Shareholders Get a Louder Voice As Companies Become More Democratic

Publicly traded companies in the U.S. provide their shareholders with a voice on who runs the company. But corporate governance is not like a political democracy where voters usually choose between two candidates. The company's slate of directors is typically the only one presented to its shareholders who have a limited choice - vote for the company's slate or withhold their votes.

Recently, however, the director election process has begun to become more democratic. This is happening gradually on an individual company basis under Delaware law, and not by a federal rule applicable to all publicly traded companies.

In the United States, the traditional rule is that a company's current board nominates its slate of directors for the next annual election. Then the company foots the bill to prepare and solicit proxies for this slate from all the company's shareholders, typically mailing them ballots.

Although shareholders may nominate their own candidate to be a director, they must bear the entire expense of preparing and distributing proxy materials to all the company's shareholders. For large publicly traded companies, this expense is so high that it effectively prevents most shareholders from making director nominations (unless someone is waging a proxy fight for control).

In an effort to help even the playing field, the Securities and Exchange Commission (SEC) in 2010 adopted the "proxy access" rule, which would have allowed certain shareholders to nominate less than a majority of a company's directors. Then these shareholder nominees would have to be included in the company's proxy materials along with its slate of proposed directors. However, the SEC rule was struck down by the DC Court of Appeals on procedural grounds.

While the SEC has not proposed a revised proxy access rule, Delaware law now permits companies chartered in that state to adopt a bylaw authorizing shareholder nominations (the charters of most large American companies are registered in Delaware because of its favorable corporate laws). Thus, Delaware law now provides a mechanism for a large company to allow proxy access under conditions acceptable to that company and its shareholders.

On February 6 of this year, General Electric led the way by adopting a bylaw allowing shareholders to nominate a few directors if these shareholders held at least 3 percent of the company's voting shares for at least three years. Given the size and prominence of General Electric, it is a signal event - many companies should follow suit.

More broadly, this 3+3 approach of General Electric is being advocated by officials at New York City's
pension plan (NYCers), which holds over $160 billion in assets. NYCers has submitted "advisory" shareholder resolutions to 75 public companies in which it holds shares. While these resolutions are not binding on the company, they carry significant weight if approved by a substantial majority of voting shareholders.

In response, Whole Foods has proposed to allow director nominations by shareholders owning at least 9 percent of their shares for at least 5 years. After a series of complex legal moves, the SEC has declined to permit Whole Foods to exclude the 3+3 proposal because the company is making a different proposal on the same subject.

The SEC's non-decision, together with General Electric's dramatic move, reopens the debate on the pros and cons of proxy access. Here are some of the key arguments and counterarguments.

· Company officials worry that proxy access will lead to special interest groups hijacking boards for their own purposes. But shareholder advocates say that the hijacking scenario is unlikely because of the 3 percent ownership threshold and the need to garner over 50 percent of shareholder votes for their nominees.

· Company officials believe that shareholders would be confused if there were more than one set of directors nominated in the same proxy materials. But shareholder advocates can show how proxy materials can be easily understood by clearly separating company and shareholder nominees.

· Shareholder advocates believe that proxy access is likely to increase constructive engagement between company directors and their large institutional shareholders. But company officials are concerned that proxy access will disrupt the election process and lead to dissension among directors.

· Shareholder advocates point out that in countries like Australia and United Kingdom that do have proxy access, it is used sparingly by large shareholders. But company officials emphasize that the U.S. is a much more adversarial society, with more aggressive tactics by activist hedge funds and others.

We cannot resolve these arguments and counterarguments on proxy access in the abstract. Instead, through actions of companies like General Electric and shareholders like the New York City pension plan, we will be able to examine the actual effects of various methods and conditions for shareholders to nominate directors. Let's see what happens on the ground.