The SEC explicitly forbids shareholders from tabling proxy proposals that deal with “ordinary business matters.” Is it time to change that policy at least for firms that are chronic under performers?
A while back, I had written a piece on Forbes highlighting the presence of 37 firms in the S&P 500 that have not even earned what short-term US treasuries have earned in the last 10 years! Remember that most investors cannot simply sell these 37 firms as they are an integral part of the S&P 500 index. Constructing a set of derivatives to hedge these 37 firms out of the S&P 500 is also likely to be costly. In that piece, I had complained that proxy proposals at some of these companies looked quite benign and pretty much ignored the “elephant in the room” question of poor performance. When I tried probing to understand why, I realized that the proxy voting process perhaps needs a reboot. Let me explain.
In the days of yore, shareholders could show up at an annual meeting and take a CEO to task in case the company has not performed. As shareholders became more dispersed, especially with the advent of passive indexed based investing, attendance of shareholders at annual meetings became somewhat impractical. You cannot possibly attend 500 meetings in a year if you owned the S&P 500 index even if you wanted. Covid made things worse for obvious reasons. So, how can shareholders engage with management?
I guess that depends on who the shareholder is. The Big Three institutions, Blackrock, Vanguard and State Street, claim that they engage privately with management but my co-authors, Dhruv Aggarwal, Lubo Litov and I, find that such engagements fail to move the needle on either stock returns or governance outcomes in a meaningful way. You could argue that short sellers or activists such as Trian or Elliott, hold unresponsive managements to task. Yes, but only a small number of stocks are shorted or attract the unwelcome attention of activists.
So, what mechanisms are shareholders left with to engage with management? The proxy voting process. And this is where my beef comes in. I argue that the rules of the proxy game are set up in a way to almost preclude shareholders from contributing any meaningful input on operations and the strategy of the firm. That is why we see so-called “frivolous” proxy proposals. “Frivolous” almost becomes the norm if we exclude the “substantive.”
Because directors are responsible for supervising the business of the firm, the SEC permits a company to exclude a proxy proposal that “deals with a matter relating to the company’s ordinary business operations.” The purpose of the exception is to “confine the resolution of ordinary business problems to management and the board of directors, since it is impracticable for shareholders to decide how to solve such problems at an annual shareholders meeting.”
In particular, the SEC further indicates that a two-part test would be used to determine whether a proposal could be excluded under the ordinary business exception. Under this two-part test, a proposal could be excluded if it “first involve[d] business matters that are mundane in nature and second, must not involve any substantial policy or other considerations.”
I am not sure this rule serves the interests of the shareholders of chronically under-performing firms. Why should shareholders not be allowed to introduce proposals suggesting strategic or operational fixes and get owners to vote on these ideas? Chronic under-performance has hopefully established that leaving “ordinary business problems” to the board and the management has not worked.
The only way companies are held accountable by shareholder for questionable business strategy or performance has been via “Say on Pay.” It turns out that in 12 of these 37 laggards (roughly 32%), either shareholder support on say on pay resolutions fell below 50% at least once in the last 10 years or the firm was sued for excess CEO pay. On average, in any year, 90% of S&P 500 firms pass the Say on Pay vote. Hence, the rejection rate is roughly three times as high for our sample of laggards. It may well be that CEO pay plans were not really the focus of the fall in voting. Perhaps, shareholders were disappointed in business strategy and performance, and this failed Say on Pay vote was the only way to register that frustration.
In essence, we currently lack channels for shareholders to express dissatisfaction with corporate performance because of how the SEC has historically approached proxy filings. Shareholder proposals are often thrown out if they cross the line with oversight and micromanagement and, in practice, good governance is not equated with business results. So, while shareholders can file proposals about governance and business transparency, there is no formal mechanism for holding companies accountable for performance, other than divestment. And remember, you cannot easily sell a member of a prominent index, if you are a passive indexer or a closet indexer.
In sum, the proxy process was not designed to hold management accountable for performance, and voting down boards for poor performance has historically been the purview of activists, who cannot possibly go after all under-performers.
Is it time for the SEC to consider approving proxy proposals that deal with “ordinary business matters” at least for chronic under-performers?
Read the full article here
