new rules on electing company directors

The SEC wasted no time in acting on the authority it got under the recently enacted Dodd-Frank (or Frank-Dodd) Wall Street Reform and Consumer Protection Act to determine shareholder ability to add materials to proxy materials of publicly traded companies.

Yesterday it set new rules that permit shareholders to place their nominees on the ballot for election to the board of directors, providing:

–the shareholder owns at least 3% of the company’s shares,

–it has been a 3% holder for three consecutive years,

–it doesn’t hold the stock as part of an effort to change control of the firm, and

–it has no side agreement to support the existing management.

A qualifying shareholder can submit nominations for up to 25% of the board.

The new rules will go into effect in about two months.

the “system” this replaces

Any shareholder could submit names to a corporation and ask that they be considered for inclusion on the proxy ballot.  But the firm had no obligation even to consider these requests, which I would imagine went directly into File 13.  A shareholder wanting change could raise his objections at the annual meeting–a futile undertaking, since management would already have obtained enough proxies to control any vote.  The only other alternative for an unhappy shareholder has been to wage a proxy fight, that is, to contact other shareholders directly and ask for their votes–a very expensive process.

Until July 2009, a proxy fight was an even more futile process than it sounds, since a brokerage firm could vote all the shares it held for clients in “street name” (basically, all of them) for the directors the broker desired, provided he had received no instructions from the shares’ owners.  Effective with voting at meetings after January 1, 2010, brokers must either vote the shares they hold for customers in accordance with their instructions, or–without instructions–not vote them at all.  Since a company’s management control the flow of investment banking business, guess who brokers tended to vote those silent shares for?

are new rules needed?

Yes, in my opinion.  Think about the recent GM bankruptcy.  Through 35 years of almost continual loss of market share, a complacent board defended stunningly incompetent management.  Both were in denial to the very end.  Both rebuffed all outside attempts to change a corporate culture of failure.

two observations–my opinions–about boards and individual shareholders

1.  In theory, shareholders elect the board of directors to supervise the operation of  company.  Directors set strategy and hire the management that carries out the board’s wishes.  In practice, the opposite is the case.  Typically, management in effect controls the board both by influencing its composition and by regulating the amount and completeness of information that it supplies to board members.  Many board members are managers or former managers of the company.  “Independent” directors may come from politics or academia and have little experience in, or even knowledge about, the industry the company is in.  All are paid for serving on the board and are indemnified by insurance against lawsuit damages for any action they may take.

It’s easy to pick a company and check.  Google the board members.  Ask yourself what industry background the independent directors have.  What’s their “day job” and how much of their time does that take?  How many other boards are they on?

2.  Oddly–to me, anyway–individual shareholders tend to be intensely loyal to management and the sitting board.  The invariably support management/board recommendations, even when company performance is poor and when proposals they are asked to vote on seem to very clearly run against shareholders’ interests.  I’ve never gotten why.  Maybe it has to do with the just-abolished practice of brokers voting clients’ stock for them.

much ado about nothing?

The consensus seems to be that the teeth have been pulled from the new voting rules by provisions two and three above, concerning change of control and three-year ownership requirement.  And you might argue that even if someone gets control of a quarter of the board, they’ll still be a frustrated minority that isn’t able to crack an “old boy” board.

maybe not

1.  25% of the board is more than it seems to be at first glance.  Suppose a large pension fund (the obvious large, benign holders of corporate stock) ended up with such representation on the board of a given firm.  I think this would say two things:  a) the company is receptive to change, and b) if you can ally with the pension fund, half the work of being able to force change through control of the board is already done.  Arguably, the first step in becoming open to change, the one taken by the pension fund, is harder, so maybe well over half the work is done.

2.  The new rules may change legal leverage in unusual ways.  I can imagine that if a few leading pension funds begin to place directors on corporate boards, they may establish a new standard for good stewardship of pensioners’ assets.  Other funds may  follow suit, if for no other reason than fear of negligence lawsuits if they don’t.

Also, when a board is a closed club that speaks with one voice and provides no information about its deliberations to the public, members may feel there are no penalties for acting as a rubber stamp for management.  If board minutes contain well-reasoned dissenting comments, or if a new board member is willing to make deliberations public–even to campaign against sitting board members in the next election–that may change.

Pressure on sitting board members to take an active part in the management of the company can come in two ways, I think.  One is possible public embarrassment, or loss of a board seat, for members who simply collect a check from the firm (for big companies, payments to directors can be hundreds of thousands of dollars) and do nothing.  Another is perhaps the greater worry that clear evidence of board members’ negligence will invalidate the liability coverage that they think protects them from the consequences of their actions.

investment implications

I think the first few proposals of alternate director candidates will be crucial in setting the tone for what will follow.  It should be interesting to watch.  It may well be that either the proposal itself, or the election of new board members, will be a signal for a period of stock outperformance.