Thursday, May 14, 2009

A Call for Greater Shareholder Rights under U.S. Law

The proposed Shareholder Bill of Rights Act of 2009 in the U.S. that comes in the wake of the financial crisis gives rise to an important debate regarding the rights of shareholders in companies. The rationale for the Bill is the perceived failure of corporate governance that led to the crisis. It is worthwhile to set out the larger objective behind the Bill:


Congress finds that—

(1) among the central causes of the financial and economic crises that the United States faces today has been a widespread failure of corporate governance;

(2) within too many of the Nation’s most important business and financial institutions, both executive management and boards of directors have failed in their most basic duties, including to enact compensation policies that are linked to the long-term profitability of their institutions, to appropriately analyze and oversee enterprise risk, and most importantly, to prioritize the long-term heath of their firms and their shareholders;

(3) such failure has led to the loss of trillions of dollars in shareholder value, losses that have been borne by millions of Americans who are shareholders through their pension plans, 401(k) plans, and direct investments;

(4) a key contributing factor to such failure was the lack of accountability of boards to their ultimate owners, the shareholders;

(5) policies that serve to limit the ability of shareholders to nominate and elect board members has served to minimize the accountability of boards and management to shareholders;

(6) it has always been the intent of Congress that the Securities and Exchange Commission should have the full authority to determine the use of issuer proxy with regards to the nomination and election of directors by shareholders; and

(7) providing a greater voice to shareholders while not impinging on management prerogatives is in the best interests of shareholders, public corporations, and the economy as a whole.


The Bill seeks to make certain key changes to corporate law at the federal level. These include the following:


- Annual stockholder advisory (almost non-binding) votes on executive compensation;

- Nomination of candidates by shareholders holding a minimum of number of shares (and access to proxy solicitation materials supplied by the company);

- Elimination of staggered boards;

- Director elections should ensure that all directors receive a majority of votes cast at an elections; and

- Separation of the position of Chairman and CEO.


These changes spring up some interesting comparisons with the position in India. To an Indian corporate lawyer, some of these changes that have been spearheaded by U.S. shareholder activists more recently may appear trite because such shareholder rights have always been available in India for a number of years (and certainly from the time of the Companies Act, 1956). Some of the comparisons are explored below:


Executive Compensation: In Indian companies, shareholder approval is mandatory for senior management pay by virtue of Sections 309 and 198 of the Companies Act, 1956. Apart from that, they are also subject to ceiling on amounts depending on the profitability of the company. On the other hand, in the U.S., even the present Bill only provides advisory (non-binding) voting powers to shareholders as regards executive compensation.


Director Nominations: Section 257 of the Companies Act, 1956 allows any member to propose a person to stand for directorship of the company, and the company is in turn required to inform its members of the intention to propose such candidate for office of director.


Staggered Boards: This concept, which is prevalent in U.S. companies, ensures that only a third of the board can change each year. Furthermore, shareholders are usually not in a position to remove directors, other than for reasons of “cause”. Hence, it would not be possible for shareholders to replace the board, except through a gradual process of changing a third of the board each year. In the Indian context, Sections 255 and 256 of the Companies Act, 1956 provide for an element of staggering of the board, in as much as they provide that at least two-thirds of the board should consist of directors who retire by rotation. The remaining one-third is appointed in the manner permitted by the articles of association. Despite some shades of similarity between the Indian and U.S. position, there is one stark difference. And that is that Indian directors (whether appointed by general meeting through rotation or in the manner permitted by the articles) are all liable to be removed by the shareholders through an ordinary resolution (simple majority) at a shareholders meeting (Section 284, Companies Act, 1956). This is a significant power in the hands of Indian shareholders.


Director Elections: The seemingly radical proposal in the Bill of Rights is the accepted norm in India. Section 263 of the Companies Act, 1956 provides for a general rule whereby each director is required to be elected by a way of a separate resolution, thereby requiring at least a majority of the votes at a shareholders’ meeting.


Duality of Posts: Although there is no requirement in India for the posts of Chairman and CEO to be occupied by separate individuals, it is indeed the case in practice. Some studies have pointed to the fact that nearly 60% of Indian listed companies have a separation of posts.


This comparison seems to indicate that shareholders’ rights are firmly entrenched in the Indian Companies Act and even progressive corporate law jurisdictions such as the U.S. (including Delaware) are only now moving in that direction. While we often lament that India adopts several corporate governance principles (e.g. in Clause 49 of the listing agreement) from the West, including the U.S., the Bill of Rights is an example of a progressive corporate law, such as the U.S., moving towards what is the stated position in India. Having said that, it is not as if the principles of Indian corporate law provide a sense of optimality. Although shareholders as a body possess significant rights under Indian company law, their exercise is skewed due to the presence of controlling shareholders or promoters who tend to use these powers, sometime to the detriment of the minority shareholders.


For an earlier discussion of governance failure as a cause for the financial crisis and further comparison between Indian and U.S. corporate governance systems, see here, here and here.


Returning to the Bill of Rights, there is an intense debate about the suitability of granting these rights to shareholders. For instance, in a post on the Harvard Law School Forum on Corporate Governance and Financial Regulation and an op-ed piece in the Wall Street Journal, Martin Lipton and Theodore N. Mirvis of Wachtell, Lipton, Rosen & Katz and Jay W. Lorsch of Harvard Business School attribute short-termism among shareholders, primarily hedge funds and institutional investors, as the cause for the crisis. They argue that the Bill of Rights will only exacerbate this problem:


Increased stockholder power is directly responsible for the short-termist fixation that led to the current crises. The bulk of the specific provisions suggested would increase stockholder power. Stockholder power has already substantially increased over the last twenty years. Concomitantly, our stock markets have become ever-increasingly institutionalized. The undeniable fact is that the true “investors” are now professional money managers who are inherently short-term (even quarterly) focused. That “stockholder” pressure pushed companies to generate high financial returns at levels that were not sustainable, with management’s compensation being tied to producing such returns (at stockholder urging). The increase in stockholder power and stockholder pressure to produce unrealistic profits fueled the pressure to take on increased risk. As the government arguably relaxed regulatory checks on excessive risk taking (or, at minimum, did not respond with increased prudential regulation), the increased stockholder power and pressure for ever higher returns contributed significantly to the current financial and economic crises. That pressure became all the more irresistible as it combined with increased stockholder power to oust or discipline managers and directors — power available to enforce the stockholder and activist investor agenda of ever higher short-term returns.


Other arguments the authors make include the substantial concern that this will result in the usurpation by the federal government of matters that are otherwise within the domain of state law (e.g. Delaware). This argument has been supported by others as well, e.g. see Professor Bainbridge.


Hat tip: Shaun Mathew

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