By HAL S. SCOTT
Originally published by Forbes on December 21, 2016
Under the Trump Administration we can expect that there will be many changes at the Securities and Exchange Commission. One important area that has gone largely ignored and is ripe for reform is the system of “unelected directors” for public companies.
The Committee on Capital Markets Regulation—a policy group with executives from across the financial sector and leading academics—recently studied how boards of directors of public companies respond to unfavorable votes by their shareholders. The Committee’s startling discovery is that, in 85% of cases where a director does not receive a majority of shareholder votes, the director will continue to serve on the board for at least two more years.
We also found that the retention rate for losing directors is almost as high as winning directors (91%—winning directors may depart the board anyway for various reasons, e.g. health or alternative opportunities). So in other words, losing a shareholder election barely increases the probability that a director will actually resign.
But what does the continued tenure of “unelected” directors on corporate boards say about shareholder rights?
The obvious concern is that shareholders are unable to hold their boards of directors accountable and, as a result, boards may not be adequately representing shareholder interests when dealing with management or making other major strategic decisions for the company. Further, if votes against directors have no impact, then shareholders are discouraged from even participating in the election of the board of directors. Such disenfranchisement of shareholders can lower corporate performance and investor returns.
The evidence also shows that the election of boards of directors is more contentious now than ever before. According to a Georgetown study, in the early 2000s, board members would fail to receive majority support from their shareholders only a few times a year across all public companies. Today, it is occurring at a rate of more than 50 public companies each year—likely due to increased voting activity by institutional investors and activist hedge funds. Yet the losers stay on the board.
It is true that there may be instances where boards are actually acting in the best interests of shareholders by keeping an “unelected director” on the board. For example, the board could be defending itself against a “say on pay” campaign that just happens to single out a board member standing for election.
In any case, the Committee strongly believes that the SEC should require that boards meaningfully disclose why an unelected director stayed on the board. Such transparency would enhance the legitimacy of the board’s decision and improve their relationship with shareholders. Of course, this would require a specific statement by the board.
The Committee’s study found that public companies generally do not provide meaningful disclosure of why an “unelected director” remained on the board. Indeed, in virtually all cases there were absolutely no relevant disclosures provided to shareholders, and in the cases where disclosure to shareholders were made, they were generally boiler-plate. For example, in one instance, a public company simply stated that it would be “detrimental to shareholders” if the losing director left the board.
Unfortunately, data companies are no longer collecting the information regarding board member resignations that the public needs to continue to update the study of “unelected directors” and push for enhanced shareholder rights. The SEC should fill this gap by itself collecting the data.
In 2015, SEC Chair White offered strong support for further disclosures, stating “any company that is serious about good corporate governance should provide such information on its own. It should share the board’s thought process and reasons with shareholders—inform the shareholders in clear terms why the board member’s resignation was not accepted, why the director was considered important for the strength of board decision-making, for the growth of the company, for the relevant experience represented, or for the expertise that would be lost.”
This is good advice, but it is just that. The SEC has failed to correct the situation, with a rulemaking or formal guidance, despite numerous pleas from the Committee. Indeed, the unelected directors issue is not even on the SEC’s regulatory agenda.
If the SEC were to focus on the “unelected directors” issue it would send a clear signal to shareholders and the market that the SEC is serious about passing rules that strengthen our capital markets.