US Corporate Governance: Boards of Directors Face Increased Scrutiny

*Skadden's 2014 Insights - Governance

Marc S. Gerber

In many ways, corporate governance in 2013 looked similar to corporate governance in 2012. Most public company directors were re-elected with shareholder support in excess of 90 percent of votes cast and only a handful of directors failed to achieve majority support. Most companies received strong support in their say-on-pay votes. And many shareholder proposals on topics such as board declassification, majority voting for directors in uncontested elections and elimination of supermajority vote requirements in corporate charters and bylaws continued to attract significant shareholder support.

Nevertheless, a number of developments in 2013 continued the paradigm shift from board-centric to shareholder-centric governance of public companies. These developments involved activist investors, governance activists such as state and labor pension funds, mutual funds and other traditional long-term investors or combinations of these market participants. And every indication is that this paradigm shift will continue to increase the scrutiny on boards of directors — including with respect to board composition and boards’ substantive business and strategic decisions.

The Framework of Director Elections. Institutional investors and governance activists have largely succeeded, at least at S&P 500 companies, in changing the election framework so that most directors stand for election annually (rather than once every third year) and must submit their resignation if they fail to receive majority support from shareholders. As a result, the re-election of directors can no longer be taken for granted, and shareholder concerns need to be considered in a company’s assessment of an upcoming proxy season. Notable trends and events include:

  • Almost 90 percent of S&P 500 companies (and almost 60 percent of Russell 3000 companies) have annually elected boards. The Harvard Shareholder Rights Project led a campaign in 2012 and 2013 to wipe out classified boards, getting almost 100 large companies to declassify; shareholder proposals to declassify received average shareholder support of 79 percent in 2013.
  • Approximately 90 percent of S&P 500 companies (and approximately 46 percent of Russell 3000 companies) have a majority voting standard in director elections and/or a policy requiring resignation if a director fails to get majority support; shareholder proposals on this topic received average shareholder support of 58 percent in 2013.
  • Shareholder efforts to declassify boards of directors and to expand majority voting/resignation policies will continue in 2014 and will migrate to companies outside the S&P 500. Vanguard, a significant shareholder at many public companies, recently launched a letter-writing campaign, targeting approximately 350 companies, encouraging them to declassify their boards, adopt majority voting and give shareholders the right to call special meetings. Although Vanguard describes its approach as “quiet diplomacy,” Vanguard’s efforts on these issues may be difficult for companies to ignore.

“Vote-No” Campaigns. Although vote-no campaigns against directors are not a new phenomenon, they were more effective in 2013 than in previous years. Based on Institutional Shareholder Services (ISS) data, there were vote-no campaigns against 15 directors in 2013, resulting in average votes of 59 percent in favor and 41 percent against targeted directors. Although many of these directors were re-elected, even under majority voting standards, the relatively low level of shareholder support in some cases achieved the campaigns’ desired result. Although the number of attempts likely will be limited, vote-no campaigns will continue to be part of the landscape in 2014. Two of the more noteworthy campaigns were:

  • Hewlett-Packard: CtW Investment Group (a labor pension fund-affiliated group) led a vote-no campaign arising from HP’s acquisition of Autonomy Corp. and subsequent write-off. The campaign focused on the finance and investment committee chair and the audit committee chair, each of whom received more than 40 percent negative votes and (even though re-elected) resigned from the board. Also, the non-executive chairman received more than 40 percent negative votes and remained on the board but resigned as chair. In July, HP added three new directors.
  • JPMorgan Chase: CtW Investment Group led a vote-no campaign against members of JPMorgan Chase’s risk committee and the chair of the audit committee. The three risk committee members received 40 percent or greater negative votes, and two of them resigned. In September, JPMorgan Chase added two new directors.

Proxy Access. With many companies having annually elected directors and a meaningful (rather than symbolic) ability to vote against directors, a number of institutional investors look at proxy access as the next important step in the evolution of the director election framework. Proxy access would allow qualifying shareholders to nominate a limited number of director candidates and have those candidates appear in company proxy materials, alongside the board’s nominees, presumably making it easier for investors to elect candidates they favor over the board’s nominees. A consensus among institutional investors appears to be emerging to support proxy access proposals modeled on the vacated SEC rules. Those proposals allow a group of shareholders holding 3 percent or more of a company’s shares for at least three years to include in company proxy materials candidates for up to 20 or 25 percent of the total number of board seats. Notable developments include:

  • Pursuant to an agreement for the withdrawal of a proxy access shareholder proposal in 2012, Hewlett-Packard proposed a proxy access bylaw amendment for shareholders holding 3 percent of HP stock for three years to nominate candidates for 20 percent of the board; the bylaw was approved by holders of 68 percent of the shares outstanding.
  • Western Union negotiated the withdrawal of a one-year/1 percent proxy access shareholder proposal in 2013 by adopting a three-year/3 percent proxy access bylaw.
  • Nonbinding shareholder proposals to adopt proxy access with three-year/3 percent standards and relating to either 20 or 25 percent of the board seats achieved majority shareholder support at CenturyLink (72 percent of votes cast), Darden Restaurants (62 percent of votes cast) and Verizon Communications (53 percent of votes cast). Recently, in response to this shareholder support, Verizon announced the adoption of a proxy access bylaw, subject to shareholder approval at the company’s 2014 annual meeting.
  • Significantly, the universe of proponents of proxy access shareholder proposals is expanding. The proxy access proposal at Darden Restaurants was proposed by the Nathan Cummings Foundation. At a recent panel discussion, a representative of Nathan Cummings indicated the foundation was likely to submit at least three proxy access proposals in the 2014 proxy season. In addition, CtW Investment Group, which has a history of governance activism and running vote-no campaigns, has proposed a three-year/3 percent proxy access proposal for Walgreen’s 2014 annual meeting. These developments may portend an increase in three-year/3 percent proxy access shareholder proposals, and if 2013 voting trends continue many of these are likely to receive majority support.

Board Composition. The developments described above share a fundamental theme — making director elections more meaningful so as to give shareholders greater ability to influence the composition of the board. Where all is going well, shareholders may be content to defer to the judgment of a nominating committee consisting of independent directors and, ultimately, to the board to ensure that the board is comprised of men and women with the relevant skills, experiences and independence, as a group, to ably oversee and direct company management. Where shareholders perceive the company to be off course — languishing stock price, ill-conceived strategy or acquisitions, illegal or scandalous corporate actions, poor executive compensation practices or otherwise — or perhaps at increased risk of heading off course, that deference can dissipate and shareholders may ask themselves whether the team in the boardroom is the right one. The factors institutional investors focus on include:

  • Directors’ Skill Sets: Since the 2010 proxy season, companies have been required to discuss in their proxy statements the specific experience, qualifications, attributes or skills that led to the conclusion that a person should serve as a director. Over time, some companies’ disclosures have become more detailed or elaborate, using skill matrices or other graphic representations to reflect the quality and diversity of skills and experiences in the boardroom. We anticipate continued investor scrutiny as to whether boards have the right skills relative to a company’s business and competitive circumstances.
  • Diversity: While board diversity includes having directors with a range of skills and experiences, it also includes racial and gender diversity. Gender diversity in the boardroom continues to be an area of particular focus, in the U.S. and internationally. The European Union is considering legislation that would require large public companies in which women comprise less than 40 percent of the non-executive directors to give priority to female candidates and permit sanctions for noncompliance. Although it is unlikely that such a scheme would be considered in the U.S., various institutional investors and other groups have touted data suggesting that companies with gender-diverse boards have better performance. Many of these investors, together with women’s groups and others, formed the Thirty Percent Coalition, which has been engaged in letter-writing campaigns and has submitted shareholder proposals seeking commitments from companies to increase gender diversity on their boards. We expect these efforts to continue.
  • Director Tenure: Long-tenured directors present a quandary for some institutional investors. On the one hand, these directors can bring to the boardroom significant experience and familiarity with a company and an industry. At the same time, some investors are concerned that long-tenured directors may lack independence or objectivity and that the absence of director turnover comes at the expense of introducing fresh perspectives into the boardroom. The Council of Institutional Investors added a provision to their corporate governance policies that boards should consider director tenure when making independence determinations. ISS has been engaged in a dialogue with market participants on this topic but did not change its 2014 voting policies to incorporate any position on director tenure. ISS has decided to engage in additional market participant outreach and may consider voting policy changes relating to director tenure in the future. A number of non-U.S. jurisdictions already have adopted guidelines or requirements aimed at limiting director tenure. We anticipate that boards’ consideration of director tenure — both in terms of individual directors and average tenure for the full board — will increasingly become an important topic. We expect institutional investors will want to engage with lead directors and nominating committee chairs to discuss director tenure, and that, over time, companies may consider proxy disclosure to preemptively address investor questions on this topic.

Activism and the Second-Guessing of Board Business Decisions. Traditional institutional investors understand that they do not necessarily know better than the board and management how a particular company should manage its businesses. But, perhaps more so than ever before, where a company has had long-term underperformance, institutional investors have become much more open to hearing from, and supporting, “activist” investors who have amassed significant investments in companies and who purport to know better than management and the incumbent board the steps a company should be taking to increase shareholder value.

Shareholder activism in the U.S. has increased significantly over the past several years, and activists now often target large, well-known companies once thought to be sufficiently large so as to be immune to these efforts. Although every activist campaign is unique, an increasing number of instances involve activists presenting operational and longer-term strategic changes rather than short-term financial gimmickry. Increasingly, activists are hiring experienced financial, legal and public relations advisers and are nominating candidates for boards who bring significant industry expertise and other strong credentials.

In one of the more interesting developments of the past year, a shareholder activist and a traditional institutional investor directly and very publicly teamed up to push a company to make an important strategic change. Relational Investors and the California State Teachers’ Retirement System (CalSTRS) joined efforts to advocate that Timken Company separate its steel business from its bearings business. Relational presented its views to Timken management and CalSTRS submitted a 14a-8 shareholder proposal requesting that the company engage an investment bank to effectuate a spin-off of the steel business. That proposal received the support of 53 percent of the votes cast at the annual meeting and, shortly thereafter, Timken announced that the board had created a strategy committee to explore the separation of the steel business and the committee had retained an investment banker. In early September, Timken announced that it would spin-off its steel business in 2014.

Going Forward. This implicit or explicit alliance of activists and institutional investors can and will use the full arsenal of corporate governance tools to scrutinize boards of directors. Where applicable, they will seek to influence board decisions or, when necessary, seek to change board composition.

Among the key steps boards need to take before an activist enters the landscape is shareholder engagement. Institutional shareholders should know that the board and management have a strategy to create shareholder value and are actively executing on that strategy. Ongoing engagement and relationship building with a company’s long-term shareholders can help the board establish the credibility it needs when the benefits of strategies are not realized as quickly or as completely as originally envisioned or other unforeseen circumstances damage corporate performance. Engagement also provides an important avenue for companies and boards to hear investor concerns and attempt to address them before they develop into problems that damage a board’s credibility or call into question the board’s composition or strategic decisions. Robust shareholder engagement has become, and will continue to be, an important part of the corporate governance landscape in 2014 and beyond.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.


*This article appeared in the firm's sixth annual edition of Insights on January 16, 2014.