April 04, 2006
Requiring Contested Elections
Posted by Elizabeth Brown

Thanks Gordon, Christine and Vic for inviting me to be a guest blogger!  I am really looking forward to this opportunity.

In my Business Associations class, we have just finished discussing the problems inherent in the current process by which shareholders in publicly-traded companies elect directors.  While many proposals have been offered in the last few years regarding ways to address some of these problems, one possible solution, which I have not seen raised to date, would be for the SEC to require publicly-traded corporations to hold contested elections for directors.  In other words, the corporation must nominate at least two persons for every vacancy on the board of directors that shareholders will be asked fill in an election.  So if there are five directors on a board of directors, then the corporation would have to nominate at least ten people as candidates to fill those slots.  The five candidates who received the most votes would become the directors.  Some non-profit corporations routinely hold contested elections. 

This proposal is similar in some respects to the State-Authorized Ballot Access Statute that Vice Chancellor Leo Strine proposed, although he advocated opening the ballot for directors up to include nominations by shareholders only every three years for corporations without staggered boards of directors and he wanted his proposal to be enacted at the state level, not the federal level.

A requirement by the SEC that publicly-traded corporations hold contested elections would not conflict with state law.  Certainly, Delaware’s General Corporation Law would allow corporations to adopt such a structure for electing directors in their bylaws.  Requiring contested elections only for publicly-held corporations would make sense because individual shareholders in publicly-held corporations lack the access to control the corporation’s management and directors that shareholders in closely-held corporations have.  Since the requirement would be aimed at publicly-held corporations, it makes more sense for the SEC to adopt it rather than the individual states as it would keep all public-traded companies on a level playing field with regard to the costs to comply with the regulations governing their corporate governance processes. 

This requirement would avoid some of the problems that have been leveled at the SEC’s proposed Rule 14a-11.  For example, opponents of Rule 14a-11 have argued that shareholders would nominate unqualified candidates to serve as directors and that directors nominated by shareholders would create factions within the board that would undermine the board’s effectiveness.  If the corporation is required to nominate enough candidates to hold a contested election for its directors, it would probably be choosing only individuals that it considers qualified to sit on its board.  All of the candidates nominated by the corporation also are likely to be people who would be willing to work as a team.  Nevertheless, all of the directors who are elected would know that if they do not manage the business in a manner that the shareholders deem appropriate then the shareholders can replace some or all of them at the next election.  As a result, requiring contested elections would increase director accountability.

Obviously, one problem with this approach is the ability of corporations to find enough qualified people who are willing to undergo a contested election in order to sit on the corporations’ boards.  Probably some of those who are currently willing to serve as directors might not want to do so if they might suffer the indignity of not being elected as a director in a contested election.  I have read many articles asserting that the Sarbanes-Oxley Act’s requirements have made it more difficult to find people willing to serve as directors of publicly-held corporations.   I have not, however, seen any empirical studies that back up the anecdotal evidence provided in these articles.  I would appreciate it if someone could point me to any empirical studies that back up (or refute) the claims that corporations having difficulty finding qualified directors in the wake of Sarbanes-Oxley.

One way to address the problem of a lack of identifiable, qualified candidates to serve as directors would be to allow shareholders to nominate individuals, who meet certain minimum qualifications, to the corporation as possible candidates.  The corporation would then screen those nominations to select the most qualified candidates.  REI uses a similar process when seeking candidates to possibly serve on its board of directors.

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Comments (8)

1. Posted by Bill Sjostrom on April 4, 2006 @ 12:48 | Permalink

I don’t think your proposal would satisfy those pushing shareholder access to companies’ proxy materials. It would result in contested elections in form but not in substance. Management would still essentially select the board given it selects all the canidates.

Also, note that a shareholder activist got your exact proposal on several companies' proxy statements in 2001 via Rule 14a-8. I believe it was overwhelmingly voted down.

2. Posted by Gordon Smith on April 4, 2006 @ 20:19 | Permalink


I like it when people shake up the debate over director elections, but Bill makes a good point about form over substance. Another obvious objection is that many corporations wouldn't benefit from contested elections. For those of us who favor more shareholder input on board composition issues, the problem lies in permitting contested elections where they might do some good, without imposing contested elections where they are not needed. In short, mandatory contested elections seems like overkill.

3. Posted by Robert Schwartz on April 4, 2006 @ 23:35 | Permalink

This is such a bad idea that I hardly know where to begin. No, you will not be able to recruit quality candidates. Yes, you will destroy board collegiality. Yes, you will open the gates to massive corruption.

At the bottom is a massive misunderstanding of the nature of businesses and corporations. They are not political communities, and notions, like contested elections have no relevance to their operation.

4. Posted by Jeff Lipshaw on April 5, 2006 @ 7:24 | Permalink

I have to agree with Robert's last sentence. Much of what we see in the corporate area is a solution in search of a problem. To repeat something I have written before, in algebraic terms if y=fx, and y equals good governance, we need to understand the relationship of the variable x to good governance before we suggest changing it to impact y. What precisely is the governance problem that would be solved by having "contested elections?"

Voting, like procedure (e.g., Robert's Rules) is one form of solving problems and getting along. So is consensus. It's not a natural act for lawyers to consider how to solve problems by consensus, so we propose these algorithmic solutions to incredibly complex problems (see my article on Sarbanes for one example).

Look, it is a political act to pass statutes that permit the creation of institutions that can amass huge amounts of passive capital. By and large, the impact of those politics has been the creation of unsurpassed material wellbeing. But the distribution of wealth by politics is still politics, and let's not fool ourselves that when a "shareholder" institution like Amalgamated Bank (which is union owned) or AFSCME is promoting "shareholder rights" it really means shareholder rights. I'm not saying labor unions don't have the right to press for political redistribution of wealth. Nor am I suggesting that directors do not have a hefty obligation to mediate the rights of those passive shareholders who have let the capital amass. But let's just call the politics for what they are.

5. Posted by Elizabeth Brown on April 5, 2006 @ 9:27 | Permalink

Thank you Bill, Gordon, Robert and Jeff for your comments. I had meant the post to be provocative and so I am glad to see the comments.

I am not envisioning a political process, which is why the term "contested election" may have been a poor one to use. I am envisioning a hiring scenario. I view the shareholders as "hiring" the directors to run the corporation and monitor the officers.

As a result, I would analogize the situation to this one. When a CEO is seeking to hire a COO, he may ask the Director of Human Resources to work with an outside executive search firm to identify qualified candidates for the position. The HR Director will give the CEO at least 2-3 candidates to choose from. The CEO doesn't usually let the HR Director give him only one choice because the COO is the Director's boss and the Director's choice may be influenced by his conflict of interest. The HR Director may prefer someone as COO who will keep the HR Director's position secure even though it may be in the best interests of the corporation to get someone else who will force the HR Director to perform better.

While 9 times out of 10 the HR Director may pick the best candidate for the job, CEOs don't usually leave the choice up to the HR Director. The CEO makes the choice not only because the HR Director's choice may be influenced by his conflict of interest, but because the CEO wants the COO to understand that he owes his position to a decision of the CEO, not the HR Director, and to act accordingly.

Most people would think it odd if the CEO let the HR Director pick the COO and yet we don't seem to think it odd when the CEO picks his bosses (the members of the Board of Directors). Under the current practice for publicly-held corporations, the CEO presents to the shareholders only one candidate for each director slot. The CEO is analogous to the HR Director in the above example, because he essentially recommending the people who are to his bosses to the shareholders, but he is not giving them any choice in the matter.

If we don't think it is appropriate for HR Directors to pick their bosses, why is it any more appropriate for CEOs to pick theirs? I don't think it is appropriate for CEOs to be selecting the directors who are responsible for monitoring them and ensuring that they perform in the best interests of the corporation. As a result, I am not sure that my proposal is overkill. I think that my proposal is bringing the hiring of directors back into conformity with other hiring situations.

Because my proposal would give shareholders a choice of candidates, I do think that it is changing the substance of the relationship between directors and shareholders. If the shareholders are presented with 10 candidates - 5 of whom are the present members of the Board and 5 of whom are not, the shareholders could replace the entire Board if they felt it was not performing adequately. The new directors would clearly understand that their ability to continue as directors is now contingent on pleasing the shareholders, not just the existing management of the corporation. Under the current system, directors know that they owe their positions almost exclusively to the existing management of the corporation, not the shareholders, because shareholders almost never offer an alternative slate to the one proposed by management.

I admit that my proposal would not satisfy some of those who are pushing for the ability of shareholders to put their own candidates in the company's proxy statement. Nevertheless, I think that it forces directors to more accountable to shareholders than they are under the current system.

One must remember that the practice of offering shareholders only a single slate of directors was begun when the duty of care owed by directors to the corporation was stronger than it is today. Most publicly-held corporations are Delaware corporations and have incorporated exculpation clauses into their certificates of incorporation. As a result, it is difficult for shareholders to hold directors accountable for actions that previously would have been classified as violations of their duty of care. While it might have made sense to turn the decision of who should serve as directors over to the CEO when directors owed strong fiduciary duties to the corporation (and ultimately, to the shareholders), it makes less sense now when those fiduciary duties have been weakened by exculpation clauses.

As Peter Drucker noted, "Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years it is futile to blame men. It is the institution that malfunctions." My proposal is aimed at fixing one of the malfunctions in the system by giving shareholders a choice over who is hired as the directors of the corporation and, thus, making the directors more accountable to the shareholders for their actions.

6. Posted by Scott Taylor on April 5, 2006 @ 9:43 | Permalink

I must endorse Elizabeth's proposal, especially to the extent that she is attempting to make the election process one of real and intelligent choice. In hiring situations, it is quite common to consider more than one candidate and then select the best person for the job. Her proposal is likely to encourage more shareholder participation in the election process. In addition, directors wanting to keep their positions would need to think about doing a good job. With corporate board elections in name only, we would have a more transparent system if we borrowed from the non-profit sector and allowed coprorations to have self-perpetuating boards.

7. Posted by Jeff Lipshaw on April 5, 2006 @ 12:44 | Permalink


Here are some observations if you are interested in pursuing this. This comes from the perspective of somebody who spent over 11 years as a senior lawyer in public companies, 6 as the GC, and who attended well over 30 public company regular board meetings and many times that number of special meetings and committee meetings.

1. As to the last point, I'm still not sure that there is empirical evidence, regardless of the state of the law, which is generally developed in egregious cases, that the institution of directors looking out for shareholders has failed. There are thousands of public companies with no hint of scandal, in which directors labor in good faith every day. To take a current example of perception versus reality, look at the Dubai port deal. Most people who have looked at the merits know there was no security issue, but it's a story that sells, gets votes, promotes careers. Without for a minute suggesting WorldCom, Enron, etc. were anything but crooks, there are huge costs imposed with these systems that do not benefit anyone.

2. Your analogy to the hiring of the COO doesn't work for all sorts of reasons. Invariably, the hiring of the COO, CFO, CIO, CLO is subject to approval of the board. Compensation for those officers is set by the comp committee of the board, which is independent. The HR VP has no conflict of interest in the hiring decision. Most of the time there is no conflict issue at all, but in the pathological cases (I lived through one)if anything the conscious dilemma most C level officers deal with is the day to day relationship with the CEO versus the obligations to the board.

3. Under present practice, the CEO doesn't present the single nominee to the shareholders. Under NYSE rules (I haven't looked at NASDAQ recently) the nomination or renomination of directors must come from a fully independent nominating committee. Under the proxy rules, the nominating committee is obliged to disclose its standards for review, and to advise if there is a mechanism by which nominations may be submitted to it.

4. Large institutional shareholders are perfectly capable of letting boards know when they are unhappy with something the board has done, and it's not necessarily by selling the shares. Where you do get a fair amount of gnashing of teeth are funds with a political agenda, or funds that can't sell the shares (e.g., an index fund that has to keep shares of the XYZ Company because it's a Smith-Jones 250 Index Fund, and XYZ is in the Smith-Jones 250 Index.

5. Even if the description of the hiring of a senior corporate officer were correct, still the analogy to the "hiring" of a director by the shareholders to the hiring of an employee doesn't work. When I hire an employee (or a fellow director!), I am looking at a whole set of criteria: competence, integrity, ability to get along, pleasantness, articulateness. As a shareholder, all I care about is that the director be competent to oversee the corporation as part of a multi-person body, in the same way that I care that my bank is competent to lend the money I deposit to good credits, or my insurance company to make good investments and not go bankrupt on me. Unless you plan on having campaigns, personal appearance, meet and greets, photo ops, the decision is going to be based on some minimal level of meaningless data (job history, other boards, and maybe some pablum about what the director's vision is). Any lawyer who has ever voted for bar association leadership knows exactly what it looks like, even when it's contested. Or like going into the booth on Election Day, voting for the big offices, and realizing there is a contested race for drain commissioner and you have no clue.

6. Directors of public companies meet 4 to 12 times a year and conduct business, much of which requires continuity, consensus and trust. Directors review acquisition and disposition proposals, review executive compensation, approve strategic and operating plans. Moreover, in the current political atmosphere, staggered boards are frowned upon, so all the directors are up for renewal each year. At what point do the directors starting running for reelection? And who would put up with it?

7. Remember: the life of the law is not logic but experience. Pick randomly say 30 or 40 companies from the bottom 300 companies of the Fortune 1000, and talk to some of the GCs and directors. Run the proposal by them. My guess is you would get some thoughtful and surprising perspectives.

8. Posted by Elizabeth Brown on April 6, 2006 @ 8:05 | Permalink

Again I would like to thank everyone for their comments. I would like to note a few things.

1. The requirements of the NYSE and NASDAQ that directors be "independent" have only been in place since mid-2003. So the first director elections that these rules would have effected, would have been the 2004 elections for most corporations. On the vast majority of Boards, the CEO serves as Chairman of the Board. In that position as Chairman prior to 2003, the CEO had significant power to influence directly and indirectly the selection of the members of the Board. The NYSE and NASDAQ rules only limit the ability of the CEO to influence directly the selection of the director nominees. They do not hinder his ability to use his position as Chairman to influence indirectly the director nominee selection process. Since 2003, the NYSE requires that listed companies have a nominating/corporate governance committee comprised entirely of independent directors. The corporation can decide whether the nominating committee will select or merely recommend that the Board select the director nominees for the next annual meeting of the shareholders. Since 2003, NASDAQ has required that either an independent nominating committee approve the director nominees or that a majority of the independent directors must approve the director nominees. In determining whether a director is "independent", both the NYSE and NASDAQ only look at financial and employment ties between the director and the corporation. So the fact that a director may have been a friend of the CEO since childhood would not disqualify that director as independent as long as the director met the financial and employment restrictions set by the NYSE and NASDAQ.

2. The Boards of publicly-held corporations in the US today are essentially self-perpetuating. The directors select themselves and their allies to serve on the board year in and year out. Between 2002 and today, shareholders of publicly-held corporations did not have any real ability to propose or select an alternative slate of directors. In addition, at least 60% of the publicly-held corporations still have staggered boards. So the "independent" directors currently sitting on the Board were selected by the directors whose selection prior to 2003 was significantly influenced, if not controlled, by the CEO. It is likely that the directors in 2003, who owed their positions on the board to the CEO and were friends of management, were still going to be influenced by who the CEO would have liked to see on the Board when selecting the new director nominees.

3. Even if one assumed that the directors were completely free from any influence by the CEO, I still do not see why it is desirable for directors to hire themselves year after year and to effectively prevent the owners of the corporation from having any real say in who is hired to manage the business on their behalf. I cannot think of another situation in which an employee routinely gets to decide that he will hire himself for a position and the owner of the business has virtually no say in the decision.

4. I agree that shareholders do not have as much information when they are relying on information supplied in a proxy statement as they would if they could interview the nominees. I do think that corporations could do more to provide shareholders with better information about the people who they are being asked to select to run the corporation for them.

5. If the nominating committee is doing its job of selecting qualified candidates, then I don't think that the analogy to the election of the drain commissioner is valid. In municipal elections, the candidates may be self selected and vetted by nobody. As a result, one candidate for drain commissioner may be very qualified and the other may not be qualified at all.

6. Between 2000 and 2005, several people proposed about a dozen shareholder resolutions pursuant to Rule 14a-8, which asked corporations to require 2 candidates for each director slot to be filled. Some of these proposals were excluded because they were duplicative. Others were withdrawn by the proponents. As far as I can tell, none of these proposals were adopted. The failure of these proposals does not make them unique. The vast majority of shareholder proposals have failed to be adopted. Directors sometimes refuse to act on the few shareholder resolutions that are approved. Nevertheless, shareholder proposals are being made with increasing frequency. The number of shareholder proposals made in 2003 was 87% higher the number made in 2000 and the issues most frequently addressed by shareholder proposals focused on corporate governance.

By the way, below is an example of what these shareholder proposals requesting the corporation provide 2 candidates look like. This comes from the 2005 proxy statement for Peregrine Pharmaceuticals:

Stockholder Proposal

“The shareholders urge our board of directors to take the necessary steps to nominate at least two candidates for each open board position, and that the names, biographical sketches, SEC-required declarations and photographs of such candidates shall appear in the company's proxy materials (or other required disclosures) to the same extent that such information is required by law and is our Company's current practice with the single candidates it now proposes for each position.”

Supporting Statement

“Stockholders today are not given a `true' option in regards to exercising their voting rights in the election of directors. In the past, the company presents only one nominee to fill each open seat on the Board of Directors. Shareholders who oppose a candidate have no easy way to do so unless they are willing to undertake the considerable expense of running an independent candidate for the board. The only other way to register dissent about a given candidate is to withhold support for all the nominees, but that process rarely affects the outcome of director elections. The current system thus provides no readily effective way for shareholders to oppose a candidate that has failed to attend board meetings; or serves on so many boards as to be unable to supervise our Company management diligently; or who serves as a consultant to the Company that could compromise independence; or pose other problems. As a result, while directors legally serve as the shareholder agent in overseeing management, the election of directors at the annual meeting is largely perfunctory. Even directors of near bankrupt Companies enjoy re-election with 90%+ pluralities. The “real” selection comes through the nominating committee, a process too often influenced, if not controlled, by the very management the board is expected to scrutinize critically.”

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