Proxy Access: Investors Losing What They Never Had

In the wake of scandals at Enron, WorldCom and others, the Securities and Exchange Commission proposed a so-called proxy access rule that would give shareholders more power to nominate board members. But the rule has become mired in controversy, with business leaders saying it goes too far and corporate watchdogs saying it doesn't go far enough.

The ultimate outcome is a crucial one to the now-struggling corporate reform effort, according to Nell Minow, editor of The Corporate Library, an independent research firm specializing in corporate governance issues.

Proxy access is the most important of all the reforms that have been passed or proposed in recent years, she said. That's because it was the only reform that has the potential truly to empower shareholders by giving them the chance to take on entrenched boards and imperial CEOs.

No wonder then that business leaders have been so adamant in their opposition.

Led by the Business Roundtable and the U.S. Chamber of Commerce, corporate America has fought bitterly against the proxy rule, part of a broader effort to challenge the Sarbanes-Oxley law and other post-Enron reforms. The efforts have seemed to gain strength in recent months: SEC members are deadlocked over the proxy access rule, with Chairman William Donaldson having withdrawn his earlier support.

Should reformers lose the fight over proxy access, the reform movement may end without fundamentally altering the balance of power between investors and corporate managers.

This Firm Is Your Firm

To be sure, shareholders do have some say in corporate affairs. Mergers, management option plan proposals and shareholder recommendations all require investor votes. But when it comes to determining the composition of corporate boards, shareholders have little power.

In a typical election, board candidates are nominated by sitting board members and generally face no competition. Further, shareholders usually don't have the option to vote against director candidates, only to vote for them -- or abstain.

All said, a board candidate can be elected with just one vote. Even if they get no votes at all, sitting directors can remain in office until the board names a replacement. That's not exactly the model of a democratic system.

"The system is effectively broke," said Robert Howell, a visiting professor of finance at Dartmouth and co-founder of the Center for Corporate Change in Denver. "The system is really not conducive to the democratic process."

Although the SEC's proposed rule would give shareholders more power to place candidates on the ballot, it would come with severe restrictions, including:

  • Shareholders would only be able to place their candidate on the ballot when certain "triggering" conditions had been met. These include cases where the company had failed to enact a shareholder proposal passed by a majority vote, and where 35% or more shareholder votes were withheld from a particular director. According to published reports, the SEC is considering raising the threshold for withholding votes from a director to 50% or more.
  • Even if those conditions were met, shareholders couldn't place a board member on the ballot unless they owned 5% of the company's shares, or formed alliances with other investors so together they owned at least 5% of company shares.
  • While investors would be able to place their candidate on the initial proxy ballot, the rule would not guarantee them access to subsequent proxy mailings by the company. Nor does the rule do anything to limit the amount the company's board could spend to defeat the shareholder-backed candidate.
  • Assuming they meet all the necessary conditions, shareholders would be able to place between one and three director candidates on the board ballot, depending on the size of the board. Regardless, shareholder candidates would be a distinct minority on boards and would likely have little real power to shape corporate decisions.
  • Many shareholders' activists view the proxy access rule as a weak measure at best that would affect only a small fraction of public companies, noting the triggering events required rarely happen: Between 2001 and 2003, only 1.1% of companies had a director from whom shareholders withheld more than 35% of their votes, according to the SEC. (That helps explain why the 45% of votes withheld from Disney ( DIS) chairman Michael Eisner last spring was such big news.)

    Additionally, just 161 shareholder proposals received a majority vote last year, noted Ann Yerger, the deputy director of the Council of Institutional Investors. Companies later enacted 78 of those, taking away the potential trigger for proxy access.

    Shareholders will likely invoke the proxy access rule fewer than 10 times each year, predicted Rich Ferlauto, the director of pension and benefit policy for the American Federation of State, County and Municipal Employees.

    "We think the current proposed rule is a very modest step that is designed to only go after boards that have failed in the minds of a significant number of shareholders," Ferlauto said. "It's a misnomer to call that proposal shareholder democracy in any sense."

    In contrast, trade groups such as the Business Roundtable fear the unintended consequences of proxy access. The proposed rule could result in the election of board members who represent special interest groups and who push narrow agendas instead of looking out for the broad corporate interest, opponents claim. Battles over board members are likely to divert the attention of corporate managers and directors away from the running of the company, the Roundtable argues.

    Meanwhile, some argue that the proposed proxy measure -- in tandem with the other reforms already on the books -- has already shifted power to shareholders. Companies have been much more likely to enact shareholder proposals in the past year than they have in previous years, noted Pat McGurn, special counsel to proxy adviser Institutional Shareholder Services.

    Lucent ( LU), for instance, eliminated its staggered board structure after shareholder proposals urging the annual election of directors received a majority vote from investors in three straight years. Likewise, Merck ( MRK) agreed to declassify its board after shareholders passed a proposal urging it to do so for five years running.

    "The real impact of ballot access -- we're already seeing it this proxy season," McGurn said. "The anticipation of punishment is almost worse than the punishment itself."

    Still, it remains to be seen how willing directors will be to enact shareholder proposals if the SEC fails to enact the proxy access measure.

    Even without the right to proxy access, shareholders have other options. Those dissatisfied with current management can simply sell their shares or mount a proxy contest, offering a competing slate of directors against the incumbent board on a separate ballot.

    Granted, both alternatives have their problems. Selling shares runs counter to the advice of most financial planners, who urge investors to hold shares for the long term. Selling amid management failures could also mean selling at the bottom of the market. And many investors don't have the option to sell, either because their stakes are too large to divest at once, or because their investment guidelines require them to invest broadly in the stock market.

    Proxy battles, in the meantime, can be prohibitively expensive. Stan Gold, the former Disney director who helped lead the fight to oust Eisner, estimated that the campaign cost dissident shareholder Roy Disney some $3 million to $5 million. Sam Wyly, who in 2001 ran a competitive slate against the then current directors of Computer Associates ( CA), spent an estimated $12 million on his unsuccessful effort. (CA has replaced much of its board in the past two years in the wake of a financial restatement and an SEC investigation.)

    "The cost of mounting a proxy fight is impossible for the small investor," Howell said.

    So, the best hope for shareholders to influence corporate boards lies in a seemingly weak measure that may not pass.

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