Friday, April 21, 2006

Shareholders Want to Change the Rules for the Election of Directors

Dale A. Oesterle
Special to

There are more than 100 pending shareholder resolutions asking corporations to change their voting procedures for the election of directors. This follows last year's deluge of proposals that shocked corporate insiders.

What are the proposals and what is at stake?

The dominant proposal is a request by shareholders that directors be elected by a majority of the votes present at a meeting. The historical system allows the election of directors by a plurality vote. Under a plurality standard, a director is elected by receiving the highest number of votes cast for an open seat. Since directors usually run unopposed this means that, in theory, a single affirmative vote (check the "for" box), even if all other voters abstain (check the "withhold" box), is sufficient to put a director in office.

In the 2005 proxy season, shareholders submitted 79 majority vote proposals. Fifty-five made the ballot and 17 won. An average of 43 percent of shareholders supported the proposals. Several influential institutions and institutional shareholder advisory services have come to support the proposals, including the Council of Institutional Investors, the California Public Employee's Retirement System and the Institutional Shareholder Services. At the conclusion of the 2005 proxy season, for example, CII sent letters to the largest 1,500 public companies in the United States requesting that they voluntarily adopt majority voting standards.

Over a dozen corporations, seeing the writing on the wall, have voluntarily adopted the majority vote procedure. Eighty or so corporations, attempting to blunt the effect of the proposals, have adopted a corporate governance policy guideline requiring a director who receives more "withheld" than "for" votes to tender his or her resignation to the sitting board. The board could choose whether or not to accept it.

The resignation policy permits the board to retain key board members, the CEO, the chairman of the audit committee or another independent director necessary to sustain a functioning independent subcommittee. Most activist shareholders do not consider the resignation policies adequate and want directors who fail to receive a majority of the votes cast to not be seated.

The toughest battles in the 2006 proxy season will be over majority vote proposals for companies that have put resignation guidelines in place. In three early elections, at Analog Devices, Hewlett-Packard and Ciena, the majority vote proposals failed.

It is stunning how little is at stake in this controversy. Last year, out of more than 35,000 director elections, only 14 -- 14 -- nominees for directorships received a majority of "withhold" votes. We are fighting over the seating of 14 nominees, whose situations were very, very unusual. Corporate control over who is on the firm's proxy means that the threat of denying a management nominee a seat on the board is negligible, even infinitesimal. Companies in the United Kingdom and Australia, and several other countries, have operated under majority vote requirements for years without difficulty.

Why are companies so concerned? Some of the reasons given in opposition make technical sense but lead to easy fixes. First, a plurality vote works best in contested elections, but there are few contested elections and, in any event, a contested election exception can be put into the majority vote requirement. Second, if a nominee cannot be seated, there is the "hold-over" problem; the incumbent director, who may be the nominee defeated, continues to serve until a successor is validly elected. An irritation perhaps, but the holdover rule can be eliminated or modified.

Some of the reasons given for opposition ought to induce a chuckle. Some claim that the failure to seat an independent director could cause a company to not comply with stock exchange listing requirements or SEC rules regarding board committee membership. This is a "gotcha" argument; the corporations do not like the membership rules either. In any event, insider directors, not independent directors, are the most likely to be displaced by a majority vote procedure.

The real reasons for the displeasure of corporate managers lie elsewhere. First, a majority vote procedure enables shareholders to remove a chief executive officer, who is often the board chairman, from the board. This would be a major embarrassment for the CEO, may require a board to consider major internal management changes, and may trigger a variety of legal problems including severance payment provisions in employment contracts. Even though a successful vote is very unlikely, CEOs have never faced the threat before in uncontested elections and do not want to face it now. Even an unsuccessful "withhold" campaign that attracts serious support, as Eisner discovered at Disney, can be a painful setback.

Second, if majority vote proposals succeed, shareholders may follow their successes with elections proposals that have more teeth. Over the past few years, board declassification proposals have been growing in popularity. Classified boards elect only a third of the directors in any given year and make hostile proxy contests much more difficult. Classified boards are also a necessary part of successful takeover defense strategies that include poison pill plans and state anti-takeover legislation (a hostile billed can remove the board and waive the defenses). In the 2005 proxy season, 44 declassification proposals received an average affirmative vote of over 60 percent. It appears inevitable that classified boards, like plurality vote systems, will go the way of the dinosaur.

Even more troublesome for incumbent managers is the small but growing effort of shareholders to gain access to the company's proxy for contested elections. The effort of the American Federation of State, County, and Municipal Employees (AFSCME) to require American International Group (AIG) to allow shareholders access to the company's proxy is an example; AFSCME has pursued the matter all the way up to the 2nd U.S. Circuit Court of Appeals.

These are the proposals, proposals that encourage contested board elections, that will effect a sea change in corporate governance in the United States. If majority vote proposals are the precursor to contested board elections, then something big is in the air.

A graduate of the University of Michigan Law School, professor Dale Oesterle is a nationally recognized corporate law scholar with broad interests. He has a particular expertise in mergers and acquisitions and has written a leading casebook on that subject. He practiced law and served as a federal law clerk before beginning teaching at Cornell Law School. He is currently the J. Gilbert Reese Chair in Contract Law at Ohio State University.'s ongoing LEGAL MINDS article series highlights opinion and analysis from our site's contributors and writers across the ALM network of publications.

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