Giving Shareholders a Voice

Editor’s Note: Lucian Bebchuk is a Professor of Law, Economics, and Finance and Director of the Shareholder Rights Project (SRP) at Harvard Law School. This post is based on an op-ed article by Professor Bebchuk published today in the New York Times DealBook, available here. The post responds to a critique of the SRP’s activities in a memorandum issued by Wachtell, Lipton, Rosen & Katz, which appears in a post here. Any views expressed and positions taken by the SRP and its representatives should be attributed solely to the SRP and not to Harvard Law School or Harvard University.

Staggered boards have long been a key mechanism for insulating boards of publicly traded firms from shareholders. This year, several institutional investors and a program working on their behalf have used shareholder proposals to move a large number of publicly traded firms away from such structures. Despite strong and expected criticism from the usual suspects, shareholders should welcome and support this work.

The Shareholder Rights Project, a clinical program that I run at Harvard Law School, assists public pension funds and charitable organizations in improving corporate governance at publicly traded companies. During this proxy season, we represented and advised five such clients – the Illinois State Board of Investment, the Los Angeles County Employees Retirement Association, the Nathan Cummings Foundation, the North Carolina State Treasurer, and the Ohio Public Employees Retirement System – in connection with their submission of proposals for a vote at the annual meetings of more than 80 companies on the Standard & Poor’s 500-stock index.

The proposals urge companies with a staggered board, which allow shareholders to replace only a few directors each year, to place all board members up for election every year. Such a move to annual elections is viewed by investors as a best practice of corporate governance. By enabling shareholders to register their views on all directors each year, annual elections make boards more accountable to shareholders.

Staggered boards, also known as classified boards, certainly have their staunch supporters. As DealBook reported, the law firm Wachtell, Lipton, Rosen & Katz recently denounced the work undertaken on behalf of institutional investors by our program. Wachtell’s sharply worded memo, titled “Harvard’s Shareholder Rights Project Is Wrong,” was signed by four of the firm’s senior partners, including the founding partner and inventor of the poison pill, Martin Lipton.

What particularly drew Wachtell’s ire were the results of the proposals, which Steven Davidoff called “stunning” in a recent Deal Professor column. Following active engagement, many of the companies receiving shareholder proposals entered into agreements to bring management declassification proposals that would require all directors to stand for election each year. As of today, 44 Standard & Poor’s 500 companies – over one-third of the S.&P. 500 companies that had staggered boards at the beginning of this proxy season – have entered into such agreements, and 35 companies have already disclosed management declassification proposals made in accordance with such agreements.

Wachtell, the go-to legal counsel for incumbent directors and managers seeking to insulate themselves from removal, has been a strong advocate for rules and practices that facilitate such entrenchment. It is thus unsurprising that Wachtell and some of its clients may have a negative view of the large-scale move away from staggered boards taking place in corporate America. This change, however, serves the best interests of shareholders.

Investors’ support for annual elections is consistent with a significant body of empirical evidence. A study by Alma Cohen and myself documented that staggered boards are associated with lower firm valuation, and this finding was subsequently confirmed in a study by Prof. Olubunmi Faleye of Northeastern University and another study by Michael Frakes of Cornell. Incumbents opposing declassification proposals often cite a study reporting that targets with staggered boards capture a larger slice of the surplus created by acquisitions, but even this study confirms that, over all, staggered boards are associated with lower firm value.

Furthermore, studies find that firms with staggered boards are associated with lower returns to shareholders in the event of an unsolicited offer, are more likely to make acquisitions that decrease shareholder value, tend to provide executives with pay that is less correlated with performance, and exhibit lower association between chief executive replacement and performance. Indeed, having a staggered board is a significant element of two “poor governance” indexes that have been used in hundreds of studies by financial economists: the G-Index and the E-Index.

Despite such studies, Wachtell claims that “there is no persuasive evidence” on the value of annual elections. Wachtell does not back up its claim with any empirical evidence or analysis, but merely asserts that “it is our experience that the absence of a staggered board… is harmful to companies that focus on long-term value creation.” Investors, however, have formed a decidedly different view of the value of moving away from staggered boards: during the last two proxy seasons, shareholder proposals to declassify at S.&P. 500 companies received an average level of support exceeding 75 percent of votes cast.

In criticizing the Shareholder Rights Project’s work, Wachtell quotes the statement of Chancellor Leo Strine of the Delaware Chancery Court that “stockholders who propose long-lasting corporate governance changes should have a substantial, long-term interest that gives them a motive to want the corporation to prosper.” However, Wachtell overlooks that the five institutional investors represented by our program are exactly the type of long-term shareholders that Chancellor Strine views as desirable proponents.

Although Wachtell professes general support for a “robust debate” on staggered boards, the firm would prefer to have fewer shareholder proposals on the subject. Yet shareholder proposals are the very mechanisms that the securities laws (and, in particular, S.E.C. Rule 14a-8, known as the “town hall meeting” rule) provide for conducting debate at publicly traded firms. Both a shareholder who puts forth a proposal to eliminate a staggered board and the board members themselves make their case in the proxy materials sent to voting shareholders, who then cast votes to indicate which position they support.

In recent years, supporters of staggered boards have been on the losing side at an overwhelming majority of votes on shareholder proposals urging board declassification. Two proposals submitted by our program’s clients recently passed with large majorities. Additional such proposals are expected to go to a vote this spring at more than 30 other companies, and defenders of staggered boards are expected to continue losing such votes.

Preferring therefore to discourage such proposals, Wachtell also claims that it is “inappropriate” for a law school’s clinical program to assist clients that are not “impoverished or underprivileged.” However, as Columbia law professor Jeffrey Gordon explained in a response to this claim, clinics that advance the contested agendas of clients who are neither impoverished nor underprivileged are (for good educational reasons) are standard at law schools nationwide. These clinics do not represent the views of the law schools in which they operate but only those of the clients and, in some cases, of faculty and students who choose to work in a particular clinic.

Rather than seeking to discourage our program from representing institutional investors submitting shareholder proposals, Wachtell should focus on engaging in a substantive debate about the merits of staggered boards. I welcome such a debate.

In the meantime, shareholders should continue to be given the chance to vote on whether to eliminate staggered boards at companies – and boards should take those preferences into account. Doing so would serve the long-term interests of shareholders and the economy.

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One Comment

  1. Alex Todd
    Posted Friday, April 20, 2012 at 11:57 am | Permalink

    I don’t think the issues of staggered boards is as black and white as presented by the debating parties. Each is based on a competing, but equally incomplete theory of corporate governance, namely stewardship theory that supports Wetchell’s arguments, versus, the more popular, agency theory that colours Harvard’s thesis.

    Here is an excerpt from a chapter I contributed to the book, “Corporate Governance: A synthesis of theory, research, and practice,” that discusses the inadequacy of both theories, and thereby weakens the basis for both arguments:

    Agency theory presumes that self-interested managers are agents of the company’s owners (principals) who need to be monitored and controlled in order to effectively align their behavior with the interests of the owners. Corporate boards of directors preside over management on the premise of mistrust. The outcome has been an increase in regulation and controls that restrict board and management activity, such as growing demand for director independence and alignment of executive compensation to performance. As Turnbull (2000, p. 24) notes, “A basic conclusion of agency theory is that the value of a firm cannot be maximised because managers possess discretions, which allow them to expropriate value to themselves.”

    In contrast, stewardship theory presumes that managers are inherently good stewards of corporations and can be trusted to work diligently to attain high levels of corporate profit and shareholders returns. Ironically, this presumption leads to the ultimate conclusion that boards of directors are reduntant and that stakeholder advisory boards are sufficient.

    Both theories are valid in understanding the relation between boards and managers. In many cases, such as in family or government controlled companies, boards are simply “advisers devoid of real power” (Leblanc and Gillies, 2005). In other cases, the inherent limitations of blindly following corporate governance best practices adopted by boards that do not go far enough have backfired (Tarantino, 2008). The corporate scandals at Enron, WorldCom, Parmalat, and the U.S. sub-prime mortgage crisis that precipitated the global economic recession of 2008 are examples of instances where boards with complete corporate governance best practices checklists were misguided by the lack of perspective and appreciation for overriding principles to guide their activities.

    Stout (2003, p. 667) offers another point of view: “shareholders also seek to ‘tie their own hands’ by ceding control to directors.” In other words, shareholders of public companies generally prefer to trust rather than control their boards. Paradoxially, in jurisdictions where directors’ fiduciary duties to the corporation have been interpreted to extend to shareholders (beyond the corporation), executive and independent directors’ duties are based on the higher standard suggested by stewardship theory, because directors are expected to be good stewards of shareholder interests. As Turnbull (2000, p. 28) notes, a fiduciary duty “is higher than that of an agent as the person must act as if he or she was the principal rather than a representative.” These examples do not invalidate the prinicipal-agent conflict, but serve to demonstrate its inadequacy as a sufficient theory for corporate governance.

    Both agency theory and stweardship theory lead to self-fulfilling prophecies. Agency theory, founded on a presumption of mistrust, propels a downward spiral of increased regulation. In contrast, stewardship theory, founded on a presumption of trust, fuels an increasing trust that leads to boards without independent directors, or even to boards that have no monitoring function but rather serve only as advisors (Turnbull, 2000). As Turnbull notes, both theories are valid but contingent upon the institutional and cultural context. He explains that individuals sometimes behave competitively, sometimes collaboratively, but usually both. To coexist, both agency and stewardship theories must form part of a broader dialectic theory. For example, the political theory for corporate governance, proposed by Gomez and Korine (2008) is consistent with the OECD’s (2004, p. 17) first principle of corporate governance: “Ensuring the Basis for an Effective Corporate Governance Framework.”

    The stakeholder model provides another perspective that puts the corporation’s self-interest ahead of shareholders and other stakeholders. According to the stakeholder model, the corporation is entirely dependent on its stakeholders’ resources to create value, and considers stakeholders interests as critical for sustaining itself and its value creation activities. This model is consistent with Adam Smith’s notion of capitalism based on enlightened self-interest. Smith (2009, p. 11) wrote, “It is not from the benevolence of the butcher the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Institutions such as the OECD now recognize this inherent interdependence between a firm and its stakeholders (OECD, 2004). As Reiter (2006, p. 59) notes, literal interpretation of the law that “directors owe their fiduciary duty of loyalty exclusively to the corporation, not to its shareholders nor its creditors, even where the corporation is in distress” is consistent with the stakeholder model. This is because the stakeholder model views the firm as incomplete. The firm is seen as entirely dependent on and vulnerable to the board of directors. This is a critical test for a fiduciary relationship.

    Finally, the political model offers a macro framework to provide context for corporate governace. Under the political model, governments use corporate governance as a mechanism to allocate corporate power, privilege, and profits between corporations and their stakeholders. In other words, corporate governance is an instrument of public policy (Turnbull, 2000).

    This review of theories and models suggests that corporate governance is about more than resolving the principal-agent conflict. In fact, corporate governance is highly complex as it must consider and adapt to numerous important relationships with uncertain cause-effect influences on matters that range from survival to sustainability.

    I believe the answer lies first in fixing the boardroom, then in trusting its judgement. The board should be accountable to critical stakeholders, not shareholders at large, and be given an opportunity to focus on the long term success of the business. I elaborate on this in my submission to the the Harvard Business Review/McKinsey M-Prize for Management Innovation: Long-Term Capitalism Challenge , with my proposed corporate governance innovation, “Humanistic Corporate Governance: A universal model for balancing power and aligning interests.” The following is a relevant excerpt:

    Applying Roman property law principles to today’s capital markets may seem like a step back rather than progress, but what if it were to offer a simple solution to many of the problems plaguing modern capitalism? Suppose that capital stockowners had the right to part of the residual equity of the firm (fructus) and the right to vote for corporate directors and other matters (usus), but were restricted from selling their shares on public markets (abusus). This has historically been the customary practice of family-owned businesses, as they preferred to not exercise their right to sell (abusus) in order to keep the business in the family. Suppose, also that all other shareholders retained their right to an equal proportion of the gains (fructus) and exclusivity to sell (abusus), but their right to vote (usus) were restricted or rescinded. This could potentially eliminate the problem of shareholder oppression by removing the incentive of capital stockowners to expropriate capital resources from other non-voting shareowners. It would also systematize long-term stockownership by contributors of capital (and specified opt-in shareholders), analogous to today’s buy-and-hold, long-term shareholders.

    This approach potentially offers an added benefit of unravelling the snarl of regulations that attempt to align management interests with shareholders. By also replacing shares given to management with a class that restricts selling (abusus), same as capital stockowners, management interests would inevitably become better aligned with voting stockowners, and would remove a major incentive for them to “play the expectations game”[vii] of stock price timing and manipulation. Corporate directors, together with other strategic stakeholders, could receive transferable (abusus), non-equity voting (usus) shares. This would give society a direct voice in corporate governance, rather than being relegated to proxy voting of equity shares.

    A derivative benefit would be the cost savings associated with stockowners not having to vote on every issue, thereby largely eliminating the plethora of current incarnations of internal and external proxy voting resources. Instead, voting considerations by capital stockholders would largely be oriented toward considerations that affect long-term financial performance of the business. Voting by other stakeholders (possibly including trading shareholders) could be conducted via stakeholder councils elected to represent the interests of the firm’s strategic stakeholders. As a result, relatively few proxy votes would need to be counted.

    Finally, I would add that my own research has found stronger shareholder influence on boards to be associated with inferior stock performance for the period 2006 to 2010, while issuers having a “sovereign board style” significantly outperformed the market for the same period (see

    I apologize for the length of this comment, and hope it contributes a useful perspective to the debate.

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