Corporate Governance Reform: Electing Directors Through Shareholder Proposals

By Diane K. Schooley, Celia Renner, and Mary Allen

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In an unusual move, the SEC is considering director election reform to increase shareholder confidence in the corporate governance process. The SEC has proposed allowing larger shareholders, under particular circumstances, to nominate members of the board of directors. Reaction to the SEC’s proxy-access initiative has ranged from strong support by shareholder-rights activists to equally strong opposition by corporate America.

Shareholder Proposals and Sponsors

Shareholder proposal activity is increasing; the number of proposals submitted in 2003 was 668, up 87% from 358 in 2000, according to the Wall Street Journal. Topics range from corporate governance to environmental and social issues. For example, Wal-Mart management included several shareholder proposals on its 2003 annual shareholders’ meeting agenda. Four dealt with corporate governance (including one on officers’ deferred compensation), one with genetically engineered food, and another with labor organization standards (“Beware of Shareholder Wielding Issues,” Tim Craig, DSN Retailing Today, June 23, 2003).

Out of the 668 shareholder proposals submitted during 2003, 423 were corporate governance proposals, a significantly greater number than the 273 voted upon the previous year. The 423 corporate governance proposals submitted during the 2003 proxy season are categorized in Exhibit 1, which uses data collected from DEF 14-a proxy statements filed with Edgar by companies listed in Georgeson’s Annual Corporate Governance Review (2003).

Nearly 40% of the 423 corporate governance proposals were related to executive compensation. Issues included whether to award stock options and, if so, when to expense them. Stock options are often issued with the aim of aligning executives’ interests with those of the shareholders. The recent use of stock options, however, has taken executive compensation to such absurdly high levels in the minds of some that they think that the executives are overpaid, a situation that is not in the shareholders’ best interests.

Fifty-two of the proposals were board-related, some of them calling for separation of the CEO and board chairman positions. Others required that a majority of the board be independent. Board members that are not independent of the company may profit, for example, by promoting business relationships with any affiliated company. Such business relationships may not serve the other shareholders well.

A number of the proposals dealt with governance issues such as poison pills and board declassification. Poison pills are provisions by which corporations reduce the chance of hostile takeover by making their stock less attractive. They do not necessarily work to shareholders’ advantage, because there may be situations where a takeover is in the shareholders’ best interest. Theoretically, rescinding the poison pills promotes better corporate governance. Classified boards are those in which members have staggered terms. While staggered boards create continuity, they may hamper the corporate governance process by impeding the removal of ineffective board members.

While individual shareholders have historically been the primary sponsors of corporate governance proposals, in 2003 labor unions sponsored almost half of all these types of resolutions. Institutional investors, such as mutual funds and pension plans, which were responsible for most of the corporate governance proposals during the 1980s, have greatly reduced their sponsorship activity. For example, public pension funds sponsored only 2% of governance proposals, down from 6% in 2002. Investment managers and mutual funds submitted just fewer than 4% of proposals in 2003.

Sponsorship Process

Regulation 14a-8 (first enacted in 1976 and last amended in 1998), which falls under the 1934 Securities Exchange Act, details the formal process through which shareholders can include proposals in companies’ proxy statements. A shareholder eligible to submit a proposal must have continuously held at least $2,000 in market value, or 1% of the company’s voting stock, for at least one year at the date of proposal submission and must continue to hold the stock through the meeting date. Each shareholder may tender only one proposal for a particular meeting. Proposals may not exceed 500 words and must be submitted by a specified date.

Submission of a proposal does not guarantee its inclusion in the company’s proxy statement. Companies may exclude shareholder proposals if the sponsor does not meet eligibility requirements or does not follow the correct procedures. Other excludable proposals are those that violate proxy rules, relate to operations accounting for less than 5% of a company’s total assets, relate to the company’s ordinary business operations, relate to an election for membership on the company’s board of directors, or specify amounts of cash or stock dividends. In addition, proposals may be excluded if they violate state law.

If a company wants to exclude proposals for other procedural or substantive reasons, it must file a “no-action letter request” with the SEC to determine excludability. If a proposal is listed on the proxy statement, management states its position. In most cases, management recommends voting against a shareholder proposal. Even if a proposal is passed by majority vote, the board has the option to not implement it.

SEC Proxy-Access Initiative

To give shareholders a stronger voice, the SEC has proposed a proxy-access initiative that would allow shareholders to nominate members to the board of directors. In mid-October 2003 the SEC made available for public comment its proposed revision of Section 14 of the Securities Exchange Act. By the end of the comment period, the SEC had received over 13,000 comments, the vast majority of which supported the proposal. This may be the largest number of comments ever received on a single proposed rule (Shareholder Access to the Corporate Ballot, Lucian Bebchuk, ed., Harvard University Press, 2004). Interestingly, as of this writing, the SEC has taken no action on this proposed revision.

Currently, some state laws allow shareholders to affect board composition by conducting an election contest, recommending a candidate to the company’s nominating committee, or nominating a candidate at an annual meeting. Unfortunately, shareholders rarely find these options to be satisfactory. The considerable expense of conducting an election contest, including the cost of producing the proxy materials, is borne by the nominator. Additionally, shareholders often find recommending a candidate to the nominating committee to be ineffective. A candidate nominated at the annual meeting is difficult to elect, because most shareholders vote by proxy before the meeting. Because of the difficulty for shareholders to directly nominate and elect board candidates, most nominations originate from the current board of directors. A nominee need only receive a plurality of the votes; thus, directors may be elected by receiving only a handful of votes.

Shareholders are increasingly expressing their dissatisfaction with the plurality vote by withholding votes for board nominees. Shareholder vote-withholding campaigns would effectively weaken the plurality system if the SEC proxy-access initiative is passed. The SEC’s proxy-access initiative allows shareholders to nominate directors if proof exists that shareholders’ concerns are being ignored. To that end, shareholders would obtain the right to nominate board members after one of two triggering events occurs: 35% of the voters fail to support a company’s nominee to the board, or 50% of voters approve a shareholder proposal to allow a shareholder-nominated candidate on the company proxy. Given the triggering events, no board-nominated director would likely be elected with a plurality of less than 35%. This rule would better ensure that shareholders generally support the board candidate elected.

The incidence of the triggering events permits a shareholder or group of shareholders that owns at least 5% of voting shares to nominate directors. The company would have to include the names of shareholder-nominated board candidates on proxy statements for as long as two years, if the nominee is not elected in the first year. The number of nominations allowed would depend upon the size of the board. One proxy nomination is allowed for boards composed of eight or fewer members. Two shareholder candidates may be nominated for boards made up of nine to 19 members. For boards with 20 or more members, three nominations are permitted. If more nominations were made than allowed above, the nominees of the largest shareholders or groups of shareholders would be included on the ballot.

Arguments for and Against

Exhibit 2 outlines the arguments for and against the SEC proxy-access initiative. Those in favor argue that the mechanisms currently in place, such as nonbinding shareholder resolutions and traditional proxy fights, are ineffective. The new rules would allow for more-diversified boardrooms, give shareholders a stronger voice in decision making, and create a more open selection process.

Most proponents agree that restrictions are necessary in order to inhibit shareholder nominations from replacing the long-established proxy contest as a means of gaining control of a board of directors. Advocates of shareholder nominations tend, however, to disagree about the details, such as the triggering events, the minimum ownership needed to make a nomination, and the limitations on the number of nominees. A coalition of the nation’s largest pension fund managers argued that the SEC’s initiative does not provide shareholders meaningful access (Sarah Mulholland, “SEC to Grant Voting Power to Shareholders,” Investment Management Weekly, October 13, 2003). The organization contended that the triggering mechanisms are sufficiently restrictive to allow for a lower than 5% ownership threshold.

Groups such as the Business Roundtable (made up of chief executives of large corporations) and the United States Chamber of Commerce oppose the SEC’s initiative. They make three basic arguments against the proposal. First, opponents say that the changes mandated by the Sarbanes-Oxley Act of 2002 (SOA) should be given an opportunity to take effect before the SEC institutes more regulations. SOA provides many reforms that should strengthen the corporate governance process, including the establishment of the Public Company Accounting Oversight Board (PCAOB) to oversee audits of public companies. In addition, there are provisions for audit independence, including restrictions on the types of nonaudit services that the auditor can provide, and a requirement for audit partner rotation every five years. The SEC has also acted to ensure that members of boards are independent of company management. The New York Stock Exchange (NYSE), under the SEC’s guidance, has enacted standards that require listing companies to have corporate boards composed of a majority of independent members. In addition, the NYSE requires that three committees formed from the board members (audit, nominating, and compensation) be composed entirely of independent directors.

Second, opponents argue that the presence of shareholder-nominated board members could create adversarial relationships that would affect collegiality among board members.

Third, they fear that special-interest groups will seize the election process. Groups or individuals may use the proposal process to advance their own agendas, which could include socially responsible or environmental causes, that do not seek to maximize shareholder return. Using the process outlined in the SEC’s proposal, an organization interested in mitigating global warming could nominate and elect a board member who would work toward instituting a policy that the company purchase supplies only from certain environment-friendly providers, regardless of price. Most shareholders may be unaware that the corporation’s profitability is suffering at the expense of another agenda.

An Uncertain Initiative

Shareholders are increasingly concerned about corporate governance. They have become involved in the proxy process by making proposals on a wide range of topics. The SEC has proposed a reform to corporate governance rules to allow shareholders to nominate individuals for election to the board.

The SEC’s proxy-access initiative has received an enormous amount of attention. The goal of allowing shareholder nominations is to increase the responsiveness of the board to shareowners. However, regulators must strike a balance between giving shareholders access to nominations and ensuring that boards provide effective oversight and guidance to company management.

Not surprising to some, the proxy-access initiative was kept on the back burner before the 2004 election. As two new commissioners settle into their positions and address the multitude of issues currently facing the SEC, the fate of the initiative remains uncertain.