The attached article, Corporate Governance Update: The Changing Dynamics of Governance and Engagement, was published in the New York Law Journal on July 22, 2015.
July 23, 2015
Corporate Governance Update: The Changing Dynamics of Governance and Engagement
David A. Katz and Laura A. McIntosh∗
∗ David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. Laura A. McIntosh is a consulting attorney for the firm. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole.
1 The Conference Board Governance Center White Paper, “What Is the Optimal Balance in the Relative Roles of Management, Directors, and Investors in the Governance of Public Corporations?” 2014, available at conference-board.org (subscription required).
As anticipated, the 2015 proxy season has been the “Season of Shareholder Engagement” for U.S. public companies. Activist attacks, high-profile battles for board seats, and shifting alliances of major investors and proxy advisors have created an environment in which shareholder engagement is near the top of every well-advised board’s to-do list. There is no shortage of advice as to how, when, and why directors should pursue this agenda item, and there is no doubt that they are highly motivated to do so. Director engagement is a powerful tool if used judiciously by companies in service of their strategic goals. As companies and their advisors study the lessons of the recent proxy season and look ahead, it is worth examining recent shifts in corporate governance dynamics. With an awareness of the general trends, and by taking specific actions as appropriate, boards can prepare and adapt effectively to position themselves as well as possible to achieve their strategic objectives.
Governance Dynamics Trends
Since 2000, the corporate environment has changed in many ways. A thoughtful white paper by The Conference Board discusses five of the most significant legal, social, and market trends during this time period that have contributed to the changing dynamics of corporate governance.1 These trends have been transformative, and, taken together, they are foundational to shareholder-director engagement today. The first is the increased influence of institutional investors. This is due primarily to the concentration of stock ownership in institutionally-held investment and savings accounts, and to a lesser extent to changes in voting rules and practices and proactive steps by institutional investors to influence corporate governance and direction. The second trend is a shift toward a purely commercial understanding of the purpose of a corporation. Though mid-20th century America generally agreed that a corporation had responsibilities to society as well as to its shareholders, in recent years the prevailing view held by many investors is that public corporations exist primarily to maximize shareholder value. Conflicting interpretations of this goal have produced a further debate as to whether the appropriate timeframe for doing so is the long- or short-term horizon.
The third trend is declining public trust in business and its leaders. Public confidence in corporate America plummeted with the collapse of Enron and WorldCom and the financial scandals that followed, and it was further undermined by the bankruptcies, bailouts, and stock market losses that accompanied the 2008-2009 financial crisis.
The fourth trend, largely a reaction to the third, is the expansion in federal regulations designed to increase the accountability of directors and senior management and provide shareholders with greater power. Federal regulations over the last decade and a half have, among other things, expanded the range of mandatory company disclosures, provided the U.S. Securities and Exchange Commission (SEC) with authority to introduce proxy access, diminished companies’ ability to exclude shareholder proposals from their proxy statements, required regular shareholder advisory votes on executive compensation, and identified shareholder fiduciary duties in certain types of proxy voting by some institutional investors.
This shift in the SEC’s focus recently was clearly articulated by SEC Commissioner Dan Gallagher in his last public speech as a Commissioner: “Part of the SEC’s tripartite mission is to protect investors. But too often, our concept of ‘investor protection’ reflects a prejudgment that a corporation is a democracy, where shareholders participate directly in the governance of the corporation.”2 Commissioner Gallagher went on to argue for a more traditional view of federal versus state regulation:
2 Securities and Exchange Commissioner Daniel M. Gallagher, “Activism, Short-Termism, and the SEC: Remarks at the 21st Annual Stanford Directors’ College,” June 23, 2015 (footnotes omitted), available at www.sec.gov/news/speech/activism-short-termism-and-the-sec.html.
4 See, e.g., David A. Katz & Laura A. McIntosh, “Corporate Governance Update: Important Proxy Advisor Developments,” Sept. 25, 2014, N.Y.L.J., available at corpgov.law.harvard.edu/2014/09/29/important-proxy-advisor-developments/
But, like the United States itself, a corporation can also be a republic, where shareholders elect directors, who in turn govern the corporation. The choice of a shareholder- or director-centric model is properly left to state law. The SEC increasingly has been disrespecting this distinction by interjecting opportunities for shareholder direct democracy into the securities laws. But the director-centric model is at least equally-well suited to the protection of investors, and so the SEC’s rules should provide enough flexibility to accommodate either approach.3
The fifth trend is the growing influence of proxy advisory firms. Proxy advisors successfully capitalized on the loss of public confidence in business leaders, the rise in share ownership of institutional investors, and the wide array of new regulations and governance requirements. Large investors turned to proxy advisors for guidance, smaller investors followed suit, and the soft power of proxy advisors has become disproportionately strong.4 Fortunately, over the last year or two, institutions and other large, influential investors have begun to distance themselves from proxy advisors. One factor in this reversal is the SEC’s issuance of Staff Legal -3- SLB 20 contained a number of elements that together have prompted institutional investors to take responsibility for their proxy votes rather than outsourcing them to advisors such as Institutional Shareholder Services Inc. (ISS). Some large institutional investors have created internal departments to handle much of the work they previously outsourced to proxy advisors. Investment advisors are evaluating and overseeing the work of their retained proxy advisory firms more closely. As Commissioner Gallagher might put it, institutional investors are starting to move from a “compliance mindset” on proxy voting to a “fiduciary mindset.”-4- -5-
Lipton, Rosen & Katz Client Memorandum, May 18, 2015, available at corpgov.law.harvard.edu/2015/05/18/winning-a-proxy-fight-lessons-from-the-dupont-trian-vote/.
14 Fink Letter, supra.
16 Society of Corporate Secretaries & Governance Professionals, “Role of Secretary,” 2015, available at www.governanceprofessionals.org/about/roleofsecretary
17 See Simon Osborne, “Rise of the Company Secretary,” Law Society Gazette, July 7, 2014, available at www.lawgazette.co.uk/law/practice-points/rise-of-the-company-secretary/5042026.fullarticle.
18 Andrew Kakabadse & Nada Korac-Kakabadse, “The Company Secretary: Building Trust Through Governance,” Institute of Chartered Secretaries and Administrators/Henley Business School, University of Reading, 2014, at 7.
19 See Goldstein, supra, at 18.
DuPont did exactly what investment community leaders such as Laurence Fink have encouraged corporations to do—“engage with a company’s long-term providers of capital; … resist the pressure of short-term shareholders to extract value from the company if it would compromise value creation for long-term owners; and, most importantly, … clearly and effectively articulate their strategy for sustainable long-term growth.”14 In his April 2015 letter to chief executives, Fink promised that “[c]orporate leaders and their companies who follow this model can expect our support.”15 In the DuPont-Trian proxy fight, he and a sufficient number of other institutional shareholders held up their end of the bargain.
Some institutional investors have expressed concerns regarding the rapid increase in director engagement and how they, as large shareholders whose attention is much in demand, will allocate their resources to engage meaningfully. There is some concern that companies with smaller market capitalizations may find it difficult to engage the attention of large shareholders, as these investors are likely to prioritize engagement with companies in which they have more significant investments. Smaller companies may need to seek engagement earlier in the proxy season (or before the proxy season) in order to obtain meaningful access to their institutional investors.
The Corporate Secretary
The preeminence of corporate governance and the rise of shareholder engagement have resulted in a fundamental shift in the role of the corporate secretary. As the Society of Corporate Secretaries and Governance Professionals has observed, “In recent years the Corporate Secretary has emerged as a senior, strategic-level corporate officer who plays a leading role in the company’s corporate governance.”16 In addition, many corporate secretaries have become, as one commentator put it, “the primary point of information and influence between the executive management and the board.”17 A 2014 U.K. study concluded that “[t]he role is changing: it is increasingly outward-focused (incorporating investor engagement and corporate communications), and not just about internal administration.”18 A 2014 ISS report found that when investors reach out to engage with boards, they most frequently contact the corporate secretary. The second-most frequent point of initial contact for investor-driven engagement is the board chair (or lead director), with the investor relations office a weak third.19 When it is the -6- -7-
Role of the Board
Corporate governance trends have wrought many significant changes in the management and oversight of U.S. corporations. The priorities and responsibilities of directors, investors, and senior executives have changed to varying degrees as all of the corporate actors adapt to new requirements, societal trends, and the increasingly interconnected corporate environment. Through mechanisms such as majority voting—which is becoming more widespread each year—shareholders are increasing the accountability of directors in annual elections. The hope is that these changing dynamics will have a beneficial effect. As Chief Justice Leo Strine of the Delaware Supreme Court has written:
[I]t is clear that stockholders have more tools than ever to hold boards accountable and the election process is more vibrant than ever. The election of more accountable boards should come with less tumult, not more. More accountable boards should be given more, not less, leeway to make decisions during their term. This does not mean that corporation law should strip stockholders of their substantive rights to vote on mergers or major asset sales. But it does mean that the costs of further distracting corporate managers from focusing on managing the business to generate profit would outweigh the benefits that come from more corporate referendums.24
24 Leo E. Strine, Jr. “One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed For The Long Term Unless Their Powerful Electorates Also Act And Think Long Term?” 66 Bus. Law. 1, 23 (November 2010), available at http://www.ecgi.org/tcgd/2011/documents/Strine%20Fundmental%20Corp%20Gov%20Q%202011%20Bus%20L.pdf.
25 See, e.g., Del. Gen. Corp. L. § 141.
Perhaps one outcome of increased independent director engagement with shareholders will be a decline in corporate referenda, allowing directors to focus on creating value in the long term. To date, unfortunately, that has not been the case.
Though certain aspects of the role of the board may be changing, the fundamental role and responsibilities of the board hold constant. As a matter of state law, the board is charged with managing, or directing the management of, the affairs of the corporation.25 No matter how active or activist a company’s shareholders may become, their legal responsibilities extend only to the election of directors, votes on certain fundamental matters, and advisory votes on compensation. Some academics and activists argue that state law should be revised to expand the legal rights of shareholders; the merits of this suggestion are debatable, and in any event, it has not been implemented.
Shareholder influence likely will continue to grow, but the legal rights of shareholders remain limited, and the U.S. corporate model remains managerial and director-centric. Directors cannot allow their business judgment to be usurped or overly influenced by investors, advisors, or other board outsiders. Boards are encouraged to interact strategically with investors, to address their concerns, and to reinforce the company’s long-term goals, and at the -8-
same time to keep in mind that activism, corporate governance, and engagement change nothing about the fundamental fiduciary duties of directors.