26 August 2010

Proxy Rule Strenghtens Rights Of Big Shareholders

The SEC has released new proxy rules for publicly held companies.

The Proxy Rule Status Quo

Every year, every publicly held company sends out a proxy statement which is a Soviet style ballot to appoint or reappoint the members of its Board of Directors, who are nominated one person for each position, by a committee of the Board of Directors, a process that is generally controlled, directly or indirectly, by the CEO and other members of the senior management team.

The status quo, which has been criticized in academic circles for decades, has the effect of making almost all boards of publicly held companies self-perpetuating except in cases where a hostile third part acquires a majority of the company in takeover bid. A handful of proxy proposals are brought by shareholders under a highly cumbersome process each year, but they almost always fail.

The "Wall Street Rule" that has followed from this reality is that if you don't like how a company is being managed, that you sell its shares, rather than electing directors who can turn the company around, if you are a small player, or buy the entire company and reform it so that it can be made more profitable, if you can find major financial backing.

Currently, most proxy proposals brought under the current rules are aimed a broad based social reform or ideological points, as part of multi-corporation campaigns launched by activist groups that care more about generating public interest and news coverage than actually winning changes in corporate policies. Only a small minority of proxy fights under existing law are efforts of economically oriented long term shareholders to put in place someone on the team that supervises the CEO who will hold the CEO accountable and insist on better corporate performance, and these too usually fail. Sometimes a large share of people giving a Soviet style corporate ballot refuse to vote for a director nominee as a form of protest that sometimes gets a little attention in the Boardroom, but unless that number of voters withheld is massive these little non-binding protests are usually ignored.

A variety of rules require or prefer that key board of directors level issues be handled entirely, or mostly by "independent directors," but in the current corporate environment, where the CEO has de facto control over board nominations, and shareholders are given no alternatives to vote for on their proxy ballots, the term "independent" simply means "not an employee of the company." Thus, an "independent director" can be a likeminded friend hand picked by the CEO to agree with him on all matters of importance, rather than being a force on the Board that in some way checks the authority of the CEO.

The New Rules

The new SEC proxy rules provide that:

1. Any shareholder group with a 3% interest in the company that has been held for three years can put nominations for members of the board of directors on the same ballot that management places its nominations upon.

2. Shareholder nominations are limited to a quarter of the total number of board of directors seats.

3. The rule does not apply to small publicly held companies for the first three years.

4. "Borrowing" shares to get to the 3% ownership level is not permitted.

The analysis notes that this may not have much of an effect of larger capitalization companies, because the amount of investment necessary to acquire the 3% ownership interest necessary to make a proxy bid in a large company is in the tens of billions of dollars which is beyond the financial resources of most would be shareholder activists. But, the rules may spur a wave of efforts to replace directors at small firms that are perceived to be poorly governed, where an investment of tens of millions of dollars may be enough to earn the privilege to nominate directors.

The change was passed on a party line vote in the SEC, with majority Democrats favoring the reform, and minority Republicans voting against it.

My source is the hardcopy of today's Wall Street Journal.

What Do Corporate Directors Do?

Before and after the reforms the modern board of a publicly held corporation has just a few roles (beyond perpetuating itself:

1. Hire, supervise, fire and set the compensation for senior management, and in particular the CEO. Some Board also see themselves as supervisors of a handful of other "C" level members of the executive team, while others focus on supervising the CEO and leave management of other senior executives to the CEO.

2. Set policy on dividend payments, redemption of shares, and issuance of new shares on the advice of management and other outside consultants. One these policies are set initially, tradition plays a powerful, although not binding, part in future decisions on these matters.

3. Make a minimal effort to retain an honest and competent public accountant (almost always from one of the four dominant firms in the market) to audit the books of the company, determine that the public accountant is conducting its business in a workmanlike way (through meetings in which the public accountant almost invariability provides adequate evidence that the company is doing the right thing), and to discover material facts about the company or misconduct that has not been disclosed to the public (usually by passing on tips received from anonymous dissenters in the company to the appropriate internal authorities in the company). Provide feedback to the public accountant through an appropriate committee in the rare instances where there is a close call on an accounting issue and the accounting firm refused to provide any guidance on how it should be resolved, usually in close consultation with legal counsel and senior management.

4. Plan for and negotiate transactions that could result in a change of control of the company, a merger, a split up of the company into multiple divisions, the sale or purchase of one or more major divisions of the business, or a profound change in the financial structure of the company or the scope of its business.

5. Vet proposals to take the company bankrupt or otherwise engage in major debt restructuring arrangements in lieu of a bankruptcy.

6. Put on a good public face for the Company and provide senior management with constructive suggestions from one's own experience when appropriate.

7. Document and rubber stamp decisions made by others in the organization that it is their job to make.

Typically, today, about half of the members of the board are senior managers of the company, and the other half are academics and senior people at other companies with financial or business interests that are strategically important to the company. The can number from half a dozen to a couple dozen. The usually meet monthly or quarterly, depending upon the size of the company, but rarely much more than a couple times a month absent an emergency, and receive a healthy chunk of compensation, usually in the five figures, for showing up, and are treated lavishly during the meetings.

Boards have almost no staff, with a corporate secretary, the chairman of the board, and inside board members usually serving as their liasons with management. Board members start meetings with immense binders packed with information that tend to be discussed in long boring lectures and reviewed only on a cursory basis. Matters put to a vote are almost always approved unanimously, with little discussion.

Politics on corporate boards, to the extent that they happen in public meetings, tend to be very subtle. A board member may ask a long term questions which management is expected to scrupulously investigate and report back upon in a timely fashion. Or, a board member in the discussion of a minor issue may note tangentially some general concern about a long term course of action that this may reflect that will be considered by management and perhaps addressed in future proposals.

But, ultimately, corporate boards as they are now, are the corporate equivalent of a United States Vice President, or State Lieutenant Government, they are kept in the loop and expected to appoint a successor if necessary, and are given some very light and inconsequential decisions to consider and act upon, but they aren't expected to actually take an active role in the management of the company.

The most important dispute in corporate law today is whether this should change, and how, and this SEC proposal goes to the heart of that question, striking a compromise, but a compromise that appears generally to favor the faction that has long been pushing for greater shareholder rights.

Why Reform Proxy Rules?

The hope of reformers is that this reform will approve the accountability of management to ownership. The hope is that a shareholder nominated director of a publicly held company would be dispositionally inclined towards, beholden to, and loyal to the shareholder group that nominated the director, rather than to the CEO and his management group that effectively make all other appointments to the Board of Directors.

To be clear, this is no recipe for mass social justice or micromanagement of publicly held companies by their boards of directors. One would expect to see as a result of the reform in the way that some of these key functions are carried out:

1. Senior executive pay that is less generous, particularly in cases where the company isn't performing well, since they must bargain with true shareholder representatives at arms length.

2. Directors attempting to develop incentives that cause senior management to adequately consider downside risks that could harm shareholders to a much greater extent than they do executives with stock options.

3. More dismissals of poorly performing senior managers.

4. Negotiations in merger discussions and hostile takeover defense strategies that shift more compensation to shareholders and less to management buyouts.

5. More directors willing to act as whistleblowers when corporate wrongdoing is discovered or contemplated.

6. More conflict on boards as pro-management and pro-shareholder factions develop over selected issues like executive compensation and dismissal of executives.

At best, this proposal could revolutionize the way that publicly held businesses in the United States operate by more swiftly replacing mediocre executives, ending self-dealing in executive compensation, giving public corporations a better balance in acceptance of risk between potential upside gains and downside losses that make the macroeconomy more robust, give shareholders a bigger share of takeover deal proceeds, and reduce corruption in big business.

At worst, it could fill boardrooms of publicly held companies across the nation with nasty arguments while not doing much to change anything of substance.

Time will tell how it plays out in practice.

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