Proxy Contests

Proxy contests arise when a dissident shareholder or group distributes its own proxy materials, apart from management's proxy materials. Both groups then wage an active solicitation campaign to persuade shareholders to vote their respective proxy cards. The dissident's goal may be to replace the entire board, and ultimately, management, or to replace only some of the directors (short slate).

Once fairly infrequent, proxy contests have become increasingly common in recent years as large shareholders, frustrated by poor returns and unresponsive boards, have sought to challenge the status quo. Even when dissidents do not achieve board seats, studies indicate that at least some of their objectives are often achieved because the response to a proxy contest, or one that was narrowly averted, usually includes new strategic initiatives, a restructuring program, governance changes, or selected management changes.

Typically, target companies in a proxy contest are those that have performed poorly over the long term, on both an absolute and relative basis. Other targeting criteria include: low insider ownership, a large number of antitakeover devices in the company bylaws or charter, and ineffectual or unresponsive management, including failure to respond to an unsolicited takeover offer.

Proxy contests are among the most difficult and most crucial corporate governance decisions because an investor must attempt to determine which group is best suited to manage the company. ISS evaluates proxy contests on a case by case basis, giving consideration to the following principles:

Enhancing shareholder value: The fundamental objective in evaluating alternatives in a proxy contest is to determine which slate is more likely to enhance shareholder value. While the post-transaction governance structure is an important factor in the decision, the paramount concern is whether the insurgents or the incumbents have better potential for producing superior shareholder returns. If poor governance is being introduced as a result of the transaction, the company must demonstrate that the economic benefits clearly outweigh any reduction in shareholder rights.

Company performance: Both financial performance and total return are viewed relative to the company's peer group over the long term.

Strategy: Dissident directors should have a strategy for improving company returns and not be seeking election based solely on the fact that they are not current management.

Responsiveness: ISS prefers a governance structure that does not entrench management and directors that are responsive to shareholders, particularly in regard to shareholder proposals that receive a majority vote, tender offers where a majority of shares are tendered, and hostile bids.

Competence: Companies should seek directors who can add value to the board through specific skills or expertise. In a contested election, the qualifications of both existing directors and the dissident directors must be assessed, including track record and relevant experience.

Independence: Generally the dissident director nominees should be independent, rather than affiliated with the investor instigating the contest because directors owe a fiduciary duty to the shareholders and must be able to respond to a third-party offer that is superior to that of the dissident group. However, if the dissidents are making a hostile bid that ISS supports the need for independence of the dissident directors is reduced.

Full slate versus short slate: Replacement of the entire board, which is usually accompanied by replacement of management, is a drastic step that should be undertaken only when existing directors have clearly failed to perform their duties, and the dissident directors have developed a viable strategy for improvement. However, the standard for support of a short slate is less rigorous. Often the addition of one or more dissident directors to an existing board can serve as a catalyst for improved governance and performance; however, shareholders should avoid supporting any director who would be so disruptive that the board would be incapable of action.

Voting on Director Nominees in Contested Elections

Votes in a contested election of directors should be decided on a CASE-BY-CASE basis, with shareholders determining which directors are best suited to add value for shareholders. The major decision factors are:

Company performance relative to its peers
Strategy of the incumbents versus the dissidents
Independence of directors/nominees
Experience and skills of board candidates
Governance profile of the company
Evidence of management entrenchment
Responsiveness to shareholders
Whether takeover offer has been rebuffed

Discussion

Voting for Director Nominees in Contested Elections

Vote Recommendation

Votes in a contested election of directors must be evaluated on a CASE-BY-CASE basis.

Do Proxy Contests Maximize Shareholder Value?

The announcement of a proxy contest, by a dissident shareholder group that claims to know more than management about how to improve target company performance, often results in a near-term rise in share price. Increased scrutiny by dissidents often leads management of the target company to renew its focus on the company's strategic direction and resource allocation. However, once the excitement and publicity surrounding a contested election subsides, is the upward movement in share price sustainable?

Jerold Warner, professor of finance and chairman of the Ph.D. program at the University of Rochester, has studied the impact of proxy contests on shareholder returns. Warner's work and that of others in the field indicates that proxy contests result in sustainable increases in shareholder returns.[1] According to another research project completed by Michael Jensen and Richard Ruback, shareholders in companies that experience proxy contests earn an eight percent higher return sustainable over the long term regardless of the outcome.[2]

This is not to imply that better alternatives to a contested election do not exist or that there are not substantial long- and short-term costs associated with proxy contests. While shareholders may benefit from ridding themselves of unyielding, incompetent and/or self-dealing management, such benefits must be weighed against the costs associated with contested elections.[3] In a research paper by Gail Farrelly, associate professor of accounting at Rutgers University, three major negative effects of proxy contests are explored:

The expense and disruption to the company's operations and relationships with shareholders, employees, consumers, and suppliers. Proxy contests entail an enormous amount of top management's time to the detriment of day-to-day operations. Employee morale is often damaged when employees are left in limbo wondering who will ultimately control the company and what impact this will have on their respective positions. Similarly, customers and suppliers may seek out a more stable firm to work with as a change in control can lead to major structural changes at the target company leaving numerous uncertainties.
The risk of shifting authority for major corporate decision making to dissidents who, in many cases, are unfamiliar with the company's internal operations and sometimes the industry within which the firm operates. As noted above, unless management is unyielding, incompetent, and/or self-dealing, it's unlikely that the dissidents will have a "quick fix" solution that management and its financial advisors have not considered. Moreover, new management will need time to acclimate itself to the company's operations and is sure to find many surprises after gaining access to the company's records and internal operations.
The possibility of constructing a wall between management and shareholders, which can permit outsiders looking for a quick profit to drain the company of corporate resources. When cooperative solutions cannot be reached, attorneys, investment bankers, public relations firms, and financial advisors may intervene collecting substantial fees in the process that could have been reinvested in the business.[4]

Importantly, the SEC's proxy reforms adopted Oct. 15, 1992, could reduce the need for contested elections by easing the restrictions on shareholder communications (see Exhibit 18). Under the previous SEC rules, any communication relating to a proxy voting issue between ten or more shareholders required the filing and distribution of proxy materials. Under the reforms, so long as shareholders are not seeking proxy authority, oral communications do not require any filing, while copies of written materials distributed must be sent to the SEC. Thus, a conversation among shareholders about company or management performance cannot be construed as a proxy solicitation. Permitting dissatisfied shareholders to communicate with each other more freely could facilitate negotiations and settlements between management and shareholders, and thereby reduce the necessity of resorting to a proxy contest.

Voting in a Contested Election

For shareholders, the decision making process in a contested election is always a difficult one, compounded by the fact that, in many cases, members of the dissident slate are not well-known. Moreover, shareholders often have just a few weeks to make their vote decisions.

While information about the company, management, and incumbent directors is readily available to shareholders, gathering information about dissident nominees can require a time-consuming investigation. The dissidents will, however, distribute a proxy statement and, in many cases, "fight letters." Beyond that, shareholders must frequently initiate their own search to gather additional information. Moreover, while the proxy statements have been scrutinized by the SEC, there is no guarantee that such materials, particularly fight letters, are accurate or free of hyperbole.

ISS analysts typically schedule meetings with both management and members of the dissident group to discuss the key issues involved in a contested election. Each side is given an opportunity to make a presentation and answer questions from our analysts. Topics frequently discussed include nominee qualifications, corporate performance, business strategy, executive compensation, and corporate governance issues. Such meetings are usually scheduled after proxy materials for both parties have been cleared by the SEC. When time does not permit us to meet the parties, conference calls are scheduled with each side.

ISS also relies on the resources of its own library of business periodicals and journals, and utilizes several online databases to gather information. In addition, we review the company's annual reports, 10-Ks, 10-Qs, 8-Ks, proxy statements, press releases, industry reports, newspaper articles, and equity research.

While it is difficult to generalize about all the factors that must be considered in a proxy contest vote, following is a framework to analyze proxy contests. Review the following:

Overall long-term financial performance of the target company relative to its industry. Key measures include five-year annual compound growth rates for sales, operating income, net income, and total shareholder returns (share price appreciation plus dividends). Other financial indicators include margin analysis, cash flow, and debt levels.
Management's track record. Review of strategic decision making such as acquisition record, new business development, effectiveness of marketing campaign, and strategic positioning. Look for actions that show a blatant disregard for shareholders such as a blocked takeover bid that shareholders may have been interested in accepting. Consider executive pay and spending on perks, particularly in conjunction with subpar performance and employee layoffs.
Background to the proxy contest. Chronology of events leading up to the proxy contest. Look for evidence to indicate that the dissidents attempted to work cooperatively with management on the issues in question. Also look closely at how quickly and in what manner management responds to the dissidents' concerns.
Qualifications of director nominees-both slates. For incumbent slate, board and key committee composition is emphasized. Look for a majority of insiders to affiliated outsiders and independent outsiders as well as key board committees comprised solely of independent outsiders. Includes review of knowledge and experience of incumbents. Also includes a review of the corporate governance profile looking for entrenchment devices that reduce accountability. For the dissident slate, each candidate's knowledge and experience of the target company and industry is reviewed, as well as the nominees' track record at other companies.
Evaluation of what each side is offering shareholders as well as the likelihood that the proposed objectives and goals can be met. Look for a clear strategic operating plan from both management and the dissidents. Optimistic projections must be backed up with a realistic plan for achieving goals.
Stock ownership positions. Substantial share ownership enhances the credibility of director nominees. In the case of dissident nominees, an outstanding tender offer also serves to enhance credibility. Whereas a proxy contest typically costs between $1 million and $15 million, those seeking to gain control of the company by purchasing it must pay millions or billions of dollars.[5] When there is an outstanding tender offer, the proxy contest is considered to be a tactic to enhance the offer, and the offer itself is also analyzed.

Finally, all analyses pertaining to proxy contests are subject to review and comment by both the company and dissident group to ensure accuracy, provide clients with a balanced analysis, and facilitate dialogue between ISS and the companies we cover. Regardless of which slate offers better value for shareholders, votes should be based on a thorough analysis of what each side has brought to the table.

Mechanics of Splitting the Vote in a Contested Election

Casting a split vote in a contested election-that is, supporting one or more director nominees from each side-enables shareholders to support the best candidates from each of competing slates. "Split ticket" voting allows shareholders to place a new voice on the board, without committing to a radical departure from the existing board structure.

Prior to its Oct. 15, 1992, proxy rule changes, the SEC's bona fide nominee rule made it extremely difficult to obtain minority representation in a proxy contest, absent cumulative voting. A shareholder wishing to run a so-called "short-slate"-a slate containing nominees for fewer than the total number of board seats available-could not include any of management's nominees on the dissident proxy card without their permission. Such permission was seldom given. Shareholders who wished to support both dissident candidates and management candidates faced the possibility of being disenfranchised. Suggestions that shareholders split their votes, by executing both management and dissident cards, by executing one card on which they add or delete nominees for the other slate, or by using one party's ballot to revoke partially the other party's ballot, all proved complex, confusing, and unreliable methods. In some instances, shareholders have been told that their ballots have not been counted, despite assurances that split votes would be honored.

Now, a dissident group's proxy may be voted for both dissident nominees as well as management nominees. As a result of amendments to the bona fide nominee rule, dissidents seeking a minority of seats will be permitted to indicate that they wish to run with the management slate as a group, except for certain directors. Thus, while the dissidents' ballot would not specifically include management-favored directors by name, by running with all management nominees except for a few named candidates, the same outcome is accomplished. Dissidents must state in proxy statements and proxy cards that management nominees may refuse to serve as directors if the dissident nominees are elected.

This important rule change allows shareholders to vote for a dissident nominee without surrendering their voting power for the other management nominees. It is now much easier for shareholders to nominate their own director candidates and solicit votes on their behalf. Thus, shareholders could solicit votes for a slate comprised of both shareholder nominees and management nominees, thereby effecting a variety of incremental changes. Such an alternative may be preferable to running a full slate opposite management's nominees.