Ignoring The Long-Term: Proxy Access, Say-On-Pay And Disenfranchisement Of The Retail Shareholder

Monday, August 30, 2010 - 00:00

The Editor interviews Lizanne Thomas , Jones Day LLP. She is Partner-in-Charge of the firm's 150-lawyer Atlanta Office and heads the firm's global corporate governance team.

Editor: Please describe your practice.

Thomas: I am a public company M&A lawyer whose practice has evolved to cover corporate governance, which now represents about half of what I do. Being a corporate governance advisor, I am in board and committee meetings over 100 times per year. My counseling activities involve all aspects of corporate governance, ranging from educating boards about changes in the laws, advising directors about their fiduciary duties and providing advice on transactional and investigative matters.

My work as a public company M&A lawyer has been enhanced by my governance awareness and the reverse is true as well. If people in corporations look at governance simply as a checklist matter as opposed to viewing it as an important tool that allows companies to maximize their corporate strategies, then we have utterly failed. Governance is a tool and not an end in itself.

Editor: Describe the proxy access provisions of the Dodd-Frank Act?

Thomas: Dodd-Frank does nothing specific with respect to so-called proxy access; it simply authorizes the SEC to impose proxy access on terms to be set by the SEC. "Proxy access" is shorthand for a way that shareholders, who meet requirements yet to be established by the SEC, can place - or piggyback - their own nominees for director in a company's proxy statement, without the costs of a separate solicitation.

Historically a great deal of respect and deference has been accorded to a board's own efforts to select nominees to the board, given its fiduciary duties to the company. Now, individual shareholders who do not bear any such fiduciary duties, and who may be single-issue voters or carry a short-term ownership horizon, will be able to place their own nominees in consideration in furtherance of their own goals.

This is precisely why we think that Dodd-Frank does not promote a commitment to long-term corporate performance.

In fact, proxy access is a mechanism that invites a focus on short-term results. The average shareholder holds stock for less than nine months today, down from two to three years just a decade ago. If your investment horizon is less than a year, you don't want the company to make capital investments. You do want the company to maximize income over the short term.So in my view, proxy access will result in board leadership being selected by shareholders with a decidedly short-term focus. Progress and innovation will erode as a result. Editor: Do some institutional investors act more like true owners?

Thomas: Not all institutional holders have such a short-term horizon. There are a number of long-term, very thoughtful, very committed institutional investors who in fact buy and hold because they believe in the business in which they are investing and are not trying to maximize their stock performance in a purely short-term way. Nonetheless, statistics don't lie, and we do have a significant subset of investors influenced by the short-term perspective. Some statistics even indicate that many investors have an investment horizon of as short as four months, and then there are the day traders as well - although we don't think they really move the market.

As with most challenging issues, the devil is in the details. The SEC was authorized by Congress to fill in the particulars on proxy access. One important issue that the SEC will address is whether or not the shareholder nominating a director is qualified to place a nominee in the proxy statement. We hope and expect that the SEC will impose a requirement that such a shareholder have a measurable stake in the company, both in size and duration of investment, sufficient to demonstrate that the shareholder is truly an investor and not a speculator or "renter." If the SEC imposes real standards in this regard, then my concerns about proxy access would be somewhat reduced but not eliminated - good corporate governance tells us that the board as fiduciary for all shareholders should be involved in the selection of nominees, so that the board as a whole possesses a portfolio of experience that will best guide the company.

Editor: What is the role of proxy advisory services coupled with the requirement that institutions must vote?

Thomas: The proxy advisory firms, Glass Lewis and most prominently RiskMetrics Group, have really enhanced their ability to influence the voting marketplace. They are compensated and retained by a variety of investors, primarily institutional investors, to do some of the back office analysis that the institutional investors don't want to expend money or effort to do.

As a result, advisory firms like RiskMetrics are increasingly influential in determining the outcome of the voting for directors and on shareholder proposals. Because their role has become so important, it is essential that they do their homework properly, that they don't make mistakes and that they focus on issues that will yield real value given the circumstances of the particular company whose shares are being voted. Their recommendation should not be based simply on blind allegiance to a one-size-fits-all approach to governance.

The role of the proxy advisors has become increasingly important as a result of two trends. One is that shares are becoming increasingly institutionally held. The other is that the retail vote is eroding as a result of rulemaking by the SEC.

Historically, investors who typically hold shares through a broker knew that the broker would have the discretion to vote the shares as the broker sees fit. Investors drew comfort from the fact that brokers traditionally have voted in a manner that is consistent with a company's recommendations. This structure was simple and avoided the paper chase of seeking voting instructions on routine matters.

What has happened over the last few years is thatthe New York Stock Exchange, at the SEC's direction, amended its Rule 452 to provide that brokers no longer may exercise their discretion to vote on the election of directors. Dodd-Frank extends that prohibition to cover voting on any matter that relates to executive compensation or any other significant matter as determined by the SEC.

You may say this doesn't sound so bad. Why shouldn't my broker come to me and ask how do you want us to vote on this? The dilemma is that there is simply not enough time in the proxy solicitation season for instructions to be obtained and then returned. The practical effect is that the retail vote is disenfranchised, which typically represents about 17 percent of the vote. This means that the outcome of a shareholder vote is likely to be determined by institutional shareholders, more of whom carry a short-term focus.

Editor: Describe the Dodd-Frank "say-on-pay" provision?

Thomas: The Dodd-Frank Act makes say-on-pay a federal requirement for all public companies. What we are going to see in the next annual meeting season are two proposals being voted on by shareholders. The first will be the inaugural mandated advisory vote on say-on-pay, and the second will be a vote on how often shareholders want to have a bite of that apple, one year, two years or three years.

While the UK has comfortably absorbed similar advisory votes on say-on-pay for a number of years, I think the marketplace and the dynamic in the U.S. is quite different. What we are going to see coming out of say-on-pay in the U.S. is - yet again - an increased emphasis on achieving short-term results.

Say-on-pay also encourages instability in the boardroom. That is illustrated by recent events at Occidental Petroleum.Occidental is one of the smaller petroleum companies, but it is one of the industry's strongest performers. It has outperformed its peers for a number of years. Because the company has a compensation structure that emphasizes pay for performance, its CEO has been handsomely compensated.

Last year Occidental Petroleum lost an advisory vote on say-on-pay. As a result, Relational Investors, an activist investor, wrote a letter to the board of directors challenging the company's compensation arrangements and demanding a change in the composition of its board as a result. We think this is a significant shot across the bow that portends more boardroom challenges for any company that has a vulnerability, be it compensation or otherwise.

Editor: Why will say-on-pay cause CEOs to focus on short-term results rather than building for the future?

Thomas: If the management team and the board know thatdecisions regarding compensation are going to be subject to question by the shareholders annually, for example, it's going to incentivize them to post successful short-term results at the expense of investing resources in the company's future.

One of the reasons I find Dodd-Frank so incongruous is because if you look at the political commentary surrounding Dodd-Frank it was all about moving away from a culture dominated by short-term profits toward creating innovation and economic success for our country as a whole. Yet, the very structures that Dodd-Frank puts in place are going in the opposite direction. It's potentially tragic.

Companies will be incentivized to look for short-term mechanisms like stock buybacks to yield a blip in the stock price so that the near-term investor can secure its gain and then move on. John Bogle, the founder of Vanguard, said that investors buy shares of businesses and prosper over time as the company grows profits, while speculators trade wiggles on a stock chart, hoping to sell shares at a higher price to other speculators within a few quarters.

Editor: You mentioned your concerns with the disappearing retail vote. Won't this be addressed in the current SEC examination of the proxy process?

Thomas: Yes. This gives the SEC the opportunity to rethink the whole process. I see an important role in this dialogue for comments by individual corporations and for various organizations representing the concerns of business - with leadership on the broad issues being borne by organizations like the U.S. Chamber and the Business Roundtable and with the Society of Corporate Secretaries and Governance Professionals doing its usual brilliant job of addressing the technical side. The concerted contribution of all of these good organizations is critical to ensuring a debate on the legitimate issues - and the avoidance of unintended consequences.

Please email the interviewee at lthomas@jonesday.com with questions about this interview.