The Fundamentals of Director Oversight Under Threat

Andrea Unterberger is Assistant General Counsel and the Director of CSC Media at Corporation Service Company. This post is an excerpt from the 2010 Edition of The Directors’ Handbook, by Thomas J. Dougherty of Skadden, Arps, Slate, Meagher & Flom LLP. In the foreword to the edition, Mr. Dougherty explores how recent reform initiatives will result in an irrevocable shift of power in the boardroom.

Several “reform” initiatives bred by the financial and regulatory crises of 2008–2009 now threaten to undermine the fundamentals of director oversight in 2010 and beyond. Collectively, if not individually, these destabilizing dynamics will alter the balance of power utterly between directors and activist stockholders, between federal and state regulators, between American and foreign sources of capital, and between models of consensus and contentious corporate governance.

The principal forces amassing to shift power and destabilize those respective relationships are the combination of these “significant seven” developments:

    • 1. Proxy Access: the SEC’s new sweeping “proxy access” proposals;
    • 2. No Broker Voting: the SEC’s abolition of broker voting of “uninstructed” retail client shares;
    • 3. Anemic “e-voting”: the perverse decline in retail stockholder voting following recent substitution of “e-voting” for slow-mail proxy distribution;
    • 4. “55 × 70 × 55”: the ever-upward rise of institutional share ownership dominance from “55-cubed” a decade ago (when more than 55 percent of the shares of more than 55 percent of Fortune 500 companies were owned by fewer than 55 respective institutions) toward “55 × 70 × 55” today (more than 55 percent of the shares of more than 70 percent of Fortune 500 companies are now owned by approximately 55 respective institutions);

  • 5. Short Slates: the underappreciated catalytic effect of SEC “short slate” director nomination rules;
  • 6. Stockholder Proposal Dynamics: the cumulative effects of seven years of post-Sarbanes-Oxley “precatory” stockholder proposals to dismantle all semblance of corporate takeover defenses, accompanied by the specter of “withheld” or “against” votes on director nominees if directors failed to dismantle defenses following favorable stockholder vote; and,
  • 7. Structural Shifts: concomitant widespread elimination of (i) supermajority voting requirements, (ii) staggered or classified board terms, and (iii) stockholder rights plans (often done to avoid or compromise likely stockholder proposals), accompanied by limitations on (iv) change-in-control executive severance agreements, along with (v) increased stockholder rights to call special stockholder meetings, in tandem with (vi) highly publicized proposals advocating multiflavored “pay-on-pay” criteria.

The foregoing “significant seven” phenomena manifest a swelling, powerful riptide that at a minimum will erode director discretion and, more likely, if left unchecked, will have tsunami-like impact on corporate governance in America.

It is very important that you assess how these factors will affect directors. Here is a summary.

Proxy Access Makes It a “Significant Seven”

The SEC proposes to mandate a “one-size-fits-all” proxy access federal rule requiring the more than 7,000 public company SEC registrants to provide, at company expense, disclosure in company proxy materials about stockholder nominees for director positions, potentially commencing with the 2011 proxy season. This would enable dissident stockholders to avoid much of the expense of a proxy campaign, including eliminating the current requirement that dissidents print and mail their own proxy statement, which can be a considerable cost. SEC registrant companies could not opt out of this mandate. Any stockholder or combination of stockholders may have nominees included in the company’s proxy statement if they (individually or collectively) hold 1 percent or more of the outstanding shares and have held them for more than one year while continuing to hold them through the date of the election of directors at the annual meeting, so long as they disclaim an intent to change control of the company via the election of their director nominee(s) (3 percent stock ownership for companies with net assets below $700 million and above $75 million; 5 percent ownership for companies with net assets below $75 million).

A single stockholder (or group) may nominate director candidates for up to 25 percent of the total board seats up for election.

Immediately, you can see the myriad complications and opportunities for mischief that such a mandatory rule creates. (There have been more than 500 comment letters sent to the SEC during its twice-deferred consideration of this proposal.)


  • A. Two or more stockholders or groups may each nominate candidates which together could comprise 50 percent of the board — how to choose?
  • B. The SEC approach proposes a “first to file rule,” meaning that the first such stockholder to seek proxy access each year would have precedence over any other stockholder slates — parking criticism that a “race to the courthouse” dynamic will ensue. Furthermore, no stockholder will consider negotiating with the company to be included on the company’s slate of a lesser number of candidates, for fear of being left behind in priority by another stockholder who unilaterally files its own nominee slate first without negotiating with the company.
  • C. The proposed alternatives are no better: An alternative method of establishing priority among such stockholder groups, if the total of their nominees together would exceed 25 percent of board seats up for election, is to give precedence to the stockholder or group with the larger number of shares.
  • D. But this raises further problems because the SEC’s rule also exempts any such stockholders from the existing SEC requirement that communications made to form a group must be disclosed if more than 10 stockholders are contacted. Consequently, there is nothing to preclude undisclosed formation into a single large nominee group of the two stockholder camps described in (A) above.
  • E. Nor is proxy access denied to a stockholder or group that avowedly allies itself in a single year with another stockholder, mailing its own traditional proxy solicitation to gain board seats. Each can endorse the other, and thereby effect change in control of the board without any takeover offer to stockholders. This is an invitation for proxy access to be used as a “stalking horse” to test the waters of stockholder dissatisfaction with management as a predicate to follow-on change in control tactics at the very same annual meeting. Yet, those stockholders given proxy access under the SEC’s rule are not required to sign any standstill or even disavow control intent after the date they are initially given access!
  • F. Furthermore, the SEC proposes concurrently to eliminate its longstanding rule that company proxy cards may provide stockholders the option to vote for all management nominees as one slate, depriving the board’s nominating committee of one of its traditional state-law functions, namely, composing a slate of directors who, taken as a whole, have the individual and complementary talents believed best suited for optimal board oversight. Consequently, a nominee short slate of directors proposed through proxy access could list potential directors not qualified to serve on the audit committee, who, if elected instead of those board nominees who are so qualified, would leave the board without an audit committee compliant with other SOX and stock exchange audit committee member qualification requirements.
  • G. In addition, proxy access nominees need not be independent of “special interest” or “single issue” groups formed to espouse their election, leading to possible balkanization of boards where that special interest is affected, and potential risks in maintaining confidentiality of related non-public board information.
  • H. The SEC’s relatively recent “short slate” proxy rule change completes this very destabilizing set of dynamics: Proxy access to nominate a “short slate” of up to 25 percent of available board seats will allow issue activists (who were previously limited to stockholder proposal initiatives) to ally with public pension funds and hedge funds (neither of which are subject to such governance rules themselves) advocating election of directors, and asserting that they only “keep management honest.” Indeed, they could propose to elect 25 percent of the board seats in successive years, keeping 25 percent of the board’s seats “in play” each year, year after year. Perennial proxy campaigns, under this new rule, now required to be paid for in large part by the company itself, are not only possible but highly likely for companies in businesses with secular volatility or for businesses facing other long-term challenges, regardless of management’s capability and board vigilance. American corporations will enter a realm equivalent to the American presidential politics of “permanent campaign,” except more problematically so, because the corporations also will have to fund a substantial aspect of their competitor nominees’ election costs.
  • I. This occurs at a time when retail stockholders’ participation in annual board elections is plummeting. Before electronic proxy voting was authorized by the SEC, retail voters were already lax participants in director elections; only approximately 20 percent of retail stockholders cast their proxy ballots. And for those retail stockholders who did not cast ballots, brokers were allowed to cast “uninstructed” ballots themselves — often for the incumbent director slate or at least in proportion to all other votes cast. Either way, the broker vote often determined whether a director received a majority rather than a mere plurality of votes cast. This makes a difference because stockholder advisory firms will recommend that institutions “withhold” vote for a nominee in a subsequent year (or seek offers of director resignation) if only a plurality, not majority, of votes are cast in favor of a director. Furthermore, electronic proxy voting has reduced retail stockholder participation in director elections from 20 percent down to a mere 5 percent, possibly due to the fact that those retail stockholders who did participate are more attuned to slow-mail open-read-reply habits than to use of the internet. Taken together, “e-proxy” mechanics and abolition of the broker uninstructed vote are predicted to cause 50 directors of major American companies to be at risk of not receiving a majority of votes cast in 2010 annual elections, even before proxy access comes into play in later elections.
  • J. Finally, no one seems to have noticed that one small step away from this brave new world of proxy access boardroom dynamics awaits the already unstable world of courtroom dynamics. The SEC’s mandatory rule will supersede (“preempt”) all state statutes, such as Delaware’s statute and the so-called “Model Act” (used by other states as a template), which already provide that stockholders by bylaw can choose whether and how proxy access will be granted to other stockholders. The beauty of that state-by-state system is twofold: (a) states and companies can vary their approaches to proxy access, as the respective legislatures and stockholders decide; and (b) state courts (notably Delaware’s Chancery Court) are much more familiar with corporate governance issues than federal courts. Yet, the SEC rule mandates that only federal courts can adjudicate disputes in these new uncharted waters, and that all state laws about proxy access are supplanted by the SEC’s one-size-fits-fits-all rule.

Worse still, there is already in federal court a cadre of stockholder plaintiffs counsel (securities class action plaintiff contingent fee counsel) with an established “largest stockholder” priority-among-litigants protocol who will readily represent activist and pension fund nominee plaintiffs to assert claims in court to enforce those (many) aspects of the SEC rule noted above that favor dissidents either expressly or through the rule’s loopholes and ambiguities. This coalition of activists, pension funds and class action plaintiffs counsel has existed for more than a decade in the courtroom. Proxy access plus this coalition is a combustible mix — a very troubling boardroom-courtroom dynamic.

The historic significance of proxy access cannot be overstated. The old balance of power is altering because stockholder proposal rules merely equated to annual meeting access for activists’ self-promotional, agenda-driven platform plank referenda (annual meeting ballroom microphone access). Over the span of little more than seven years, in the absence of effective collective counteraction, those same activists found soulmates among public sector pension fund management who, in turn, felt underappreciated by incumbent public company managements. Now, they have a new additional instrument in proxy access.

Proxy access means potential boardroom access (not mere annual meeting ballroom access) for those proposal proponents, funds and others. Boardroom access means the end of consensus governance as we knew it, in favor of governance that may be annually contested and inevitably will be episodically contentious.

These developments come at an inopportune time. Boards of directors are already working exponentially increased hours on audit, compensation and governance compliance compared to several years ago. As important as those oversight responsibilities are, they are taking director time away from another, less regulated, but equally important oversight role, namely strategic oversight of the business, creating value for stockholders. Now, in 2010, as the SEC likely moves toward adoption of the proxy access rule for annual meetings in 2011, boards will need to set aside days of time to design new protocols for addressing proxy access, including (a) nominating committee protocols for meeting with and potentially negotiating with access-nominee proponents; (b) meetings with proxy solicitation advisers regarding past stockholder proposal proponents, their proposals, and stockholder votes at peer company annual meetings; (c) full board discussion and articulation of how present board (and committee) composition matches company and stockholder needs — and a preemptive communication plan to inform stockholders of this; (d) lead director participation in meetings with key institutional stockholders to educate those stockholders (through the voice of an authoritative independent director) on the benefits of present board composition and stewardship; and (e) collective action by directors across corporations through associations of corporate leaders to raise publicly the concern that America’s boardrooms could be destabilized, balkanized or, at a minimum, distracted by a federal mandate that is wholly inconsistent with a century of modern corporate governance through state-by-state experimentation and adjudication.

Risk Oversight Prioritization

Directors face unprecedented challenges as they attempt to accomplish myriad tasks of stewardship. A number of boards are focusing on ways to supplement their risk oversight by asking senior management to formalize financial and legal compliance risk reporting to the board, or audit committee via a management risk committee charter and protocols. This is laudable. At the same time, it is notable that the regulatory compliance pressures no doubt promoting such initiatives address two (financial and legal) of the three significant risk areas that boards oversee. The third, and equally important, is, of course, strategic business risk: The risk of disruptive technology not being adequately anticipated; of business plan execution being weak; of competitors attracting away key employees etc. With all the increased time and attention being devoted to compliance oversight rather than strategic vision, value creation, and mission execution, directors increasingly need to find the time and the techniques to address those fundamental board-business objectives. Please ask yourself these questions: What percentage of our time do we devote to those strategic matters versus compliance? Do we have a good balance in our allocation of director time, or do we need to add time to our agenda to avoid crowding our strategic risk oversight because compliance matters (appropriately) add to our workload?

2010: The Year of “Foreign-Cubed”

One way or another, through Supreme Court ruling or Congressional enactment, 2010 will be a significant year for foreign issuers whose foreign investors trading shares in foreign markets seek to bring class action federal securities fraud suits in United States federal courts. The U.S. Securities Exchange Act, adopted in 1934, is silent on extraterritorial application. But after 75 years, both the U.S. Supreme Court and Congress are preparing to address that in potentially very different ways. On November 30, 2009, the U.S. Supreme Court accepted certiorari to hear an appeal from a Second Circuit U.S. Court of Appeals decision holding that U.S. courts did not have jurisdiction over so-called “foreign-cubed” federal securities class actions. The case involves a foreign plaintiff class who purchased securities abroad of an Australian issuer, National Australia Bank (NAB), whose U.S. subsidiary, Florida-based Homeside Lending, Inc., allegedly knowingly provided inflated financial results that NAB included in NAB financial statements, issued and distributed from NAB’s headquarters in Australia. [1]

The Second Circuit declined to adopt a “bright line” rule, and applied a test that the Court acknowledged is “not easy to apply,” namely deciding whether a U.S. Court has subject matter jurisdiction based on determining what conduct [foreign versus domestic] is “central or at the heart of a fraudulent scheme versus what is ‘merely preparatory’ or ancillary.”

Obviously, that is a fairly fact-intensive inquiry, and it is laden with controversial consequences. On a positive note, such a standard avoids the danger of permitting courts to exercise jurisdiction over federal securities (Rule 10b-5(b)) claims in foreign-cubed cases where the activities in the U.S. were merely preparatory to statements made by an overseas entity. Otherwise, a non-declarant U.S. subsidiary’s input to parent company statements (and those of its executives), which constitute mere “aiding and abetting” of the parent’s statements, could be subject to suit in U.S. courts, notwithstanding the Supreme Court’s (already otherwise threatened) holding that mere secondary assistance cannot subject a non-preparer of statements to 10b-5 liability.

But, on the negative side, foreign corporations throughout the world, from Canada to Germany and Switzerland to China (as the NAB decision suggests) can no longer take full comfort that their respective jurisdictions limit securities remedies and/or class actions, if the potential of U.S. securities class action exposure now looms.

Most importantly, in 2010, when deciding the NAB case, the U.S. Supreme Court could adopt a different standard, and Congress is already on track to do so.

Presently pending is H.R. 4173, the Financial Stability Improvement Act, introduced by Congressman Barney Frank as part of a potential regulatory overhaul in response to the financial crises of 2008. The proposed legislation provides that U.S. federal securities jurisdiction would exist as to any case involving “conduct within the United States that constitutes significant steps in furtherance of the violation.” That is an open-door policy for U.S. courts and would be troubling for both foreign issuers and their domestic subsidiaries because “significant steps” potentially could include any manner of U.S.-based executive and adviser activity in “furtherance” of statements by the foreign issuer.

This bill could have other consequences as well. U.S.-based auditors are required under present SEC procedures to review foreign-prepared and foreign audited financial statements of foreign SEC registrants to provide so-called “negative assurance” that they see no departure from U.S. reporting requirements. However, they do not necessarily see the underlying audit or issuer work papers, even though they are a necessary step in that foreign filer’s SEC registration process. The stark contrast in standards between the foregoing NAB and H.R. 4173 is dramatic. Between the Supreme Court’s upcoming NAB decision and Congress’s upcoming final enactment (which would trump any Court ruling), 2010 will be a significant year for foreign issuers and their U.S. counterparts.


[1] Morrison v. National Australia Bank Ltd., 547 F.3d 167, 174 (2d Cir. 2008), cert. granted, 78 U.S.L.W. 3319 (U.S. Nov. 30, 2009) (Nov. 08-1191).
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One Comment

  1. Raj Desai
    Posted Friday, April 23, 2010 at 4:15 pm | Permalink

    Interesting Read. In my opinion, currently directors are not held accountable for their actions. I also think that activist investors have only short term profits in their mind. The entire system is very risky.