Classification cancels corporate accountability.

• Author: McGurn, Patrick S.
• Position: Staggered terms for corporate directors

In the wake of the corporate scandals of the past several months, ISS often receives inquiries as to our views on the two or three key governance changes that--if adopted by all issuers--would help investors to avoid similar market meltdowns in the future. (1) Unquestionably, the item on our wish list that draws the blankest stares from corporate America is the call for annual elections of all members of corporate boards.

These visceral responses are not surprising given the recent degeneration of the staggered terms versus annual election debate. (2) Few governance issues produce the same "Shareholders Are from Mars, Executives Are from Venus" level of disconnect. Simply put, executives and investors view the board-election timing issue from different perspectives. As is often the case with such genetic-level disagreements, where each group stands is dictated by where its members sit.

Executives favor strong defense. From the vantage of the executive suite, most chief executives (and their legal and investment banking advisers) view classification, first and foremost, as a potent defense against challenges to corporate control. (3) Over the past decade, executives have seen successive doomsday takeover defenses, including shareholder rights plans (poison pills) and second- and third-generation state statutes, wither in the face of a rising tide of investor activism. (4) In the absence of classified board terms, proxy fights have proven an effective antidote to all but the most toxic (read: dead hand) poison pills. In contrast, staggered terms guarantee a long delay in the bidding process. (5)

Executives argue that classification protects shareholders. Professors Bebchuk, Coates, and Subramanian shatter the shareholder-value-enhancement mythology that some boards have used to justify their staggered structures in recent years. (6) Unlike studies concerning shareholder-rights plans, (7) there is no empirical evidence that classified boards provide tangible economic benefit to shareholders.

Shareholders favor annual terms. Shareholders tend to shun staggered terms. Over the past decade, resolutions to repeal classified boards have appeared on ballots at hundreds of companies. (8) These requests to return to annual elections of the full board typically win significant amounts of support. Since the 2000 proxy season, repeal proposals have averaged support in excess of fifty percent of the votes cast. (9)

The 2002 proxy season was a high watermark. (10) Average voting support for the fifty-six proposals that made it to corporate ballots was a whopping 58.1% of the votes cast. (11) Thirty-nine proposals calling for repeal of staggered terms received support from holders of at least a majority of the votes cast at the firms' 2002 annual meetings. (12) A dozen boards witnessed holders of more than half of their companies' shares support the precatory proposals. (13) Defenders of the status quo note that these majority votes fall short of the supermajority vote lock-in requirements--typically two-thirds or eighty percent of the outstanding shares--required for repeal. (14)

This opposition is not a knee-jerk reaction to the obvious chilling impact of classified boards on the market for corporate control. Instead, most shareholders view annual board elections as an essential ingredient in maintaining corporate accountability. (15) Over the years, they have learned firsthand that directors are more likely to...