As participants in the Forum know, SEC rule changes that took effect in September 2011 once again allow shareowners the right to submit and vote on “proxy access proposals” as we had done prior to an underground reinterpretation of SEC rules in 1990 and during a brief window of opportunity after AFSCME v AIG (2006). These proposals give shareowners the right to include director nominees in the company’s proxy materials. Arguably, the most innovative recent models of such proposals have now withstood the SEC “no-action” process and will soon come to a vote at Forest Labs (FRX) on August 15th, Medtronic (MDT) on August 23rd and H&R Block (HRB) on September 13th.
Download a PowerPoint presentation and/or read the paper (pdf) on these important proposals. All three proposals were introduced by long-time activist Kenneth Steiner, with the help of John Chevedden. Design of the proposal came from a team of United States Proxy Exchange (USPX) members, including James McRitchie, Glyn Holton, Brett Davidson, Steve Neiman, Daniel Rudewicz, Steven Towns and others, with helpful input from a variety of their contacts.
When we crafted our model proxy access proposal, we carefully reviewed the SEC’s Rule 14a-11, which was thrown out by the D.C. Circuit Court of Appeals for underestimating the amount companies would spend to retain entrenched directors. The proposal included a number of onerous features, including a requirement that any nominating party have held 3% of a company’s stock for 3 years. The only justification the SEC offered for this was the following:
… we believe that the 3% ownership threshold – combined with the other requirements of the rule – properly addresses the potential practical difficulties of requiring inclusion of shareholder director nominations in a company’s proxy materials …
That would limit proxy access at large companies to billionaires and groups of the institutional investors, since most, including the public pension fund giant CalPERS, own only a fraction of a percent of any one company. Convenience or cost savings should not justify the sweeping disenfranchisement of most shareowners in the nomination process. Therefore, we took a step back and identified possible justifications for eligibility requirements in descending from most reasonable to least reasonable:
- 1. Encouraging quality nominations by requiring effort or a large stake to nominate.
- 2. Avoiding a “dilution” effect of having numerous shareowner nominees competing for a limited pool of “opposition” votes.
- 3. Avoiding frivolous or nuisance nominations.
- 4. Keeping nominations to a manageable number for convenience or to limit election costs.
- 5. Limiting nominations to certain parties, such as influential shareowners, based on a belief that they deserve a greater right to nominate.
We predicated the USPX Model Proposal eligibility requirements primarily on the first item, although we also see value in items 2-4. The USPX Model Proposal’s eligibility requirements are designed to impose the least disenfranchisement necessary to achieve the goal of encouraging quality nominations by requiring a huge effort or a large stake to nominate.
Common features of the USPX proposals are as follows:
- Precatory to afford flexibility.
- One nominee (12% of board) per nominating party.
- Nominating parties can’t coordinate nominations.
- Two alternatives to satisfy ownership requirement:
- Party holding 1% of shares for 2 years, or
- Party of 50 shareowners each holding $2,000 for 1 year
The FRX and MDT proposals have no cap on the total number of shareowner nominees. However, as one prominent ex-SEC official recently e-mailed me, “your 50 shareholder number is EXTREMELY high, given investors tend not to run together.” They also questioned the wisdom of limiting nominating parties to one nominee, since “a single director can too easily be ignored by others on the board.” The proposal at HRB is similar in every respect to those at FRX and MDT but sets an overall cap of 2 nominations (24% of board) each for 1% holder groups and 50 shareowner groups. Therefore, even in theory, no more than 48% of a board could be replaced under this varient of the USPX model proposal.
There is some consensus among shareowners that proxy access should not be used to pursue a “change of control.” Rule 14a-11 achieved this with the blunt mechanism of capping proxy access nominations at 25% of a board’s seats. This has a devastating consequence, since it guarantees existing entrenched boards will retain a supermajority.
As mentioned above, USPX model proposals address change of control concerns by limiting each party to one nominee and prohibiting coordination among nominating parties. Under the USPX model proposal, no single party can take over the board through our proxy access proposal, so there can be no change of control in the traditional sense of a proxy contest with a separate solicitation where one party assumes dominance after winning the vote.
It is conceivable that if there are enough parties nominating candidates at companies adopting the USPX proxy access model with no cap (such as the proposals FRX and MDT), and those candidates win, such situations might be treated as changes of control by corporations and state law.
The original USPX model proposal had a provision that such elections would not be treated by the company as a change of control, since the non-coordinating provision would preclude capture of the board by any single party, other than the existing board. However, commission staff deemed that provision a separate proposal, so we removed it from the model proposal. At companies that adopt the model proposal, we will likely submit follow-on proposals a few years later to address the issue.
We understand that corporations may have contractual obligations that treat elections where a majority of an existing board is removed as a change of control, even when no single coordinated party captures the board. Such provisions might appear in employment contracts, bond indenture or trust documents of pension plans or elsewhere. Obviously, such contractual obligations would have to be honored. However, the follow-on proposal would address such provisions going forward by, perhaps, requiring that as employment contracts are renegotiated, they exclude such provisions when a majority of directors are replace through the uncoordinated actions of multiple parties.
These are problems that lie far in the future. Under even a best-case scenario, we cannot imagine more than two or three proxy access nominees being elected at any board election under USPX model provisions for years to come.
While we share the former SEC official’s concern that a single director can easily be isolated, our approach depends on more than one shareowner or group taking action at any one company in order to be most effective. Our approach favors nominations from long-term shareowners who believe directors from different backgrounds and focused skill sets are critical if boards are to avoid “group think,” which played a significant role in the financial crisis.
Too many proxy contests are won by either entrenched boards, who then continue bad corporate governance practices, or by corporate raiders looking for a quick bump in sock price, so they can sell and move on to their next conquest. Instead of board elections being contests of control by those seeking to dominate, we aim to create conditions where directors bring a diversity of skills and perspectives, cooperating with each other to create more dynamic boards.
USPX model proposals give voice both to median and small institutional investors, as well as sophisticated groups of retail shareowners. Widespread implementation could move corporate elections to become more meaningful events with issues more fully debated and more qualified/diverse candidates elected. Diversified boards offer the best chance not only for individual firms (see the recent research from Credit Suisse, Gender Diversity and Corporate Performance, showing boards with women performed 17% better) but also for society if we are to tackle monumental issues like climate change.
What companies could benefit from proxy access? Chris Zook and James Allen, leaders of Bain & Company’s Strategy practice, calculate that “only about 9% of global companies have been able to achieve more than a modest level of sustained and profitable growth over the course of the last decade.” (Repeatability: Build Enduring Businesses for a World of Constant Change) That’s a very low bar. Proxy access provisions would provide good insurance at any company.
Why did we target FRX, MDT and HRB? The companies are characterized by poor corporate governance but it is not so bad that they cannot muddle through for several more years. The two-year time frame of proxy access proposals is inappropriate for companies already in crisis. The targeted firms have problems but they are not in anything approaching free-fall. Proxy access could make a real difference before substantial value is lost both by putting the feet of existing directors to the fire and by posing the real possibility that new directors could be nominated and elected next year or in future years. When shareowner nominees are put forth, hopefully by multiple parties, that is when the real debates begin.
Forest Labs (FRX)
- Underperformed peers (NYSE Arca Pharmaceuticals) over last 5 years by approximately 20%.
- Annual bonuses discretionary and long-term equity pay was time-vested – not performance-based.
- Shareowners are denied the right to call a special meeting
- 3 directors were age 71 to 83 – succession-planning concern.
- 3 directors owned no stock – lack of incentive concern
- 35% shares voted down say-on-pay last year
- 4 directors had long tenure respectively of 14, 14, 35 and 48 years
- 3 directors were insiders or inside-related
- CEO & Chairman positions are combined
Of the three firms facing USPX model proxy access proposals, the governance issues at FRX have been debated the most, primarily due to a campaign by activist Carl Ichan to replace four directors. We share many Ichan’s concerns, such as director independence, cronyism, legal issues, and succession planning. We are fortunate that GMI Ratings made their analysis available to the public. See GMI Ratings Governance Issue | Forest Laboratories, Inc.
- Underperformed peers (NYSE Healthcare) over last 5 years by approximately 30%.
- Recent legal settlements with DOJ and shareowners – risky practices
- 4 directors held no stock, and do not face same risk as owners.
- 4 directors received negative votes ranging from 9.8% to 36% in recent elections
- 1 director served on 4 boards, another on 5. MDT doesn’t have their full attention.
- 3 “outside” directors have served 12, 14, & 22 years. Independence concern.
- CEO & Chairman positions are combined. Independence concern.
H&R Block (HRB)
- Underperformed competitor Intuit (INTU) over last 5 years by approximately 120%.
- Rated “high concern” on executive pay
- Short-term focus of incentive compensation.
- Combined with tax gross-ups, executive pay practices not aligned with shareholder interest
- Unanimous written consent required without a meeting
- Special meetings only with 50%+
- Supermajority vote requirement (66.67%) to approve mergers
- 4 directors held no stock (alignment)
- 80% shares required to amend bylaws
The companies we selected for proxy access are not in death spirals. Each is valuable but each has significant performance and governance issues. It is far better to have proxy access in place, ready to go when needed, than it is to wait for them to possibly become basket cases. Proxy access will provide little insurance at each company that boards will be responsive to shareowners.
The first clause of the Magna Carta guaranteed “freedom of elections” to clerical offices of the English church to prevent the king from making appointments and siphoning off church revenues. Proxy access could have a similar impact on the governance of corporations. As direct owners, retail investors are incentivized to work to guarantee free elections at our companies and we should not be left out of the nominating process, neither should mediam and small funds.
The SEC Commission’s stated intent for proxy access was to create a process that functions, as nearly as possible, as a replacement for an actual, in-person gathering of security holders, thus enabling them ‘‘to control the corporation as effectively as they might have by attending a shareholder meeting.’’
The proposals that will soon come to a vote at FRX, MDT and HRB, if enacted, will ensure that long-term shareowners have a reasonable, but not necessarily easy, means for including board nominations in the proxy materials those corporations distribute. They would also encourage an important theoretical shift for shareowners and boards of directors away from single party contests of control to communities of dialogue and cooperation, where diversity of background, skill-sets and thought are welcome. The added DNA could revitalize companies, making them not only more profitable but with values more in tune with a creating and maintaining a salubrious environment. The key to more democratic, more accountable corporate governance is right in front of us. Let’s hope shareowners decide to use it by voting in favor of proxy access at FRX, MDT and HRB.