SEC Approves Elimination of Broker Discretionary Voting in Uncontested Director Elections

On July 1, the Securities and Exchange Commission stepped up pressure on boards of public companies by approving an amendment to New York Stock Exchange Rule 452 that would eliminate the so-called “broker discretionary vote” in uncontested director elections. Previously, under NYSE rules, brokers were permitted to vote their clients’ shares in “routine” matters (such as uncontested director elections and ratification of auditors) so long as the beneficial owner of those shares had not provided voting instructions to the broker at least ten days before a shareholder meeting. The practice of most brokers, until recently, had been to automatically support the board’s recommendations on routine matters, although some brokers had already adopted practices of voting uninstructed shares in proportion to those shares that were voted. The amendment changes the categorization of uncontested director elections from a “routine” matter to a “non-routine” matter.

Brokers who are members of the NYSE will no longer be able to vote their clients’ shares in director elections (including those elections at companies that are not listed on the NYSE) without clients’ instructions beginning with meetings held on or after January 1, 2010. The amendment does not apply to elections at companies registered under the Investment Company Act of 1940 (for the most part, mutual funds); however, it does prohibit broker discretionary voting for material amendments to investment advisory contracts. Foreign private issuers are not affected by the amendment to Rule 452 as they are not subject to the U.S. proxy rules. 

Some commentators have declared the elimination of broker discretionary voting as the most significant development in activism and shareholder voting in more than a decade. The failure to achieve a majority of votes cast in director elections has potentially serious consequences now that almost 70% of S&P 500 companies and a growing number of smaller capitalization companies require directors who fail to achieve a majority vote to submit their resignations. Even absent a director resignation policy, majority votes against directors, or even a relatively high opposition vote, can create potential investor/public relations challenges for companies.

Key Takeaways

The elimination of broker discretionary voting in uncontested director elections creates difficult governance challenges for management and boards. We recommend the following steps in response:

• Analyze the impact of broker discretionary voting on past uncontested director elections to determine the likely degree of impact on future elections.

• Plan to educate retail investors on the even more critical importance of affirmatively voting proxies in the post-broker discretionary voting environment and prepare a contingency plan to “get out the vote” of retail investors that incorporates the potential for additional proxy mailings and a direct calling plan.

• Review the company’s corporate governance profile for “red flag” issues that could lead to a failed director election.

• Develop a response plan for the hopefully rare occurrence of a failed director election (for majority voting companies) or exceptionally high opposition vote (for plurality voting companies).  

Analyzing the True Impact of Broker Discretionary Voting

The degree to which the loss of broker discretionary voting impacts a company is based on a confluence of circumstances that vary by company. We recommend that companies take steps to analyze its impact based on a number of factors, including:

• The composition of its shareholder base e.g., the level of institutional versus retail ownership and how that composition may affect the ability to obtain quorum or the level of support for directors.

• Voting patterns and shareholder participation, or quorum, over the course of two or three years of annual meetings, taking note of the fact that certain brokers had already begun a self-imposed elimination of discretionary voting through proportional voting or simply nonvoting of their client’s uninstructed shares.

• The corporate governance profile of the company as it relates to the likelihood of activism or potential recommendations against elections of directors by proxy advisory firms like RiskMetrics (ISS Governance Services), Glass Lewis and PROXYGovernance. 

• Agenda items anticipated for future annual meetings and how those proposals may impact the ability to achieve quorum to conduct the business of the meeting. Bear in mind, however, that for most companies, achieving quorum is not the critical issue arising from the elimination of broker discretionary voting in director elections. Broker discretionary voting is still permitted for a number of other common agenda items such as ratification of auditors or approval of changes to a company’s authorized common shares (if not related to a specific transaction). Merely including the ratification of the company’s auditors as a voting item (on which brokers may still exercise voting discretion) would likely establish the presence of sufficient shares at the meeting that would result in a quorum.

• As the amount of retail voting has dropped in the Notice and Access model environment, the use of the Notice and Access model for furnishing proxy materials and its impact on voting activity requires careful consideration. We believe that companies should consult with their solicitors and transfer agents to determine the best way to implement Notice and Access in the post-broker voting environment in order to maximize cost savings and retail voting participation.  

• The likelihood that some brokers may adopt “client directed voting”--a system in which the shareholder would give standing instructions to brokers on how to vote their shares on director elections and other issues. 

Preventing Failed Director Elections

The increased risk for a failed director election in the wake of the elimination of the broker discretionary vote, particularly in the circumstance of a company with majority voting or a director resignation policy in place is obvious. For those companies at risk, developing an outreach campaign targeted at retail shareholders is an effective way to offset any potential shortfall in director support. The outreach can take two forms, both designed to encourage increased participation in the voting process:

• Including distinctively designed written material in proxy packages and through company websites (designed for purposes of Notice and Access) to educate shareholders on the change in the proxy rules that will make their votes even more critical. In its statements at the July 1 open hearing, the SEC explicitly expressed the need to improve retail investor education about the proxy system. We recommend that, for the next few years, companies include an eye-catching informative insert that alerts voters to the change. We would be cautious of relying on homogenized, look-alike forms provided by brokers or their mailing agents that may not truly attract the attention of loyal shareholders. It will likely take time before educational efforts begin to get shareholders in the habit of voting in greater numbers. 

• Implementing an outreach campaign to retail investors that consist of (i) voting reminder letters or “buck slips” as well as (ii) solicitation telephone calls to your larger retail investors, which may increase retail voter turnout significantly when combined with mail campaigns. 

Reviewing The Corporate Governance Profile

Companies with largely institutional ownership have little trouble with quorum issues and their focus can be more narrowly tailored on the successful election of directors. The biggest threat to these director elections is withhold campaigns by dissident investors and, more commonly, negative recommendations by the key proxy advisory firms. Because such advisory firms offer turn-key voting services to institutions, it does not require a serious breach of a governance guideline to result in a recommended “withhold” or “against” vote for some or all directors which may result in a company being perilously close to a failed director election. Issues that frequently result in recommendations against directors include: (i) the failure to adopt shareholder proposals that have been adopted by a majority vote of a company’s shareholders; (ii) the perceived lack of independence on the board (or key committees); (iii) certain compensation practices (e.g., repricing options, certain types of tax gross-ups and poor pay-for-performance practices); (iv) directors who serve on too many boards (also called “overboarding”); (v) the failure of directors to attend at least 75% of their board or committee meetings; and (vi) the adoption of rights plans or poison pills without shareholder approval.

A host of other performance and governance issues can create opportunities for activists to target boards with “vote no” campaigns.  The elimination of the broker discretionary vote magnifies the already considerable pressure on boards. Therefore, it is critical for companies to re-evaluate their position on a wide array of governance issues and practices and to at least consider modifications of certain practices or adoption of “best practices” in order to avoid either a failed director election or a high opposition vote that creates credibility and public relations problems at a time when strong corporate leadership is crucial.

Potential Public Relations Issues for Boards of Directors from Failed Director Elections

Most majority voting policies provide boards with discretion to reject the resignation of a director who fails to receive a majority vote for re-election. However, majority voting statistics show that directors who are the object of failed elections either do not remain with their boards very long (even if their proffered resignations are rejected) or that companies are forced to take corrective actions to address the core reason for the failed director election.

How does the loss of broker discretionary voting increase the risk of a failed director election? Set forth below is series of vote outcomes for a sample company that has the following shareholder composition: (i) institutional shareholders (52%, of which 22% are influenced by RiskMetrics); (ii) individuals holding through brokerages (30%); (iii) other individual shareholders – typically holding at a company’s transfer agent and not   through brokers (10%); (iv) company stock retirement plans (3%) and (v) officers and directors (5%).

The first chart presents a company’s status quo (prior to broker discretionary vote elimination).  Note that with discretionary voting, directors are overwhelmingly approved (82.3% of the votes cast FOR):

Director Vote (With Discretionary Voting)

Second, a vote outcome that is affected by the loss of the broker discretionary vote.  Note that without broker discretionary voting, directors are still approved, but by a significantly lower margin (65.8% of the votes cast FOR):

Director Vote (Without Discretionary Voting)

Finally, a vote outcome that is affected by (i) the absence of broker discretionary voting and (ii) a RiskMetrics’ withhold recommendation. Note that this perfect storm results in less than a majority (46.3%) of votes cast for directors: 

Director Vote (Without Discretionary Voting and With RiskMetrics “Withhold”)

Be Prepared for the Possibility of Failed Director Elections

Voting against directors, particularly by institutional shareholders, has become more common in recent years.  The charts below present (i) the number of S&P 1500 companies with director withhold votes of 15% and higher from 2004-2008 and (ii) the number of directors at those companies who received director withholds as a percentage of votes cast:

With the elimination of broker discretionary voting, boards and management teams should prepare for the eventuality of a failed director election, even if they believe the likelihood of such an outcome is low. While most majority voting policies afford boards with the discretion not to accept the required resignations of directors who fail to achieve a majority vote, the consequences of doing so may be severe.  While there are many legitimate reasons not to accept a given director’s resignation, such an action might be viewed by shareholders and proxy advisory firms as ignoring the will of shareholders.

Companies should be prepared to explain their actions. For example, a company may have discerned the problem resulting in a failed director election and is committed to making a governance change, such as removing a non-independent board member from serving on a key board committee. The change can be communicated in a number of ways – through press releases, SEC filings of additional definitive proxy material or on a Form 8-K. Companies should also be prepared for responding to a failed director election of all directors, an eventuality that should be discussed with counsel. We recommend that even companies maintaining plurality voting systems in which there is no resignation policy  prepare a communications/response plan for high opposition votes, particularly those that exceed a majority of votes cast.

Proxy Voting Reform and Post-Broker Voting Elections

On the same day that the SEC amended Rule 452, it also announced that it would begin a review of the current proxy voting system with an eye towards major reforms in a number of areas, including shareholder communications. We encourage this comprehensive review as we believe the challenges presented to companies from watershed changes (the Rule 452 amendment and the proposed “Proxy Access” rule) should be accompanied by reforms that help companies keep pace with the need to identify shareholders and to communicate more directly with them. Companies can learn more about efforts to reform the proxy voting system by organizations that participate in the Shareholder Communications Coalition, including the Business Roundtable, the National Association of Corporate Directors, National Investor Relations Institute and the Society of Corporate Secretaries and Governance Professionals, at www.shareholdercoalition.com. Georgeson will continue to monitor and advise clients on the potential effects of these critical developments in proxy voting.

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Georgeson has a team of experts who will continue to monitor this situation for you and who can advise you in connection with uncontested director elections and other broader reforms proposed to be introduced to the proxy system. If you have any questions, please feel free to contact your Account Executive or any of the following Georgeson executives:

David Drake, President
212-440-9861, ddrake@georgeson.com

Rachel Posner, Senior Managing Director & General Counsel
212-440-9921, rposner@georgeson.com

Rhonda Brauer, Senior Managing Director, Corporate Governance
212-805-7168, rbrauer@georgeson.com

Rajeev Kumar, Senior Managing Director, Research
212-440-9812, rkumar@georgeson.com