This article originally appeared in the July 2015 issue of the AAII Journal.
Contrary to what many believe, significantly increasing the proxies voted by informed individual investors would appreciably improve the corporate governance landscape.
Why not just sell shares of poorly governed corporations?
Selling the “bad” stocks may help with individual investments in the short-term, but the long-term negative effects of corporate governance shortfalls on broader portfolios have been shown to be significant. The underperformance tends not to be smooth. It is jerky and appears as unpredictable large downturns. Everything looks to be fine until it’s not.
These corrections follow the paths of whatever governance failure triggered them. They are not usually limited to one company and sometimes spread through wide swaths of the market and general economy. For example, portfolios that didn’t hold Enron stock were still hurt when the governance failures became known in 2001. An investor also did not have to hold stock in an investment bank or mortgage broker to notice the economic fluctuations that began in 2007.
In addition to the anecdotal evidence, a body of research supports the claim that good corporate governance generates both short-term and long-term shareholder value across the entire market.
And not voting your proxy can make matters worse.
There have been arguments that corporate governance failures were a primary driver of the recent economic downturn. Some also point to the government/corporate “revolving door” policies that may invite profiteering and bad behavior of regulators, corporate boards and executives.
One often-cited example is that several corporations have explicit policies, found in filings with the SEC, outlining automatic financial rewards and employment guarantees for executives who rotate into government positions. The government positions are often with regulatory agencies with responsibilities to oversee the business practices of the executives’ former industries. These payments are routine at energy companies and major banks.
“Broker voting” is another reason for individual investors to vote their proxies, even if they vote to “abstain.” Under SEC rule 14a-4(b)(1), brokers, and perhaps banks and other voting agents, apparently have the authority to vote proxies at their discretion if they are unvoted or left blank by shareholders. Usually, these “uninstructed or discretionary” proxies are voted according to recommendations of the soliciting committee of the corporation, but not always.
In other words, if you don’t vote your proxy, it can be voted by others who may have financial interests that do not include building wealth for you. This is a particular governance problem for shareholders of corporations where there is undiscovered fraud, influence peddling between broker and corporate boards, or situations where corporate power is being abused in other ways. The SEC has been petitioned on this matter, but no action appears to have been taken as of this writing.
Ideal vs. Flawed Governance
Ideally, shareholders vote to elect the board of directors. The board of directors then creates corporate policy and makes major decisions on behalf of the shareholders to maximize shareholder value. The board hires the chief executive officer (CEO) to execute the policy and its specific strategy. It is important to note that the CEO is supposed to be an employee of the board. The CEO’s job is to implement policy, not make it.
In reality, companies are generally formed by a small group of individuals. This core group serves both as board members/directors and executive employees. Later investors may get board seats or simply have influence based on the amount of money they have invested. By the time the company grows large enough to offer shares to the public, the fiefdoms are fairly well-established and difficult to change.
The CEO, chief operations officer (COO), chief financial officer (CFO) and others often continue to be employees and also hold seats on the board. In the worst situations, the other board seats could be patronage positions held by unskilled relatives or even people who have no interest in the company other than their compensation for board membership. They may serve on a dozen or more boards as professional directors. They have no reason to attempt to protect the interest of the collection of smaller shareholders, who may hold the majority of the outstanding shares. They have large incentives to build their own wealth by cooperating with the core group. The core group is now effectively their own boss. As the most powerful board members, they control all manner of corporate policies as well as their own compensation. As key managers, they are essentially unaccountable.
There are still many well-established corporations where the CEO and the board chair are the same person. Shareholders of such corporations depend on the goodwill of one conscientious manager with near-absolute control over the execution of policy. Sometimes, the CEO will also have significant de facto influence on the composition of the board. This individual can come to further dominate the corporation’s affairs by fashioning a loyal group of board members and executives around them.
Together this group could direct corporate resources and cash flow for the benefit of shareholders, but over time, they tend to favor their own ends. Although they can inflate their own cash compensation directly and by alleging nonexistent performance, much more wealth can be redirected through corporate policies that allow private use of corporate resources and both legal and semi-legal stock issuance, option, and buyback strategies that disadvantage general shareholders. They can also alter corporate strategy to consolidate their control and hire auditors who are favorably disposed.
There are four pillars of good corporate governance shareholders should focus on: shareholder rights, the board of directors, auditors and compensation.
Shareholder Rights: Reasonable shareholder access to the proxy ballot is key to all other forms of governance change. Minority, but not necessarily small, shareholders are currently blocked from nominating director candidates. Though they agree in general, institutions have somewhat diverse opinions on the details of proxy access proposals. They also differ on what forms potential abuse might take and how to mitigate these problems. Therefore, the institutions, which set up “proxy voting policies” carried out by an agent, have difficulty creating broad policies on proxy ballot access issues in an organized way. Individual investors can thus have a significant impact here.
The Board of Directors: A simple Internet search for the director’s name will generally produce a one- or two-paragraph biography. Individuals who are overworked or with no effective oversight have an increased probability of endangering shareholder value. Many institutional proxy voting policies withhold support from director candidates who already serve as an executive or board chair of any other corporation or serve as a director on more than two public company boards. They also withhold support from director candidates who are current employees or contractors of the corporation or its close affiliates.
Most proxy policies also encourage support for increasing the number of independent directors—that is, an individual who has not worked for the company for at least a year. The theory is that these individuals can improve the performance of the company with a more objective view of the company’s operations and financial health.
Unsurprisingly, proxy policies withhold support for any director or board member who has failed to implement a shareholder proposal that received the majority of votes cast in the prior year. Institutions also withhold support from continuing directors who are members of the board’s audit committee if the independent auditor has issued an “adverse opinion” or found a “material weakness” during the director’s current term. These are both very serious issues that should not be overlooked by shareholders.
Auditors: It is important that the auditing firm is truly independent. The external auditor must have no financial interest in the corporation and not be affiliated with it in any way other than as independent auditor. However, reputable auditing firms can have relationships that are red flags in their work with one corporation, but that are non-issues working for another.
Compensation: Research on compensation proposals must be done on a case-by-case basis. The purpose of a good compensation policy is to attract and retain appropriate employees and align their interests with those of the corporation and its shareholders. Employee stock purchase plans do this very well, especially for the rank-and-file. Options, cash and other performance incentives appropriately sized and truly linked to corporate performance and profitability are beneficial to shareholder value. Rich supplemental executive retirement plans, automatic benchmarking of pay in the top 50% or less of the peer group, base pay that is excessive for the peer group, and supplemental compensation tied to anti-takeover provisions (golden parachutes) are generally considered detrimental to shareholder value. It is likely that you will want to heavily weight research prepared by an institution you trust when you vote compensation issues.
Limit your votes on issues to what you can research. Remember to specifically abstain rather than leave issues blank on your ballots and realize that most individual investors are limited in their ability to accurately evaluate the merits of complicated ballot initiatives without some level of research. Use blogs and financial websites to help evaluate such things as anti-takeover measures and complex executive compensation programs evaluated across industries and professions. Table 1 lists other issues you might see on proxy ballots.
You can sometimes view the upcoming votes of an institution that has a proxy voting policy you like. Open records laws require that public institutions like pension funds make their policies and votes public.
A typical ballot can be voted in less than 10 minutes after catching stride. A fairly substantial proxy ballot takes about 15 minutes to vote starting from scratch.
When you are finished, you might consider allowing others to benefit from your research by posting on social networking and financial sites that discuss the proxy issues for companies in which you own shares. You will either help someone understand the issues better or gain new understanding yourself.
→ Robert Stein is the board chair and chair of the investment committee for the State Teachers Retirement System of Ohio.
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