Reforming Corporate Elections

The current hodge-podge approach to reforming corporate elections is creating the potential for some very serious problems.  Let’s connect the dots here.  First, there is an increasing trend towards majority voting.  This means that no measure can pass, including uncontested direct elections, unless each person receives at least 50% of the votes that have been cast.

Second, the broker vote has just been eliminated.  The broker vote involves shares held in street name for which no instructions had been received by the broker for voting.  If no voting instructions were received from the beneficial owner, the broker had the right to vote on matters such as uncontested director elections – and typically sided with management.  Let’s translate that into a practical situation.  In the case of a company that has 100M shares outstanding, if the broker vote is removed, which is typically 10% to 15% of the vote, then the actual number of shares that can be cast would be 85-90M.

There has been a huge trend among institutional shareholders to make money by lending shares.  When an investor lends shares, as a practical matter it retains economic ownership, but gives voting power to the borrower of the shares.  Let’s again look at the practicalities.  By borrowing shares, a shareholder who has a limited and potential minimal economic investment in a company can borrow shares from other investors and dramatically increase the borrowing shareholder’s voting power. So, taking a relatively small percentage can suddenly be expanded geometrically to a great number of votes.

Third, like it or not, there is almost certainly going to be access to the company proxy statement. What that means is shareholders are going to be able to nominate people for the board of directors.

Fourth, the final dot in this puzzle involves voting by governance advisors such as RiskMetrics.  It is not uncommon for these firms to vote 25% to 30% of shares outstanding on behalf on various institutional shareholders.  The advisors’ voting policies, however, follow their own rigid guidelines in which failure of a board of director to follow the advisor’s mandate results in votes against management.

Now let’s connect the dots.  Directors must be elected by a majority of votes cast.  However, eliminating the broker vote has both lowered the number of votes cast and taken a bloc of votes from the board’s position.  In our example, if there are 100M shares outstanding, with the broker vote gone there are at most 90M votes cast.  A majority vote then needs 45M instead of 50M.  An investor or group of investors owning 10M shares can, by borrowing votes easily increase their voting power – in this case, let’s say by 20M votes.  That means that in this scenario, 15M shares – perhaps voted by a proxy advisor – will swing the outcome of the election.

While the motivation for changing the electoral rules are noble, changing only a portion of the rules creates fertile ground for an unscrupulous shareholder who understands how to game the system, to control the vote and alter the composition of the board of directors, not necessarily on behalf of all shareholders but certainly on behalf on that particular shareholder’s investment strategies.  If there’s going to be a change in the way in which corporate elections are run, then the reform should be a holistic overall change so that the equities, the fairness in the system, can be understood and a reputable system established.