming changes to Delaware law will permit bylaw modifications allowing shareholders to nominate directors, along with expense reimbursement for proxy solicitations.

There’s more. The Schumer bill also would allow for wide-ranging governance changes many institutional investors have long been clamoring for, including:

Shareholder advisory votes on executive compensation and retirement benefits;

Separate chairman and CEO roles;

Annual director elections rather than ones staggered over a period of years;

A majority-vote threshold for directors in uncontested elections; and

Creation of board-level risk committees, comprised of independent directors.

That’s a lot to chew on (especially the mandated separation of the CEO and Chairman) requiring much more space than available here. So let’s take a closer look at the idea of allowing shareholders to take a direct role in nominating directors.

The Search for More Effective Boards

The crux of the matter is finding a way to put boards in place that will make better decisions to increase the likelihood of growing share value. Yes, there is also an element of investors feeling they’ve long been shut out of governance processes, with their boards self-perpetuating and ignoring shareholder wishes. True or not, these beliefs are strongly held, and shareholders now claim the time is right for a more democratic process.

Clearly there is strong support for change. Performance of commercial and investment banks, insurance companies, and other financial institutions has been horrible, supporting shareholders’ demands for a real say on who sits on their companies’ boards.

Let’s hope wisdom prevails, and we don’t destroy, but rather refine, governance processes to make them better.

There’s some empirical evidence to back up a need for change, too. One study of 120 boards with at least one director chosen by activist shareholders reportedly shows that those companies outperformed their peers significantly. But there’s the question of cause and effect; it may be that those companies subject to such shareholder activism already had performance issues, with no where to go but up. Interestingly, those companies with only one “dissident” director did well, while those with three new directors did not. More on that in a moment.

On the other hand, some still argue against changing the current nomination process. One issue arises with regard to certain derivative instruments where the right to vote shares is separated from economic interest—which gives rise to the question of whether some voters might actually benefit from a company ending up in bankruptcy court, for example. Or perhaps the most qualified directors will refuse to run in an election where they could be rejected by shareholders. Other arguments include the notion that as more companies require majority voting, and with a coming rule of the New York Stock Exchange to prevent brokers from voting shares where the beneficial owner stays silent, direct elections won’t be necessary.

For Better or Worse

When Charles Elson and I ran the University of Delaware-PricewaterhouseCoopers Directors’ College, I found one of our speakers, New York Times columnist Floyd Norris, to be insightful and balanced. No surprise, then, that he recently framed the issue surrounding director elections quite well: “In principle, shareholder access seems to be an obvious good ideal. Companies do, after all, belong to their shareholders. We will see if this does become, as its advocates forecast, a rarely used instrument to change companies whose boards have failed to perform adequately, or if it will lead to a series of bitter battles—sometimes instituted by institutions with ulterior motives—that result in divided boards and divert both directors and managers from running companies to benefit all shareholders.”

I share Norris’s concern based on first-hand experience with divided boards, especially what I call “constituent” boards where directors are selected by different constituent groups. One such board, of a large pension fund, can be categorized only as dysfunctional. Each board member has its own agenda (sometimes at odds with the organizations’) to the point where it’s questionable whether the directors are carrying out their duty of loyalty. There was, and may still be, finger pointing and yelling in the boardroom, and directors speaking to the microphone to the detriment of working to the common interest.

Another constituent board relates to a bank, where again each director acted in the interests of his or her constituents more than in the shareholders as a whole. While reasonably cordial in their behavior, directors’ posturing was so ingrained and governance so weak that the bank ultimately was forced into a takeover by another institution.

I’ve also worked with boards with one dissident director and found that while some meetings were disruptive, the problem was not insurmountable. Basically there were two results: Either the other directors were well positioned to “contain” the dissident and continue to provide effective guidance to and monitoring of management; or the dissident director raised some substantive issues that contributed positively to the range of matters on which the board needed to focus. But this begs the question of what might happen where multiple dissident directors are seated in the same boardroom.

The Bottom Line

We won’t really know whether these shareholder rights proposals, which seem assured of moving forward in one form or another, will benefit Corporate America and investing shareholders. Should we be concerned about the ramifications and potential damage? Yes. Can it work to everyone’s benefit? Probably, if done with thoughtfulness and care. But it’s certainly a case of “be careful what you wish for,” or stated another way, the potential of “unintended consequences.”

Yes, boards of some companies in the recent past have done a terrible job, damaging their shareholders and the broader economy. But the boards of many other companies have been doing just fine within the current structure. Let’s hope wisdom prevails, and we don’t destroy, but rather refine, governance processes to make them better.