Creating 'a Bigger Mess?' Battle Lines Are Drawn on the Proxy Access RulePublished: September 02, 2009 in Knowledge@Wharton
"Tyranny," "incompetence" and "rubber stamping" are just some of the words characterizing the state of corporate governance that have appeared in recent posts on the Securities and Exchange Commission's website, in response to a proposed "proxy access rule" that would change the way directors are nominated to company boards.
In a nutshell, the proxy access rule, or Rule 14a-11, would make it possible for certain shareholders to include the names of opposing candidates on a company's proxy ballot. In theory, shareholders of public companies already elect the board of directors. In practice, however, a company's management often nominates a single slate of candidates that runs unopposed. Although shareholders have the right in some cases to nominate opposing candidates at the annual shareholder meeting, the nominations are essentially meaningless by then, because the majority of shareholders have already voted using a proxy ballot sent out in advance of the gathering.
But after the recent economic meltdown and trillions of dollars in shareholder losses, many Americans are questioning whether boards have been doing their job. "This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors to the interests of shareholders," SEC Chairman Mary Schapiro said in a speech on May 20, when the Commission voted to consider the proposal. "The time has come to resolve this debate."
"I'm surprised the SEC is finally" moving forward on the rule, says Wharton legal studies and business ethics professor William C. Tyson. The Commission proposed proxy access changes in 2003 and 2007, but eventually withdrew the proposals because there was so much controversy. "The SEC ... has been too constipated to do this because corporate America is so against it."
Since releasing a detailed proposal on June 10, the SEC's website has been flooded with comments, ranging from four-word emails ("I'm for it 100%") to a 154-page tome from Business Roundtable, a Washington, D.C.-based association of CEOs. Proponents -- which include large pension funds and shareholder activist groups -- say the proposal would make boards more shareholder-focused and less prone to taking unnecessary risks. Opponents -- largely companies and small businesses -- argue that the rule change would drive up costs, distract board members and leave companies vulnerable to the interests of minority shareholders.
"The way it usually works for most companies ... [is] they have a nominating committee [that puts forward] a slate of directors each year, and most of the time that just gets passed by shareholders," says Wharton professor of legal studies and business ethics, Eric W. Orts. "The standard method of elections has been: Here's the slate of candidates. Shareholders haven't had much choice."
Shareholders do have the option of taking control of a company's board by mounting a proxy battle, Tyson points out. But in a proxy battle, the shareholders who oppose the management's nominees have to come up with a full slate of alternative candidates, print their own batch of proxy materials to send to shareholders, and raise enough support for the opposing board. For many shareholders, the cost of mounting such a proxy battle is prohibitive. "It's rare because it's so expensive, but there have been proxy battles that have reached epic proportions in our country's history," Tyson says. In a proxy battle, "you take over the whole company; you take over the whole board."
The SEC's current proposal offers an alternative to the proxy battle because it would allow a shareholder (or group of shareholders) to nominate one or two directors, rather than having to nominate an entire slate of candidates, Tyson notes. "What they're doing now is an attempt to get some representation on the board but not take it over."
If the rule passes as proposed, shareholders would have the right to include their candidate's name in the company's proxy materials if they own at least 1% of the shares of a large company (one with a market value of $700 million or more); 3% of a company with a value between $75 million and $700 million; or 5% of a company with a market value of less than $75 million. Shareholders could combine their holdings to meet the minimum share ownership threshold, and would be required to have held their shares for at least one year.
"What's magical about this is that it costs [the shareholder] no money," Tyson says. "You can simply nominate someone on a proxy statement and get the shareholders to vote." Proxy ballots would list all candidates on the same ballot and ask shareholders to vote for individuals, rather than the current system of checking one box for a slate of directors.
"It's part of a general movement towards more shareholder involvement," says Wharton accounting professor Wayne R. Guay. "There are those who argue that giving shareholders easier access ... will keep people honest [and] make it easier to get better directors on the board. So that's the question: Should we or shouldn't we allow outside shareholders greater access to select directors?"
David F. Larcker, an accounting professor and co-director of the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford University, calls the SEC's proposal "a big deal. It's sort of like shareholder democracy," he says. "You're basically opening up the proxy machinery to an additional set of people. Once you change the board, if the board is active, it would have an impact on what the company does.... The proxy access [proposal] is not trivial by any stretch of the imagination."
But the proposal is "problematic in a couple of respects," says Charles M. Elson, chair of the John L. Weinberg Center for Corporate Governance at the Lerner College of Business and Economics at the University of Delaware. Putting someone on a proxy "is just a tenth of the cost of actually getting someone elected," Elson says. "It only covers the printing and mailing costs. The real expense is the campaign." The proposal is "also duplicative of what Delaware has already done," he adds. Delaware, home to nearly 80% of the nation's corporations, recently passed laws to address, not only proxy access, but also reimbursement of proxy contest expenses. Those expenses are "critical" to opening up board elections, Elson argues.
Leaving Companies Vulnerable
In addition, Elson says that the SEC proposal is flawed because it moves the issue of proxy access to the federal level. "Delaware gives each company flexibility. The SEC would be a one-size-fits-all approach, which could work in some circumstances and not work in others.... You also introduce the federal courts into this, whereas the Delaware law allows the Delaware courts to take care of it." Unlike Delaware and other state courts, which have considerable expertise in corporate law, Elson says the federal courts would end up using "a patchwork of inconsistent approaches" and take considerably more time to resolve disputes. "I don't think [the SEC proposal] solves anything. I think it creates a bigger mess."
Opponents also argue that the proposal leaves corporations vulnerable to unqualified board members. Shareholders, while well intentioned, may not necessarily nominate the most appropriate candidates. "You can't just pick smart people, or people who are honest and hardworking, and put them on the board," Guay says. "They have to know how the business works; they have to be able to give managers advice, read financial statements.... Management certainly has the best idea about who the right people to elect are.... The outside shareholders might have the best interests of the company at heart, but they might not have the [necessary] information."
A danger also exists that shareholders could nominate a board member to pursue special interests. "Imagine that ... a union has enough shares [among] its union members to put its own director on the slate. Now you have a director who is not there for the benefit of the shareholders, but for the employees," Guay says. Labor representation on the board isn't necessarily bad, he hastens to add. In Germany, for example, companies usually have a labor representative on the board. "But clearly you can have shareholders who are not necessarily looking out for all shareholders; they are looking out for their own interests."
This could work just as easily the opposite way if a group of dissident shareholders was strongly anti-labor, points out Wharton finance professor Pavel Savor: "Do we want shareholders kicking out managers who treat the workers too well? It's clearly a multi-dimensional issue."
A number of new candidates in every election could also get in the way of a company doing business. "If it's very easy for individual shareholders to put their own directors on the ballot [resulting in] too many people up for election, it can be distracting to the current board," Guay says. "Do we want these directors to be constantly worried about losing their jobs?"
Savor notes that the constant uncertainty of annual elections could also change the way board members view their jobs. "You could argue that it puts too much short-term pressure on management because [shareholders] could kick [board members] out very quickly." The result is that the board "might not do any long-term value creation" for the company.
Some say the proposed changes could make it easier for a shareholder to mount a takeover attempt. Others warn that hedge funds with significant company assets could infiltrate boards and push companies to take on high levels of risk for the fund's short-term gain.
But nominees who don't have the company's best interest at heart probably won't get many shareholders votes, respond proponents of the rule. "Just because you can nominate somebody for the board doesn't mean shareholders will vote for this person," Orts notes. "That threshold is only the threshold to get on the ballot."
The comment period on the SEC's proposal officially ended August 17 -- with a decision by the Commission expected this fall -- but the controversy surrounding the proposal continues. No one knows whether the Commission will approve, reject or amend the proposal. When voting in May before the comment period, the SEC was split three-to-two in favor of the proposal: Chairman Mary Schapiro, an Independent, and Democratic commissioners Elisse Walters and Luis Aguilar voted for the proposal, while Republican commissioners Kathleen Casey and Troy Paredes voted against it. At the time, Paredes said he might support the proposal if some changes were made.
"I believe something's going to happen," says Larcker. "I believe there are going to be some pretty serious changes put into place. And my guess is, it's not necessarily going to be a good thing."
"If [the proxy access rule is] put in place, you're going to see lots of case studies where companies get messed up because of it," says Guay. Such cases may not be the norm, "but you'll see it in the press." He adds, however, that the proposal's benefits and drawbacks are generally in balance. "I do see benefits, I do see costs, and it's not clear that the benefits outweigh the costs, and it's not clear that the costs outweigh the benefits. It might be nice if there were a sunset provision," in case the new rule created unexpected problems. That way, after five years, for example, the rule could expire if it didn't work as intended.
Savor is skeptical that the sky will fall. "People tend to over-dramatize these things," he says. "It's not a cure-all, and it's not something that will permanently destroy corporate America. It's going to change things on the margin.... It's going to be a reasonably significant change, but I wouldn't say it's going to be a dramatic change."
Tyson notes that the last time the SEC tried to change the proxy access rule, the comments the SEC received were "so powerfully negative" that in the end, the Commission decided not to change anything. "That could very well happen again, [but] I don't think so because we have an additional trigger here: the economy. I think [SEC chair] Mary Schapiro doesn't care about the corporate forces.... I think [the Commission] may adopt it."