How Recent Proxy Changes Will Affect the Corporate Landscape

This week we bring you the second interview our “The Altman Interview” series where we speak with top experts and thought-leaders having an impact on corporate governance. Our interview with attorney Holly J. Gregory covers 10 questions on hot button issues for 2010.

Ms. Gregory is a well-known and highly respected figure in the world of corporate governance. As a partner at Weil, Gotshal & Manges, Ms. Gregory counsels corporate directors, executives and investors on the full range of governance issues and best practices. She played a key role in drafting the OECD Principles of Corporate Governance and advised the Internal Market Directorate of the European Commission on corporate governance regulation. Ms. Gregory has also served as an advisor to the World Bank and the joint OECD/World Bank Global Corporate Governance Forum on governance policy for developing and emerging markets.

In addition to her legal practice, Ms. Gregory has helped organize governance-related programs for the SEC, OECD, World Bank, Yale’s Millstein Center for Corporate Governance and Performance, Transparency International and Columbia University School of Law’s Institutional Investor Project.

Question 1

FH Byrd: Of all the proposed governance changes on the horizon which one, in your opinion, if adopted, will have the most impact on corporations?

Holly Gregory: This is difficult to predict given the number and range of governance reform proposals under discussion and the fact that if implemented the reforms will interact with recent rule changes concerning broker voting in the election of directors and new SEC rule interpretations that broaden shareholder power to bring advisory proposals on matters of CEO succession and risk oversight. But if I must identify one reform that threatens to work fundamental change, it is the grant to certain shareholders of direct access to the proxy for the nomination of competing candidates for director. Proxy access removes the gating mechanism of cost from a shareholder’s decision to put forward candidates to compete for board seats with the slate proposed by the board. Certain large shareholders or groups of shareholders who have held their stock for a year will be able to include their own candidates for up to 25% of the board in the company’s proxy at company expense. Greatly reducing the cost of mounting a campaign to elect a director outside of the board’s own proposed slate is designed to result in more contests for board seats. According to proponents, this is necessary to make directors more accountable to shareholders. What we will have to see play out is whether more frequent contests for board seats results in positive gains from heightened accountability. Some believe that boards are already under an unhealthy degree of shareholder pressure for immediate and ever rising share price gains. (See “Overcoming Short-termism”). Increasing the threat of election contests is not likely to reduce those pressures and improve board focus on the long-term performance that is essential to sustainable economic growth. This is especially so given the increasing number of elections that are held on an annual basis (and Senator Schumer has introduced a bill in Congress that would mandate annual elections for all directors by prohibiting staggered boards). Commentary to the SEC on the proxy access rule proposal has raised legitimate concerns about the impact of proxy access on the quality of board composition, the tenor of board deliberations and the board’s ability to reach consensus after full and constructive debate. The potential for more frequent director contests may discourage busy executives at the tops of their fields from serving on boards, and greater director turnover may undermine the quality of board decisions. New directors need time to develop the company-specific knowledge required for effective decision making. Time is also needed to develop the trust among directors that allows robust discussion, constructive debate and healthy disagreement to be followed by resolution and consensus. Greater director turnover may make it more challenging for boards to develop the appropriate culture of objectivity and constructive criticism that are the hallmarks of effective oversight of management. I hope that it will turn out that these concerns are overstated or unfounded.

Question 2

FH Byrd: Of the various stakeholders involved in U.S. corporate governance, who do you think will most likely benefit from proxy access, if adopted?

Holly Gregory: If the concerns that I’ve described are realized, proxy access will not be the panacea that the regulators intend, and shareholders as a whole will not be better off. In that scenario the primary beneficiaries will be shareholders who use proxy access to forward a specific objective or strategy that is not broadly shared by the entire shareholding body. Shareholders can no longer be thought of as powerless individuals with a common interest in corporate long-term performance that overrides other interests. The percentage of shares in the hands of institutional investors has grown considerably over the last 25 years, and these institutions and their interests are as diverse as the institutions are powerful. Public, private and union pension funds, mutual funds, private investment funds (including hedge funds), insurance companies, banks, endowments, and sovereign wealth funds are subject to varying levels of regulation, have distinct investment horizons and strategies, and exhibit varying levels of interest in the governance of portfolio companies. (What many institutions tend to have in common is their status as investment intermediaries who invest for the benefit of others and as a result face potential conflicts in managing fund assets.) Increasing diversity among shareholders brings with it heightened potential for divergent interests; this suggests a need for greater shareholder power to be accompanied with requirements for great transparency about the motives and interests of the shareholders who seek to exert the power.

Question 3

FH Byrd: With the likelihood of some form of Say on Pay, how do you think corporations should be preparing?

Holly Gregory: Corporations should be reassessing how they engage with their shareholders. It is important for boards and managers to understand who their shareholders are and what issues are important to them. In a say on pay and proxy access world, the ability to communicate clearly and effectively with shareholders about strategies and objectives — and specifically about how compensation plans are designed to create incentives for achieving strategic objectives — will differentiate companies and be associated with greater levels of “investor peace” and board and management stability. This is the time for boards and management teams to be gearing up and thinking about shareholder relations in new, more creative and more engaged ways. Improved engagement with shareholders is the best hope companies have of avoiding or mitigating the concerns addressed in my answers to the preceding questions.

Question 4

FH Byrd: With the loss of the broker vote, do you feel there will be more “vote no campaigns” in 2010?

Holly Gregory: Whether or not we see a rise in the number of “vote no campaigns” in 2010, it is a fair prediction that such campaigns will be more successful in a world in which brokers are not allowed to vote uninstructed shares in the election of directors.

Question 5

FH Byrd: Do you think HealthSouth’s decision to allow reimbursement of proxy contest expenses for dissidents (earning 40% or more of the vote) will lead other boards/companies to take similar action?

Holly Gregory: This kind of “private ordering” has significant value because it reflects board judgment about how to accommodate legitimate shareholder concerns in a company specific manner. Encouraging companies and shareholders to reach their own solutions is far preferable to the imposition of strict mandates. Recent approaches to say on pay by Microsoft (which will now give shareholders an advisory vote on executive compensation every three years) and Prudential ( say on pay every two years) further reflect the private ordering approach, and provide examples of how these concepts can be distinctly tailored. If companies believed that adopting reimbursement provisions would satisfy the SEC as a replacement for mandated proxy access, I predict many companies would seriously consider adopting it.

Question 6

FH Byrd: Excise tax gross-ups received a lot of attention in 2009, primarily due to RiskMetrics taking a harder stance on them. Do you think there are any other pay practices that corporations should be leery of?

Holly Gregory: Compensation committees and boards need to develop greater understanding of and sensitivity to the concerns about executive compensation that have resulted in such intense popular and political backlash. Many of these issues are not new, but at times boards and managements have exhibited tone-deafness or an unwillingness to set forth in plain and rational terms the legitimate justifications for certain pay practices. It is no longer enough to simply cite competition and retention concerns to justify large packages and grants.

Question 7

FH Byrd: Senator Schumer’s legislation proposes mandatory risk committees for U.S. corporations. Should boards be getting in front of this by establishing risk committees or reviewing their present risk mitigation and oversight structure?

Holly Gregory: The idea that independent risk committees of the board should be mandated for every public company is one reform idea that simply defies logic. Risk committees may provide efficient oversight structures for some boards but there is no reason to think that they are a universal solution. Only about 7% of public companies currently have risk committees — and the industry in which they are most prevalent is financial services. There is no evidence that I’m aware of to show that financial services companies are better than other companies with respect to risk management or the oversight of risk management. Indeed, the anecdotal evidence appears to draw into question the ability of the financial services industry to manage certain risks. So it is difficult to understand why the committee structure relied on in that industry should be mandated for all other public companies. Undoubtedly boards need to spend considerable energy and attention on understanding risk and the processes management has in place to identify and manage risk, since this is fundamental to the board’s ability to provide strategic guidance. The National Association of Corporate Directors’ recent Blue Ribbon Commission Report on Risk Governance: Balancing Risk and Reward, reflects a private sector effort to raise the level of understanding among directors about their responsibilities for risk oversight. In all of this, however, I think it is especially important that we recognize the growing gap between expectations about what boards can do and the reality of their limitations. Boards are neither positioned nor expected by the law to identify company-specific risks that executives have missed, let alone system-wide risks that regulators and central banks have missed.

Question 8

FH Byrd: In this environment of changing shareholder influence and pending reforms, do you have any concerns that companies considering adopting a majority voting standard may be voluntarily impeding the ability to have their directors elected?

Holly Gregory: The majority of S&P 500 companies have already adopted some form of majority voting, whether through actual charter or bylaw amendments or policies that require directors to tender their resignations if they fail to receive more “for” votes than “withhold” votes. There is a certain amount of nervousness about how all the reforms will play out in a majority vote system, and it appears that the momentum for companies to adopt majority voting has slowed. I think many companies are now adopting a “wait and see” posture given the high level of uncertainty in the current regulatory and legislative reform environment.

Question 9

FH Byrd: There has been a recent uptick in the amount of criticism leveled at proxy advisory firms, in particular RiskMetrics. Do you feel this criticism is well-founded?

Holly Gregory: There are legitimate concerns about the power of certain of the proxy advisory firms and about their capacity to provide the kind of nuanced company-specific analysis that will only become more important to our economic system as shareholders gain power. As shareholders gain influence on the actual composition of boards, the recommendations that proxy advisors make about voting in director elections gain importance. In particular, the propensity of certain proxy advisors to recommend against directors for any single item on a long list of one-size-fits-all governance no-no’s, rather than on a broader view of the director’s skills and qualifications and contributions, needs to be adjusted in the new world of heightened shareholder influence. Director elections will be too important to use as vehicles to protest what in the scheme of things are often relatively minor decisions the board makes about how it can best govern.

Question 10

FH Byrd: You recently chaired an ABA Task Force on the distinct shareholder and board roles. Will the reforms on the table change the roles of shareholders and boards in any meaningful way?

Holly Gregory: I think that the reform proposals if enacted in whole certainly will increase shareholder power, and will change the balance of shareholder and board power. Whether the roles change in meaningful ways will depend on how shareholders use their new power in the real world and how their use of their power interacts with other forces (such as the power of proxy advisors and their propensity to recommend protest votes against directors). At the extreme, we may see directors coerced to abandon their own judgment in certain circumstances to buy peace with a small but powerful and vocal set of shareholders. That would be unfortunate. As our Task Force Report emphasized, there is value to our economic system in allocating to boards the power and discretion to manage and direct the affairs of the corporation, while enabling shareholders to participate as passive investors with the benefit of limited liability for the actions of the corporation and the ability to freely enter and exit from their investments.

Francis H. Byrd is Managing Director and Corporate Governance Advisory Practice Co-Leader at The Altman Group