Governance Reform: Electing Directors Through Shareholder
Diane K. Schooley, Celia Renner, and Mary Allen
2005 - Shareholders submitted a record number of corporate
governance and executive compensation proposals during the
2003 proxy season. This increase in shareholder activism
is likely due to mistrust and skepticism in the wake of
recent corporate scandals. Stockholders have long understood
that their boards of directors represent them as the owners
of the company, but frauds such as those at Tyco and Enron
indicate that boards are not living up to those responsibilities.
In an attempt to make the boards aware of and more responsive
to their interests, shareholders are increasingly submitting
proposals for the proxy solicitation and annual meeting.
an unusual move, the SEC is considering director election
reform to increase shareholder confidence in the corporate
governance process. The SEC has proposed allowing larger
shareholders, under particular circumstances, to nominate
members of the board of directors. Reaction to the SEC’s
proxy-access initiative has ranged from strong support by
shareholder-rights activists to equally strong opposition
by corporate America.
Proposals and Sponsors
proposal activity is increasing; the number of proposals
submitted in 2003 was 668, up 87% from 358 in 2000, according
to the Wall Street Journal. Topics range from corporate
governance to environmental and social issues. For example,
Wal-Mart management included several shareholder proposals
on its 2003 annual shareholders’ meeting agenda. Four
dealt with corporate governance (including one on officers’
deferred compensation), one with genetically engineered
food, and another with labor organization standards (“Beware
of Shareholder Wielding Issues,” Tim Craig, DSN
Retailing Today, June 23, 2003).
of the 668 shareholder proposals submitted during 2003,
423 were corporate governance proposals, a significantly
greater number than the 273 voted upon the previous year.
The 423 corporate governance proposals submitted during
the 2003 proxy season are categorized in Exhibit
1, which uses data collected from DEF 14-a proxy statements
filed with Edgar by companies listed in Georgeson’s
Annual Corporate Governance Review (2003).
40% of the 423 corporate governance proposals were related
to executive compensation. Issues included whether to award
stock options and, if so, when to expense them. Stock options
are often issued with the aim of aligning executives’
interests with those of the shareholders. The recent use
of stock options, however, has taken executive compensation
to such absurdly high levels in the minds of some that they
think that the executives are overpaid, a situation that
is not in the shareholders’ best interests.
of the proposals were board-related, some of them calling
for separation of the CEO and board chairman positions.
Others required that a majority of the board be independent.
Board members that are not independent of the company may
profit, for example, by promoting business relationships
with any affiliated company. Such business relationships
may not serve the other shareholders well.
of the proposals dealt with governance issues such as poison
pills and board declassification. Poison pills are provisions
by which corporations reduce the chance of hostile takeover
by making their stock less attractive. They do not necessarily
work to shareholders’ advantage, because there may
be situations where a takeover is in the shareholders’
best interest. Theoretically, rescinding the poison pills
promotes better corporate governance. Classified boards
are those in which members have staggered terms. While staggered
boards create continuity, they may hamper the corporate
governance process by impeding the removal of ineffective
individual shareholders have historically been the primary
sponsors of corporate governance proposals, in 2003 labor
unions sponsored almost half of all these types of resolutions.
Institutional investors, such as mutual funds and pension
plans, which were responsible for most of the corporate
governance proposals during the 1980s, have greatly reduced
their sponsorship activity. For example, public pension
funds sponsored only 2% of governance proposals, down from
6% in 2002. Investment managers and mutual funds submitted
just fewer than 4% of proposals in 2003.
14a-8 (first enacted in 1976 and last amended in 1998),
which falls under the 1934 Securities Exchange Act, details
the formal process through which shareholders can include
proposals in companies’ proxy statements. A shareholder
eligible to submit a proposal must have continuously held
at least $2,000 in market value, or 1% of the company’s
voting stock, for at least one year at the date of proposal
submission and must continue to hold the stock through the
meeting date. Each shareholder may tender only one proposal
for a particular meeting. Proposals may not exceed 500 words
and must be submitted by a specified date.
of a proposal does not guarantee its inclusion in the company’s
proxy statement. Companies may exclude shareholder proposals
if the sponsor does not meet eligibility requirements or
does not follow the correct procedures. Other excludable
proposals are those that violate proxy rules, relate to
operations accounting for less than 5% of a company’s
total assets, relate to the company’s ordinary business
operations, relate to an election for membership on the
company’s board of directors, or specify amounts of
cash or stock dividends. In addition, proposals may be excluded
if they violate state law.
a company wants to exclude proposals for other procedural
or substantive reasons, it must file a “no-action
letter request” with the SEC to determine excludability.
If a proposal is listed on the proxy statement, management
states its position. In most cases, management recommends
voting against a shareholder proposal. Even if a proposal
is passed by majority vote, the board has the option to
not implement it.
give shareholders a stronger voice, the SEC has proposed
a proxy-access initiative that would allow shareholders
to nominate members to the board of directors. In mid-October
2003 the SEC made available for public comment its proposed
revision of Section 14 of the Securities Exchange Act. By
the end of the comment period, the SEC had received over
13,000 comments, the vast majority of which supported the
proposal. This may be the largest number of comments ever
received on a single proposed rule (Shareholder Access
to the Corporate Ballot, Lucian Bebchuk, ed., Harvard
University Press, 2004). Interestingly, as of this writing,
the SEC has taken no action on this proposed revision.
some state laws allow shareholders to affect board composition
by conducting an election contest, recommending a candidate
to the company’s nominating committee, or nominating
a candidate at an annual meeting. Unfortunately, shareholders
rarely find these options to be satisfactory. The considerable
expense of conducting an election contest, including the
cost of producing the proxy materials, is borne by the nominator.
Additionally, shareholders often find recommending a candidate
to the nominating committee to be ineffective. A candidate
nominated at the annual meeting is difficult to elect, because
most shareholders vote by proxy before the meeting. Because
of the difficulty for shareholders to directly nominate
and elect board candidates, most nominations originate from
the current board of directors. A nominee need only receive
a plurality of the votes; thus, directors may be elected
by receiving only a handful of votes.
are increasingly expressing their dissatisfaction with the
plurality vote by withholding votes for board nominees.
Shareholder vote-withholding campaigns would effectively
weaken the plurality system if the SEC proxy-access initiative
is passed. The SEC’s proxy-access initiative allows
shareholders to nominate directors if proof exists that
shareholders’ concerns are being ignored. To that
end, shareholders would obtain the right to nominate board
members after one of two triggering events occurs: 35% of
the voters fail to support a company’s nominee to
the board, or 50% of voters approve a shareholder proposal
to allow a shareholder-nominated candidate on the company
proxy. Given the triggering events, no board-nominated director
would likely be elected with a plurality of less than 35%.
This rule would better ensure that shareholders generally
support the board candidate elected.
incidence of the triggering events permits a shareholder
or group of shareholders that owns at least 5% of voting
shares to nominate directors. The company would have to
include the names of shareholder-nominated board candidates
on proxy statements for as long as two years, if the nominee
is not elected in the first year. The number of nominations
allowed would depend upon the size of the board. One proxy
nomination is allowed for boards composed of eight or fewer
members. Two shareholder candidates may be nominated for
boards made up of nine to 19 members. For boards with 20
or more members, three nominations are permitted. If more
nominations were made than allowed above, the nominees of
the largest shareholders or groups of shareholders would
be included on the ballot.
for and Against
2 outlines the arguments for and against the SEC proxy-access
initiative. Those in favor argue that the mechanisms currently
in place, such as nonbinding shareholder resolutions and
traditional proxy fights, are ineffective. The new rules
would allow for more-diversified boardrooms, give shareholders
a stronger voice in decision making, and create a more open
proponents agree that restrictions are necessary in order
to inhibit shareholder nominations from replacing the long-established
proxy contest as a means of gaining control of a board of
directors. Advocates of shareholder nominations tend, however,
to disagree about the details, such as the triggering events,
the minimum ownership needed to make a nomination, and the
limitations on the number of nominees. A coalition of the
nation’s largest pension fund managers argued that
the SEC’s initiative does not provide shareholders
meaningful access (Sarah Mulholland, “SEC to Grant
Voting Power to Shareholders,” Investment Management
Weekly, October 13, 2003). The
organization contended that the triggering mechanisms are
sufficiently restrictive to allow for a lower than 5% ownership
such as the Business Roundtable (made up of chief executives
of large corporations) and the United States Chamber of
Commerce oppose the SEC’s initiative. They make three
basic arguments against the proposal. First, opponents say
that the changes mandated by the Sarbanes-Oxley Act of 2002
(SOA) should be given an opportunity to take effect before
the SEC institutes more regulations. SOA provides many reforms
that should strengthen the corporate governance process,
including the establishment of the Public Company Accounting
Oversight Board (PCAOB) to oversee audits of public companies.
In addition, there are provisions for audit independence,
including restrictions on the types of nonaudit services
that the auditor can provide, and a requirement for audit
partner rotation every five years. The
SEC has also acted to ensure that members of boards are
independent of company management. The New York Stock Exchange
(NYSE), under the SEC’s guidance, has enacted standards
that require listing companies to have corporate boards
composed of a majority of independent members. In addition,
the NYSE requires that three committees formed from the
board members (audit, nominating, and compensation) be composed
entirely of independent directors.
opponents argue that the presence of shareholder-nominated
board members could create adversarial relationships that
would affect collegiality among board members.
they fear that special-interest groups will seize the election
process. Groups or individuals may use the proposal process
to advance their own agendas, which could include socially
responsible or environmental causes, that do not seek to
maximize shareholder return. Using the process outlined
in the SEC’s proposal, an organization interested
in mitigating global warming could nominate and elect a
board member who would work toward instituting a policy
that the company purchase supplies only from certain environment-friendly
providers, regardless of price. Most shareholders may be
unaware that the corporation’s profitability is suffering
at the expense of another agenda.
are increasingly concerned about corporate governance. They
have become involved in the proxy process by making proposals
on a wide range of topics. The SEC has proposed a reform
to corporate governance rules to allow shareholders to nominate
individuals for election to the board.
SEC’s proxy-access initiative has received an enormous
amount of attention. The goal of allowing shareholder nominations
is to increase the responsiveness of the board to shareowners.
However, regulators must strike a balance between giving
shareholders access to nominations and ensuring that boards
provide effective oversight and guidance to company management.
surprising to some, the proxy-access initiative was kept
on the back burner before the 2004 election. As two new
commissioners settle into their positions and address the
multitude of issues currently facing the SEC, the fate of
the initiative remains uncertain.
K. Schooley, PhD, is a professor of finance; Celia
Renner, PhD, is an associate professor of accounting;
and Mary Allen, PhD, is an associate professor
of accounting, all at Boise State University, Boise, Idaho.