Companies Must Pay for Some Shareholder Challenges

Charles M. Elson is the Edgar S. Woolard, Jr., Chair in Corporate Governance and the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. He is also "Of Counsel" to the law firm of Holland & Knight. His fields of expertise include corporations, securities regulation and corporate governance.

by Charles Elson

Central to the philosophy of the modern Delaware corporate law has been the concept of judicial restraint in the review of director decision-making. Wide discretion is granted to boards through the operation of the Business Judgment Rule.

The theory is that shareholders, through exercise of the electoral franchise, provide the best mechanism for ensuring appropriate director discretion than the review by a third-party judicial body. Of course the lynchpin to this approach is the availability of an open and fair election to provide the necessary outlet for shareholder will.

Unfortunately, for a variety of reasons, in most public companies the shareholder election process functions as a mere formality to ratify the actions of a generally self-perpetuating board and management. For the election to serve as the appropriate accountability vehicle intended by the Delaware scheme, it is important that from time to time there is the real potential that it function as a true contest over corporate policy and direction.

To accomplish this, we need to level the playing field a bit between the incumbent board and the shareholders in the electoral process.

Traditionally in a proxy contest, the expenses of the challenging party are solely borne by that party, while the board uses the corporate treasury to finance the presentation of its position.

This has been an obvious impediment to fostering vibrant elections as all shareholders effectively subsidize the board's candidacy while the challenger is forced to personally bear the cost of a campaign. If the challenge involves a legitimate debate on corporate direction and policy, there is no good reason why the shareholders of the corporation should fund the cost of the promoting one viewpoint and not the other. This asymmetry is certainly problematic in that it acts to stifle thoughtful discussion and re-examination of corporate policy which ultimately leads to lessened accountability by the incumbent board and management to shareholders. That is why reform is necessary.

The simplest solution to this problem is to provide some sort of reimbursement of reasonable expenses to challengers in non-control directorial election challenges. If one is successful in proposing and electing a director, then that one's expenses should be reimbursed by the corporation.

If an individual is unsuccessful, but loses only by a small percentage, then it is clear that the effort was over a legitimate issue. Therefore, some portion of that individual's expenses should be reimbursed. Should the challenging candidate or candidates lose by a significant vote, then no corporate funds should be expended for the support of the effort.

Such a scheme would be initiated with shareholder consent and the Delaware code should be amended to explicitly provide for the mandatory establishment of such a regime upon an appropriate shareholder vote. By removing an important financial impediment to more vibrant corporate elections, the election process would no longer be a simple formality but a real forum for informed debate and ultimate expression of shareholder will.

This would accomplish two important goals.

First, it would assure the necessary vibrancy of the electoral process vital to the appropriate functioning of the corporate regime as contemplated under the traditional Delaware corporate law.

Second, the election itself, or merely the threat of a contested election, would encourage better directorial and management accountability to shareholders and ultimately more effective corporate performance.

The Delaware corporate law has proven to be an incredibly effective vehicle for the regulation of public corporations. This proposed measured change is necessary to ensure its continued utility and effectiveness.

A version of this article appeared in the Delaware Lawyer. The article reflects the views of the author and not the views of Delaware Lawyer or the Delaware Bar Foundation.

Comments

[Jason]

Charles makes a well-founded argument. However specific questions include, at what voting percentage would the effort be considered a legitimate effort? What portion of the expenses would be covered? Would this be a hard number rule for all companies under Delaware Law, or would these decisions be made on a company and situation basis?

[Jeff Roe]

I think this is an extraordinary idea. Anything which levels the playing field, allows or encourages more debate and new ideas or corporate philosophy to be introduced, and takes away the unfair incumbent financial advantage is a good thing. No doubt these corporate boards will fight this tooth and nail for all those reasons.

Good luck with all of that.

[Trent]

Mr. Icahn,

Excellent article of educating fellow Americans on corporate governance and shareholder rights by Mr. Elson. I wonder how many fellow individual investors understand the significance of accountability, prudent oversight of existing board of directors and CEO service to duty.

I think your efforts should be commended because these business strategies have a trickle down effect on our economy, national defense, American prosperity, capital structure, jobs, housing market, manufacturing industry, Educational structure, etc.

Corporate governance must have a solid foundation built on integrity, transparency, accountability, foresight, shareholder value, waste management and fair shareholder representation.

Speaking of foresight, to drive home the significance of your efforts I believe the next immediate great challenge to our economic structure is the Agriculture/Farming Industry. Our government must govern to protect its citizens and foresee potential emergency states. Our Agricultural industry is the backbone of our Great Country and it's vunerability to the existing economical strife puts it flying under the radar of government risk.

As we incur job loss, housing loss, foreclosures, credit instability, manufacturing downturn, lender discretion, mistrust, lack of board accountability, etc. ( Affordable feeding of our fellow citizens, elderly and children will be the next stimulus). Not to mention clothing (Cotton)...

I hope all Fellow United Shareholders of America understand Mr. Icahn, that your personal mission is for prosperity for your fellow Americans, not for a select few. Keep up the Good Work.

The Federal Reserve, SEC and the Treasury should be grateful for your Service to Country!

God Bless America and the Educated Investor!

[Joe G.]

The only problem is when the "crazies" get motivated about tangential issues. The last thing shareholders want to do is reimburse some environmentalist/socialist cause. There was a case in the circuits awhile back where a single shareholder with only a few thousand dollars in shares held up an election over the force feeding in foie gras production.

[Earl Johnson]

I thank you for the work you are doing to help us.

[JGP]

One of the unfortunate outcomes of wealth being concentrated in public corporations is that they become feeding grounds for accountants, lawyers, academics and consultants as well as boards and CEOs - the latter being the corporate agents. All this feeding is at the expense of the shareowners. And, to that list, we can add the Delaware court system.

Mr. Elson is part of this assembly of vested interests who have learned how to make a good living at the trough of public corporations while spinning the "valued services" tale. His suggestion is written by a lawyer, for a lawyer - and is certainly not written for shareowners.

His proposal offers a few crumbs for shareowners without addressing the larger issue that most stock is bought through mutual funds, not directly by individuals. Such funds are, in reality, servicing companies, not investment companies. They are compensated for funds under management, not wise investment choices or interest in corporate governance. The dilemma is that share ownership is hugely fragmented by quantity and volume across a diversified ownership base and further contorted by servicing intermediaries that make the purchase decisions. This is a tough problem that has to be solved before compensating shareowners in proxy contests has any utility.

A larger point is to challenge Mr. Elson's view that Delaware corporate law has been an "incredibly effective vehicle for the regulation of public corporations". While that may have been true in the past, the Delaware courts have evolved into today’s most significant enabler of failed corporate governance, with egregious executive compensation as the most prominent evidence. Such "looting" by corporate agents is permitted by the Delaware courts under the business judgment rule. So, the corporate agents loot - because they can.

Further, Delaware court's twisted reasoning that board fiduciary responsibility is to the corporate entity even at the expense of the shareowner is a marvel of logic - and a clear indicator that Delaware courts wish to preserve their sinecure rather than the hard slog of protecting investors.

Contrary to Mr. Elson's view, I'll suggest that the answer to an effective electoral franchise by shareowners is to enact federal laws and regulations that take the matter out of the hands of the states, and especially out of the grasp of the Delaware courts. His proposal is good for the Delaware courts and other vested interests, but offers little to shareowners and doesn't deal with the root causes of failed corporate agency.

Thank you.