November 30, 2015

Who Should Pick Board Members?

Yvan Allaire and François Dauphin | The CLS Blue Sky Blog - Columbia Law School

There is a frenzied rush for shareholders to get a new ‘right”, the right to put up their own nominees for board membership. Boards of directors, so goes a dominant opinion, are not to be fully trusted to pick the right kind of people as directors or to shift the membership swiftly as circumstances change.

In 2014/2015, proposals from institutional investors (or even from management) to give shareholders access to the board nomination process have proliferated. No less than 74 U.S. corporations[1] have now inserted (or soon will) in their by-laws the “right” of shareholders to nominate members of the board, among which GE, Coca Cola, McDonald’s, Chevron, Citigroup, Verizon, and so on. And a tsunami of similar proposals is visible over the horizon.

Of course, this agitation started In August 2010 when the Securities and Exchange Commission (SEC) introduced Rule 14a-11 giving shareholders having owned at least 3% of a public corporation’s shares for at least 3 years, the right to propose nominees to the board (for up to a maximum of 25% of the members of the existing board).

This new regulation was immediately challenged in the courts and had to be withdrawn when it was struck down. However, an amendment to Rule 14a-8 (amendment made by the SEC to accommodate its proposed regulation on proxy access) remained in force; its purpose was to allow shareholders to submit proposals on proxy access rules, which, if adopted by a majority of shareholders, were to be made part of the corporation’s by-laws.

This access to voting proxies is fast becoming a part of the governance landscape in the United States; the only issues that are still debated are qualifying ones: the level of shareholding, the holding period, the maximum number of shareholders which may band together to achieve the admission criteria and various aspects of its implementation.

It is very unlikely that major corporations will try to oppose the movement as many institutional investors are fiercely supportive of this measure. However, the eventual impact of this initiative on corporate governance raises important issues that seem totally absent from the discussions around this new “right” of shareholders.

Proxy access may have adverse effect on internal board dynamics

Among the arguments supposedly supportive of shareholder access to the nominating process, one is particularly noxious: the notion that “fear” among board members of being singled out for replacement would lead them to raise their game.

The consequences for an individual director being voted out of a board would be very significant and painful, both in economic and reputational terms; this is true for both incumbent nominees and the new nominees proposed by the shareholders.

Faced with the risk and arbitrary nature of a contested election, the directors would try to promote their personal contributions with institutional investors (and proxy advisors), thus generating an unhealthy competition among colleagues. In any event, how would the thousands of shareholders, called upon to choose between several nominees, decide for which nominee to vote, which nominee to dismiss when the voting proxy contains more nominees than available seats?

Smaller institutional funds may well come to rely on proxy advisors (such as ISS or Glass Lewis), again increasing by tenfold the influence of these outfits on the governance of public corporations. These proxy advisors will propose, as per their usual practice, some obvious, measurable criteria to make this choice: age of the directors, number of years as a member of the board, which are, in fact, arbitrary criteria, uncorrelated with actual performance.

Once these criteria are well understood, it is likely that corporations will try to preventively replace directors to avoid conflicts with large shareholders and to make rooms for their nominees. Therefore, directors would be shown the way out because they no longer satisfy the arbitrary criteria selected by proxy voting advisors without taking into account their actual contribution.

Even more likely, boards of directors will initiate discussions and negotiations with institutional investors who have indicated their intention to propose their own nominees in an effort to reach common ground. These secret negotiations are likely to result in some of the nominees proposed by institutional investors becoming the nominees of management and some current directors presumably viewed, more or less deservedly, as being weaker (older, longer tenure) forcibly retired.

Anyone believing that this process is likely to produce stronger boards in the long run needs to consider anew the calculus of current and prospective board members, the actions, likely dysfunctional, of people facing the humiliation (and economic loss) of an electoral rejection.

Shareholder access to the director nomination process brings forth a host of other issues related to the logistics of its application and the potential adverse effects on board dynamics including:

  • the usurpation of a responsibility historically and legally devolved exclusively on the board;
  • the implicit, yet false, postulate whereby directors are only accountable to the shareholders and are only responsible for the interests of shareholders;
  • the reputational issues of the directors submitted to a contested election and the self‑protective behaviour this would bring about;
  • the actual risk of secret negotiations being held between management and investors who are intending to propose nominees;
  • the overwhelming influence accruing to proxy voting advisory firms, whose clients would expect their voting recommendations on the nominees;
  • the risk that the independence of directors nominated by shareholders would be compromised or so perceived;
  • the risk of creating factions and a poisonous atmosphere within the board, which would compromise the proper functioning of the board;
  • the risk of ending up with a board deficient in relevant experience or competence;
  • the risk that the process be hijacked by single-issue groups of shareholders.

These unfortunate outcomes of granting shareholders the right to propose their nominees for the board should merit careful consideration before jumping on the bandwagon.

[1] Data from, as of September 8th, 2015.

This post comes to us from Yvan Allaire, Ph.D. (MIT) and Executive Chair of the Institute for governance of private and public organizations (IGOPP), and François Dauphin, Chartered Professional Accountant (CPA, CMA), MBA and Director of Research of IGOPP. The post is based on the authors’ Institution Policy Paper, entitled “Who should pick board members? Proxy Access by Shareholders to the Director Nomination Process” and is available here.