In July, shareholder activists celebrated a significant victory. A little-known dissident shareholder named Guy Adams waged a proxy battle against Lone Star Steakhouse & Saloon and managed to unseat the company’s chairman. Adams had neither the stock (just 1,100 shares) nor the deep pockets to finance his fight, but he rallied the support of powerful investors and proxy advisors to win an unlikely victory. What was the issue that galvanized the attack against the underperforming Nasdaq company? Its board of directors allegedly had become unresponsive to shareholders.
Whether Lone Star’s shareholders specifically wanted Adams in, or merely wanted CEO Jamie Coulter out, is academic. What is important is the message sent to Lone Star executives: when shareholders saw the board no longer represented their wishes, they fought hard to win changes to the company’s governance structure.
‘Ultimately you’re talking about perception – shareholders being confident that their board is exercising independent judgment. It’s their faith in the quality and impartiality of the decision-making process,’ says Mary-Ellen Robbins, director of US proxy policy for Proxy Monitor, one of the advisors that supported Adams’ fight. ‘If management needs shareholders’ support, it has to appreciate what shareholders themselves need in order to give their support.’
As investors see it, board independence is perhaps the most important step to establishing good governance, and their push for independent boards has yielded results. Nearly 90 percent of the S&P 500 now have a majority of independent directors on their boards, according to the Investor Responsibility Research Center (IRRC), while 79.8 percent of the S&P Mid-cap and 76.4 percent of the small-cap group claim the same distinction.
Corporate executives realize the internal value of having an independent board: It gives them constructive, impartial advice, it allows them to test their arguments and plans and, in theory, it makes their strategies more robust. Companies also know that shareholders reward them for having good governance structures. According to a recent McKinsey & Company survey, three quarters of investors say board practices are at least as important an investment criterion as financial performance, and over 80 percent say they would pay more for shares of well-governed companies.
Or so it seems
The message is clear: independent directors keep management in check, and they comfort shareholders by maintaining fresh oversight within the boardroom.
Consider this. Each year the Council of Institutional Investors (CII) tracks companies that report majority votes on shareholder-sponsored resolutions. In 2000, a record-breaking 51 companies faced majority votes, yet only three of these companies (PG&E, Nashua and Mattel) said they would adopt the proposed actions in some form. A fourth, Chase Manhattan, said it supported the shareholder resolution, describing it as consistent with the company’s existing confidential voting policy.
The majority-vote resolutions are usually common proxy issues – poison pills, declassification of boards, shareholders’ right to call special meetings – and many have won majority votes for two, three and, in some cases, four consecutive years.
Investors are left to wonder where communications with so-called independent boards break down. ‘It’s stunning the number of companies that ignore majority votes,’ gasps Meredith Miller, the State of Connecticut Treasury Office’s assistant treasurer for policy. ‘It’s one of the reasons shareholders have been forced to rethink their relationship with companies and seek solutions through litigation, short slates and other desperate acts,’ she said at the American Society of Corporate Secretaries (ASCS) annual meeting in June.
At issue is the question of who decides what’s best for shareholders – is it the shareholders themselves or the directors that represent them? The board’s function, in its most basic form, is to represent the shareholders in deciding what is best for the company. If a board does its job properly, considers shareholders’ wishes, and has sufficient autonomy from corporate management, presumably it would only resist majority-vote resolutions if it believed shareholders had unwisely voted against their ultimate best interest. ‘In other words, just because a proposal sounds good and shareholders perceive it to be in their best interest, board members may respectfully disagree,’ says Carol Bowie, director of the IRRC’s corporate governance service.
Giving boards the benefit of the doubt, could so many shareholders be wrong? After all, 47 of the 51 CII majority-vote companies ‘respectfully disagreed’. Robbins believes corporate law also comes into play: ‘In my opinion, the spread really shows that business corporation laws don’t necessarily truly reflect governance policies – at least those espoused by shareholders.’
She may have a point, considering Delaware corporate law – which continues to set the stage for US law – has evolved out of a paternalistic view of shareholders, according to Charles Elson, director of the University of Delaware’s Center for Corporate Governance. ‘The idea of board and management was to protect the shareholders from their own foolishness. The shareholders were bereft of information and financial sophistication, and it was important to strengthen the hand of the board and management to protect the shareholders from their own potential folly,’ he said at the ASCS conference. However, Elson also believes shareholders are becoming more and more sophisticated, and he predicts Delaware law is following suit to gradually become more investor-friendly.
An ounce of prevention
Whether or not corporate law is stacked in management’s favor, shareholders have to feel as if the board is acting in their best interest. That is, they have to believe directors are sufficiently objective so as to challenge management when the need arises. The board’s role is not to micro-manage the company, but to ensure that proper managers are in place and their decisions are sound. ‘What we feel is that the role of the non-executive directors is very important in making sure the right questions get asked about the strategy, and it is very important that the independent non-executives are in charge of the remuneration committee and the audit committee in particular,’ says Peter Montagnon, head of investment affairs for the Association of British Insurers, a powerful UK opinion-leader. ‘That’s a very important check and balance.’
Montagnon advocates a system in which shareholders and independent directors communicate together and support each other to help avert problems before they arise. ‘When the share price has collapsed and the profit warning is there and the market has turned against the company, it’s very easy to impute blame and actually demand blood. But it would be much better if you could at least limit the damage in the first place,’ Montagnon suggests. ‘It doesn’t mean that if you have this system of checks and balances in place you’re never going to get accidents. It means you’re going to have fewer of them. And if you look at the companies that have difficulty, quite often it relates to governance problems at the origin.’
All the same, Montagnon realizes there may be some instances when it is impractical for companies to have majority-independent boards. For instance, a company may operate within a unique business niche where directors’ expertise may require them to be in some way affiliated with the company. He also points out that executives may resist the board because they fear it prevents them from being able to move quickly: ‘From the executives’ point of view, the drawback is that they may be itching to get a move on. They think they’ve got some brilliant ideas – and they often have – and they’re frustrated at having to get them through this group of old farts.’
Carol Bowie cites an IRRC study on director independence that found dot-com boards to be far less independent than most. ‘The explanation by the dot-com companies was that they needed these particular people on their boards because they had certain expertise, or they brought something else to the board that was extremely valuable at this stage of the company’s growth,’ she recalls. ‘Some of this is applicable to any start-up company. Their boards tend to be smaller, and more populated by people with the kind of expertise that is going to help the company develop specifically. Whereas a more mature company is looking for people with experience, but not necessarily direct experience in the company’s operations.’
While lack of director independence certainly shouldn’t bear all the blame for the dot-com meltdown, Bowie says the companies – and the sector – could have benefited from more boardroom independence. ‘Ultimately, it’s a safeguard to their thinking,’ adds Robbins, ‘because you can start doing things in a vacuum. Everyone knows if you get too close to something, it’s hard to be objective. And objectivity is very valuable. So board independence protects executives too. It keeps people straight.’
Meanwhile, boards have to make shareholders feel they’re responsive. For instance, some appoint a lead non-executive director who routinely meets with shareholders in order to understand their pleas.
As each new proxy season shows, investors are becoming less tolerant of unresponsive boards. Global shareholder activism continues to rise; dissidents continue to improve their organizational abilities (like Travis Street Partners, which drummed up support using the internet and won three seats on the board of Houston’s ICO); and new resolutions continue to proliferate, such as ‘vote no’ campaigns to reject the entire slate of board nominees.
‘If shareholders don’t like the board, they have the option to kick the bums out. But while they’re there, the bums ought to be exercising their fiduciary responsibility to decide what is in the best interest of the corporation and the shareholders,’ quipped Frank Balotti, director of Delaware law firm Richards Layton & Finger, at the ASCS conference. He went on: ‘We ought to admire directors who are willing to get themselves thrown out by doing the right thing – at least what they view as the right thing.’
One wonders if Lone Star’s erstwhile chairman would agree.
