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E-MailThis post by Stanley Keller of Edwards Angell Palmer & Dodge LLP is based on an article in the Massachusetts Lawyers’ Weekly.
Classified boards, where directors serve staggered terms (typically for three years with one-third of the directors elected each year), has been a recognized corporate governance alternative for a long time. The laws of every state permit corporations to structure their boards in this way. In fact, it is the default rule in Massachusetts for publicly traded companies unless the board of directors or the shareholders elects to opt out.
This should sound familiar because it is the way members of the United States Senate are elected, with Senators serving six-year terms and one third elected in each two-year election cycle. The Constitution’s Framers understood the stabilizing effect of this arrangement, which they believed would ensure continuity and allow Senators to take responsibility for measures over time and make them independent of rapid swings in public opinion. For more than 200 years, this policy has served the nation well. It is a policy that also has served corporations and their investors well when they have chosen to use it.
Yet undoing this corporate governance system is precisely what is now being proposed – ironically, by two Senators. They want to prohibit for stock exchange traded companies the very governance system under which they serve. They claim that classified boards of directors are part of what they call a “widespread failure of corporate governance” that was one of the “central causes of the financial and economic crises that the United States faces.”
Such a claim ought to be accompanied by hard evidence – but it is not, and with good reason. There is no evidence suggesting that classified boards were in any way a contributing factor to the ongoing economic crisis. To the contrary, companies involved in recent financial meltdowns whose boards were not classified include AIG, Washington Mutual, Bear Stearns, Citigroup, Bank of America, Lehman Brothers and General Motors. Going back to the 2001-era financial frauds, Enron, WorldCom, Tyco and HealthSouth all had unclassified boards. If anything, then, good policy and common sense suggest that we would want to retain the alternative of classified boards, not prohibit them.
As is the case with the U.S. Senate, too-frequent elections, rather than staggered terms of office, are what can undermine desired continuity and the ability to govern for the long term.
The key point is that we should not have a one-size fits all mandate for corporate governance. Rather, investor choice ought to be retained, not discarded. Certainly, corporations and their shareholders should be free to decide whether or not they want a classified board and whether the governance structure that is fine for the United States Senate works for them. Indeed, the current system is working as we would want it to, with individual choice at individual companies exercised freely – less than 40% of the S&P 500 companies have classified boards and, during the last six years, more than 200 companies have successfully put to a shareholder vote proposals to declassify their boards of directors.
In short, there is simply no evidence that classified boards bear any of the blame for the recent economic crisis. The laws of all states allow for classified boards, with Massachusetts mandating it, and there is the ability for investors to make a choice on the matter. In these circumstances, the current legislative proposal to preempt state laws and do away with classified boards is an inadvisable step back from investor choice, and toward the imposition of an unjustified one size fits all federal governance rule that will do nothing to prevent future financial breakdowns.
One Comment
This article is a classic demonstration of disingenuous argument. The point of corporate governance reform is to reduce the risk that those in de facto control of corporations can abuse their powers to the detriment of shareholders. The aftermath of the Crash of 2008 has been the occasion for attempts at reform. If Congress finally gets around to examining risky corporate practices, there is no good reason why it should be limited to those directly implicated in the Crash.
Classified boards serve primarily as an anti-takeover device. Having to re-elect the whole board rather than one third of it does not further strain the resources of a corporation or consume more of the directors’ valuable time. But it does make it possible for an outsider to replace a majority of the board. It also makes it more likely that shareholders may demonstrate their displeasure with a particular director’s performance if the whole board is up for re-election each year. Without directors submitting their names to the shareholders for re-election, there is virtually no mechanism by which shareholders can express their concerns regarding how the company is being run.
The analogy with the U.S. Senate is similarly misplaced. The Constitution is concerned with creating a stable government. Since there is no political entity above a national government, stability has to be a prime concern; this is less true of a corporation. Moreover, the Constitution provides for a co-equal House of Representatives to be elected every two years—there is no analogous body in a corporation. And public elections are far more disruptive than the election of directors to a corporation.
The author’s strained arguments are indicative of a fundamental weakness in the position of the defenders of directorial autonomy. They want the board and management of a company to be immune from any outside disruption. Indeed such a system has been more stable; the problem is that it has permitted many companies to proceed blithely along the road to self-destruction. Good governance is about avoiding unnecessary risk. It should not be sacrificed so that directors can enjoy a good snooze in the boardroom.