What Your Activist Shareholders Want Now
from
March/April 2007
by Rob Norton
Shareholder activists have been buoyed by support from an unexpected source: the blue-ribbon Committee on Capital Markets Regulation, whose 22 members included the likes of former Commerce secretary Donald L. Evans and Samuel DiPiazza, global CEO of PricewaterhouseCoopers. Besides offering suggestions to reel in the excesses of Sarbanes-Oxley, the group’s report late last year argued for an end to staggered boards, which would mean annual elections for all directors, and also spoke up in favor of majority voting instead of the plurality system that’s the norm at most companies.
Activists who are after the same changes are sure to make much of the committee’s implicit support during the coming proxy season. The Securities and Exchange Commission and the New York Stock Exchange have proposed other rule changes that will give additional muscle to shareholders fighting for more power over how directors do their job.
“When you add it all up, it simply means that the board will be subject to greater shareholder participation in the nominating process,” predicts Charles M. Elson, chair of the Center for Corporate Governance at the University of Delaware and a director of Alderwoods Group, a chain of funeral parlors; AutoZone Inc., an auto-parts retailer; and HealthSouth, a health-care-services provider. “Boards will have to be more sensitive to the concerns of shareholders than was previously the case, and that’s a positive.”
But many others find the arithmetic behind the gathering momentum of shareholder power unnerving. “When you add all of these changes together, they may hinder rather than help the kinds of things we’ve been doing to improve governance and increase long-term shareholder value. It could create corporate anarchy rather than democracy,” warns Bernard Rethore, former CEO of Flowserve Corp., a manufacturer of pumps and valves, and a director of Belden CDT Inc., a cable and wire manufacturer; Dover Corp., a diversified maker of industrial products; and Walter Industries, a conglomerate based in Tampa, Florida. “I’m worried that we’re creating the conditions for a perfect storm.”
Elizabeth Ising, an attorney in the Washington, D.C., office of Gibson Dunn, agrees, though she uses a different metaphor. “All of these trains appear to be heading toward the station at the same time,” she says, noting that many of her clients are concerned about the pace of change in governance rules. “Each issue is being debated individually, and there are unintended consequences when you change the system simultaneously in so many respects. These changes need to be addressed in a global fashion.”
What are the weather patterns—or train schedules—that are converging on the coming proxy season? Here are the main ones:
The decline of the staggered board
Critics have long seen the staggered, or classified, board as a way to entrench management and make a company less vulnerable to hostile takeover. The system has defenders, however, among them Joseph Hinsey, an emeritus professor of business law at Harvard Business School and a former corporate attorney. “The conventional wisdom is that the staggered board is a device employed to protect incumbents,” he says. “But at least in part, the concept was to preserve continuity, and I think there’s a benefit to that. Someone going on the board of a major corporation faces a period of orientation, of learning the business.” Hinsey still holds the majority view, though the margin is shrinking. In 2002, 62% of the Standard & Poor’s 500 companies had classified boards. By 2005, the number had decreased to 53%. Look for that trend to continue as more shareholders pressure companies to make all their directors stand for election every year.
The rise of majority voting
At most outfits, a director can be elected with a plurality of votes, meaning that he or she can win a board election even if shareholders representing a majority of the stock withhold their support. For the last two years, activists have been pushing companies to adopt majority voting, which denies a board seat to any candidate who doesn’t collect more than 50% of the votes, whether or not anybody else is running for the seat. Again, Hinsey: “The concept of majority voting is very appealing. It’s consistent with political democracy; it resonates. But it’s not clear to me there are real benefits for the typical shareholder.” Hinsey argues that most individual shareholders are unlikely to have enough information about new nominees to decide whether to vote for or against them, and in the case of renominations have little ability to gauge the past performance of individual directors. Nevertheless, a small number of companies have opted for majority voting, including Dell and Pfizer. During the coming proxy season, shareholders are likely to press more to follow suit.
Activist shareholders attempting to gain board seats
Labor unions and religious and environmental groups have long sought to serve as directors of companies. More recently, as
Corporate Board Member
reported in its last issue, a growing number of hedge funds have pushed their nominees onto boards. Annual director elections and the adoption of majority voting would significantly shift power to such dissidents and increase the likelihood that board seats would become hotly contested. A. Gilchrist Sparks, a partner at Morris Nichols Arsht & Tunnell and a litigator with extensive experience in mergers-and-acquisitions and governance cases in the Delaware courts, warns that “such elections would provide leverage to activist special-interest groups within the largely disinterested shareholder electorate, permitting them to impose their agenda on the broader shareholder base.” Sparks also says that the voting tendencies of shareholders with short-term objectives “may result in additional and undesirable pressures upon management to maximize short-term gains at the expense of long-term wealth.”
Clearly he’s talking about hedge funds, and his view is shared by Bernard Rethore, who isn’t persuaded that these investors have changed their spots and are in the game for the long haul. “Despite the occasional rhetoric, they’re in there for the very short term,” he says. “It’s mostly rape, pillage, and burn, and they’re not looking at the kind of long-term horizon that directors are supposed to have.”
Various reforms under consideration at the New York Stock Exchange and the Securities and Exchange Commission are also likely to surface in the debate leading to the 2007 proxy season—and beyond. Among them:
The end of the “10-day rule”
Both the NYSE and NASDAQ permit brokerages and other institutions that hold shares on behalf of individual investors to vote them at their own discretion on various matters, provided the owners have not specified how they want to vote. Some issues are mundane, such as the approval of the minutes of the last meeting. Others are far more important, including the right to vote individual investors’ shares in a company’s annual election of directors. Typically, and to the chagrin of activists, brokerages vote in favor of management proposals, which means they’d back management’s nominees for board membership. The NYSE has proposed excluding director elections from the 10-day rule, effective in 2008. Activists are sure to push NASDAQ to do the same.
Since individual investors tend to be apathetic about voting their shares (as few as 40% bother to vote, according to the Society of Corporate Secretaries & Governance Professionals), while institutions are more punctilious (about 90% vote), the change could have a significant effect on the number of shares cast in favor of director slates—more than enough to sway an election where activist shareholders are voting against management recommendations.
Renewed attempts to give dissidents direct access to the proxy
Activists have hitherto been frustrated by their inability to list their candidates for board seats on the official proxy statement under traditional SEC rules. The commission introduced a new rule in 2003 that would have created a mechanism enabling dissidents to get access to the proxy, but it collapsed after intense lobbying by the business community. Last year, however, a federal appeals court rejected the SEC’s traditional rationale for keeping the dissidents at bay. The commission announced plans last October to revisit the subject, and the early betting was that it would put out a new rule for comment reiterating its traditional approach. That proved controversial, however, and further action was postponed until this year.
SEC-watchers are unsure which way the commission will jump. A contentious new debate seems inevitable in view of the pro-shareholder stance of the Committee on Capital Markets Regulation, along with the arrival as chairman of the House Financial Services Committee of Massachusetts Democrat Barney Frank, an advocate of shareholder democracy. If the SEC changes its tack and backs some version of direct access for activists, the balance of power between dissidents and incumbents will certainly shift. But given the delays, any action may come too late to affect the 2007 proxy season.
Electronic proxy voting
The SEC proposed a new rule in December that would permit companies to deliver proxy materials over the Internet, which would not only open the process up to dissidents who want to fight proxy wars in the ether but also just possibly encourage more shareholders to complain about how a company is run. While there is no way of knowing how online proxy voting might play out in practice, one prediction seems safe: Most people are far more likely to write an angry e-mail than they are to write an angry letter or make an angry phone call. Still, many companies favor the new rule, since it would allow them to stay in closer contact with their shareholders and also save a lot of money in printing and postage.
Directors and attorneys who are wary of all these changes have fundamental problems with the way governance reformers compare corporate governance to political democracy. Attorney A. Gilchrist Sparks believes that the analogy is false, and that understanding the differences between governments and businesses is “a first step in understanding what a sound definition of corporate democracy should be.” A few of the distinctions he cites: First, political elections are less frequent than the annual corporate election. Congressmen get two years in office, for example; presidents, four; and senators, six. Second, in the U.S. two-party system, well-organized, well-funded primaries and nominating processes are used to select candidates and make them familiar to voters, unlike the circumstances in corporate elections. Third, the voting public, by its nature, is much more stable than the corporate electorate. And finally, corporate directors, unlike politicians, have a specific fiduciary responsibility to a company’s shareholders.
A second major problem to critics of many of the proposed changes is that the more politicized boards become, with some directors representing special interests and others put in place by a single investor, the less likely it is that they will be able to operate in the best interests of all shareholders. Jane Scaccetti, an independent director at Pep Boys-Manny Moe & Jack, an automotive retail chain, sees herself as being in just this kind of quandary. The company, which has been undergoing a restructuring since 2003, is under pressure from institutional shareholders, and five of the 11 directors represent hedge funds. “My role is to represent all of the shareholders, both short- and long-term,” says Scaccetti, who is a principal at Drucker & Scaccetti, an accounting firm in Philadelphia. “If you want to make a company look good in the short run and get the price up as quickly as possible, there are always things you can do, but in many cases that may leave the company weaker in the long term.”
Scaccetti worries that the trend toward increased shareholder democracy won’t allow for the kind of long-term vision boards need. “The people talking about shareholder democracy and proxy access may not understand the impact of such proposals on the decisions made inside the boardroom,” she says, and the result could be “less creative, more conservative behavior, since few board members will risk thinking outside the box and being wrong.”
Whether the unease of directors like Rethore and Scaccetti and of attorneys like Ising, Hinsey, and Sparks will slow the corporate-democracy train remains to be seen. If anything, its momentum seems to be increasing. Directors need to consider how the various changes coming down the track might affect the workings of their own boards.
