Posted by Holly J. Gregory,
Sidley Austin LLP, on Friday December 12, 2014 at
Holly J. Gregory is a partner and co-global coordinator of the
Corporate Governance and Executive Compensation group at Sidley
Austin LLP. This post is based on an article that originally
appeared in Practical Law The Journal. The views
expressed in the post are those of Ms. Gregory and do not reflect
the views of Sidley Austin LLP or its clients.
Governance of public
corporations continues to move in a more shareholder-centric direction.
This is evidenced by the increasing corporate influence of shareholder
engagement and activism, and shareholder proposals and votes. This trend
is linked to the concentration of ownership in public and private pension
funds and other institutional investors over the past 25 years, and has
gained support from various federal legislative and regulatory
initiatives. Most recently, it has been driven by the rise in hedge fund
remains unclear whether, over the long term, greater shareholder influence
will prove beneficial for shareholders, corporations and the economy. In
the near term, however, there is reason to question whether shareholder
influence is the panacea that some posited, or whether the current focus
on shareholder value and investor protection is at the expense of other
values that are central to the sustainability of healthy corporations.
These concerns underlie the issues that will define the state of
governance in 2015 and likely beyond, including:
» The long-standing debate
about the purpose of the corporation and governance roles.
» Tensions between achieving
short-term returns and making long-term investment.
» The impact of shareholder
activism on board decisions.
» Shareholder litigation and
the reactive use of corporate by-laws to protect boards.
» Concerns about proxy advisor
power and influence.
» Drawing the line between
board oversight and management.
» Rebuilding society’s trust
in the corporation.
The Corporate Purpose and Governance Roles
corporation is a legal construct that arose as a way to accumulate and
devote capital to, and share risk for, large-scale entrepreneurial
activities that would otherwise be difficult to fund. Shareholders bear
the risk of their investment and receive the residual profit, expressed as
an increase in share value or dividends. Therefore, the ability of the
corporation to return long-term shareholder value is a key metric for
assessing whether the corporation is effective and efficient in its
purpose of the corporation has been a matter of debate since its
formation. This debate centers on whether maximizing shareholder value is
the ultimate goal of corporate activity or whether the goal is some other
broader societal “good.” Where the balance between these interests is
defined is relevant to how the corporation is regulated through state
corporate law and federal securities regulation, and the role and
responsibilities of and limits on shareholders and directors with respect
to corporate decisions.
While investor protection is a primary goal of securities regulation, it
cannot be viewed in isolation. As a regulatory goal, investor protection
has value in that it provides positive value to capital formation and the
long-term contributions of viable corporations to the economy. More
intentional deliberation about the role of the corporation and its
relationship to society is necessary in the dialogue over expanding
shareholder influence, and also with respect to rebuilding societal trust
in the corporation. These considerations should be a priority for 2015.
closely related issue concerns the balance in governance roles and
responsibilities between shareholders and boards. Two theories of
corporate governance failures have emerged in the past 15 years. The first
theory is that there is too little active and objective board involvement.
This theory is reflected in the Sarbanes-Oxley Act and its focus on:
» Improving board attention to
financial reporting and compliance.
» Securities and Exchange
Commission (SEC) rules and listing rules on independent audit committees
and their function.
» Director and committee
independence and function.
second theory is that there is not enough accountability to shareholders.
This concern is expressed by the focus of the Dodd-Frank Act, and related
SEC rules and rule interpretations, on providing greater influence to
shareholders through advisory say on pay votes and access to the proxy for
shareholders to nominate director candidates.
Given federal law and regulations, listing rules, and other related
influences, the question that emerges is whether these are altering the
balance that state law intentionally provides between the roles of
shareholders and the board, and if so, whether that shift is beneficial or
detrimental. State law places the management and direction of a
corporation firmly in the hands of the board. This legal empowerment of
the board, and the implicit rejection of governance by shareholder
referendum, goes hand in hand with the limited liability afforded to
Short-Term Returns v. Long-Term Investment
Management has long reported significant pressures to focus on short-term
results at the expense of making the investment necessary to position the
corporation for long-term success. Observers point to short-term pressures
of financial markets, which have increased with the rise of institutional
investors whose investment managers have incentives to focus on quarterly
performance relative to benchmarks and competing funds.
These short-term pressures may also be furthered by the increasing
reliance on stock-based remuneration in the structure of executive
compensation. It is estimated that the percentage of stock-based
compensation has tripled since the early 1990s. In 1993, 20% of executive
compensation was based on stock, in contrast to about 60% today (Motivating
Corporations to Do Good, The New York Times, July 15, 2014).
Although boards should be positioned to support management in taking a
long-term view and help balance competing interests, boards are also under
pressure to focus on short-term results, including from both governance-
and financially focused shareholder activism. This activism in turn is
supported by proxy advisors who generally favor some degree of change in
board composition and tend to have fairly defined, and arguably rigid,
views of governance practices.
The Value of Shareholder Activism
prudent fiduciaries, boards must apply independent and objective judgment
in responding to both governance- and financially focused activism.
Engaging with activists and other shareholders can provide value, but also
has limits (see Box, Preparing for Shareholder Activism). Boards
must come to their own judgments and cannot simply defer to the wishes of
shareholders. Activist shareholders may press for changes to suit
particular special interests or short-term goals that may not be in the
corporation’s long-term interests.
Preparing for Shareholder
The ability of a board and
management to address activism pressures largely depends on the ability
to communicate effectively on long-term strategy, risk oversight,
management succession and company performance. Successful communications
can be made through the company’s investor relations efforts and
shareholder outreach, as well as in periodic filings and proxy
statements. To prepare for shareholder activism, the board and
management should assess the company’s vulnerabilities through an
activists’ lens, and:
» Identify areas in which the
company may be subject to activism.
» Consider the company’s
positions on those topics and prepare responses.
» Assess the company’s defense
» Monitor governance and
activist updates to keep abreast of “hot topics.”
» Ensure that a protocol
(including a script) is in place that details how members of
management and directors should respond if they receive a call from an
» Invest in building relations
with the company’s large long-term shareholders.
» Identify the team of
advisors that the board would turn to in an activist situation and
discuss these issues with them.
Shareholder pressure for greater rights and influence through say on pay
votes, shareholder proposals and director elections are expected to
continue in the 2015 proxy season. Directors need to assess the reasons
underlying a shareholder request for a course of action, including efforts
to influence the corporation’s strategic direction through shareholder
proposals on CEO succession, risk management, and environmental and social
issues. However, if an issue is one that is reserved by law for the board,
director duties may not be abdicated or delegated to shareholders, even
when a majority of shareholders have a clear preference on the issue.
ability of boards to apply objective fiduciary judgment is under pressure
from advisory shareholder proposals. The universe of shareholder proposals
included in corporate proxy statements under Rule 14a-8 has grown
significantly over the years. Proxy advisors will recommend that their
clients vote against the re-election of directors who fail to implement
advisory proposals that receive a majority of votes cast.
Moreover, in 2015 large institutional investors will use non-binding proxy
access shareholder proposals to pressure boards on other issues, including
climate change, board diversity and executive compensation issues. It was
recently announced that New York City Retirement Systems has filed proxy
access proposals with 75 companies to give shareholders a greater voice in
nominating board members. In 2014, of the 14 proxy access proposals that
went to vote, six received majority support, with an average support of
Financially focused shareholder activism tends to seek relatively
immediate returns to shareholders through the sale of assets, payment of
special dividends or share buybacks. These activists often use tools of
governance activism, such as efforts to seat directors, to achieve their
goals. Emerging research suggests that shareholder activism may provide
some immediate wealth for some shareholders. However, this may be at the
expense of long-term gains.
debate between Harvard Law Professor Lucian Bebchuk and Martin Lipton on
the wealth effects of hedge fund activism provides valuable perspective
(see Harvard’s Corporate Governance Blog, available at
blogs.law.harvard.edu). Bebchuk argues that hedge funds are not
“myopic activists,” and instead, bring long-term improvements to the
However, a recently published paper from the Institute for Governance of
Private and Public Organizations finds flaws in Bebchuk’s research (”Activist”
hedge funds: creators of lasting wealth? What do the empirical studies
really say?, July 17, 2014). The paper concludes that activist funds
may create some short-term wealth for some shareholders, because investors
tend to jump to the stock of targeted companies upon the announcement of
activist activity. However, the paper states that there is little evidence
of any long-term wealth creation:
“In a minority of cases, activist hedge funds may bring some lasting
value for shareholders but largely at the expense of workers and bond
holders; thus the impact of activist hedge funds seems to take the form
of wealth transfer rather than wealth creation.”
paper also notes that hedge funds tend to focus on the short-term, with
half of their interventions lasting fewer than nine months.
Litigation and Protectionism
Corporations today are routinely subject to shareholder litigation which
is often paid for by corporations and, by extension, their shareholders.
According to an oft-cited paper by Matthew Cain and Steven Davidoff, in
2013, 97.5% of takeover transactions valued at over $100 million resulted
in shareholder litigation, up from 39% in 2005. Board decisions and proxy
disclosures related to executive compensation are also leading to an
increase in shareholder litigation, although on a smaller scale.
surprisingly, since even weak shareholder claims pose uncertainty,
significant costs and settlement pressures, corporate interest has grown
on how to reduce nuisance lawsuits. Recent Delaware court decisions
underscore the potential for corporate by-laws, including those adopted by
boards, to reduce incentives for the plaintiffs’ bar to file such
lawsuits. For example, the Delaware Court of Chancery has upheld, at least
as a general matter, the statutory and contractual validity of
board-adopted by-laws that seek to limit the forum for intra-corporate
litigation. The Delaware Supreme Court has upheld the statutory and
contractual validity of by-laws that allocate the costs of intra-corporate
litigation to the losing party.
Although these court decisions have spurred significant interest in
board-adopted by-laws aimed at reducing incentives for the plaintiffs’ bar
to file claims, caution is advised. Notwithstanding strong arguments in
favor of deterring nuisance lawsuits, some shareholders, shareholder
rights advocates and proxy advisory firms have expressed disfavor with
board-adopted exclusive forum and arbitration by-laws. Moreover, the
Corporation Law Section of the Delaware State Bar Association has proposed
amending the Delaware General Corporation Law (DGCL) to prohibit Delaware
stock corporations from adopting fee-shifting by-laws. However, action on
this proposal is currently on hold.
Concerns about Proxy Advisors
Over the past decade, the growing influence of proxy advisory firms on
shareholder voting, executive compensation and corporate governance
practices has caused no small degree of consternation and concern among
public companies. In addition to the perceived power of the highly
concentrated proxy advisory industry to effectively coordinate shareholder
voting, criticisms have been raised, including:
» The general opacity and lack
of nuanced analysis underlying vote recommendations.
» Potential conflicts that
arise when proxy advisors also provide consulting services to public
» Inherent pressures in the
proxy advisory firm business model that appear to cause them to
continually push the envelope on corporate governance and disclosure
ISS Policy Changes for 2015
ISS’s policy changes for 2015
focus on four main areas and provide:
» A new “balanced scorecard”
for evaluation of equity compensation plan proposals.
» A negative bias regarding
director elections where boards have adopted unilateral by-law (or in
certain circumstances, charter) amendments that ISS views as limiting
» A more nuanced analysis with
respect to shareholder proposals that call for an independent board
» A modified approach to
shareholder proposals relating to political contributions and
greenhouse gas emissions.
Federal legislation and the SEC rules and guidance are perceived to have
played a role in the growth of proxy advisor influence. Not surprisingly,
the corporate community, including The Business Roundtable, the US Chamber
of Commerce and the Society of Corporate Secretaries and Governance
Professionals, as well as members of Congress and several SEC
Commissioners, have pressed the SEC to consider whether additional
regulation of the industry is warranted.
June 2014, the staffs of the SEC’s Division of Corporation Finance and
Division of Investment Management (SEC Staff) issued long-awaited guidance
related to both proxy advisory firms and their investment adviser clients.
The guidance, published in the form of 13 questions and answers in Staff
Legal Bulletin No. 20 (SLB 20), addressed investment adviser
responsibilities for the voting of proxies and diligence considerations
regarding the retention and oversight of proxy advisory firms. It also
addressed two exemptions to the proxy solicitation rules on which proxy
advisory firms often rely.
While the SEC Staff’s guidance could cause investment advisers to more
carefully scrutinize the capacity of proxy advisors with respect to the
quality of the analysis and recommendations they provide or even to reduce
their reliance on these services, the guidance does not directly address
many of the concerns raised to date.
November 2014, Institutional Shareholder Services Inc. (ISS) issued its
final 2015 proxy voting guideline updates, effective for annual
shareholder meetings on or after February 1, 2015 (see Box, ISS Policy
Changes for 2015). Most notably, the policy changes incorporate a
negative bias regarding director elections where boards have adopted
unilateral by-laws (or in certain circumstances, charter) amendments that
ISS views as limiting shareholders’ rights.
Board Oversight: Key Focus
Boards need to prioritize the
focus of their oversight based on the unique circumstances facing the
corporation. Although the details will vary across corporations, the
main focus should be on:
» Corporate performance and
» CEO selection, compensation
» Internal controls, risk
oversight and compliance.
» Crisis preparedness.
» Shareholder activism and
» Board composition,
leadership and performance.
While the board has much to
attend to, in most circumstances the majority of board time should be
reserved for discussions on corporate strategy and performance. A recent
Blue Ribbon Commission report of the National Association of Corporate
Directors emphasizes the role of the board in providing guidance through
the development of a strategic plan through an iterative discussion with
management. The board should also give special attention to supporting
appropriate long-term investment and prudent risk- taking in the face of
significant short-term pressures for immediate returns, or other
Although not identified in the draft policy changes that ISS released for
comment, ISS will now recommend against directors when the board
unilaterally adopts by-law or charter amendments that in ISS’s view
“materially diminish shareholders’ rights or…could adversely impact
shareholders.” Board actions that could trigger this amended policy
include the adoption of fee-shifting or arbitration-only requirements
without a shareholder vote. However, ISS has indicated in remarks outside
its policy document that it will not recommend against directors in
situations where boards have adopted exclusive forum provisions.
The Limits of Oversight
With increasing pressures on directors, understanding the demarcation
between providing oversight and managing the corporation can be
challenging. This issue has potential implications for director liability.
Boards typically delegate day-to-day management of the corporation to the
CEO and other corporate officers and, as fiduciaries, may rely on them to
perform the delegated tasks so long as that reliance is reasonable.
However, continuing assessment of the reasonableness of the board’s
delegation and reliance are core to the board’s oversight role (see
Box, Board Oversight: Key Focus Areas).
Accordingly, when assessing whether directors have satisfied their
fiduciary duties, the focus will be on the reasonableness of the board’s
reliance on the officers to whom the day-to-day management function has
been delegated. The greater the involvement of a director in the
day-to-day management of the corporation, the more difficult it will be
for that director to stand behind her reliance on the relevant corporate
officers and use that as a basis to avoid personal liability. In addition,
directors that begin to function in a manner similar to officers run the
risk that they will be unable to take advantage of the exculpatory
provision typically included in the corporation’s articles of
incorporation, which by its terms is available only to directors.
Corporations create wealth for shareholders, but their contributions to
the economy extend well beyond the return of profit. They can provide
employment, support innovation, purchase goods and services, pay taxes,
and support various social and charitable programs. Given the important
role that corporations play in our society, concerns about the use of
corporate power and expectations for the board continue to expand,
especially related to the oversight of risk management, compliance and
response, boards need to approach these issues with objectivity and
fiduciary judgment. Boards should work with management to ensure that the
corporate culture is one that, among other things, encourages employees to
come forward with concerns. Boards should assess the quality of the
corporation’s messaging and communicate at every opportunity that internal
reporting is expected, valued and critical to the corporation’s success.
Management integrity is also key to building trust with customers,
suppliers, employees, regulators and investors. Integrity and trust can be
difficult to assess, but should be of particular concern in efforts to
focus on the long-term interests of the corporation and its shareholders,
balance a host of competing special interests and pressures, and address
the expectations of the broader society.
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