The Battle over the Election Ballot : A survey of the Movement to Reform the Director Election System for US Corporations

01 June 2007

Until very recently, director elections were not the subject of great debate among corporate governance activists or lawmakers. Director elections have historically been uneventful affairs in which incumbents and their chosen successors are elected to office with little or no opposition from stockholders. The absence of a proxy contest could be taken as sign that stockholders are content with the directors who are leading the corporation, but governance reformers question whether the absence of a contest really represents satisfaction or whether the present director election system does not provide stockholders sufficient means to voice dissatisfaction with incumbent directors. According to these reformers, the election system must be changed to mitigate the financial barriers that disincentivise stockholders from presenting rival nominees for election. Reformers believe that creating an environment where stockholders can more easily bring election contests will incentivise directors to listen more carefully to stockholder constituencies.

In this article, we survey this reform movement by first describing the importance of director elections in the corporate governance system of US corporations. Our description focuses on the corporate law of Delaware since more than half of all publicly traded corporations are domiciled there. We next describe the perceived shortcomings of this system that have been identified by activists as well as the various responses that federal and state lawmakers, and institutional stockholders, have developed to address these concerns. Finally, we consider whether these reforms are truly necessary and question whether their implementation will really lead to better governance by directors.

The Importance of Director Elections

Although reasonable minds can disagree on whether reform is necessary, no one questions the importance of director elections in the overall system for governing US corporations. Indeed, under the laws of most, if not all, US jurisdictions in which corporations are domiciled and, with the exception of stockholder approvals required for fundamental changes such as mergers, dissolutions and charter amendments, the election of directors provides stockholders the only meaningful voice in corporate management. For example, under Delaware law, stockholders are not afforded an active role in governing the day-to-day affairs of the corporation. Rather, their elected fiduciaries, the directors, are empowered by statute to manage the corporation’s business. See 8 Del. C. 141(a) (“The business and affairs of every corporation organi[s]ed under [Delaware law] ... shall be managed by or under the direction of a board of directors”). Moreover, directors are not required to abide by the wishes of a majority of stockholders when making decisions. Because directors owe a fiduciary duty to consider the best interests of all stockholders, directors cannot simply cater to the private interests of one or more stockholder groups. See, eg, Paramount Communications Inc v Time Inc, 1989 WL 79880, at 30 (Del. Ch. July 14, 1989) (“The 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”), aff ’d, 571 A.2d 1140, Del. 1989.

Much like analogous forms of representative government, however, this statutory grant of directorial power is legitimised by the stockholder election process. As the Delaware Court of Chancery noted in one famous decision, “The shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests” (Blasius Industries v Atlas Corporation, 564 A.2d 651, 659 (Del. Ch. 1988)). If stockholders are dissatisfied with director decisions, the corporate form offers them one of two choices: they can sell their stock or exercise their voting rights to replace the directors (Id). By the same token, stockholders must abide by the decisions of their elected decision-makers until the next election.

The Focus of The Reform Effort

The constituencies interested in reforming the director election process do not take issue with the basic procedures for election. Reformers do not question the requirement that stockholders convene at an annual meeting each year to elect directors. 8 Del. C. 211(b). Instead, reformers seek to address the practical difficulties (primarily the incurrence of solicitation expenses) that arguably discourage stockholders from presenting nominees to compete with management’s candidates. These costs are a significant barrier to proxy contests, reformers assert, because a stockholder who presents its own nominees will receive only a pro rata share of the benefits that such a contest will confer on stockholders. (The benefits are typically in the form of either electing the stockholder nominees or convincing management to change existing policies in a compromise prior to the election.) Although stockholders could theoretically pool their resources to elect rival nominees, reformers believe that stockholders are discouraged by the costs associated with searching for other stockholders willing to support a contest.

Given these obstacles, activists view the relative calm at most annual meetings (where proxy contests do not occur) as evidence of a flawed election system rather than as evidence that stockholders are satisfied with management. If these barriers could be minimised, reformers believe, stockholders would be more willing to wage contests and therefore all stockholders would benefit from a choice among competing candidates for elections. And, even in situations where contests do not arise, the threat of a contest would discipline directors to be more attentive to stockholder concerns.

Early, Abortive Reform Efforts

The United States Securities and Exchange Commission (SEC) was the first lawmaker to respond to the plea for reform. In 2003, the SEC proposed a “stockholder access rule” that would have allowed certain stockholders (who owned more than 5 per cent of a company’s stock for more than two years)to present either one or two nominees on the proxy materials that the company printed and mailed to all stockholders. See Security Holder Director Nominations, Exchange Act Release No. 34-48626 (Oct. 14, 2003). The access rule would have addressed activists’ concerns by essentially forcing the company to defray solicitation expenses by allowing stockholder nominees to appear on company proxy materials. Under the proposed access rule, however, stockholder access would not be provided to stockholders at all annual meetings, but instead would be triggered only if certain events occurred at a prior meeting. The SEC proposed triggering events that, in its view, signaled stockholder discontent with management at the prior annual meeting. (For example, one triggering event would have been stockholder adoption of a proposal to require stockholder access to the proxy at a subsequent meeting. Another triggering event would have been poor election results for one or more directors at a prior meeting.)

Although the proposal sparked much debate on the election process, it failed to receive widespread support from the corporate governance community. Among the problems identified by commentators, it was not clear whether state law would permit stockholder candidates to appear on a company’s proxy materials. Moreover, many questioned whether the triggering events that would lead to stockholder access provided real indications of stockholder dissatisfaction with incumbent directors. Some commentators thought that access to the company proxy would be afforded to stockholders too often; others believed access would not be provided often enough. Others questioned whether the leverage the proposal might give to special interests was consistent with the concept of a collegial board acting in the perceived long-term interest of the corporation and all of its stockholders.

State Law Reform Efforts: The Advent of Majority Voting for The Election of Directors

Amid the debate over the SEC’s access rule, many state law practitioners began to examine the election reform movement from a different perspective by considering whether uncontested elections could be reformed to improve director accountability to stockholders. These efforts resulted in widespread adoption by many public corporations of a majority voting standard for director elections.

Under a typical majority voting regime, if an incumbent director receives more “against” than “for” votes, he or she will tender a resignation to the board, conditioned upon the board’s acceptance. A majority voting standard displaces the default rule under Delaware law, which provides that directors are elected by plurality vote, ie, the candidates with the most votes cast in their favour win election. 8 Del.C. 216(3). Plurality voting, according to stockholder activists, ensured that stockholders could not register meaningful dissent against incumbent directors because nominees running unopposed for election would be successful so long as a single vote is cast in their favour. A majority voting standard seeks to promote director accountability in uncontested elections by authorising stockholders to register a vote of no confidence by voting “against” nominees.

The Delaware legislature responded quickly to this new movement by adopting statutory provisions that facilitated majority voting provisions. Prior to the push for majority voting, Delaware law already permitted companies to adopt majority voting standards for director elections through amendment either to the company’s charter or its bylaws. 8 Del. C. 216. The ability to provide for majority voting in company bylaws is significant since bylaws may be amended unilaterally by either the stockholders or the directors (if the charter confers on directors the power to amend the bylaws). 8 Del.C. 109(a). The Delaware legislature further facilitated majority voting schemes by amending the Delaware General Corporation Law (the DGCL) in 2006 to expressly permit directors to tender irrevocable resignations that are conditioned on the failure to receive a speci- fied vote for reelection. 8 Del. C. 141(b). This amendment would allow directors to essentially opt out of the “holdover” provision in the DGCL which specifies that a director remains in office (despite his or her failure to be re-elected to a new term) until his or her earlier resignation or removal, or until a successor is elected. See 8 Del. C. 141(b). By enabling directors to tender irrevocable advance resignations, majority voting provisions permit corporations to give real effect to “against” votes.

The majority voting developments described above represent a compromise between corporations and stockholder activists. First, they offer stockholders a cost-effective way of registering dissent against directors – short of waging a full proxy contest. Second, the typical majority voting scheme provides a board the flexibility to respond to a vote of no confidence in a manner that will minimise harm to the corporation. The board can exercise such discretion because, under most majority voting regimes, a director resignation is conditioned on board acceptance. Thus, the board can weigh the reasons for the stockholder vote of no confidence against any competing factors that might warrant permitting the director to remain on the board. A director with special expertise, or who is otherwise especially valuable to the company, can be retained if the board determines that retention is best for the company and all stockholders.

Further Reform Efforts

Although public companies have been quite responsive to the majority voting initiatives, activists continue to press for further reforms to lower the barrier for proxy contests. The proposals vary in their specific terms, but each proposal seeks either to reduce the costs of waging proxy contests or to force the company to subsidise a stockholder’s proxy solicitation.

Perhaps the most controversial proposal is an effort by institutional investors to convince stockholders to adopt bylaws requiring companies to place stockholder nominees on the company’s proxy materials. Several public companies have received such “proxy access” bylaw proposals that would allow persons who have held some minimum threshold amount of stock for a certain period of time to place nominees on the company’s proxy card, along with a brief summary of the stockholder candidates’ qualifications, in the company’s proxy statement.

Although the validity of such a bylaw is an issue of state law, federal lawmakers are indirectly involved with proxy access bylaws because institutional stockholders wish to use a federal regulation, Rule 14a-8 of the Securities Exchange Act of 1934, to allow the stockholders to include these bylaw proposals in company proxy materials. There has been a significant amount of controversy over whether such bylaw proposals may be included in company proxy materials because Rule 14a-8 allows a company to exclude from such materials stockholder proposals that “relate []... to an election of directors.” See 17 C.F.R 240.14a-8(i)(8). The SEC initially determined that these proxy access bylaws relate to an election of directors, and thus the SEC would not pursue a company for a violation of Rule 14a-8 if it excluded such a proposal from its proxy materials. See, eg, American International Group Inc, SEC No-Action Letter, 2005 WL 372266 (Feb. 14, 2005). However, a federal court later interpreted Rule 14a-8 to mean that such proposals do not relate to an election of directors. American Federation of State, County & Municipal Employees v American International Group Inc, 2006 WL 2557941 (2d Cir. Sep. 5, 2006). Since that decision, the SEC announced that it would clarify Rule 14a-8 either to expressly permit or deny companies the ability to exclude these bylaw proposals from their proxy materials. The SEC has been considering such a clarification for almost a year, and the corporate governance community is awaiting a final determination.

In a proposal similar to the access bylaw, some activists are urging stockholders to adopt bylaws requiring companies to reimburse stockholders for all or part of their solicitation expenses if they successfully elect candidates to the board or if they receive some other specified level of stockholder support short of successfully electing their candidates. See, eg, Bank of New York Co Inc, SEC No-action Letter, 2006 WL 538773 (Feb 28 2006) . The SEC has permitted stockholders to place such reimbursement proposals in company proxy materials pursuant to Rule 14a-8. Id. However, the SEC’s revisions to that rule may also affect the inclusion of such proposals on proxy materials in the future.

Although the debate over stockholder access and reimbursement bylaws has largely centered on Rule 14a-8 considerations, there will likely be future controversies over whether such bylaws would be valid under state corporation law. Among other potential problems with such bylaws, it is an open issue whether the Delaware courts will permit either stockholders or directors to adopt bylaws that essentially require the company to expend corporate funds to subsidise stockholder-initiated proxy contests, especially if there is no guarantee that a stockholder solicitation will benefit the corporation and all stockholders. Existing case law specifies that stockholders may be reimbursed for expenses only if their solicitation implicates matters of company policy: in other words, the solicitation must confer a benefit on all stockholders by informing them on important managerial issues over which the incumbent and stockholder nominees disagree. Steinberg v Adams, 90 F. Supp. 604, 607-608 (S.D.N.Y. 1950)(applying Delaware law). Reformers have not yet crafted a bylaw proposal that squarely addresses this policy requirement under Delaware law.

On a less controversial front, the SEC has also recently adopted a new rule that could reduce the costs associated with a proxy solicitation by permitting companies and other persons soliciting stockholder proxies to make proxy materials available via the internet. See Internet Availability For Proxy Materials, Exchange Act Release No. 34-55146(Jan. 22, 2007). The new rule complements Delaware law provisions that permit stockholders to deliver proxies by electronic means(8 Del. C. 212(c)(2)) and also permit companies to allow stockholders to attend meetings via remote communication (such as the internet) if certain conditions are satisfied(8 Del. C. 211(a)(2)). The new SEC rule has the potential to significantly reduce solicitation costs, which could alleviate the need for further reform in director elections.

The Necessity for Reform

By continuing to press for some form of stockholder access to company proxy materials or a reimbursement scheme, governance activists have sent a clear signal to US companies that the push to reform director elections is far from over. Yet, it is fair to question whether additional reform is necessary at this time. As an initial matter, it is not clear that stockholders will benefit from a regime that encourages more proxy contests. In an era of indexed investment strategies which encourage stockholders to spread their funds over a broad portfolio of diversified stocks, individual investors may not possess an economic incentive to educate themselves to cast an informed vote in each election for the many companies in which they hold stock. Indeed, mutual funds and similar investors increasingly rely upon the advice of proxy advisory services to help them determine how to vote shares. These advisers include firms like Institutional Shareholder Services (ISS) and Glass, Lewis and Co. Yet, little is known about these advisers and their qualifications because they are not subject to government regulation. In addition, the relatively recent emergence of these advisers deprives the governance community of much needed data concerning whether their advice really enhances the longterm growth of companies.

Furthermore, the lack of participation in corporate governance by many investors leaves open the possibility that certain election reforms urged by activists will likely benefit more active stockholders, such as labour unions and hedge funds. Such investors may seek to use proxy access as a means to extract private benefits for their own constituencies at the expense of other stockholders. (For example, a labour union may want to extract concessions for employees of a company – concessions that might diminish stockholder value. Hedge funds may also have short positions in companies that might incentivise them to pursue policies that harm rather than benefit other stockholders.) Reformers should be mindful that stockholders are not bound by fiduciary duties and are not required to act for the benefit of other stockholders. Given these divergent interests among stockholder constituencies, it is hardly clear that enhancing stockholder power will also enhance stockholder wealth.

Moreover, the corporate governance community may be well advised to provide sufficient time for the reforms that have already been implemented to take full effect and then evaluate whether further reform is necessary. Indeed, the latest reform effort – majority voting – has been in place for hardly more than one year. It is simply too early to determine whether additional reform is necessary.

Furthermore, there have also been several fundamental changes relating to the director election process that have strengthened the integrity of nominations of candidates by incumbent directors. Both the New York Stock Exchange and Nasdaq rules require that the boards of publicly traded companies form nominating committees comprised of independent directors to evaluate candidates and to consider incumbents for re-nomination. See NY Stock Exchange Manual, 703A.04; National Association of Securities Dealers Inc, Rule 4350(c)(4). Moreover, companies are required to disclose to stockholders the criterion for selecting nominees, which allows stockholders to scrutinize the nomination process. 17 C.F.R. 240.14a-101; 229.407. These improvements, combined with the fact that incumbent directors already owe stockholders a fiduciary duty to select only nominees who will further the best interests of a company, suggest that corporate governance can be improved without additional incentives for proxy contest activity.

Activists and lawmakers should proceed cautiously to avoid pursuing reform for its own sake. Corporate governance is meant to ensure that the persons who actively manage the company are working to maximise its wealth rather than advancing management’s own private agenda or the agenda of stockholder factions not shared generally by other investors. Corporate governance is not an end in itself, and its benefits will produce negative or diminishing marginal returns if too much of management’s time is diverted from the underlying business of the company to focus on governance issues or if reforms shift power to interest groups with agenda inimical to the long-term interests of stockholders generally. Accordingly, it may be prudent to digest the reforms that have already been implemented and then determine whether further reform is necessary.

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