United States: Recent Developments Regarding Majority Voting in Director Elections

The issue of majority voting for directors has emerged as a widely discussed corporate governance topic. This is particularly true with the beginning of this year’s annual meeting season, as many companies may be faced with the issue, whether as a result of shareholder proposals or otherwise. This Update addresses recent developments relating to the majority vote debate, including institutional shareholder actions and shareholder proposals, considerations regarding a change from the plurality voting standard, corporate governance policy changes that some companies are adopting in response to the issue and the recent policy update of Institutional Shareholder Services (ISS) on majority voting.

In October 2003, at the urging of certain institutional shareholders and their representatives, the Securities and Exchange Commission (SEC) proposed proxy rule changes that would have provided shareholders with a limited right of access to company proxy materials for shareholder nominees to make it easier for shareholders to elect their own director nominees to a company’s board. As it became clear that the SEC would not adopt these proposed rules, certain institutional shareholders and their representatives shifted their focus to changing the required vote for the election of directors. More specifically, ISS and various institutional shareholders initiated an effort to change the threshold for the election of directors from a plurality voting standard to a majority voting standard.

A plurality voting standard is the standard used in the election of directors under most state corporate laws. Under the plurality standard, a nominee is elected as a director by receiving the highest number of votes cast for an open director’s seat, even if less than a majority. Accordingly, only votes "for" a director candidate have any legal significance. As a result, a director nominee in an uncontested election needs to receive only a single affirmative vote to be elected. Even if holders of a substantial majority of the voting shares choose to "withhold" support, the director nominee still is elected, rendering votes withheld only symbolic.

Under a majority voting standard, a director nominee will be elected (or re-elected) only if he or she receives an affirmative vote of the holders of either (depending on the standard) a majority of the shares present and voted at a meeting or a majority of the total outstanding shares entitled to vote. Under this standard, "withhold" votes in the election of directors are significant to the extent they result in a nominee failing to receive the requisite majority vote. As a result, the majority voting standard is preferred by institutional shareholders.

Earlier this year, the Council of Institutional Investors sent a letter to 1,500 of the largest U.S. companies urging adoption of a majority voting policy. The letter stated that, if permissible under state law, companies’ charters and by-laws should provide for election of directors by a majority of votes cast at shareholders meetings. The letter further provided that, if state law requires plurality voting or prohibits majority voting for directors, then boards of directors should adopt corporate governance policies mandating that a director tender his or her resignation if votes withheld exceed votes for the candidate, and providing that a director will not be re-nominated after the expiration of his or her current term in the event the director fails to tender such resignation.

Additionally, many companies have received or will be receiving shareholder proposals from certain institutional investors under Rule 14a-8 of the Securities Exchange Act of 1934 regarding a majority vote standard. These proposals typically (1) recommend that the board of directors take action to adopt the majority vote standard by charter amendment if the company is incorporated in a state that only permits changes through such an amendment or (2) propose binding bylaw amendments if the company is incorporated in a state such as Delaware that permits voting requirements to be determined through a bylaw amendment adopted by shareholders. In general, the shareholder proposals recommending that the board take action tend to defer to the board to craft language that addresses technical aspects of the majority standard, including how to treat a failure to re-elect an incumbent director and contested elections.

Many of the shareholder proposals are of the type described in (1) above, which are "precatory", meaning that they are not binding on a company because the shareholders do not have the corporate authority (without board approval) to propose for shareholder consideration an amendment to a company.s charter. The SEC has required companies to include in their proxy statements precatory shareholder proposals that recommended that the board of directors act to adopt a majority vote standard, refusing to exclude the proposals on the grounds set forth Rule 14a-8. In fact, we are not aware of any instance in which the SEC has allowed a company to omit from its proxy statement a shareholder proposal regarding majority voting.

According to ISS, in 2005, shareholder proposals seeking a majority vote in director elections were voted on at over 60 shareholder meetings. Seventeen proposals won the support of a majority of the shareholders (average affirmative vote 44%). This is expected to be one of the top shareholder proposals in the upcoming proxy season.

There are various factors that a company may wish to consider before adopting a majority vote standard, including the following:

• There were reasons that state corporate laws adopted the plurality voting standard. Among others, plurality makes sense in an election in which there are more candidates than seats available. This is the case in a contested election in which other nominees are running against management.s nominees. If the plurality standard were not applicable to contested elections, then the election could result in no directors being elected if no candidates received a majority of the vote.

• Shareholders often vote against directors or withhold votes to further their own policy agendas rather than in response to the performance or qualifications of the director in question or something that has a potential impact on long-term shareholder value. Accordingly, adopting a majority voting standard could give certain shareholders another means to advance their agendas and to attempt to micromanage a company. In this regard, long-term shareholders have other means to communicate with and influence management regarding bona fide business matters, including through direct communications. It could ultimately be a disservice to shareholders generally if certain shareholders used relatively inconsequential reasons to oust directors under a majority voting standard.

• Majority voting could cause a company to fail to comply with stock exchange or SEC requirements regarding board and board committee membership if a sufficient number of independent directors are not elected.

• Given developments affecting public companies and their directors, it has become increasingly difficult for companies to recruit directors. A majority standard may exacerbate the problem by providing another disincentive for directors to serve. In a related point, a majority standard can result in a sudden, binding removal of a director and a resulting vacancy on the board. On average, it takes a company a year to find a suitable director candidate.

• Majority voting is likely to result in more costs to public companies in terms of proxy solicitation expense and management time, adding to the burden of being a public company.

• A majority voting standard does not address the so-called "holdover" concern - under most state corporate laws an incumbent director will continue to serve until his or her successor is elected. Thus, if an incumbent director was not reelected, then the director would nonetheless continue to serve until the company held another election or the director resigned.

• The failure to re-elect a chief executive officer as a result of a majority voting standard could trigger a variety of issues, including potentially obligating a company to make payments under an employment agreement.

In the face of shareholder action, some companies are simply resisting proposals and/or taking no action in the face of successful proposals. For example, Paychex Inc. recently defeated a binding shareholder proposal that received 18% of the shareholder vote. In this case, ISS recommended a vote against the proposal because it did not distinguish between contested and uncontested elections.

A number of companies have adopted majority withheld vote policies in their corporate governance principles or bylaws, perhaps in an attempt to reach a "compromise" and avoid having the proposals included in their proxy statements, including Pfizer, Inc. and General Electric Company. Generally under these policies, which include a number of variations on the theme, director nominees receiving a greater number of withheld votes than votes for in an uncontested election must tender their resignation. The governance committee or the board then decides within a specified time period whether to accept the resignation, and the company publicly announces the result. The policies vary on factors such as whether they apply to contested elections (it may apply only if a majority of the shares outstanding withhold votes) and whether the policy provides that the decision maker should accept the resignation absent "compelling reasons."

Some institutional shareholders and their representatives have indicated that this .compromise. approach is not sufficient. For example, the Sheet Metal Workers. National Pension Fund has noted that companies targeted for 2006 majority vote proposals include those that have adopted the Pfizer model. In addition, the Council of Institutional Investors has stated that the Council supports the majority voting default rule approach under which a director who fails to garner a majority of votes cast should be required to step down with no provisions for the board to overrule shareholders.

ISS recently issued its 2006 updates of U.S. corporate governance policy. Those updates provide that ISS will "generally recommend" voting for reasonably-crafted shareholder proposals calling for directors to be elected by an affirmative majority of votes cast. However, ISS will "consider" recommending voting against a shareholder proposal if a company has adopted formal corporate governance principles that present a meaningful alternative to the majority voting standard and provide an adequate response to new and incumbent nominees who fail to receive a majority of votes cast. Pursuant to the ISS policy, the governance principles must include the following elements to address director nominees who fail to receive an affirmative majority of votes cast in an election:

• Guidelines that a company discloses in its proxy statement concerning the process to follow for nominees who receive majority withhold votes.

• A clear and reasonable timetable for all decision making regarding a nominee’s status following a majority withhold vote.

• That the process of determining a nominee.s status must be managed by the independent directors (excluding the nominee in question) following a majority withhold vote.

• An outline of the range of remedies that can be considered regarding a nominee.

• That the final decision on a nominee’s status should be promptly disclosed in an SEC filing, including a full explanation of how the decision was reached, and the timeframe for disclosing the decision.

• An explanation to shareholders why this alternative to a true majority voting standard is the best structure for demonstrating accountability to shareholders.

Even if a company adopts governance principles that meet these guidelines, it does not necessarily follow that ISS will support the board’s recommendation as to a shareholder proposal regarding voting in the election of directors. ISS noted that it will evaluate a company’s history of accountability to shareholders in its governance structure and in its actions, in particular whether a company has a classified board or a history of ignoring majority-supported shareholder proposals.

In light of the uncertainty as to the final outcome of the majority voting debate, we do not believe that companies need to rush to adopt a majority voting standard. Whether a company’s board needs to take action – either proactive or reactive – on the director election standard remains subject to a facts and circumstances analysis that should take into account the host of factors discussed above as well as the size and composition of the company’s institutional shareholder base.

It may make sense for some companies, particularly those facing a shareholder proposal on majority voting, to adopt a Pfizer-like policy. The policy approach may be sufficient to help a company win on a shareholder proposal vote or to "buy time" to see what trends develop in this area before taking formal action to amend its charter. A policy does not require the approval of shareholders – it can be implemented by the board and, conversely, can be removed or modified by the board as this issue of corporate governance continues to develop.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.