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11.5 Prospects for Further U.S. Governance Reform
Greater director independence to enhance accountability continues to be a major, if not the primary, focus of U.S. governance reform. A quick glance at the list of shareholder proposals of the most recent proxy season confirms this trend. The most popular shareholder resolutions filed concern issues, such as majority voting; access to the proxy statement; declassifying boards; “entrenchment” devices, such as classified boards, poison pills, supermajority vote requirements, and the right to call special shareholder meetings; and, of course, compensation alignment and disclosure. The latter issue, which Monks once called the “smoking gun” of U.S. corporate governance failure, is not only being targeted by shareholders but also by lawmakers.Monks (2005, March), p. 108.
During the past year, many institutional shareholders have called on companies to adopt majority votingA type of director elections in which a nominee must get a majority of the votes cast. for director elections as opposed to what has been more common, plurality voting. Under the plurality model, directors who receive the greatest number of favorable votes are elected. Shareholders cannot vote against director nominees but can only withhold or not cast their votes. Thus, most nominees are elected, even if they receive very few favorable votes and even if many votes are withheld or not cast. Under majority voting, to be elected, a nominee must get a majority of the votes cast. The states in which most U.S. public companies are incorporated make either of these models available to corporations.
Companies faced with a majority voting proposal, binding or nonbinding, should pause before adopting the traditional approach of trying to defeat this kind of shareholder proposal. Clearly, investor, and increasingly regulatory, sentiment favors this proposal, and any victory is likely to be short-lived as the proposal will almost certainly be reintroduced every year until it prevails. Moreover, fighting the proposal will be a negative in the company’s “corporate governance rating” and may well lead to a new or reinvigorated campaign to withhold votes. Instead, boards would be wise to seize the corporate governance “high ground” by either adopting a modified plurality voting policy or a full-fledged majority voting regime.
Another corporate governance issue that remains high on activists’ lists concerns shareholder proxy accessA type of voting in which director candidates nominated by the nominating and governance boards are then voted on by shareholders on a piece of paper called a “proxy,“ which is mailed to all shareholders. Shareholders usually receive one vote for every share they own. in director elections. A few years ago, the SEC proposed rules that would have allowed certain shareholders to place the names of director nominees in the company’s proxy solicitation materials and proxy card. However, after reviewing the proposal, it decided against enactment. Arguments against proxy access included that, under current law, shareholders are free to utilize the proxy rules to solicit votes for their own nominees in director elections. Another argument was that proxy access might allow special interest groups to unduly influence the election process. Not all shareholders have the same interests. Arguments in favor of proxy access were that it would diversify boards and give shareholders a more prominent voice in decision making.
Elimination of “Entrenchment” Devices
Shareholders also continue to fight for the elimination of so-called classified or staggered boards, and the elimination of poison pills and related entrenchment devices. A staggered board of directors occurs when a corporation elects its directors a few at a time, with different groups of directors having overlapping multiyear terms, instead of en masse, with all directors having one-year terms. Each group of directors is put in a specified “class,” for example, Class I, Class II, and so on, hence staggered boards are also known as “classified boards.” In publicly held companies, staggered boards have the effect of making hostile takeover attempts more difficult because hostile bidders must win more than one proxy fight at successive shareholder meetings in order to exercise control of the target firm. Particularly in combination with a poison pill, a staggered board that cannot be dismantled or evaded is one of the most potent takeover defenses available to U.S. companies. Favole, in the Wall Street Journal, reported in January of 2007 that 2006 marked a key switch in the trend toward declassification or annual votes on all directors: More than half (55%) of the S&P 500 companies have declassified boards, compared with 47% in 2005.Favole (2007).
The 2008 proxy season “hot-button” issue was CEO pay, as evidenced by the large number of shareholder proposals calling for an annual advisory shareholder vote on executive pay, so-called “Say on Pay” proposals. Say on Pay is politically and emotionally appealing, attracts positive press, and, most important, is strongly supported by ISS (currently a part of RiskMetrics Group) and other proxy advisory firms. As with the issue of majority voting, given the strong national trend in favor of corporate governance activism and the obvious popular appeal of “Say on Pay,” momentum is building toward a pervasive “Say on Pay” regime for U.S. public companies.
The strong momentum for “Say on Pay” is, in part, explained by its international roots. As noted earlier, the concept originated in the United Kingdom in the early 2000s and was made mandatory for LSE-listed companies by an amendment to the Companies Act in 2002. Mandatory shareholder advisory votes on executive compensation have since been legislatively adopted in Australia and Sweden. “Say on Pay” has also been implemented in the Netherlands and Norway in the form of a binding annual “vote of confidence” on executive compensation.
As a practical matter, for a U.S. company, “Say on Pay” means that its executive pay policies and procedures will have to meet ISS guidelines on executive compensation or suffer a very strong risk of ISS recommending that shareholders vote “No on Pay.” Such a negative vote, if not addressed promptly by modifying executive compensation to fit ISS guidelines, will almost certainly lead to an ISS withhold-vote recommendation against the compensation committee and perhaps the entire board. The only clearly visible alternative to accepting ISS guidelines on executive compensation is for the board to negotiate exceptions with ISS based on particular facts and circumstances or with investors voting enough shares to overcome an ISS recommendation to vote “No on Pay.”
Looking ahead, there are indications that shareholders activists are shifting their focus to shareholder proposals for bylaw amendments to implement corporate governance reform in place of traditional nonbinding shareholder proposals that merely recommend board action. Two major reasons for this change in focus are the continued frustration with company boards that either fail to act in response to a successful nonbinding shareholder resolution or “water down” implementation of the proposal and a concern that boards can too easily amend or rescind board adopted policies under the umbrella of fiduciary duty obligations.
The continued focus of shareholder activists on director independence, director nomination and election, and issues of disclosure and transparency described above is useful and undoubtedly has substantively contributed to improving the U.S. governance system. At the same time, we should ask why they have not adopted a broader and even somewhat bolder agenda for change, especially since it now has been clearly established that increased director independence is not a panacea that will prevent future misconduct—or even managerial inefficiency. Moreover, the evidence in support of a positive relationship between independence and performance is also weak.
As Hinsey (2006) suggests, there are corporate governance issues that warrant greater activists’ attention. Separating the CEO and chairman positions is chief among them. In most U.S. boardrooms, the CEO continues to serve as board chair. As noted earlier, in this scenario the boardroom leadership responsible for independent directors’ oversight of management is the responsibility of none other than the corporation’s number one manager, a conflict of interest that is awkward at best.
The obvious solution is separating the two positions—the subject of only a handful of shareholder proposals filed in the last few years. The reason most often given against this idea is that having two leaders is confusing and does not work. The simple fact is, however, that it does work well, as demonstrated by the evidence from Great Britain. And rather than making the recently retired CEO the chairman of the board, outside directors should show their independence by filling the separate chair position with a nonexecutive boardroom leader of their own choosing.Hinsey (2006).
Another potentially productive debate concerns the issue of whether boards and shareholders should talk to each other. Most U.S. companies meet only (infrequently) with their largest shareowners and then only when threatened with resolutions or proxy contests. Resistance to increased communication between directors and investors is typically attributed to current SEC rules. It seems time, however, to test whether these regulations enhance or inhibit stronger corporate governance.