ProfessorBainbridge.com

A Critique of ISS's One Size Fits All Political Donations Policy

Keith Bishop's critique gets republished by Forbes.com. Good stuff. Couldn't agree more.

Does "responsible capitalism" mean shareholders should "behave like business owners rather than absentee landlords"?

Apparently yes, according to the coalition government in the UK:

The Deputy Prime Minister, the Rt. Hon Nick Clegg MP, delivered a speech in London today in which he reflected on "responsible capitalism" and argued that shareholders should "behave like business owners rather than absentee landlords": see here. 

I'd like to make Clegg reflect on my posts Will New Tools Help Small Shareholders Topple Giants and Shareholder Activism by Retail Investors. He'd learn two valuable things: (1) shareholders are not owners and (2) both sound social policy and rational shareholders themselves prefer that shareholders be passive investors rather than activists. Assuming, of course, that politicians are capable of learning.

Shareholder Activism by Retail Investors

On January 7th, Jason Zweig -- the talented author of the Intelligent Investor column at the WSJ -- published a very interesting article on the development of web sites intended to reduce the cost of corporate governance activism by retail investors. As Jason (if I may be so bold) summarized it:

If you think the directors at XYZ Corp. should be fired, you will be able to circulate a throw-the-bums-out proposal on Sharegate with the click of a mouse. Every other XYZ shareholder on the site will see it immediately; you will promptly be able to tell whether they agree with you.

Contrast that with the status quo, in which you can't know what actions other investors are prepared to take until your annual proxy statement arrives—assuming that any grievances haven't already been quashed by the company.

The article prompted me to write a long blog post touching on a couple of points that are standard fodder here at PB.com. First, shareholders don't own the corporation. Second, the system properly is designed to keep shareholders passive rather than active participants in the governance of firms. Third, assuming arguendo that these web sites reduce the cost of shareholder activism, an increase in shareholder activism would be a very bad thing.

Jason has now posted a responsive blog entry, which continues the discussion by making some very interesting points. Here's the gist:

There isn’t any doubt that when you buy stock, under normal circumstances you delegate the making of business decisions to the board of directors and the management they oversee. But circumstances aren’t always normal. When management and the board make operational and strategic blunders, then — at the very least — investors will want to consider hiring different people to make the decisions about how the company should be run.

...

Must an investor revolt come from big institutions, or can it come from smaller stockholders instead?

In support of an affirmative answer to that question, Jason relies on what debaters would call an argument by appeal to authority. And he picked quite a good authority:

The great financial analyst Benjamin Graham had little faith that investors, large or small, would take intelligent action. He wrote in 1949 that “stockholders are lazy, indifferent, accustomed to obey the management, and suspicious of outside suggestions.” He applied similar criticisms to professional as well as retail investors.

To me, it is telling that Graham devoted barely 17 pages of the 1940 edition of his monumental textbook, “Security Analysis,” to a discussion of how professional investors should confront underperforming corporate management.

By contrast, Graham dedicated 34 pages in the first edition of “The Intelligent Investor,” his 1949 handbook for individual stockholders, to a discussion of the rights and responsibilities of owners. (True, the later book has fewer words per page, but it also has more passion.)

All of which prompts yours truly to take up the basic question left unaddressed in my prior post: Will reducing the costs of shareholder activism encourage more activism by retail investors or simply make life easier for the gadflies who have long used the proxy system as recreation.

I start with a claim that amounts to an article of faith on my part. Rational investors are apathetic.

A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of proxy statements, especially in a proxy contest where the shareholder is receiving multiple communications from the contending parties, the opportunity cost entailed in reading the proxy statements before voting is quite high and very apparent. Shareholders also probably do not expect to discover grounds for opposing management from the proxy statements. Finally, most shareholders’ holdings are too small to have any significant effect on the vote’s outcome. Accordingly, shareholders can be expected to assign a relatively low value to the expected benefits of careful consideration. Shareholders are thus rationally apathetic. For the average shareholder, the necessary investment of time and effort in making informed voting decisions simply is not worthwhile.

The efficient capital markets hypothesis provides yet another reason for shareholders to eschew active participation in the governance process. If the market is a reliable indicator of perfor¬mance, as the efficient capital markets hypothesis claims, investors can easily check the perfor¬mance of companies in which they hold shares and compare their current holdings with alternative investment positions. An occasional glance at the stock market listings in the newspaper is all that is required. Because it is so much easier to switch to an new investment than to fight incumbent managers, a rational shareholder will not even care why a firm’s performance is faltering. With the expenditure of much less energy than is needed to read corporate disclosure statements, he will simply sell his holdings in the struggling firm and move on to other investments.

Finally, many investors rationally prefer liquidity to activism. For fully-diversified investors even the total failure of a particular firm will not have a significant effect on their portfolio, and may indeed benefit them to the extent they also hold stock in competing firms. Such investors might prove less likely to become involved in corporate decision making than to simply use an activist’s call for action as a signal to follow the so-called Wall Street Rule (its easier to switch than fight—a play on an old cigarette advertisement) and switch to a different investment before conditions further deteriorate.

 In his original article, jason wrote that:

The great investor Benjamin Graham wrote in 1949 that "the only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him."

Rational apathy perfectly explains why Graham (a) had to devote so much space to haraunging investors to be active and (b) admited that activism required explosive motivation.

All of which tees up the question of whether these new web sites solve the problem of rational apathy. I think the answer is likely to be no.

A rational investor -- and I explicitly exclude the proxy gadflies of the world from this group, since they get utility from (I guess) seeing their name on proxy statements and such -- incurs at least four sets of costs when choosing to pursue corporate governance activism:

1. Coordination costs: An agreived shareholder who owns a tiny fraction of a company's shares is individually powerless. He must communicate with and coordinate with other shareholders. The websites prsumably will reduce this cost.
2. Regulatory costs: A shareholder who colicits proxies as part of his efforts to engage with management must comply with the SEC's detailed proxy rules. This can include the very expensive process of drafting and disseminating a proxy statement. It also exposes one to litigation under the proxy rules' antifraud provision. Sharegate recognizes this is a potential problem and therefore states on its website that "As a general rule, proxy solicitation is not authorized on Sharegate." Because proxy solicitatons remain the most effective way of really challenging management, the websites don't necessarily eliminate regulatory costs. In particular, the websites don't eliminate the risk that an unsophisticated activist will inadvertently stray over the line into a solicitation and find both the SEC and incumbent management filing proxy lawsuits against him.
3. Opportunity costs. What's the use of your time that returns the greatest utility? Would you rather spend time reading dull corporate disclosures drafted by lawyers or watching TV? As noted above, proxy statements and other corporate disclosures tend to be long and complex. Accordingly, the opportunity cost entailed in becoming an informed investor are quite high. Gadflies are willing to incur that cost either because they get utility from annoying management or they're willing to look like idiots because they failed to become informed before starting to jump up and down about something or both. But why should rational investors do so?
4. Free riding. Activism is problematic  because on those occasions in which gains might arise from activism, only a portion of them would accrue to the activist. Suppose that the troubled company has 110 outstanding shares, currently trading at $10 per share, of which the potential activist owns ten. The activist correctly believes that the firm’s shares would rise in value to $20 if the firm’s problems are solved. If the activist is able to effect a change in corporate policy, its ten shares will produce a $100 paper gain when the stock price rises to reflect the company’s new value. All the other shareholders, however, will also automatically receive a pro rata share of the gains. As a result, the activist confers a gratuitous $1,000 benefit on the other shareholders. All of this makes shareholder activism a classic example of a situation in which free riding is highly likely. In a very real sense, the gains resulting from activism are a species of public goods. They are costly to produce, but because other shareholders cannot be excluded from taking a pro rata share, they are subject to a form of non‑rivalrous consumption. As with any other public good, the temptation arises for shareholders to free ride on the efforts of those who produce the good. Given that activism will only rarely produce gains, and that when such gains occur they will be dispensed upon both the active and the passive, it makes little sense for rational investors to incur the expense entailed in shareholder activism. Instead, they will remain passive in hopes of free riding on someone else’s activism. As in other free riding situations, because everyone is subject to and likely to yield to this temptation, the probability is that the good in question—here shareholder activism—will be under-produced.

In sum, these vaunted "new tools" affect only one part of the cost schedule faced by retail shareholder investors. Hence, I still think retail investor activism will remain the province of gadflies and not rational retail investors.

Lastly, before you try to switch tacks and talk about institutional investors, read my article Shareholder Activism in the Obama Era, which argues that:

The logic behind the shareholder empowerment project is that institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, institutional investors could play a far more active role in corporate governance than dispersed individual investors traditionally have done. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm’s performance and to make changes in the board’s composition when performance lagged. 

In fact, however, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

"Will New Tools Help Small Shareholders Topple Giants?"

Just read an interesting column of that title by the WSJ's Jason Zweig. The gist is that the internet makes it possible for small investors to become corporate governance activists. But is that a good idea?

I'm on record, of course, as doubting the desirability of activism by any shareholders--small or large--but I'm particular skeptical of the former. See The Case for Limited Shareholder Voting Rights. UCLA Law Review, Vol. 53, pp. 601-636, 2006. Available at SSRN: http://ssrn.com/abstract=887789

Some specific comments on Zweig's column follow:

... networks are springing up online to rally investors large and small. These websites could enable investors—anyone from a dogcatcher in Dubuque with 100 shares to giant pension funds holding tens of millions of shares—to mingle online and pool their dispersed power as never before.

Granted, corporate managers make mistakes (See, e.g., Kodak). But why on earth would we think "a dogcatcher in Dubuque" brings anything to the table as a governance activist that would add value to the firm?

Kenneth Steiner ..., 45 years old, is a private investor from New York's Long Island who filed petitions at five companies late last year under the new SEC rule. Over the past decade or so, Mr. Steiner estimates, he has formally made several hundred proposals to improve how companies are run—including simplifying the election of directors, giving more say over how top executives are paid and eliminating "poison pills" that can entrench management.

... Using a form he downloaded from proxyexchange.org, Mr. Steiner late last year requested that the boards at Bank of America, Textron, Ferro, Sprint Nextel and MEMC Electronic Materials amend their companies' bylaws to permit any group of 100 or more shareholders who have held at least $2,000 in stock for at least one year—or any holder of 1% or more for at least two years—to nominate directors.

First, private investors really ought to be in low fee passively managed index funds. Second, anybody who makes 100s of shareholders proposals over a 10 year period really needs to get a life. We're talking obsession here folks. Finally, this is a classic example of why shareholder activism doesn't improve corporate governance. The proxy access proposals Steiner is pushing are a really bad idea. As I've discussed before:

... there can be no doubt that giving shareholders access to the proxy statement to nominate directors is going to be expensive. Plus there are all the indirect costs. Companies are already having a hard time attracting independent directors. The shareholder access proposal likely will make that search even harder. Why would somebody be willing to serve on the board if he or she might be the one singled out to be ousted?

The election of a shareholder representative also will disrupt the delicate internal dynamics that make boards successful. ... The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the board's decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes. A chief indirect cost of the proposed compromise therefore will be less effective governance.

Back to Zweig:

Argus Cunningham ...  is a former Navy pilot whose portfolio crash-landed in 2008. "Losing a lot of money will cause you to re-evaluate your role," he says. "You feel disempowered and disconnected even though you are the owner of your companies, and I started thinking about what I didn't like about the system."

Frustrated by how hard it is to find other investors willing to shake up moribund companies, Mr. Cunningham founded Sharegate. Likely to launch later this year, the website will join others that seek to rally shareholders, including United States Proxy Exchange, ProxyDemocracy.org and Moxy Vote.

Again, seriously, unless Navy pilots get paid a lot more than seems likely, low fee passively managed index funds are incredibly superior over the long run to direct stock ownership for the vast majority of private investors. As the Guardian summarized the economics of stock market investing:

Markets are, broadly speaking, efficient. You can't beat them, so fire your financial adviser and put your money into index funds. These are unburdened by investment management costs, so they will always outperform the average active fund. Build an asset allocation model that suits your age and risk profile, then diligently put money in every month until you retire. Annually rebalance your portfolio – selling what's gone up, and buying what's gone down. And that's about it, really. Oh, and don't forget China.

Next, Mr. Cunningham has a fundamental misunderstanding of the nature of stock ownership. He owns a share in the residual claim on the corporation's assets. He does not own the corporation. As I've explained before:

How do you own the a legal fiction? Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.

Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.

As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.

Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. 

As a shareholder, you're therefore supposed to be "disempowered and disconnected." As I've discussed before:

State corporate law provides clearly that the corporation’s business and affairs are “managed by or under the direction of a board of directors.” The vast majority of corporate decisions accordingly are made by the board of directors acting alone, or by persons to whom the board has properly delegated authority. Shareholders have virtually no right to initiate corporate action and, moreover, are entitled to approve or disapprove only a very few board actions. The statutory decision-making model thus is one in which the board acts and shareholders, at most, react. ...

... As Delaware’s Chancellor William Allen observed, our “corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm.” Paramount Communications Inc. v. Time Inc., 1989 WL 79880 at *30 (Del. Ch. 1989), aff’d, 571 A.2d 1140 (Del. 1990).

Allen further recognized that the fact that many, “presumably most, shareholders” would have preferred the board to make a different decision “done does not . . . afford a basis to interfere with the effectuation of the board’s business judgment.” In short, corporations are not New England town meetings.

I've dealt with these issues in greater length elsewhere, most notably The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601-636 (2006), which explained that:

Recent years have seen a number of efforts to extend the shareholder franchise. These efforts implicate two fundamental issues for corporation law. First, why do shareholders - and only shareholders - have voting rights? Second, why are the voting rights of shareholders so limited? This essay proposes answers for those questions. 

As for efforts to expand the limited shareholder voting rights currently provided by corporation law, the essay argues that the director primacy-based system of U.S. corporate governance has served investors and society well. This record of success occurred not in spite of the separation of ownership and control, but because of that separation. Before changing making further changes to the system of corporate law that has worked well for generations, it would be appropriate to give those changes already made time to work their way through the system. To the extent additional change or reform is thought desirable at this point, surely it should be in the nature of minor modifications to the newly adopted rules designed to enhance their performance, or rather than radical and unprecedented shifts in the system of corporate governance that has existed for decades.

And Director Primacy and Shareholder Disempowerment, 119 Harvard Law Review (2006), which was a response to Lucian Bebchuk's article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements. 

In response, I made three principal claims:

First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm's organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights. 

Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule. 

Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.

In sum, corporate law was designed to make small investors like Steiner and Cunningham essentially powerless. Despite the agency costs inherent in that design, the benefits of director primacy have been so profound that the corporation has been the dominant form of economic organization for over a century and a half. There is no reason--nada, zilch, none--to think a regime of shareholder empowerment would be an improvement. To the contrary, there's lots of reasons to think it would make corporate governance far worse.

The Complete Cover for Corporate Governance After the Financial Crisis

The countdown to publication of Corporate Governance after the Financial Crisis continues to run rapidly. Today, we signed off on the final cover, reproduced below:

Be sure to check out the glowing blurbs!

And then go preorder your copy now:

Makes a great Christmas gift too.

ABA Keeps Plurality Voting as the Default for Electing Directors

First, some background. In most cases, state corporate law contemplates that shareholder action requires the affirmative votes of a majority of the shareholders present at a meeting at which there is a quorum.  When it comes to electing directors, however, state law until recently merely required a plurality shareholder vote. Delaware General Corporation Law § 216(3) formerly provided, for example, that “Directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors.” The comments to MBCA § 7.28(a), which also used a plurality standard, defined that term to mean “that the individuals with the largest number of votes are elected as directors up to the maximum number of directors to be chosen at the election.”

The federal proxy rules accommodated state law by providing, in former SEC Rule 14a-4(b), that the issuer must give shareholders three options on the proxy card with respect to electing directors. A shareholder could vote for all of the nominees for director, withhold support for all of them, or withhold support from specified directors by striking out their names.

The net effect of these rules was that the corporate electoral system did not provide for a straight up or down vote for directors. Instead, one either granted authority to the proxy agent to vote for the specified candidates or one withheld authority for the agent to do so. Absent a contested election, because only a plurality vote was required, so long as the holder of at least a single share granted authority for his share to be cast in favor of the nominees, the slate of directors nominated by the incumbent board therefore would be elected even if every other shareholder withheld authority for their shares to be voted.

The origins of the plurality rule are somewhat obscure. It presumably arose to deal with situations in which there are more nominees than vacant director positions, which is most commonly the case in contested elections. In a close race, abstentions and spoiled ballots might mean that fewer nominees than the number of vacancies would receive a majority of the votes cast. In the worst case, which is made more likely by the use of slate voting, the election might fail completely as no directors would receive a majority. Plurality voting avoided that risk and the adverse consequences that might follow.

Over time, withholding authority to vote for some or all of the nominees put forward by the incumbent board became a common protest tactic by shareholder activists. In the 2004 shareholder revolt at The Walt Disney Company, for example, shareholder activists opposed the election of CEO Michael Eisner and certain other candidates. Under the then-existing plurality standard, Eisner would have been reelected even if holders of a majority of the shares had withheld authority for their shares to be voted for him. In the event, holders of 43% of Disney shares withheld such authority. Although Eisner was reelected, the high vote was seen as a powerful protest. Shortly thereafter, he initiated a succession process.

The Disney episode triggered considerable interest in changing the traditional plurality standard so as to transform the process from a mere opportunity to send a protest signal into a real election. In 2006, Delaware responded to considerable pressure from activists and others by amending the statutory provisions on director election to accommodate various forms of majority voting.

A number of Delaware corporations had responded to post-Disney pressure from shareholder activists by voluntarily adopting so-called Pfizer policies—named after the first prominent corporation to adopt one—pursuant to which directors who receive a majority of withhold “votes” are required to submit their resignation to the board. Section 141(b) of the Delaware General Corporation Law was amended to accommodate such bylaws. It does so by providing that: “A resignation [of a director] is effective when the resignation is delivered unless the resignation specifies a later effective date or an effective date determined upon the happening of an event or events. A resignation which is conditioned upon the director failing to receive a specified vote for reelection as a director may provide that it is irrevocable.”

The trouble with these so-called Pfizer or plurality-plus policies, at least from the perspective of shareholder activists, is that the board retains authority to turn down the resignation of a director who fails to get the requisite majority vote. In City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., 1 A.3d 281 (Del. 2010), the Delaware Supreme Court confirmed that the board has substantial discretion to do just that. Axcelis Technologies had a seven-member board staggered into three classes. In 2008, all three of the incumbent directors up for reelection failed to receive a majority of the votes cast. Pursuant to the company’s plurality-plus policy, all three submitted their resignations. The board rejected all three resignations. A shareholder initiated a § 220 request to inspect the relevant books and records of the company preparatory to filing a derivative suit challenging the board’s decision. In order to prevent shareholders from conducting fishing expeditions, Delaware courts will grant such inspection requests only where there is a credible basis from which to infer that some wrongdoing may have occurred. In acknowledging that § 220 requests sometimes can be meritorious in this context, the Court observed that “the question arises whether the directors, as fiduciaries, made a disinterested, informed business judgment that the best interests of the corporation require the continued service of these directors, or whether the Board had some different, ulterior motivation.”  It thus seems fair to infer that the business judgment rule will be the standard by which courts evaluate board decisions under such policies.

Activists also objected to the Pfizer-style approach because it typically was effected by changing board of directors corporate governance policies rather than by amending the bylaws or articles. As such, continuation of the policy was subject to the discretion of the directors.

Shareholder activists therefore began using Rule 14a-8 to put forward bylaw amendments mandating true majority voting. A bylaw voluntarily adopted by Intel received wide activist support as a model for bylaw amendments at other issuers. Under it, a director who fails to receive a majority of the votes cast is not elected. In the case of an incumbent director who fails to receive a majority vote in favor of his reelection, there is the complication that, under DGCL § 141(b), a director’s term continues until his successor is elected. The Intel (a.k.a. majority-plus) model requires resignation of such a director.

Shareholder activists preferred a bylaw approach to one based on the articles of incorporation because of the latter’s board approval requirement. In most states, however, a shareholder-adopted bylaw would be vulnerable to subsequent board amendment or even repeal. Recall that DGCL § 109(a) provides that the articles of incorporation may confer the power to amend the bylaws on the board of directors, but that such a provision does not divest the shareholders of their residual power to amend the bylaws.

The resulting concurrent power of both shareholders and boards to amend the bylaws raises the prospect of cycling amendments and counter-amendments. Suppose the shareholders adopt a majority vote bylaw. The board then repeals the new bylaw provision using its concurrent power to amend the bylaws. The MBCA allows the shareholders to forestall such an event. MBCA § 10.20(b)(2) authorizes the board to adopt, amend, and repeal bylaws unless “the shareholders in amending, repealing, or adopting a bylaw expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw.” In the absence of such a restriction, however, the board apparently retains its power to amend or even repeal the bylaw. If the board does so, the shareholders’ remedies presumably are limited to readopting the term limit amendment, this time incorporating the necessary restriction, and/or electing a more compliant board.

Delaware § 109 lacks any comparable grant of power to the shareholders. Worse yet, because the board only has power to adopt or amend bylaws if that power is granted to it in the articles of incorporation, a bylaw prohibiting board amendment arguably would be inconsistent with the articles and, therefore, invalid.

In American Int’l Rent a Car, Inc. v. Cross, 1984 WL 8204 (Del. Ch. 1984), the Delaware Chancery Court suggested that, as part of a bylaw amendment, the shareholders “could remove from the Board the power to further amend the provision in question.” Dicta in several other Delaware precedents, however, was to the contrary. In General DataComm Industries, Inc. v. State of Wisconsin Investment Board, 731 A.2d 818, 821 n.1 (Del. Ch. 1999), for example, Vice Chancellor Strine noted the “significant legal uncertainty” as to “whether, in the absence of an explicitly controlling statute, a stockholder-adopted bylaw can be made immune from repeal or modification by the board of directors.” In Centaur Partners, IV v. National Intergroup, Inc., 582 A.2d 923, 929 (Del. 1990), the Delaware Supreme Court addressed a shareholder-proposed bylaw limiting the number of directors. As proposed, the bylaw contained a provision prohibiting the board from amending or repealing it. Noting that the corporation’s articles gave the board authority to fix the number of directors through adoption of bylaws, the Supreme Court opined that the proposed bylaw “would be a nullity if adopted.” Consequently, it seemed doubtful that restrictions on the board’s power over the bylaws would pass muster in Delaware or other states likewise lacking a MBCA-style provision.

In response to activist shareholder pressure, however, Delaware amended § 216 by adding the following sentence: “A bylaw amendment adopted by stockholders which specifies the votes that shall be necessary for the election of directors shall not be further amended or repealed by the board of directors.” It is curious that the legislature did not adopt a more explicit validation of bylaw provisions requiring that a director receive a majority vote in order to be elected. Section 216, however, clearly seems to imply their validity and, if so, ensures that such bylaws could not be undercut by subsequent unilateral board action.

Like Delaware, the ABA Committee on Corporate Laws has amended the Model Business Corporation Act so as to permit the use of majority voting. MBCA § 7.28 sets out the default rule: “Unless otherwise provided in the articles of incorporation, directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at which a quorum is present.” Notwithstanding the proviso, the Committee has also adopted § 10.22, which provides for a majority vote option to be effected by the bylaws:

(a) Unless the articles of incorporation (i) specifically prohibit the adoption of a bylaw pursuant to this section, (ii) alter the vote specified in section 7.28(a), or (iii) provide for cumulative voting, a public corporation may elect in its bylaws to be governed in the election of directors as follows:

(1) each vote entitled to be cast may be voted for or against up to that number of candidates that is equal to the number of directors to be elected, or a shareholder may indicate an abstention, but without cumulating the votes;

(2) to be elected, a nominee must have received a plurality of the votes cast by holders of shares entitled to vote in the election at a meeting at which a quorum is present, provided that a nominee who is elected but receives more votes against than for election shall serve as a director for a term that shall terminate on the date that is the earlier of (i) 90 days from the date on which the voting results are determined pursuant to section 7.29(b)(5) or (ii) the date on which an individual is selected by the board of directors to fill the office held by such director, which selection shall be deemed to constitute the filling of a vacancy by the board to which section 8.10 applies. Subject to clause (3) of this section, a nominee who is elected but receives more votes against than for election shall not serve as a director beyond the 90-day period referenced above; and

(3) the board of directors may select any qualified individual to fill the office held by a director who received more votes against than for election.

All of which brings us up to date. Now BNA reports that:

The American Bar Association's Corporate Laws Committee declined a request from Council of Institutional Investors' general counsel Jeffrey Mahoney to revise the Model Business Corporation Act (MBCA) to make majority voting the default legal standard for uncontested director elections. A. Gilchrist Sparks, chairman of the Corporate Laws Committee, said in an Oct. 25 letter to Mahoney that the committee decided that a new review of the act is not warranted at this time. The MBCA is the basis for the corporate laws of most states, except Delaware, according to the CII. Section 7.28(a) of the MBCA sets plurality voting as the default standard for director elections unless a company's articles of incorporation call for a different standard.

I think the Committee made the right call. Critics of majority voting schemes correctly contend that failed elections can have a destabilizing effect on the corporation. Selecting and vetting a director candidate is a long and expensive process, which has become even more complicated by the new stock exchange listing standards defining director independence. Suppose, for example, that the shareholders voted out the only qualified financial expert sitting on the audit committee. The corporation immediately would be in violation of its obligations under those standards.

Critics also correctly complain that qualified individuals will be deterred from service. The enhanced liability and increased workload imposed by Sarbanes-Oxley and related regulatory and legal developments has made it much harder for firms to recruit qualified outside directors. The risk of being singled out by shareholders for a no vote presumably will make board service even less attractive, especially in light of the concern board members demonstrate for their reputations.

Finally, critics correctly claim that, at least as it is being implemented so far, majority voting is “little more than smoke and mirrors.”  William Sjostrom and Young Sang Kim conducted an event study of firms adopting some form of majority vote bylaw. William K. Sjostrom Jr. & Young Sang Kim, Majority Voting for the Election of Directors, 40 Conn. L. Rev. 459 (2007). They found no statistically significant market reaction to the adoption.  The implication is that the campaign for majority voting has created little shareholder value.

There thus is no case for making majority voting the default rule.

Bainbridge Joins Comment to ISS on Corporate Political Spending

Along with former California Commissioner of Corporations and Manhattan Instiutute Center for Legal Policy Director, I today submitted a comment letter to Institutional Shareholder Services with regard to ISS' proposed change in policy on corporate political spending. As Commissioner Bishop explains:

The ISS Global Policy Board recently solicited comments with respect to its proposed updates to its benchmark proxy voting guidelines. One of the policy changes under consideration relates to corporate political spending disclosure proposals. Under ISS’ current guidelines, these proposals are evaluated on a case-by-case basis. ISS is now proposing to change its position to a “generally vote FOR recommendation”.

This week, I joined Professor Stephen Bainbridge (UCLA Law School) and James Copland (Director, Center for Legal Policy at the Manhattan Institute) in submitting this comment letter
opposing the change. ISS’ proposed change is unwarranted for a number of reasons, including:

• From 2008 through August 1, 2011, no shareholder proposal concerning political speech came close to achieving majority support;

•  All public companies are not similarly situated with respect to either the potential beneficial or negative impacts of disclosures;

• The actual proposals submitted to date differ materially; and

• The evidence suggests that nearly all of these proposals have been “sponsored by funds affiliated with labor unions or social or religious interests—investors who either may or expressly do seek goals apart from investment return”.

I hope that ISS eschews a “one size fits all” approach corporate spending proposals. 

Ditto.

Manhattan Institute's 2011 Proxy Monitor Report

I got an email today from the good folks at the Manhattan Institute who passed along this news:

James Copland's latest report, Proxy Monitor 2011: A Report on Corporate Governance and Shareholder Activism, reveals that in recent years activist groups, including labor unions, have exploited the shareholder proposal process to exert influence over corporate management and to pursue policy goals outside the legislative process.

Copland's analysis draws upon information from the recently expanded ProxyMonitor.org shareholder-proposal database of Fortune 150 public companies (January 2008 to August 2011.) Copland suggests that activists are reshaping American corporate governance both directly in the boardroom and indirectly by influencing legislation, such as the Dodd–Frank Wall Street Reform and Consumer Protection Act which mandates new shareholder votes on "say-on-pay" proposals. Copland finds that special interests may be gaining leverage over management, and there is reason to believe that these activists' agendas might be adverse to the interests of the typical diversified shareholder.

REPORT

Miscellaneous shareholder activism stories

Ted Frank has collected some recent commentary on shareholder activism that's well worth reading.

Proxy access dead ... for now

Broc Romanek reports that:

SEC Chair Mary Schapiro issued a statement that the SEC would neither seek a rehearing of the US Court of Appeals for the District of Columbia Circuit decision nor appeal the decision to the US Supreme Court. ...

... Schapiro reaffirmed her support for the proxy access concept - but she also pledged not to rewrite a proxy access rule anytime in the near future. While this means that "mandatory" proxy access is dead for now, the real story is that the SEC did allow the Rule 14a-8 amendments to go into effect (when the current stay expires next week), which means that the agency will allow access shareholder proposals ("absent further Commission action") for this proxy season. Private ordering, here we come - a nice boon for corporate lawyers. Here's the SEC's statement:

The Securities and Exchange Commission today confirmed that it is not seeking rehearing of the decision by the U.S. Court of Appeals in Washington, D.C. vacating a Commission rule, Rule 14a-11, which would have required companies to include shareholders' director nominees in company proxy materials in certain circumstances. Nor will the SEC seek Supreme Court review.

Chairman Mary L. Schapiro issued the following statement:

"I firmly believe that providing a meaningful opportunity for shareholders to exercise their right to nominate directors at their companies is in the best interest of investors and our markets. It is a process that helps make boards more accountable for the risks undertaken by the companies they manage. I remain committed to finding a way to make it easier for shareholders to nominate candidates to corporate boards.

At the same time, I want to be sure that we carefully consider and learn from the Court's objections as we determine the best path forward. I have asked the staff to continue reviewing the decision as well as the comments that we previously received from interested parties."

# # #

Last year, when the Commission adopted Rule 14a-11, it also adopted amendments to Rule 14a-8, the shareholder proposal rule. Under those amendments, eligible shareholders are permitted to require companies to include shareholder proposals regarding proxy access procedures in company proxy materials. Through this procedure, shareholders and companies have the opportunity to establish proxy access standards on a company-by-company basis -- rather than a specified standard like that contained in Rule 14a-11.

Although the amendments to Rule 14a-8 were not challenged in the litigation, the Commission voluntarily stayed the effective date of those amendments at the time it stayed the effective date of Rule 14a-11. The Commission's stay order provides that the stay of the effective date of the amendments to Rule 14a-8 and related rules will expire without further Commission action when the court's decision is finalized, which is expected to be September 13. Accordingly, absent further Commission action, Rule 14a-8 will go into effect and a notice of the effective date of the amendments will be published.

At least for now, we end up where I thought we should have ended up all along; namely, no mandatory rule but instead a system that allows for private ordering. I expect we'll see a slew of shareholder proposals on proxy access in the next proxy season.

Spitzer joins shareholder activist crowd

You remember Eliot Spitzer. Former NY Attorney General. Former NY Governor. Former client of prostitutes who liked unprotected anal sex.(Sordid details here.)

Now he's back, commentating (that really ought to be a word) on shareholder activism, putting his head where he used to put his ... well, let's call it his other head.

Last week, a conservative panel of judges on the D.C. Circuit's Court of Appeals—the second-most important court in the land—struck down an effort to inject a tiny bit of democracy into corporate governance. ...

Those shareholders who try to influence the behavior of management ought to get a more welcome reception, right? After all, management is legally bound to act on behalf of shareholders and owes them a fiduciary duty, an obligation of loyalty. So how have the traditional voices of corporate leadership reacted when asked to provide a greater opportunity for their owners to participate? Just as they did when responding to regulators or litigators.

In unison, the voices of management said: Leave us alone. We know better than you. Even though you may own the company, we are better equipped to decide what to do than you.

CEOs and board members afraid that shareholders will actually be able to select a new slate of candidates are acting just as politicians do when they are supposed to represent the public but are really afraid of democracy. The D.C. Circuit's opinion is the same as a decision made by old party bosses in a smoke-filled room. What gerrymandering is to politics, limiting board nominations is to corporate governance. Protecting incumbents is the goal, not serving the best interests of voters or the corporation.

Typical Spitzer. Opinionated. Uninformed. What's particularly interesting to me, however, is Spitzer's not very well concealed accusation that the DC Circuit was playing politics. Just as he did back when he was AG, Spitzer accuses judges who disagree with him of being corrupt.

The case against proxy access has been made many times on PB.com. Instead of rehearsing that argument again, I will simply refer you to the archives, and ask you to join me in wishing that Spitzer would crawl back under the rock where he came from. Why we continue to let this hooker's john opine in polite society is simply beyond me.

P.S.: Did you know "spitzer" is now a verb, referring to condomless sex? As in "The hooker wasn't gonna let me spitzer her unless I tipped her an extra thousand dollars"?

Private ordering private access

Pro-access blogger James McRitchie reviews some relevant history and ponders how privately ordered proxy access might work.

Where now on proxy access?

Steven Davidoff analyzes the SEC's options:

The United States Court of Appeals for the District of Columbia Circuit has taken a chainsaw to the Securities and Exchange Commission’s proxy access rule, striking it down in a 21-page opinion. A panel of three judges from the appeals court based its ruling last week on what it perceived to be the S.E.C.’s failure to fully consider the costs and the benefits of this rule. With the S.E.C. wounded and proxy access seemingly on life support, if not dead, the question is what comes next?

The S.E.C. has three options:

1. Appeal the D.C. Circuit opinion to the full federal appeals court.

2. Rewrite the rule and address the deficiencies cited by the D.C. Circuit.

3. Do nothing and let the proxy rule die.

.... The S.E.C. has invested years in proxy access, so if it does not appeal I also suspect the commission will not let the rule die. Instead, I believe the S.E.C. will rewrite this rule with more analysis along the lines advocated by the D.C. Circuit Court. But any rule-making process will take another six months to a year as the S.E.C. again deals with the controversial nature of these rules. Proxy access will at best not be proposed again until 2012 and likely not be effective until 2013. And there will be another court challenge, meaning a likely delay even beyond that.

Which means the outcome of proxy access may depend on the outcome of the 2012 election. As Davidoff correctly points out, a GOP-dominated SEC is unlikely to move forward with proxy access.

A caustic take on say on pay litigation

TK Kersetter lets loose with both barrels on a phenomenon we've been tracking here at PB.com for a while:

... companies that failed the say-on-pay shareholder vote (that is, they did not garner a majority of shareholder support) that are now being sued have fallen into the black regulatory hole known as: UNINTENDED CONSEQUENCES. I equate this to the modern-day expression: “My Bad!” In other words, it’s the creators of the regulation saying, “Oh, sorry companies… This wasn’t our intention, but now it is what it is.” Who couldn’t see this coming? Even I (fully admitting I’m not the sharpest tool in the shed at times), knew that the plaintiff’s bar would capitalize on this newly formed soft underbelly of American companies. And it sure didn’t take long.

You'll recall from our earlier discussion that aggressive plaintiff lawyers are suing companies with failed say on pay votes, despite the undisputable fact that "Dodd-Frank and the legislative history make clear that while both the say on pay and say when on pay votes must be tabulated and disclosed, neither is binding on the board of directors. The act and its legislative history further make clear that the votes shall not be deemed either to effect or affect the fiduciary duties of directors. S. Rep. No. 111-176, at 134 (2010)."

Anyway, back to Kersetter:

The sad part is, every expert I have been able to talk to believes these cases (eight filed so far) are frivolous and cannot be won if they to go to trial. And that’s OK for the law firms that filed the suits because more often than not they would prefer to settle than fight it in court. Two of the cases, one of which was clearly in the “egregious abuse of comp” category, have been settled. The other targeted companies are going through that frustrating exercise of, “Should we spend the time, energy, and money to fight a frivolous lawsuit that we are pretty sure to win?”… or “Do we settle, pay our blood money for not getting shareholder support, and get our company and board out of the negative limelight?” I wish that decision was as easy as it sounds and that all companies would stand their ground. But the facts are, sometimes settling is the best business decision… no matter how bad it ticks you off.

That's what the plaintiff's bar is counting on. As I've said before, "Sharks got to eat. Until Rule 11 has real teeth and we adopt loser pays with respect to class action legal fees, lawyers are going to bring these sorts of cases."

Kersetter continues:

As I’ve said before, many of these lawsuits aren’t developed based on mass shareholder discontent and unfortunately they don’t have to be. All it takes is one volunteer or malcontent shareholder (or sometimes a recruited shareholder) for the plaintiffs’ bar to file the suit. Then they hope for what all these chasers hope for: a company eager to settle. Well I’m here to support those companies, because what’s right sometimes overrides what’s prudent ,and I hope that some companies will fight the battle and clear up this mess for the rest of us.

Maybe more important, though, is to make sure your congressmen and the SEC see how ridiculous some of these lawsuits are and ensure they understand that nonbinding shareholder votes—even those won but where the percentages of votes were close—are not incidental, and often there is nothing “nonbinding” about them. I promised in my last blog that after this rant I would turn to some positive issues. Honestly, it might take me a while because with all that facing today’s American businesses, this is an unintended consequence that we could have predicted and we shouldn’t be dealing with.

And the Washington idiots that passed Dodd-Frank wonder why the economy is struggling.

Blogosphere reactions to proxy access decision

In addition to my very long post below, several other prominent law and business bloggers have commented on the decision striking down the SEC's proxy access rule (14a-11). The following are snatched from my newsreader in reverse chronological order:

Sean Hackbarth at the US Chamber's blog:

On Business Roundtable and Chamber of Commerce v. SEC, Mike Scarcella at The BLT reports:

The appeals court sided with the business groups’ lawyers, who argued that investors with special interests, including unions and state and local governments, would be likely to put the maximization of shareholder value second to other interests.

“By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily,” Judge Douglas Ginsburg said in the ruling, joined by Chief Judge David Sentelle and Judge Janice Rogers Brown.

The SEC, the appeals court said, “inconsistently and opportunistically framed the costs and benefits of the rule” and also failed “to respond to substantial problems raised by commenters.”

The Chamber's president and CEO Tom Donohue was pleased with the ruling:

We applaud the court’s decision to prevent special interest politics from being injected into the boardroom.  Companies and directors need to continue to focus on the important work of creating jobs and reviving our economy. Today’s decision also sends a strong message that regulators need to meet their statutory requirement to clearly prove that the benefits of regulation outweigh the costs.

Adam O. Emmerich of Wachtell Lipton:

The court did not reach plaintiffs’ claims that proxy access rules are fundamentally unconstitutional, theoretically leaving open the possibility that an access regime could be implemented in revised form in the future if the above defects are addressed.  It is unclear whether the SEC will continue to pursue proxy access in the face of this unqualified rejection of such a high-profile initiative which had been many years in the making. What is virtually certain, however, is that proxy access will not apply to the 2012 proxy season.

While shareholder activists are likely to be disappointed by this decision and seek to portray it as a setback for “shareholder democracy,” we believe this is a positive development for American corporations and their shareholders.  As we have always said, proxy access is not a necessary or even beneficial element of corporate governance.  Shareholders have many avenues to influence boards of directors, who are in general more independent, more engaged and more vigilant than ever before, and we do not expect this ruling to decrease the frequency of proxy contests.

Gordon Smith:

The most interesting part of the opinion is where the Court considered the possibility that union and state pension funds might use Rule 14a-11 for personal gain. The Court: "By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily." ...

... The opinion is a rather limited indictment of the proxy access proposal, relying on the lack of sufficient justification. The SEC is considering its options. While it might challenge the ruling, I suspect that the agency is more likely to produce a newly justified rule in the near future. 

JW Verret:

This decision brings to light a fundamental problem at the SEC.  Speaking against my own interest as a securities lawyer, I think it is an agency with too many lawyers and not enough economists.  The Federal Reserve and Federal Trade Commission are better regulators because they have teams of sharp economists to consider the effects of new rules.  As Senator Shelby noted in a recent hearing, the SEC on the other hand has over a thousand lawyers and less than 25 economists.  Today’s decision is one of the predictable results.  So were similar decisions striking down rules on the same basis in American Equity v. SEC and in Chamber of Commerce v. SEC.

The SEC has now proposed rules on proxy access in 2011, 2009, 2007 and 2003.  It still doesn’t have a rule in place.  That’s a lot of man hours to put into writing a rule that is never ultimately adopted.  I wonder if Chairman Schapiro will look to re-write the rule given all the deadlines she is facing under Dodd-Frank.  I don’t think we’ve seen the last of Rule 14a-11, but I think it may be awhile before it is resurrected.  What would a new SEC rule look like?  I doubt it would cover investment companies, as the opinion gave particular attention to the SEC’s decision to apply the rule to them.  I would also suspect it would allow for an opt-out procedure.  We’ll see.

Let’s not forget that the changes to Rule 14a-8 are still in place.  So shareholders can still adopt election bylaws which specify proxy access procedures at a particular company.  It’s never to early for boards to consider putting into place the proxy access defenses that I have developed.

Brett McDonnell:

... let me briefly lament the D.C. Circuit's vacating of the proxy access rule.  I have my own reservations about the rule, in particular the SEC's failure to allow shareholders to opt out in any way they choose.  Still, I think it's on balance a pretty sensible and defensible rule.  The SEC's documents proposing and finalizing the rule are about extensive as I have ever seen from that agency, and they had voluminous comments from all sides to help guide them.  The D.C. Circuit cherrypicks areas where it asserts the SEC didn't do enough.  It will almost always be possible to do that with any agency rulemaking.  Requiring that level of deliberation could well make the task of rule-writing for Dodd-Frank more daunting still.  This opinion is little more than the judges ignoring the proper judicial rule of deference to an agency involved in notice-and-comment rulemaking and asserting their own naked political preferences.  Talk about judicial activism.

James McRitchie:

 

As those of us committed to proxy access start over again, difficult but not impossible in the current political climate, we would do well to take Fisch’s advice on an alternative approach:

 

1. The SEC should amend Regulation 14a to require the issuer to disclose, in its proxy statement, all properly-nominated director candidates, regardless of whether the nomination is made by a nominating committee, a shareholder or some other mechanism. Provide for comparable disclosures, regardless of the source of the nomination.
2. Amend Rule 14a-4 to require the issuer’s proxy card to give shareholders the opportunity to vote for any of the candidates included in the proxy statement. The proxy card would thus constitute a universal ballot for all properly-nominated candidates.
3. Encourage firm-specific experiments by retaining the recently adopted amendments to the election exclusion under Rule 14a-8 authorizing the inclusion of shareholder proposals concerning the process by which directors are selected.

Jim Hamilton offers up a detailed summary of the opinion.