Shareholder Democracy Is No Demon

Corporate America's objections to an SEC proposal to let investors more easily nominate board candidates are way overwrought

By Louis Lavelle

From the outraged reaction the idea received, you'd think the Securities & Exchange Commission was considering an end to the free-market system. In fact, the SEC is mulling over something much more modest: a less expensive way for shareholders to nominate board candidates.

The idea is simple. Today, the only way for shareholders to run a candidate for a board seat is to print and distribute their own proxy materials, a cumbersome and pricey endeavor. By allowing investors to place their candidate's name beside those of board-nominated contenders on the company's proxy, the barrier to entry is lowered, and more dissidents likely would run, making boards more accountable.


  Not so fast, says Corporate America. Pfizer (PFE ) CEO Henry A. McKinnell, writing on behalf of the Business Roundtable, warns that it would "diminish board accountability to shareholders" and "turn every director election into a divisive proxy contest." The American Society of Corporate Secretaries predicts divided boards, out-of-control costs, and unqualified directors. Let shareholder nominees be on the proxy, the New York City Bar Assn. opines, and qualified director candidates would refuse to serve.

The howls of protest are so loud one almost wishes the SEC would approve the proposal -- if only to see whether the sky actually falls. And with all due respect to the opponents of "shareholder democracy," the objections being raised aren't convincing.

For one thing, the "divisive" proxy contests predicted by opponents would be rare. As envisioned by the AFL-CIO, one of several groups advocating the change, only shareholders or groups with at least a 3% stake in the company would be permitted to nominate candidates for no more than a third of the directors up for election in a given year. At very large companies, that means anywhere from several to several dozen institutional shareholders would have to agree on a candidate slate, making shareholder nominations on the proxy unusual -- and winning board seats even more so.


  Even though the SEC seems to be leaning toward some director-election reform, the commission is far from unanimous, and corporate interests are likely to win some compromises that could make the phrase "shareholder democracy" ring hollow. For example, if the ownership threshold is raised much beyond 3%, institutional investors would be practically powerless to place candidates on the proxy.

Perhaps the most specious objection is that the proposal would not bring the desired results, namely accountability. But it's hard to fathom how boards could be less accountable than they are right now. Even after New York Stock Exchange rule changes and implementation of the Sarbanes-Oxley reform law, corporate boards are still accountable to no one.

Except perhaps in the most egregious cases when directors fail, shareholders are virtually powerless to remove them. At annual meetings, investors have just two choices: To vote for the board's nominees or not vote at all, a system that only a tin-pot dictator could love. Surely, any reform that gives shareholders a voice in board elections would be an improvement. By Louis Lavelle


  This reform almost certainly will make things better. Consider the issue of executive pay. When undeserving CEOs win outsize pay packages, the most that institutional shareholders can do now is to put a resolution on the proxy ballot that will likely be ignored, even if it wins a majority vote.

Consider the same scenario under a more democratic regime. Suddenly, institutional shareholders have a second, more powerful, tool in their arsenal. By running dissident director candidates against the compensation-committee members, investors could send a message that outrageous CEO pay will not be tolerated. Even if the shareholder nominees lose, the compensation-committee members might think twice next year before awarding another huge pay package. Says James E. Heard, CEO of Institutional Shareholder Services, a proxy-advisory service: "It would be a very strong antidote to bad board behavior."

If lack of accountability is the opponents' most specious argument, then their most creative must be the notion that shareholder democracy would result in "balkanized" boards made up of special-interest directors. Such a board is a bad thing, getting in the way of productive discussions and unanimous decisions, the proposal's foes say. But the opposite is closer to the truth. Governance experts say the ideal board candidate is someone with forceful opinions who isn't afraid to share them and that the best boards aren't necessarily those that agree, but those that argue.


  What opponents fear probably isn't a divided board. It's that groups that have been largely banished from the boardroom -- namely labor and environmentalists -- might gain a foothold. But given the 3% ownership threshold, candidates advocating a radical labor or environmental agenda wouldn't be nominated, much less elected.

Corporate America also argues that putting nominations in the hands of shareholders could result in unqualified nominees who lack independence -- or violate the law, as in the case of a nominee who works for a competitor. Setting aside the obvious -- that any shareholder nominee would have to be thoroughly vetted to win the support of enough institutional investors to get on the proxy -- these are legitimate campaign issues that board-nominated director candidates could raise in the proxy.

One of the few fact-based arguments opponents of shareholder democracy make is that the cost of allowing shareholder nominees in the proxy would be "tremendous," in the words of the American Society of Corporate Secretaries. Let's take a closer look. By way of illustration, the society maintains that a 15-ounce package of proxy statement, annual report, voting instruction form, and reply envelope mailed to 100,000 shareholders would cost $86,175. By adding just one ounce, the price shoots up to $395,000.


 First, an ounce is five pages, and the 500-word essay allotted to each of the shareholder nominees under the AFL-CIO proposal will not require five pages. But assuming the company has to eat the entire $308,825 added cost, the impact is minimal, amounting to less than one-third of 1% of profits for a company with $100 million in net income -- or about 4% of the average CEO's pay, as figured by the BusinessWeek Executive Compensation Scoreboard.

Shareholders have little doubt which is a better use of corporate funds. Several companies have already opted to go this route despite the costs. Among them: Apria Healthcare Group (AHG ), where the board in June agreed to allow shareholders access to the corporate proxy for director nominations, and Hanover Compressor (HC ), a Houston-based outfit that agreed to a similar proposal to settle a class action. Elections "could be more expensive," says I. Jon Brumley, who was brought in to chair the Hanover board's audit committee in 2002, following restatements that triggered the lawsuits. "Maybe it's money well spent."

If the cost argument doesn't resonate, the antidemocracy crowd has others. Having more than one candidate for each open seat on the board, investors are told, could create "confusion" among shareholders, who are apparently quite capable of dissecting complex income statements but incapable of choosing between opposing slates -- something most of them do every November. After more than two centuries of American-style democracy -- Florida's experience with hanging chads notwithstanding -- you'd think the public's ability to navigate a ballot would be beyond question.

U.S. companies have demonstrated a great willingness to enact reforms in the post-Enron era, and one hopes they don't stop at the one change that could have the most far-reaching effects. The sky isn't going to fall -- despite what Corporate America would have you believe.

Lavelle covers corporate governance for BusinessWeek in New York

Edited by Beth Belton

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