Classification/Declassification of the Board

Discussion

A company that has a classified, or staggered, board is one in which directors are typically divided into three classes, with each class serving three-year terms; each class's reelection occurs in different years. In contrast, all directors of an annually elected board serve one-year terms and the entire board stands for election each year.

Classifying the board makes it more difficult to change control of a company through a proxy contest involving election of directors. Because only a minority of the directors are elected each year, a dissident will be unable to win control of the board in a single election and would need two years to gain control of the company unless there are vacancies in the other classes.

For example, a company that has 15 directors and a classified board would structure its board in three classes of five directors each. Directors would hold overlapping three-year terms. Each year, shareholders would elect only five of the 15 directors. Anyone trying to change control of the company through a proxy contest would need two years to gain majority control of the board and three years to gain full control.

Most state corporation laws (except Arkansas) permit board classification but require shareholder approval for charter or bylaw provisions to switch from annual election of directors to a classified board. In contrast, Massachusetts automatically provides for a staggered board unless the board and holders of two-thirds of the shares elect to opt out. Maryland has an "opt in" provision, but boards may unilaterally choose to be governed by it. In presenting voting proposals relating to board structure to their shareholders, companies are required by SEC regulations to state the advantages and disadvantages-in terms of shareholder interests-of adopting a classified board.[1]

In their proxy statements, companies often argue that classifying the board will assure continuity among directors and stability of the board as an institution. As a practical matter, however, continuity generally may be achieved without classifying the board. The only real motive for board classification is to make it more difficult to change control of the board. A classified board can (1) delay a takeover desired by shareholders but opposed by management, and (2) prevent bidders from even approaching a target company if they do not want to wait more than a year to gain majority control. Shareholders lose in both cases, and management has less incentive to keep shares fully valued if the directors' board seats are secure. Although shareholders need some form of protection from hostile takeover attempts, and boards need tools and leverage in order to negotiate effectively with potential acquirers, a classified board tips the balance of power too much toward incumbent management at the price of potentially ignoring shareholder interests.

Studies performed by SEC economists and by academics support the view that classified boards are contrary to shareholder interests, showing negative effects on share value for companies that adopt classified boards. For example, the SEC studied the impact of 649 antitakeover proposals submitted between 1979 and 1985. The proposals consisted of fair price provisions, institution of supermajority vote requirements, classified board proposals, and authorization of blank check preferred stock. Stocks within the group showed an average loss in value of 1.31 percent. The study also found that the proposals were most harmful when implemented at firms that have higher insider and lower institutional shareholdings.

A 2002 study by three academics covering hostile bids between 1996 and 2000 showed that classified boards nearly doubled the odds of a target remaining independent. However, the findings revealed that a staggered board structure did not provide any countervailing benefits in terms of higher acquisition premiums. In fact, for the period covered, it resulted in the loss of $8.3 billion for target shareholders by impeding value-creating transactions without any offsetting increases in alternative transaction or stand-alone target returns. [2] Similarly, a 2001 study found that over the period 1990 to 1999, firms with weak shareholder rights, including classified board structures, exhibited lower net profit margins and sales growth and made more capital expenditures and acquisitions than firms with a high degree of shareholder rights. [3]

Classified board proposals often carry attendant provisions that make changing control of the board even more difficult. These provisions include supermajority shareholder vote requirements if shareholders wish to increase the number of directors or prohibitions against shareholders' altering the size of the board; provisions allowing shareholders to remove directors only for cause; provisions stipulating that any board vacancies occurring between elections be filled only by a vote of the remaining board members, not the shareholders; and supermajority vote requirements to alter the amendment itself (lock-in provisions).

With some 60 percent of S&P 500 companies having classified boards, shareholder activists have become more prolific in submitting proposals seeking to unwind them. Although well over half have received majority support since 2000, rarely do companies act on these precatory resolutions. Repealing a staggered board involves a charter amendment, proposed by management and approved by a majority, or in some cases a supermajority, of shares outstanding.