Real elections are coming to corporate America.
Shareholders could soon have what has been called the holy grail of corporate governance: access to the corporate proxy process to nominate directors to boards, creating competitive elections for seats. The Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, signed by President Barack Obama July 21, authorized the SEC to enable proxy access, among its other corporate governance provisions.
The proxy-voting system faces radical change in the coming months. Proxy access, coupled with the SEC rule effective this year prohibiting brokers from voting uninstructed shares for candidates to boards, means elections for directors will now be determined only by shareholders who vote.
What effect the elections will have on corporate governance will depend on the involvement of pension funds and other institutional investors.
But to complete the overhaul of corporate elections, the SEC will also have to address the practice of so-called “empty voting.”
Empty voting separates, or decouples, the voting rights from the economic interest, allowing investors to have more voting power than their economic interest justifies. This can occur when investors hedge away economic risk. Such investors could have a negative economic interest, where they have more motivation for a stock's price to fall than rise.
This threatens the foundation of corporate governance: that shareholders possess both voting rights and economic interest, and use those rights to protect those interests.
“It is a source of some concern that elections of directors and other important corporate actions, such as business combinations, might be decided by persons who could have the incentive to elect unqualified directors or block actions that are in the interests of the shareholders as a whole,” the SEC notes in the concept release on ways to overhaul the proxy-voting system.
Institutional investors should be ready for proxy access. Many of them have fought for almost a decade at individual corporations and at the SEC for access, and in the past year, in Congress. Proxy access is the cornerstone of corporate governance and accountability of directors and management. The SEC proposed different access rules in 2003, 2007 and 2009.
Now it will have to propose a rule again.
Institutional shareholders have to prepare to nominate individuals to represent the interest of shareholders more effectively than directors they would replace.
Are pension funds and other institutional investors ready for it?
The power likely will require dedication of more resources by pension funds and other shareholders to corporate governance activity than they have expended in the past. Their influence will depend on the extent to which they make such a commitment.
In anticipation of proxy access, the California Public Employees' Retirement System is recruiting executives for a slate to have ready to nominate as directors to corporate boards.
Much of the impact of access will depend on actions by the SEC to implement the new law.
The SEC will have to adopt an ownership threshold that will qualify shareholders, or groups of shareholders, to make nominations. In previous proposals, 3% to 5% has been suggested. In addition, it likely will limit shareholder nominations to only a few seats so as not to cause a change in control. The SEC has studied this issue over the past eight years, in each instance proposing a different set of conditions, but never adopting the proposals.
The legislation doesn't set a timeframe for the SEC to act on proxy access, so it need not rush its decision.
A final rule, too, will depend on how much resistance comes from the U.S. Chamber of Commerce and the Business Roundtable. They will likely seek to toughen eligibility requirements and limit the number of seats that would be open for contest at any corporation in any year. One of their concerns is that public employee and union pension funds will use proxy access to push a pro-union agenda not necessarily in the best interests of the majority of shareholders, and that other interest groups might push narrow interests.
Officials at pension funds and other activists groups believe few companies in any year will be subject to shareholder nominations through the corporate proxy process, and that challenges will occur only in egregious circumstances. But having the power will strengthen pension fund influence on corporate nominees through the threat of nominations and campaigns, making corporate boards more willing to negotiate compromises.
Even without access, shareholders already have the power to nominate directors in separate materials at their own expense. The SEC's existing rule that allows soliciting shareholders to use the Internet eases the cost of a proxy contest, and allows more latitude. But if shareholders take advantage of access, they might become more ambitious and move to use the proxy contest mechanism to bring about more boardroom change.
Shareholders soon will likely have greater power than ever to influence corporate governance. No longer can they lament a lack of tools. But they can only bring about change if they use them.