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Shareholder Democracy and Special Interest Governance

By John H. Matheson & Vilena Nicolet. Full text here.

In the past several decades, the corporate governance landscape has changed dramatically and positively. Recently, shareholders have found new ways to directly impact the governance regime and the board of directors. These new means derive from various sources, including a more favorable regulatory environment and the influence of proxy advisory firms. The results of shareholder activity have been amazing, including majority votes for director elections, declassification of corporate boards, shareholder approval of executive pay, and proxy access for shareholder nominees for board seats. Shareholder proposals on a multitude of social issues, from environmental concerns, such as climate change and sustainability, to board diversity and gender pay gap issues, have been vetted with some success. This movement and increased role for shareholders suggest that something approaching shareholder democracy might actually be possible. This Article proposes two fundamental corporate governance changes designed to enhance the shareholder democracy landscape: (1) establishment of shareholder advisory committees (SACs) to improve the communication and consequently the relationship between the board, management, and shareholders; and (2) introduction of a requirement that, with some exceptions, all settlement agreements between boards and activists be approved by the other shareholders to ensure that boards do not bind companies to self-interested agreements protecting their own positions and those of the activists without shareholder validation.

The development of corporate democracy is now at a stage where it is important to let shareholders participate in the corporate governance process more directly. If shareholder engagement and shareholder democracy are to take a leap forward, they need to be part of a formal process in which shareholders directly interact with companies and work together in more proactive ways. This Article proposes institutionalization of shareholder engagement through the creation of shareholder advisory committees (SACs) by companies. The adoption of SACs can fundamentally improve the shareholder-management relationship. Whether proposed by shareholders as a resolution for board adoption under the proxy rules or mandated by the SEC through the stock exchanges, this Article provides a detailed algorithm for the creation, constitution, and function of SACs.

Unfortunately, the latest development in shareholder activity has gone counter to this democratic trend. As happens in the political sphere, where power exists, preference is sought. The result in the corporate sphere is the rise of special interest corporate governance. Activist investors are increasingly working outside the main governance mechanisms to advance private agendas. They acquire an ownership stake in the company that is too small to command any change in the target company but then advocate for that change nevertheless. Among such advocacy tactics are threats to unseat the board, get rid of current management, or seek a sale or breakup of the target company. These activists threaten to take these demands directly to the other shareholders and to have these results occur through a proxy fight at the upcoming annual meeting of the company. The only alternative the activist offers to this, potentially very public, corporate war is that the target company’s board agree to special concessions and benefits for the activist alone.

Corporate boards may be intimidated by these tactics. The result is often that the target company board often accedes, with the activist and the board cutting a private deal, whether termed a settlement, standstill, or shareholder agreement, which may not advance the interests of the corporation or the larger shareholder base, but only those of the activist and the board. These private deals often result in special benefits for the activist, primarily in the form of their representatives being appointed to the board outside of the normal shareholder election process. Through this benefit, they access the inner sanctum—the board of directors.

The thesis of this Article is that these special interest deals are bad for corporate governance and antithetical to the shareholder democracy movement. This Article demonstrates how the resulting special agreements violate basic governance principles to the detriment of the vast majority of the corporation’s other shareholders. Shareholders as a whole should have the right to determine if it is in the best interests for an agreement with an activist to be binding on the corporation. This is the only path by which shareholder democracy can continue to ascend in the publicly held corporation. This Article embodies that solution in a proposed model statute, which could be adopted by individual states or used as a template for shareholder proposals to change governance documents in individual companies.