What options do you and other shareholders have to protect the value of a business in which you have invested when board governance and oversight of company management cause the share price to erode?
Let’s begin with a few definitions of who’s who in this scenario.
- Shareholders (stock or equity holders): owners of the business, be it public or private.
- Board of Directors: shareholders’ elected representatives. Directors are fiduciaries, charged with the duties of “loyalty and care” to those they represent. Shareholders are invited to convene annually at a General Meeting (as described in the corporate bylaws) to elect directors. Directors are expected to provide oversite of the affairs of the business for the coming year.
- Senior Management: individuals hired by the board to run the day- to-day operations of the business and report to the board on a periodic basis to ensure the business is operating according to the board’s direction. Senior management are accountable to the board of directors. Members of the board are accountable to shareholders.
Too often this system breaks down and companies suffer. Shareholders suffer in tandem.
How and why does this happen? Let’s review a few common themes.
1. Directors a fail to provide adequate oversite of senior management, leading to periods of poor performance and unrewarding returns for shareholders. Public company directorships in America are prized roles, thus creating a natural disincentive for those elected to “rock the boat.” It is sometimes easier for a board or its directors to defer to the judgment of management.
2. Management corrals control of the board, i.e. the CEO becomes the board Chairman, thus controlling meetings and agendas. It is difficult to have objective oversite when the CEO also sits in the controlling seat on the board. Although this is not a “best practice” in corporate governance, according to a current report from the National Association of Corporate Directors, a full 36% of all public company boards are chaired by the CEO.
3. Compensation is biased toward management (and directors) to the disadvantage of shareholders. This is most clearly evidenced in the annual proxy statement which discloses executive compensation. In many instances senior management and directors receive outsized pay packages despite ongoing failures to create value for shareholders. These packages involve stock grants, but few directors and management actually buy meaningful amounts of stock in the very company they are running.
What can you do as a shareholder? Should you sell your shares? Exercise patience in the hope things will change? Vote through proxy and demand change?
Unfortunately, there are practical and systemic challenges which interfere with the enforcement of your influence.
Selling shares is a practical response but avoids the core issue. As owners of a business, you have every expectation that directors have your best interests in mind, and nothing else. Selling out of frustration or the sense of helplessness is an undesirable and unfortunate option that many investors exercise.
Embracing a strategy of passive or patient expectation is another option. Some wrongs self-correct over time. Change can occur which naturally remedies or improves a situation absent shareholder intervention.
By far the most potent option for shareholders is the annual vote to replace directors. Directors represent shareholders and must act first and foremost in your interests. When this fails, shareholders have an annual option to replace their representatives with others whom they feel are qualified and aligned with their interests.
However, replacing poorly performing directors is challenging to say the least. The power of incumbency is high with sitting directors, and some companies have taken great measures to insulate themselves from dissatisfied shareholders. Most commonly, through amendments to the corporate bylaws, directors can insert language limiting shareholders from calling special meetings if they become dissatisfied with the board. Other measures include staggering board elections by which only a fraction of the board is subject to re-election annually or inserting conditions in commercial agreements that trigger adverse consequences in the event of a change of control with the company or its board.
A full-blown proxy contest to replace directors can be expensive. A company will effectively use shareholders’ money to hire legal counsel to defend its position, while a shareholder or group of shareholders must fund its own initiatives. Proxy contests can easily run in the hundreds of thousands of dollars, limiting many from participation. Putting forth new directors on a proxy is a complicated process. A shareholder proposal must be delivered separately from the company’s proxy, further adding to cost and complexity.
With the explosion in passive or index fund investing many of your “co-owner” shareholders have effectively become “absentee owners.” Indexed investors generally have no view of the business itself, but rather own a business simply as a function of its inclusion in a particular stock index. In many ways passive investing has empowered poorly performing directors and management who recognize shareholders will demand little or no accountability. This creates a dilemma for those actively engaged shareholders.
This is why you must expect that your mutual fund manager or third-party advisor is paying attention. Taking an “active” approach to communicating with the board of a public company is beneficial to all shareholders.
Companies need active and engaged shareholders to hold them to account. The best time to act is 60 to 90 days prior to the Annual General Meeting of shareholders. The most effective way to defend shareholders’ interests is through public comment and the proxy vote. Seeking established and experienced investment professionals who have been successful in running proxy contests is an intelligent first step. Running a public communications campaign can be a very effective strategy. Social media is a powerful tool when used skillfully. Company directors and management generally respect an informed and knowledgeable investor who approaches a company with a thoughtful and respectful message. This is not just an option, it is your right.
When shareholders and investment managers work closely and collaboratively, our capital market system works most effectively. In as much as the system works, shareholders are rewarded and encouraged to continuously commit capital. When shareholders commit capital, businesses grow.