There has always been a certain mystique about how corporate boards are constructed.
In broad terms, corporate boards are guided by the bylaws set in place to oversee and approve annual budgets, make sure there are adequate resources to run operations, elect the chief executives and provide general oversight on behalf of shareholders and any entity with a stake in the company. The board is also responsible for verifying the availability of future capital-raising sources and reviewing the business practices of their most senior leaders.
The board's most important duty is keeping tabs of the company in all matters including performance, relative and absolute delivery of direction and the decision to fire CEOs when needed.
Board members of companies are rarely thrust into the spotlight, especially when companies have kept pace with their industry's competitors, delivered profitable quarters and, ultimately, rewards to shareholders in the forms of dividends and capital appreciation. With so many companies having been caught in illegal or unethical scandals over the past few decades, the board's responsibility has been called into question by the investing public.
There has also been a sense of an old-boy-network, as most boards have had an almost monopoly on who is placed on the ballot before the proxy materials are sent to shareholders. The process for nominating board member candidates has become more investor-friendly, opening up the playing field while still maintaining the original concept of having that extra layer of oversight.
Where Boards Come From
The most important role for any corporate board is to provide a level of oversight between those who manage a company and those who own the company, whether it's public shareholders or private investors. Most boards are comprised of high-level managers and executives of other companies, academics, and some professional board members who sit on multiple boards.
Historically, board members nominate, via proxy mailings, candidates who they feel will best suit the needs of the company rather than from a pool of shareholders. Some say the construction of boards, by its very nature, creates an almost disinterested party as there is not much incentive for boards to get too involved and many have been accused of voting with management.
In addition, board members are rarely held directly responsible for company failures and scandals. Part of this is due to the fact that their powers to actually run the company are limited, and after their terms, they just move on to the next appointment.
Political oversight and regulations like the Sarbanes-Oxley (SOX) Act of 2002 have been developed partially in response to some of the most famous large scale company failures and scandals, like Enron and Worldcom, which cost investors billions of dollars.
So far, while not lacking its share of skeptics, SOX has raised the bar for high-level managers and CEOs who are now accountable in writing for the information they present to the Securities and Exchange Commission (SEC) and their shareholders. As for the construction of corporate boards, very few changes have been made, but the SEC in 2010 adopted a new set of procedures for the nomination of potential board candidates.
The Problem for Investors
The problems shareholders have argued for as long as there have been boards is that only current board members or a separate nominating committee can nominate new board candidates, and this information is passed along to investors in the proxy materials.
During the nomination period, shareholders have little or no say in the process, and their choice for board nominations have little or no chance of getting on the ballot prior to proxy release. Most investors, including institutional holders, find it more convenient to vote for the candidate presented to them in the proxy materials rather than attend the annual shareholders' meeting and vote personally. In fact, most investment groups have dedicated teams for this purpose alone.
Since shareholders in most situations have to attend shareholders' meetings in order to nominate their own candidates, you don't have to be anti-big-business to see the apparent flaws in the current system and the SEC has stepped up with a permanent change in the process.
What Investors Can Do?
The SEC allows investors and shareholders to nominate board members by placing them on the proxy ballot mailings before they are mailed out. To limit an overflow in nominations, there is a 3% ownership requirement for individuals or groups, but investors are taking action that will forever change how investors are represented. In a simplified application, just about anyone can successfully nominate themselves via the proxy system, and if they receive enough votes they join the board.
Investors and their advocate groups of all sizes are looking for a permanent overhaul and a new level of representation and board accountability.
Benefits, Changes and the SEC
While a nomination on a proxy ballot by no means guarantees an elected seat, the potential benefits for shareholders are monumental:
- Shareholders with the desire, resources and time can access the nomination process once held only by current boards.
- Shareholder groups, from large influential pension funds to small groups, can now back their own candidates.
- Shareholders will have a much closer relationship with boards.
- Accountability will increase dramatically, as nominees become elected and results are expected.
Shareholder advocates look for the following characteristics in a board:
- No more of the old-boy network where old boards essentially control who replaces them through nominations.
- New corporate boards that are actually shareholders who want to help shape the company's direction.
- The arrival of the representation by those outside of an Ivory Tower.
- The eventual composition of a board that has no interest in just voting with management because they are influenced in some way.
- The elimination of the "professional board members" who sit on multiple boards.
- Higher turnover at the board level as shareholders nominate and vote in their choices.
- Potentially higher levels of transparency and ultimately accountability.
The SEC—most government-related agencies—have not enjoyed the best of press throughout the 2000s, regardless of political party or responsibility. While the Financial Industry Regulatory Authority (FINRA) has escaped much criticism, the SEC has been accused of letting shenanigans and even crimes carry on for years. While most of the criticism has been of the agency in general, one of the most publicized cases was the Bernie Madoff scam, which cost large and small investors billions.
Because the SEC had actually visited and "audited" Madoff's operations and had received various complaints and accusations, this left the SEC with a bit of a black eye. This proxy process change is one of many ideas the SEC has put in motion to present itself as a more investor-friendly group rather than some of the negative views many have expressed of them.
The Bottom Line
The process of board construction has been on the wish list of shareholders for a long time, and the companies they may eventually influence are not as responsive to the process.
This will inevitably mean higher administrative and legal costs to all companies big and small. While large companies will probably see less influence, once shareholders start flooding the proxy process, costs are destined to rise. It will take years to see significant changes as the rulings phase-in, but it looks like the SEC is becoming a little more investor responsive, and soon anyone will have the opportunity to join that elite group of board of directors.