While a lot of attention has been paid to government's efforts to reign in systematic risk in the financial system and increase oversight, very little has been written about the mechanisms by which our corporate economy will "self correct" after the failures of the past few years. That's unfortunate because reforming the way corporations govern themselves is key to avoiding another crisis.
Although slightly under the radar, in 2010, the Securities and Exchange Commission is set to unveil new rules that will recalibrate the balance of power between corporate management and shareholders by, hopefully, requiring corporations to adopt "proxy access" rules. Proxy access refers to the ability for shareholders who meet certain thresholds (amount of shares owned and the length of continuous ownership are two of the most prominent) to use management's proxy to nominate their own directors and, in some cases, recommend changes to the corporation's by-laws for the purpose of changing the way directors are nominated. In the corporate governance universe, proxy access is one of the few ways shareholders, as opposed to management, can actively govern a corporation.
The contours of the debate are stark but are little known out side the insular world of corporate boards, activist shareholders and the lawyers and consultants who love (and loath) both. You see,
for a long time the Securities and Exchange Commission (and the federal government as a whole) has supported a proxy access regime that, essentially, disenfranchised shareholders and empowered management. The prevailing idea was what is called "private ordering:" every corporation was free to determine its own proxy access rules without any "public" interference. Most corporations simply decided that the best proxy access was no proxy access. Shareholders could always try to take matters into their own hands and force the corporation to adopt fair proxy access rules but that rarely happens because of the myriad ways that corporations can prevent changes to their by laws by shareholders.
For good measure, SEC Rule 14a-8 requires corporations to have some semblance of proxy access. But Rule 14a-8 is so loophole ridden that its almost a farce. For example, under the current rule corporations are allowed to exclude shareholder proposals that relate to elections (so no insurgent director nominees needed to be included on management's proxy) and corporations are permitted to exclude proposals that "are improper under State law." That last one is a doozy: turns out that the Model Business Corporation Act, the template for most States' Corporations Law, says that by-law amendments requiring mandatory proxy access are prohibited. (There is some change afoot because Delaware, where many large corporations are incorporated, recently changed its law. However, the fact that the law can vary from State-to-State is itself problematic since those differences create large transaction costs for diversified investors. That is a topic for another post). I like government and believe in democratic law making, but things like that make me wonder: who writes this stuff?
The proposed rule changes would create a "public ordering" of proxy access rules. Public ordering means that every company would be required to have some form of proxy access so shareholders could nominate their own directors using management's proxy (basically, the names of shareholder nominated directors would appear next to the slate of management/board nominated directors). Companies would be able to "opt-out" of the rule (the default rule would allow for proxy access) but only by a vote of their shareholders where the benefits of proxy access are full disclosed. An alternate proposal would amend SEC Rule 14a-8 to that it no longer allows corporations to exclude shareholder proposals for proxy access from management's proxy. The latter (permitting access to management's proxy for the purposes of proposing proxy access) is sort of a modified "public ordering:" it would, essentially, require companies to ask shareholders whether they want proxy access (to "opt-in"), although the default rule would be no access.
Modified public ordering might do the trick but its fraught with risk. If the SEC adopts a rule that requires shareholders to place proxy access proposals on their proxies (an "opt-in regime") you can be sure that corporations will attempt to short circuit the process by proposing their own "watered down" proxy access rules. This is not some hypothetical threat: in fact, some of the "great minds" of corporate governance are proposing, in part, just that. Examples of "watered down" proxy access proposals include those are merely precatory (fancy legal word for "optional") and those with prohibitively high ownership and length-of-holding-requirements. I believe that the proxy access rules yielded by an opt-in system with a default no access rule would would be a little short of worthless to shareholders.
The SEC needs to adopt a uniform proxy access rule ("public ordering") that every company must adopt - a default access rule with the ability to "opt-out" if shareholders so desire. Of course, my opinion is not shared by most of the lawyers and consultants who advise corporations on governance issues: they oppose public ordering and tend to support various opt-in proposals. I regard their opposition as somewhat suspect because most of these lawyers and consultants do a lucrative business in custom tailoring corporate by-laws to be resistant to shareholder demands. Its possible that some genuinely fear that some malignant force will infiltrate corporate boards and will, somehow, do a worse job running American corporations than the current crop of directors. As with most conspiracy theories, the hard evidence for that threat is lacking. For one, many large investors are "buy-and-hold" pension funds looking for a sound investment and a steady return for the pensioners whose retirement funds they have a fiduciary obligation to maintain (and U.S. equities are probably one of the less risky investments these funds are in).
Whatever their motives, the anti-public ordering gang's reasoning doesn't stand up well under scrutiny. On the first spin of the anti-public ordering "Wheel-Oh-Excuses" we land on the idea that a company should not be required to adopt a "one size fits all approach" but rather should be permitted to "opt-in" to the rule if its right for them, or design their own. That would make proxy access the only SEC rule that is, essentially, "voluntary." A voluntary rule is unworkable and the idea that companies can decide whether to adopt or reject a financial regulation designed to protect investors requires a degree of intellectual contortion that I find unbecoming. There is nothing stopping boards from adopting proxy access now but, by one count, only three companies (out of the thousands registered) have actually put in place a workable proxy access rule. Besides which, if a company believes that the SEC uniform rule is inappropriate for them it can always design its own proxy access rule that conforms to whatever minimal protections are provided by the publicly ordered proxy access regime. In other words, the SEC's "one-size-fits-all" suit is made with a lot of elastic.
A second objection is, perhaps, more interesting and more intellectually honest: under principles of federalism, corporate governance should be left to the States. Its an old argument that has a simple retort: State control of corporate governance has lead to a "race to the bottom" where management has been able to pick and chose where to incorporate based on the States with the weakest protections for shareholders. While apologists for corporate America celebrate this system, I think it's a boon for hucksters. Professor Bainbridge of UCLA, an expert in these matters, gives a spirited defense to the idea of State control of corporate governance matters. Unfortunately, if you read his posting as a whole, it has a glaring inconsistency: the first part of the post talks glowingly about the benefits of a strong board insulated from outside pressures (even going so far as to deride the generally non-controversial idea of cumulative board voting because it, allegedly, exacerbates majority-minority splits and leads to board dysfunction) while the second part seems to indicate that shareholders are willing to pay a premium for corporate governance structures that have generous shareholder protections. At the risk of starting an argument with someone far smarter than me, I don't think it really adds up. There is also a three-card-monte element to the argument since Professor Bainbridge should be well aware that the ability for shareholders to nominate directors in the first place is an issue of State law (a few States actually prohibit it, a silly prohibition that rests with those retrograde State legislatures to address). However, the proposed proxy access rules address disclosure of the nominees on management's proxy. That distinction is critical because disclosure issues have been governed by the Feds since at least the 1930s.
Perhaps the most insidious of the arguments against a uniform rule is what I will call the "love you to death" argument: corporate democracy is about choice, so shareholders should have a choice to adopt their own rules even if that means that shareholders can disenfranchise themselves. (Pause for a head scratch). While that's all well-and-good, there are so many ways that management stymies shareholder control that requiring shareholders to select their own proxy access regime ("opt-in") without a default access rule means that there probably won't be one. Finally, I would be remiss if I did not mention that some observers think that a uniform proxy access rule violates something called the Administrative Procedure Act. While this may or may not be true, I've been practicing law long enough to know that every legal opinion has a counter-opinion and, in any event, the APA, being a creature of Congress, can certainly be amended if it's the only true legal obstacle to corporate democracy.
How to sum this up? Well, let me try it this way: Proxy access relates to the most fundamental aspects of corporate governance which is the ability of shareholders to run the corporations that they own. If the economy was humming along and American corporations were still the strongest and best run in the world you'd probably be entitled to relegate proxy access to "that's interesting" category or, for that matter, the "that's really boring" category. However, when American corporations are losing their global competitiveness at an alarming rate or just plain failing (General Motors, Chrysler, AIG, Lehman Brothers, Bear Stearns... and the list goes on, sadly) compliancy is not an option. Pay attention as the debate heats up in the coming months.