As published on Corporate Compliance Insights on December 14, 2010.
The wave of corporate scandals following on the heels of Enron’s collapse nearly a decade ago helped propel shareholder activism into a populous movement. This movement has only gained momentum from the more recent subprime controversy, which introduced such terms as “bailouts” and “toxic assets” into the common vernacular.
Boards of directors who used to enjoy insulation from shareholders now face growing pressure to increase corporate accountability to the owners of the companies that the corporate boards serve. But as shareholders raise their voice, boards push back.
Over the past decade, this struggle has taught many shareholders of public companies the hard way that despite supposed corporate democracy, shareholder rights, and what should be a healthy balance in the management of a company between executives, boards, and shareholders, corporations often resemble autocratic regimes in which shareholders suffer.
Under the modern corporate model, shareholders generally have three options to effectuate corporate change: (1) elect new members to the board of directors; (2) propose and adopt shareholder proposals; or (3) litigate. Efforts to influence a company by the director election process have largely failed due to the difficulties in unseating an incumbent board. Moreover, shareholders still have almost no power to pass resolutions that actually bind the board to act. Indeed, on several occasions, corporate boards have ignored clear mandates from shareholders, such as say-on-pay resolutions and proposals to eliminate a company’s staggered board.
There is little reason for shareholders to believe that boards will suddenly start taking non-binding resolutions more seriously. In contrast to board elections and shareholder proposals, litigation stands out as a reliable vehicle for change.
Corporate Democracy Is Failing Shareholders
It is a fundamental premise of corporate governance that the board of directors – not shareholders – manages a corporation. The board, aided by corporate executives, handles the day-to-day affairs of the company, while shareholders remain hands-off. Corporate directors are also responsible for the corporation’s overall strategy. Consequently, whoever controls the selection of corporate directors exerts considerable influence over the company.
In theory, shareholders have ultimate control over a company’s agenda because they elect the directors to the board. In reality, the average shareholder has little influence. The incumbent board usually selects the slate of directors for shareholders to vote on. Due to the massive costs and other hurdles associated with mounting a proxy contest, the board’s selection is rarely opposed by an alternate slate.
According to Robert Monks and Nell Minow in their book, Corporate Governance, more than 99% of the time corporate directors run unopposed. Further limiting the influence of shareholders, directors have traditionally been elected by a mere plurality vote, meaning that unopposed directors may be elected to the board with as little as a single vote. This is made possible because dissenting shareholders can only withhold their votes in uncontested director elections. Voting “no” is not an option. As Monks and Minow put it, “the ‘election’ is really just a formality.”
To address the inherent unfairness of plurality voting in uncontested elections, corporations during the past few years have adopted – often at the behest of activist shareholders – corporate governance in one form or another. Well over 500 public companies have adopted majority vote policies requiring a director who fails to receive a majority “yes” vote to tender his or her resignation. However, most of these majority vote policies leave the board with discretion to reject the resignation.
A smaller number of companies have adopted actual bylaws amendments requiring each director to receive a majority of the votes cast. However, as with the governance policies, the bylaws amendments have typically provided that an incumbent director failing to win a majority vote must submit his or her resignation, which the board is then free to accept or reject.
Even when the board rejects the shareholder vote and a shareholder turns to litigation, boards still have some degree of success in maintaining their entrenchment. In City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., the Delaware Supreme Court refused to allow a shareholder to inspect corporate books and records as part of an investigation into potential wrongdoing involving the board’s rejection of resignations from three directors who failed to win a majority of the shareholder vote.
However, the court indicated that, in light of the demonstrated shareholder opposition, the shareholder plaintiff could have pursued an inspection into whether the defeated directors were qualified to serve on the board. The court explained that a board should be accountable for using self-given power to override an “exercised shareholder voting right,” and in that case, “accountability should take the form of being subject to a shareholder’s … right to seek inspection” of books and records relating to the decision to reject the resignation of defeated directors. The Axcelis court helped provide a roadmap for shareholders seeking to wrangle in renegade boards. Boards, therefore, may be well advised to heed the will of shareholders to accept resignations of directors who fail to win majority approval.
Shareholder Rights Take a Back Seat to Federal Proxy Rules
Federal proxy rules – designed to ensure fair and accurate disclosures to shareholders – prohibit the solicitation of votes from shareholders until the soliciting person files a proxy statement with the U.S. Securities and Exchange Commission (SEC). With limited exception, federal proxy rules give boards of directors extensive discretion to decide whether to include director nominations or shareholder proposals on the company’s proxy.
Thus, unless the board agrees to support a shareholder-nominated director or allow a shareholder’s proposal on the company’s proxy, a shareholder typically would have to file a separate proxy at his or her expense. Waging a proxy contest or otherwise soliciting votes is often so expensive that most shareholders are unable to bear the costs. As a result, corporate boards were able to dispense with most opposition by simply denying access to the company’s proxy.
Recognizing that federal proxy access rules impaired the ability of shareholders to effectively exercise their rights to nominate and elect directors, the SEC (backed by The Dodd-Frank Wall Street Reform and Consumer Protect Act passed by Congress earlier this year) recently adopted long-awaited reforms to open up the company’s proxy for shareholders. Among other things, these new rules allow a shareholder or a group of shareholders who held at least 3% of the company’s voting power for a minimum of 3 years to nominate a limited number of directors and have those directors appear on the company’s proxy.
The new rules also require a company, under certain circumstances, to include shareholder proposals relating to the nomination procedures and disclosures in its proxy materials. These rules were supposed to go into effect in November of 2010. However, the SEC has agreed to stay their implementation while the U.S. Chamber of Commerce and Business Roundtable challenge the validity of the rules in court.
Assuming the new rules go into effect, shareholders may find that little has actually changed. First, the vast majority of shareholders will be unable to meet the 3% control requirement. Second, even if shareholders meet the requirements of the new rules, the company is only required to include shareholder nominations for up to a quarter of the board seats on the company’s proxy. Thus, absent a proxy contest, shareholders are still limited in removing the majority of a company’s unwanted board members in a given year.
Other than nominating directors, shareholder rights pertaining to shareholder proposals are even more limited. While the SEC has considered expanding a company’s proxy for shareholder proposals, the agency has so far opted to only focus on director nominations. Thus, the SEC’s new proxy rules, with the exception of certain proposals affecting the nomination and election of directors, would do nothing to expand proxy access for shareholder proposals. Shareholder proposals also suffer from an even more fatal shortfall. As a general rule, shareholders cannot propose binding resolutions for corporate governance changes. In other words, even if all shareholders manage to vote on and approve a shareholder proposal, the board is still free to disregard it.
During the past decade, shareholders have passed several non-binding resolutions that corporate boards have outright ignored. For example, in May 2000, 55% of the shareholders of KeyCorp withheld support for executive compensation awarded by the board, but the board nonetheless left the compensation package intact. Similarly, a Harvard study published in 2004 showed that more than two thirds of shareholder-approved resolutions to eliminate staggered boards were still not implemented roughly a year later.
Sometimes boards ignore repeated votes by shareholders for governance changes. Motorola, Inc., for instance, ignored successive shareholder votes to de-stagger the company’s board year after year. The board finally had a change of heart in 2008, but only when it faced a proxy contest and litigation by shareholder activist Carl Icahn.
Just this year, Congress passed legislation that gives shareholders a limited say on executive pay. Dodd-Frank, signed into law by President Obama on July 21, 2010, requires public companies to submit the company’s executive compensation practices, including golden parachute arrangements, to a shareholder vote at least once every three years. However, the vote is only advisory, meaning little will change unless corporate boards actually heed the expressed will of shareholders.
Litigation Has Produced Results
Due to difficulty in effectuating change through the democratic process, litigation has emerged as a useful tool for shareholders in obtaining corporate reform. Unlike non-binding shareholder proposals, litigation can often secure immediate implementation of governance changes. As seems to have been the case with Motorola’s board, litigation can get the attention of management who otherwise may lend shareholders a deaf ear. Not surprisingly, shareholders are increasingly resorting to litigation and seeing successful results.
Shareholders have obtained substantial reforms through litigation, including a shake up of management, new policies to improve the board’s oversight and accountability, or both. For example, in 2005, shareholders of Dynegy Inc. secured sweeping corporate governance changes, including an overhaul of senior management, the board of directors, and the company’s outside auditors. Similarly, shareholders of OM Group, Inc. obtained the termination of the company’s chief executive officer, the addition of two shareholder-nominated directors, and the implementation of new corporate governance procedures.
Shareholders of Hanover Compressor Company (now Exterran Holdings, Inc.), likewise convinced management to appoint two shareholder-nominated directors to the board and rotate the company’s outside auditing firm every five years. Shareholders ofWireless Facilities, Inc. (now Kratos Defense & Security Solutions, Inc.), meanwhile, recently moved the company to appoint two independent directors and to review annually the performance of the board’s chairman. Litigation helped significantly change the corporate structure and policies at each of these four companies.
Litigation is also one of the few options available to shareholders who lack the resources to engage in the proxy solicitation process. Whereas a proxy contest can cost hundreds of thousands of dollars, litigation can be relatively inexpensive. A shareholder with a good and legitimate cause can often retain aggressive lawyers on a contingency basis. Indeed, even hiring lawyers at an hourly rate to litigate such a case might, in the end, be less expensive (and more effective) than a proxy fight. As a result, almost any shareholder – big or small – can, under the right circumstances, afford to go head to head against a management who ignores the voice of disgruntled shareholders in order to bring about meaningful corporate governance reform.
Although companies should not cave to every shareholder’s demands, a sizable portion of shareholder lawsuits can be avoided if management properly responds to the legitimate wants and needs of shareholders. By resisting shareholder-supported governance changes – particularly those designed to give shareholders a greater voice or increase accountability of management to shareholders – a company’s leadership runs the risk of being perceived as out of touch, if not entrenched. This perception emboldens shareholder activists to run to court for help.
On the flip side, engaging shareholders in the corporate governance process and being in tune with their interests will help stave off shareholder revolts and avoidable litigation. Just recently, MGM Studios Inc. averted a costly legal battle with Carl Icahn in bankruptcy court by agreeing to, among other things, several corporate governance changes that included restrictions on poison pills and expansion of the ability of shareholders to call special meetings. But this still took a serious threat of litigation before the company agreed to such changes
The Way Forward
Litigation is often seen by shareholders as one of the only options they have to effectively obtain corporate governance changes when companies will not do so on their own. If companies want to avoid confrontation in court, they need to implement corporate governance that connects the desires of their shareholders to how the company is managed. By giving shareholders meaningful opportunities to be heard and effectuate corporate reforms, companies help avert the perceived need by shareholders to resort to litigation. This should, in turn, lead to increased corporate value – not just because of financial savings, but because companies will offer more control for their owners.
About the Authors
Brian J. Robbins and Jay R. Razzouk are attorneys at Robbins Umeda LLP,* which represents individual and institutional shareholders in derivative, direct, and class action lawsuits.
The law firm’s skilled litigation teams include former federal prosecutors, former defense counsel from top multinational corporate law firms, and career shareholder rights lawyers.
Robbins Umeda LLP has helped its clients realize more than $1 billion of value for themselves and the companies in which they have invested. For more information, please go to www.robbinsllp.com.
This article was also published on The Recorder on February 22, 2011, under the title, Litigation Drives Corporate Change.
* The firm name changed from Robbins Umeda LLP to Robbins LLP on January 1, 2013.