Does the Director Election System Matter?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday August 22, 2011 at 9:28 am
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Editor’s Note: The following post comes to us from Yonca Ertimur of the Department of Accounting at Duke University and Fabrizio Ferri of the Department of Accounting at Columbia University.

In our paper, Does the Director Election System Matter? Evidence from Majority Voting, which was recently made publicly available on SSRN, we examine the economic consequences of a change in the director election system, namely, the switch from a plurality voting to a majority voting standard.

Under a plurality voting standard—until recently the default arrangement under most state laws—the candidate with the most votes “for” is elected, a system that helps avoid the disruptive effects of failed elections. In uncontested elections, the plurality voting standard means that each nominee will always be elected as long as she receives one vote “for,” irrespective of the number of votes “withheld” (under SEC rule 14a-4(b) shareholders cannot vote “against” a director nominee, they can only vote “for” or “withhold” support).

Under a majority voting (MV) standard, instead, even in uncontested elections a director would not be elected unless the majority of votes were cast in her favor. Starting in 2004, firms have begun to adopt some form of MV standard, often in response to non-binding shareholder proposals filed by activists and policy makers have debated whether to mandate a MV standard. By the end of 2007, about two thirds of the S&P 500 firms had adopted some form of MV.

Ex ante, the effect of a MV standard is not clear. On one hand, proponents of mandatory MV argue that a greater threat of replacement will result in stronger alignment of interests between directors and shareholders, with beneficial effects on firm value. On the other hand, shareholders could withhold (or threaten to withhold) votes for reasons unrelated to shareholder value maximization. In addition, failure to elect a director may cause firms to fail to comply with SEC or exchange requirements, with potentially negative net effects on firm value. A third possibility is that MV, as put into practice, is little more than “smoke and mirrors” since under most forms of MV standard currently put into practice the election outcome ultimately remains a board decision, protected by the business judgment rule.

To empirically examine the economic consequences of the adoption of MV we perform three sets of tests. First, using a regression discontinuity design that mitigates the issues commonly associated with interpreting investor response to voting results at annual meetings, we document abnormal returns of 1.43-1.60% on annual meeting dates where shareholder proposals to adopt a MV standard are voted upon. This result suggests that (at least for targeted firms) shareholders perceive the adoption of the MV standard as a value enhancing change in governance.

Second, we examine how MV affects shareholder voting behavior—an observable action aimed at influencing firms’ conduct and, thus, potentially directly influenced by this new election system designed to increase directors’ accountability to shareholders. We find that, in the presence of a withhold recommendation from ISS (a proxy for perceived problems with the director‘s performance), the percentage of votes withheld at director elections is about 3% higher at firms adopting MV relative to pre-adoption as well as to non-adopters. Similarly, the voting support for proposals to declassify the board at firms that adopted MV is substantially higher compared to the pre-adoption period and to control firms. These results are consistent with shareholders exerting greater pressure at firms adopting MV because they expect boards to be more responsive to shareholder votes under MV.

Finally, we focus on the impact of the adoption of a MV standard on board behavior, and, in particular, on board turnover. We find that the sensitivity of board turnover to votes withheld from directors at annual elections is higher subsequent to the adoption of MV, consistent with the notion that the MV election system makes boards more responsive to shareholder pressure. Our study contributes to the growing literature on the director election system and, more generally, on the economic relevance of governance arrangements.

The full paper is available for download here.

  1. This article commits the common error of conflating the execution of a proxy with the act of voting. Properly understood, there is no such thing as a “withhold vote”.

    A proxy is a limited agency pursuant to which a shareholder authorizes someone else to go to a meeting and vote on the shareholder’s behalf. See, e.g., Cal. Corp. Code Sec. 178 and Moran v. Household Int’l, Inc., 500 A.2d 1346, 1355 (Del. 1985)(“[T]he relationship between grantor and recipient of a proxy is one of agency . . .”).
    The proxy provides the authority and any desired instructions or limitations on that authority. Voting is what occurs at the meeting. A shareholder need not execute a proxy in order to vote at a meeting (the shareholder can attend the meeting and vote directly). Also, execution of a proxy does not constitute a vote per se. For example, the proxy holder an fail to attend the meeting or fail to vote the shares represented by the proxy at the meeting. Also, the proxy authority can in most cases be revoked before the proxy holder votes the shares.

    A shareholder can withhold its vote in at least two ways. First, the shareholder may execute a proxy but specify in the proxy that authority to vote on specified matters is being withheld. Second, the shareholder may simply decline to execute a proxy. Neither of these actions constitutes an abstention per se.

    An abstention (i.e., the voluntary act of not voting) occurs when either a shareholder or its proxy is counted as present at a meeting but does not vote its shares. See Hammersmith v. Elmhurst-Chicago Stone Co., C.A. No. 10837 (Del. Ch. Aug. 17, 1989). The authors do not explain why they assign more importance to the former than the latter.

    The authors’ assertion that “under SEC rule 14a-4(b) shareholders cannot vote ‘against’ a director nominee, they can only vote ‘for’ or ‘withhold’ support” is incorrect. The SEC’s rules regulate the form of proxy; not the act of voting. State law generally governs the process of voting (e.g., whether voting must be by ballot), how votes are tabulated (e.g., when shares are held in multiple names),. who tabulates the votes, and the legal effect of votes cast for and against and abstentions.

    The SEC originally proposed a requirement allowing shareholders the opportunity to instruct a proxy holder to vote against a nominee. However, when the SEC adopted the final rule, it replaced the “against” option with a “withhold” requirement due to concern that shareholders might misapprehend the legal effect of instructing a proxy holder to vote against. SEC Release No. 34-16356 (Nov. 21, 1979) [44 FR 68769]. Thus, the SEC’s final rule allows shareholders to execute a proxy that requires the proxy holder to abstain with respect to specified nominee(s).

    Comment by Keith Paul Bishop — September 2, 2011 @ 6:38 pm

 

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