Shareholder Democracy: Good, Bad or Unimportant?A discussion of activism and its economic and political consequences

Moderator: Professor Jill E. Fisch, Perry Golkin Professor of Law and Co-Director,Institute for Law and Economics University of Pennsylvania Law School

The December IIEF Roundtable brought together a diverse mix of public and private fund managers, universityprofessors, corporate lawyers, proxy advisors and shareholder activists. The roundtable participants werecarefully selected to represent a range of perspectives and opinions on this topic.

Executive Summary

As promised in Moderator Jill Fisch’s introduction, the conversation covered a wide range of issues relatedto Shareholder Democracy. Despite many areas of disagreement (to be expected given the diversity of theparticipants), the conversation was collegial and there were several areas of agreement.

Several found the term “democracy” to be problematic. Unlike political elections, which are held yearsapart with term limits for elected officials, corporate board member elections are held every year and do notinvite long-term thinking. Some believe that the interests of long-term investors are not being met in thecurrent system.

Voting is just one of the tools of shareholder activism, and it’s too early to gauge the impact of recentlegislation. Shareholder voice is being exercised in many other ways besides voting, with some impact.Litigation in particular is a powerful tool.

Several participants pointed out that shareholders can “vote with their feet” but other institutionalinvestors pointed out that they do not have that option.

Most everyone agreed that many corporations are doing a better job of listening to shareholders, anddirectors are more concerned about the potential embarrassment of a negative vote. Whether this is just aPR effort or shareholders are actually influencing decisions is less clear.

A one-size-fits-all approach to regulation is troubling to virtually everyone, though some argued for theneed for a federal base-line standard. Many participants favor the Delaware approach, which has historicallyallowed companies to decide how they want to be governed.

All agreed that proxy advisors have become major players in the new world of shareholder activism, butthere was considerable disagreement about how powerful they are. Several corporate attorneys assertedthat their recommendations have a huge impact on how shareholders vote, while a major fund managerinsisted that they follow their own policies and do not always line up with proxy advisors’ recommendations.

Given the magnitude of the task of monitoring elections in the over 15,000 companies in the US, there wasstrong argument for focusing on the outliers – the bad apples.

The participants were generally in agreement about one big question: Will shareholder democracy have apositive effect on corporate performance? Will it result in better corporate governance? While some of theparticipants were more optimistic than others, others voiced healthy skepticism.

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Shareholder Democracy: Good, Bad or Unimportant?Full Discussion Summary

Moderator Jill Fisch invited to the participants to explore a wide range of potential topics:“Shareholder Democracy; what is it? Are we talking exclusively about voting? How hasShareholder Democracy evolved? Is Shareholder Democracy good, bad or indifferent, andin what areas is shareholder involvement good or problematic – and why?”

Is voting the key avenue for activism?

The head of corporate governance for a largeprivate investment fund indicated that voting is justone aspect of shareholder activism. “A lot of whatwe do is engagement – writing letters, trying to getdirect access to board members, general day to dayaccess. I would not call this democracy.” Whenreminded by a university professor thatshareholders can also vote with their feet, shecountered, “The reason we’re here and the‘governance industrial complex’ has grown up isthat a lot of the market doesn’t have the choice tovote with their feet.”

A noted corporate governance expert believes thatvoting is critical to the whole system. “It’s criticalthat the process be open – not so much to influencethe direction of the company but to ensure that thevoice of the shareholder is adequately representedin day to day decisions. That’s why the emphasis onputting people on slates. We need to rethink ourlegal regulatory system. There’s been moreemphasis in recent years on suffrage.”

“Democracy,” “Voice” & “Accountability” – Semantic or substantive differences?

A corporate lawyer doesn’t like the termshareholder democracy because, “It creates a falseanalogy to our political system. If you’re a UScitizen, most voters are in it for the long run – whichmakes elections very important.“

XXWith corporate votes: 1) a few interested peoplehave so much leverage; and 2) there are electionsevery year. The vast majority of shareholders aredisinterested. We shouldn’t have contestedelections every year or companies won’t have timeto manage; how do you balance what’s too far?”

A representative from the SEC also doesn’t like theterm “democracy.” “I like the terms ‘voice’ and‘accountability.’ Voting is the tail end of voice.Proxy access and Say on Pay came to the forebecause of the lack of a mechanism for boardresponse to the shareholder community.Shareholders felt cut off from the board. Whenthere are owners with a particular view there needsto be a way for the Board to process that view. Thecompany gets into trouble when the board becomescut off and self-centered.”

Moderator Fisch inserted that, “Voice andaccountability sound like different things.Shareholder influence is different from voice. Whatare we trying to accomplish?”

An SEC representative believes the “two haveemerged together. I think boards are listening, and Ithink that’s why the proxy system as it is todayworks pretty well.”

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Will states or the feds do the regulating?

A corporate attorney questions how it will be regulated and where. “Will it be regulated under a one-size-fits-all approach or will there be flexibility and respect for the states’ systems? I think it’s better to follow theDelaware system, which has always been one that allowed companies to decide how they want to begoverned. The notion that one system should control the process is wrong.”

“99% of the time, whatever the corporate policyturns out to be will be what management haschosen,” the litigator concluded.

“The idea of experimentation and flexibility isterrific,” stated Moderator Fisch. “But when youlook at some of the shareholder voting issues, evenDelaware has come to this relatively late with itsproxy access bylaws in 2009. And many states aremuch farther behind. If shareholders don’t have thepower to adopt bylaw amendments, how doesprivate ordering happen? Does it happen at thecompanies where you need it?”

A corporate attorney countered that Delaware wasone of the first to allow proxy access on nominatingdirectors. “The right thing to do is let corporationsdecide for themselves. Is deferring to the Federalsystem better?”

Who makes the rules is key

The overseer of a large public pension fundbelieves the issue goes beyond money. “It’s stillcorporations that make the rules. I think of thenumber of corporations that allow directors to beput on the board with a bare minimum number ofoutstanding shares. And we as an institutionalinvestor have no recourse; we can’t vote againstdirectors. Certain companies are adopting themore European model of allowing a certainpercentage of outstanding shares to go for adirector, but we’re then left with just two choices -if we’re informed at all. We may not like eitheroption and all we can do is sit out and watch.”.

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Will Shareholder Democracy Result in Better Corporate Performance?

A corporate governance litigator said, “There’sbeen, for the past 15-20 years, an increasing moveon the part of shareholders to improve theaccountability of both boards and strengthenshareholder voice. Shareholders have supported anumber of mechanisms like proxy access andmajority voting, all of which are intended toincrease influence of shareholders in corporations,and primarily this increase in influence is throughsome kind of voting.

“However you describe the shareholder movement,whatever label you give to it – democracy oraccountability – the fundamental question iswhether this increasing influence will have a positiveimpact on corporate performance. In terms of Statev Federal regulation, there has to be a defaultstandard as to what corporations are required to doif shareholders don’t alter the statutory status quoon their own. Before it looked like proxy accesswould pass at the Federal level, Delaware had theopportunity to implement some type of proxyaccess rule but failed to do so. By the timeDelaware got around to it, it was too late to havethe impact it would have had 10 years ago. We alsohave to keep in mind that it’s not a level playingfield. When presenting proposed rule changes toshareholders, corporations have the advantage ofthe corporate treasury; shareholders do not havethe same advantage when contesting managementproposals. It’s very one sided, with one side havingall the money. It’s important what the default rulesare “because you can’t just say that we’ll have a fairelection where corporate policy will be decided.

Waiting for the impact x

Moderator Fisch: “We’re still waiting to see what the result of majority voting will be. Last year a number ofdirectors didn’t receive a majority vote but it was in companies without majority voting so there was noimpact. It has caught on with a few companies that are responsive to shareholder needs, but there are a lotof companies without majority voting where there is clearly shareholder dissatisfaction.”

A business publisher, who is about to publish anarticle about the “Too Sensitive Board” believes thatboard members “need to get over the idea that theyneed to be unanimously reelected. Shareholderdemocracy may be a pushback.”

Moderator Fisch: “Most directors today areindependent directors; it’s embarrassing to not bereelected. The foundations of political democracy,where people hold positions for fixed terms,eliminated the vested interest in keeping theirpositions.”

The pros and cons of more regulation

A representative from the SEC believes, “Theanalogy to public officials is very apt. How manycorporate scandals do we need in order to showthat people on boards act the same way, whetherthey’re sitting on a board or sitting in Congress? Inmy view, there’s been a dearth of enforcementagainst boards. We’re not holding them asaccountable as we should. What would be theimpact be if we started making board membersaccountable? The area is ripe and I think we’reheading in that direction.”

“Corporate governance is really a triad withmanagement,” said another SEC representative.“Board responsibilities include succession planning,risk management, strategic planning, internalevaluation and CEO incentives. And when they failin those responsibilities, how does the shareholderintervene to overcome that failure? In the mostextreme cases, you have fiduciary or fraud failure, inwhich case the SEC needs to intervene. Hopefullywe don’t get to that extreme case. “

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A corporate lawyer believes, “Like politicians facingreelection, nothing makes a company moreaccountable than a real proxy contest. I’ve neverseen a company go through a proxy contest wherethere were not substantive changes that would nototherwise have made.”

Another corporate lawyer asserted, “A criticalfunction of a board is to be neutral amongshareholders; we don’t want to destroy that. In thewhole corporate governance debate, no one hassuggested scrapping the whole system. The Board’srole is to protect Shareholder A against ShareholderB. In the next phase, we should focus on building uptransparency, which would allow shareholders tounderstand who their fellow owners are.”

Shareholder influence: not always positive

Moderator Fisch: Should we cater to shareholderinterests? Does that get us to the right place? Onefactor in the financial crisis may be connected toshareholder empowerment. To the extentshareholders care about stock price, whichobviously they do, there are aspects of corporatedecision making such as risk taking that improvestock price in the short term. In the recent crisis,some of the companies (particularly financialinstitutions) that did really well and then blew upwere arguably acting in response to shareholderdemands for accountability. So there’s a worryabout going down this path. Does the democraticconcept of majority rule really make sense?

To the extent an activist makes people sit up and take notice and create changes – can we say with confidence that those changes are good for the corporation in the long run?”

Too Much Regulation?x

A corporate attorney wonders “if this is an opportunity to take a breather on regulation. Stockholders haveaccess to litigation. Balance is key and there are a lot of pressure points in both directions. I’m uncomfortablewith too much regulation. The dynamics in the courts is huge.”

Shareholder democracy is like living in DC and voting for President

A securities fraud litigator believes, “Shareholderdemocracy is like living in DC and voting forPresident. It feels good but has no impact becauseDC has no electoral votes. Do outside directorsactually make a difference? We have a system nowwhere you have bright, part time folks who spendmaybe one day a month at the business. They haveno staff, and we say to them, ‘you’re supposed tosupervise the management of that business.’ Sowhat do you get? Someone who can set a tone atthe top and hire and fire the CEO.“That’s all you can get. If that’s all we’re gettingexcept in extreme situation, who cares? Is it worththe investors’ time to look at thousands of elections,and all the time that would take – or do we just lookat extraordinary situations? Delaware appears tolegislate for the 95% who run a corporation in thenormal way and expect them to sort out what theywant to do. The Feds are legislating for the absolutebottom. The big question is, ‘Does my voice meananything and is my voice so diluted that it makes nodifference?’”

x

The role of proxy advisorsx

A corporate governance university professor said,“We looked at 2500 director elections and foundonly four cases of contested elections. In one case,the director stayed on even without a majority ofvotes. Are votes meaningful? Yes, but not inelecting directors. We do find that directors are veryresponsive to even slightly lower votes in terms ofreducing excess compensation and repealing poisonpills. The most important factor in a directorelection is a proxy advisor recommendation. Theirrecommendation can swing a vote 18%.”

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What real impact are shareholders having?

x

Moderator Fisch: “Where we’ve seen anevolution and directors lose their job in seriousnumbers is where fraud is involved. Empiricalstudies years ago suggested that it didn’t muchmatter – that those board members stay onregardless of restatements and SEC investigations.More recent literature does show an effect fromthings like broker discretionary voting, majorityvoting and proxy access on board members losingtheir positions – even without the level ofshareholder control that some of the new reformsmight produce.”

A corporate board member said, “The Board’sresponsibility is to focus on the tone at the top;their #1 role is to hire and fire the CEO. All directorsshould be focused on risk v. reward and strategicplanning. I’ve yet to see a situation where theboard did not take their responsibility very seriously.Years ago, board members were buddies appointedby the CEO. Those days are gone. Things arechanging rapidly for the good. Are directors tryingto do a good job? Yes.”

Moderator Fisch: “How much of this shift is theresult of shareholder democracy – through morepressure and monitoring by institutions?”

The board member agreed that “outside influencesare a factor in the change. Years ago, no one tookthe proxy advisors seriously; now they take themvery seriously. The advisors are looking at us; who’slooking at them? That’s a huge concern.”

Proxy Advisors Are Not Transparent

A proxy advisor agreed that “Proxy advisors are not transparent. Board members of failed companies often get appointed to other boards. We’re at a disadvantage because we don’t have a team of analysts; we can’t do the fundamental research, but are relying on what companies tell us. Many companies have their own custom policies. Voting correlation with our recommendation doesn’t mean control. The perception is that people rely more on our recommendations than is actually the case.”

“Without an understanding of the context,”Moderator Fisch pointed out ”what are we reallygetting with our vote? With respect to Say on Pay,can a shareholder vote really provide meaningfulinput on pay packages and pay design, and will ittake us in the right direction? There are someacademic commentators that argue that theproblem with executive compensation is that wewent down the path the institutional investorsadvocated – performance based compensation,stock options - which led to this dramatic inflation inpay. So if we’re responsive to shareholders, willthat improve operations and corporateperformance?”x

Long term investors’ interests are not being met

xx

A securities fraud litigator suggested that “Theboard is supposed to be the neutral refereebetween different groups of shareholders and theircompeting interests. I would suggest that theemphasis we put on Shareholder Democracy is aresponse to the board not serving properly as aneutral referee. Many boards are more focusedmore on the shareholders who can divestthemselves of their interest more than on thecaptive, long-term investors. The long terminvestors don’t have the degree of influence thatthey should, and their interests are not being takeninto account to the degree that they should be interms of their relative size and significance. If wehad different ways of putting people on boards ofdirectors, would that make a difference? Wouldthey focus more on the long term, and would thatultimately make a difference?”

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A private institutional investor challenged thegroup to “show us evidence of undo advisorinfluence. We have not seen it either in votingoutcomes or on policies.”

A corporate attorney disagrees. “It’s hard to arguethat they don’t have undo influence. Mostshareholders will follow the recommendations ofthe two major proxy advisory firms. Companies gohat in hand to them asking, ‘What can we do to getyou to endorse our slate because that will have a bigPR impact?’ Their reports are not publiclyavailable.”

A corporate board member insisted, “We thinkabout what’s in the best interest of shareholdersand sometimes that goes against advisorrecommendations. What’s our remedy? We go andtalk to the relationship manager at the advisory firmand explain our position. A good example is theissue of the separation of the CEO and Chairman.Both systems work with the right people. You votethe way you should regardless of the advisor’srecommendation.”

A proxy advisor believes that few companies aretaking advantage of shareholder accessopportunities. “That’s why the Feds stepped in.Shareholders are reluctant to vote against the boardbecause that’s what they’re investing in. The US isin a small minority in the world; shareholder accessis almost universally accepted elsewhere and it hasnot led to going overboard. I believe the effect ofshareholder involvement is very healthy. Recentvotes at Pfizer, Washington Mutual and HomeDepot are examples of directors leaving evenwithout majority voting.”

A Little Knowledge Can Be a Dangerous Thing

A public institutional investor wonders, “Are these people qualified to make these decisions? I hear concernon both sides; do we trust short term anger? I don’t know that my client is well informed enough to throwtheir weight around on some of these issues. I appreciate the proxy advisors’ role in explaining things - theirability to boil things down and explain them to our board members. We didn’t take part in proxy voting for along time because we understood that a little knowledge is a dangerous thing. You have a similar problemwith general elections, where you have the problem of media swaying public elections. You have anelectorate that is not well informed but they have no other option for participating in the process.”

Proxy access addresses the“bad apple” problem

A private institutional investor said, “We write a lotof letters and are very particular about what wewrite. It has to be driven by one of our fundmanagers and we have to own a substantial amountof the company (over 4% or 5%) and it has to besomething that is actionable. The corporateresponse over half the time is, ‘We have no interestin your recommendation.’ About a quarter will playalong for awhile and then take no action. About aquarter actually take some action. We supportedproxy access because of the bad apple problem. Wesee it as a tool in the toolbox to be used rarely but inspecific situations. We would consider partneringwith a pension fund that could take the lead.Lending our weight to an effort like that is a gooduse of our resources.”

A corporate board member said, “I do supportproxy access. I was brought onto the board after anactivist got elected through a proxy fight. Thecompany needed a lot of change. He then broughtin new, independent directors. Proxy access issometimes the only way to bring about change. Allindependent directors have is our reputation. Thatdrives a lot of people to make the right decision.”

Moderator Fisch: “Do we accept the idea that insome cases the only way to shake up the company isthrough some kind of shareholder access?“

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A corporate governance expert believes ”boardsare more accountable than they were. The problemis ultimate accountability. Last year approximately50 board members did not get a majority vote andin fact stayed on; only one or two actually left andthey’re likely to end up on other boards. And thereare many examples of failed companies where theboard members resurface at other companies –even on governance committees.“

“Why? Boards are collegial bodies; it’s difficult todissent. We need to change the culture. The ethoson a board is consensus voting; disagreement is notencouraged. It should be more like this roundtable.We need to encourage debate and dissension. Howyou do it is important; it doesn’t need to beunpleasant. Until boards recognize that dissensionis an important part of reaching the right decision,you’ll have a problem with accountability.”

Moderator Fisch: “Let’s talk about shareholders’nominating power, what it should look like, andwhether we should have it. Is it better to haveshareholders vote on director nominations ratherthan on compensation packages? Is that a betterway to impose accountability? Will the rightshareholders use the nominating power? How dowe structure the nominating power and can it makea difference? Can investors really get together? Itstands that the money that can walk also has moreincentive to be informed. Do we want this in somegroup or collective way?”

One size does NOT fit all

There was consensus among the roundtable participants on this issue: one size does not fit all. A corporateattorney believes, “It’s impossible to generalize. It’s a great thing to have proxy access. I believe we need amulti-pronged approach through the election process, proxy access and litigation. We can’t ignore the factthat litigation plays a huge role. The notion that one- size-fits-all is a bad idea.”

“The proxy advisors’ technology allows for crowdsourcing within the corporate governance realmthat allows for good and appropriate decisionmaking. The new corporate governance response,both in Federal action and the work of advisoryfirms, is designed to overcome the barriers tocollective action.”

Will the SEC’s rulings limit our creativity?x

Moderator Fisch: “We’ve been told thatshareholders in other countries have much morepower, but they also have a very differentownership structure and composition. The globaldebate raises the question: Are we being creativeenough in our approach? Are we focusing toonarrowly? I wonder if a side effect of 14a-11 andthe SEC’s focus on this path is to reduce our thinkingmore broadly.”

x

A corporate governance professor believes that“majority voting is a paper tiger. Most companiesand directors are getting 94% of the vote anyway.The empirical evidence shows that the marketdoesn’t believe in a one-size-fits-all approach. Whenthe House passed Say on Pay in 2007, the marketresponded positively in the case of companies withpoor pay for performance and those where CEOswere getting abnormal compensation – but theyresponded negatively for other companies. Theunions have been targeting Say on Pay in the wrongfirms – not those with poor performance or poorgovernance but large firms where pension fundshave some interest. And the market has reactednegatively to those proposals.”x

Respecting the schedule two-hour agenda, theRoundtable adjourned at 10:03 AM.

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A corporate attorney asserted, “With 15-16,000public companies in the country, it’s clear that onesize does not fit all. It’s also clear that somethingneeds to be done about the nomination process andproxy reimbursement. It’s my sense that a lot ofcompanies are doing this on their own.”

Moderator Fisch: We see companies not waitingfor Delaware to take the lead on majority voting,but not on proxy access. Why?”

A corporate attorney believes there are “tworeasons why more companies didn’t take the lead:pending federal legislation in this area, and theSEC’s refusal to allow states to experiment. 14A-8took away the shareholder pressure point thatmight have caused some corporations to moveforward in this area. Everyone agreed that 14A-8should be changed to allow investors to participatein this area.”

Both regulation and proxy advisors provide a structure for collective action

An SEC representative said, “The history has beenthat the Chamber and others were opposed to 14a-8 solution until it became inevitable and the less oftwo evils. I’d like to have a philosophical discussionabout the nature of a federal v. state response as itrelates to the nature of capital formation in thiscountry. Dispersion of ownership creates aparticular issue in the US (in terms of capitalaccumulation) that other countries don’t face. Ifyou’re not going to walk away from a company, youneed a structure for collective action. A federalproxy access creates a structure and a rational forcollective action. So do the proxy advisory firms.

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