Frozen Charters

Scott Hirst is a Lecturer on Law at Harvard Law School, and an Associate Director of the Harvard Law School Program on Corporate Governance. This post is based on his recent article, available here.

Earlier this month, mega-cap oil refining corporation Phillips 66, also known for its Conoco and “76” gas stations, put forward an amendment to its charter, the central document establishing the internal rules of the corporation. The board of directors and management of Phillips 66 supported and recommended the change. At the company’s annual meeting, more than 98% of the votes cast were in favor of the amendment. But the amendment failed. The company’s charter is frozen.

(Disclosure: The amendments at Phillips 66, and those at many other companies with frozen charters, followed engagement by clients of the Shareholder Rights Project during the years 2011 to 2014, during which time I served as the Project’s Associate Director). [1]

This result is the consequence of a 2012 change in New York Stock Exchange policies relating to broker voting rules. Although the change was intended to protect investors and improve corporate governance, it has had the opposite effect: a significant number of U.S. public companies are no longer able to amend important parts of their corporate charters, despite the support of their boards of directors and overwhelming majorities of shareholders. Their charters are frozen.

My recent article, Frozen Charters, which is forthcoming in The Yale Journal on Regulation, provides the first empirical and policy analysis of the broker voting change and its significant unintended consequences. I provide empirical evidence that the broker voting change has resulted in the failure of more than fifty charter amendments at large U.S. public companies such as CapitalOne, Chesapeake Energy, Duke Energy, Goodyear, Hess, PSEG, Rockwell Collins, and St. Jude Medical, despite board approval and overwhelming shareholder support, and that hundreds more companies have their charters frozen as a result of the change. These costs substantially outweigh the negligible benefits of the broker voting change. I compare a number of solutions to address these problems, and identify several that would be preferable to the current approach. A more detailed account of my analysis follows.

How did a minor change in the arcane broker voting rules have such a widespread effect? Many investors that hold shares through brokers do not instruct brokers how to vote their shares at annual meetings (16% at Phillips 66, and about 10% on average). In order to protect shareholders from the potentially distortive effects of voting by brokers, who do not have an economic interest in the corporation, the NYSE, whose rules effectively govern broker voting, has progressively limited the instances in which brokers may vote shares. In 2012, in Information Memorandum 12-4, the NYSE restricted brokers from voting uninstructed shares on charter and bylaw amendments.

The intention of this broker voting change was to protect investors and enfranchise shareholders by eliminating distortion, but it has created a different kind of distortion. Preventing brokers from voting uninstructed shares means that none of those shares will be voted in favor of the proposal, even though some of the shares have beneficial owners that are in favor of the proposal. Where a proposal fails, but would have passed had the uninstructed shares that supported the proposal voted, the outcome is what I term a “distorted fail.”

The main type of distorted fail from the broker voting change are frozen charters. Despite strong support from shareholders and directors, there are a number of corporations, like Phillips 66, which, because of high supermajority requirements to amend parts of their charters (80% of outstanding shares, in the case of Phillips 66), are unable to reach these thresholds without the uninstructed broker votes that the broker voting change has prohibited. In the three years after the broker voting change took effect, for 54 of the 63 charter amendments that failed despite receiving overwhelming shareholder support, [2] the amendment would have passed had the broker voting change not been implemented. [3] The broker voting change has increased the proportion of charter amendments that fail despite receiving overwhelming shareholder support, and the likelihood of failure for charter amendments, in a statistically and economically significant manner.

Do the unintended distortions from the broker voting change outweigh its intended consequence, of preventing distortion if brokers vote uninstructed shares? Uninstructed broker votes will result in what I call a “distorted pass” when a majority of the shareholders of the corporation would prefer that a proposal fail, but uninstructed broker votes in favor of the proposal cause it to pass. However, because most charter amendments are strongly supported by shareholders, and because brokers would follow management recommendations to support these charter amendments, in the overwhelming majority of cases there would be no distortive effects of broker voting on charter amendments. There have been no failed charter amendments since the broker voting change that would have been distorted passes had broker voting been permitted, and only one other management proposal (0.12% of all management proposals during that period).

However, the foregoing analysis significantly underestimates the true effect of the broker voting change, because only a small number of charter amendments go to a vote each year. I use a novel method to estimate the number of companies that are affected by the consequences of the broker voting change, using corporations’ voting requirements and turnout in director elections. I estimate that between 13% and 15% of U.S. corporations have been rendered unable to amend part of their charter as a result of the broker voting change. I also estimate the number of companies where eliminating broker voting has prevented distorted pass results, and find that, based on current patterns of support for corporate governance proposals, the broker voting change would prevent distorted pass results at only 0.1% of companies.

These empirical results allow an evaluation of the broker voting change. The substantial negative effects of the broker voting change in creating distorted fails significantly outweigh its very limited benefits in preventing distorted passes. The broker voting change prevents value-enhancing changes to the corporation. Compared to the standard process by which broker voting rules have been amended in the past, the broker voting change process prevented public comment and any consideration of the effects of the broker voting change on investors, which may have made clear the negative consequences of the rule.

Given these conclusions, I consider a number of alternatives to address the distorted fail results of the broker voting change. In addition to simply reversing the broker voting change, one possibility is to reduce the number of undirected broker votes, which would reduce both distorted passes and distorted fails. However this would be costly, and is unlikely to provide a complete solution. A more promising alternative is proportional voting, whereby brokers vote uninstructed shares in the same proportion as other shareholders at the meeting, or other shareholder clients of the broker, has the possibility of eliminating both kinds of distortion. Finally, broker voting rules could be amended to allow broker voting on certain types of corporate governance proposals where distorted fail outcomes would otherwise be likely, but where distorted pass outcomes would not. These solutions allow the possibility of reducing the likelihood of distorted fail results, while also minimizing the possibility of distorted pass results. In order to avoid the procedural shortcomings involved in implementing the broker voting change, any reform should take place through the NYSE rulemaking process. In the interim, the NYSE should reverse the broker voting change to prevent the harm it is currently causing to investors.

The full paper is available for download here.


[1] Further information about the 2011-2014 work of the Shareholder Rights Project is available at its website.
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[2] I arbitrarily define “overwhelming shareholder support” as support from shareholders representing 90% of votes cast.
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[3] This assumes that shareholders would have voted or not voted in the same proportions had the broker voting change not been implemented; I consider this possibility at length in the article.
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