Corporate elections and tactical settlements.

• Author: Harris, Lee
• Position: Author abstract

1. Introduction II. Two Theories of Settlements A. Mechanics of Settlement B. An Economic Theory of Settlements C. A Political Theory of Settlements III. Empirical Evidence on Settlements A. Descriptive Evidence 1. Firm Performance 2. Firm Characteristics 3. Challenger Characteristics B. Inferential Evidence IV. Implications of the Empirical Evidence of Settlements A. Passive Shareholders B. Formal Means of Shareholder Influence C. Informal Means of Shareholder Influence D. Activist Shareholders V. Conclusion I. INTRODUCTION

   In corporate law, all power rests with the board of directors. (1) The board of directors decides whom to hire as CEO and whether to remove her, (2) makes merger and acquisition decisions, (3) decides when it is time to wind up the business, (4) and though little noticed, decides what strategies to use to sidestep a shareholder vote. As corporate law observers (including this author) have previously lamented, corporate elections are fundamentally broken and give shareholders little real opportunity to participate meaningfully in deciding who should serve on the board. (5) For one thing, board elections at most firms are staggered, such that most board seats are not up for election at annual meetings. (6) At most firms, when director posts come for a vote, shareholders get an opportunity to vote for as few as one-third of the seats on the board. (7) Furthermore, even when one-third of the board seats are up for election, shareholders have no practical method of ousting underperforming directors. The vast majority of elections are uncontested. (8) Based on the traditional rules of corporate election voting, shareholders may vote "no" in director elections, but these votes are largely symbolic. (9) Under the plurality voting rules in place, the contestant with the highest number of votes wins, regardless of whether the contestant secures a majority of the votes cast. (10) Thus, in an election with a single candidate, a candidate only needs one vote to win, since there are no other candidates, and thus no candidate with a higher number of votes. (11) Without the presence of competition, the incumbents are automatically re-elected to their posts, regardless of how shareholders vote. (12) Significantly, even when there is competition for board seats, directors have yet another arrow in the quiver to sidestep a shareholder vote. (13) Though it has been far less theorized in the general literature (and not theorized at all in law reviews) when there is a challenge, directors have been clever enough to simply settle the dispute in advance of the vote. (14) When they sense potential danger, incumbents entice challengers to drop their bid in exchange for board seats and cold, hard cash. When these pre-voting settlements happen, shareholders do not get a chance to vote on the directors' fate at all. (15)

   These settlements almost always involve board seats, if the challenger agrees to relent and give up his challenge. Directors can use bylaw provisions to expand the board of directors or carefully orchestrate resignations and then immediately fill board seats. (16) When seats on the board are filled this way, shareholders do not get a chance to take a meaningful vote on who serves on the board. (17) This elaborate dance is undertaken by a board of directors to avoid a contested corporate election. For instance, in 2008, Carl Icahn, a frequent critic of the leadership at several major corporations, famously agreed to give up his challenge for control of Yahoo's board of directors in exchange for three board seats on the company's 11-member board. (18) That same year, Motorola settled a potential fight with Icahn over control of its board by giving up two board seats. Just last year, Genzyme, a large pharmaceutical concern, also agreed to give Mr. Icahn a couple of board seats if he would abandon his contest for control. (19) In addition, these settlements almost always involve reimbursement for the challengers' expenses incurred in the runup to their challenge. (20) Worse yet, as this Article finds, these settlements are tactical. Incumbent directors make these arrangements when several of the usual measures of prior performance indicate that directors have done a poor job. Therefore, through tactical settlements, under-performing boards of directors can effectively manage or avoid corporate elections and meaningful shareholder votes that might actually result in their ouster and improve prospects for better firm performance.

   This Article investigates board behavior at public companies under threat of a contested corporate election. In particular, this Article examines the board's decision to settle prior to a contested corporate election. This Article is the first of its kind to set out a theory and evidence behind board settlement decisions.

   To begin with, the Article sets out potential theories for understanding this important board tactic. One potential theory is that a board's decision to settle a contested corporate election, or "proxy fight," might be driven by its appraisal of its own previous performance. Boards act in self-interest and make settlements in positions of desperation. Thus, boards that have failed to meet reasonable performance objectives might feel vulnerable in the face of a challenger. These boards may take the threat of a contest seriously because, based on their previous performance, they have reason to believe that shareholders might vote to support the challenger and the challenger's new strategy for the firm. Shortly, a board may use settlement offers in order to avoid a showdown over board seats when, based on indicators of previous performance, it anticipates that it is bound to lose.

   In addition, based on recent research, a board's decision to settle may be based on the political dynamics of corporate governance. (21) Corporate elections are similar, in many ways, to political elections. (22) The incumbents and the challengers hire expensive campaign consultants, run phone-bank operations, and send out mailers and other marketing materials to potential voters. (23) Importantly, research has shown that the outcome of political elections is not strongly related to legislative performance. (24) Instead, according to political scientists, the outcome of political elections is a function of many variables, notably including the amount the challenger is willing to spend on persuasive advertisement. (25) Thus, a political theory would hold that settlement decisions are driven by dynamics similar to those in political elections. In political contests (e.g., congressional races) contestants likely make strategic decisions based on their opponent's fundraising capability. (26) A congressional incumbent might not make a decision to run for re-election based on whether his performance (actual or perceived) has been good and has created a record to run on. (27) Instead, an incumbent's decision to run may be driven by a brief glance at the challenger's fundraising capacity. (28) Thus, an incumbent may choose to run for re-election if the various potential contestants have little potential to fundraise. On the other hand, an incumbent may choose to avoid running when his competitor boasts a relatively huge war chest. In contested corporate elections, like in political elections, challengers are required to disclose estimates of how much they intend to spend to mount a campaign against the incumbents. As in political elections, it may be the case that the decision to settle is related to how much money a potential challenger boasts he will spend on the election contests.

   Using data on boards that faced challenges in corporate elections between 2006 and 2009, this Article puts both these claims, along with others, to the test. Part II reviews the extant literature on election dynamics once a corporate election begins. The author did not identify any article that directly analyzes settlements prior to a corporate election. However, there is a significant literature about the dynamics of shareholder voting during a corporate election.

   Part III presents evidence from settlements of contested corporate elections. Shortly, the author finds little evidence in support of a political theory of settlement decisions. As shall be discussed, a board's decision to settle a contested corporate election is not related, at a statistically significant level, to estimates of campaign spending disclosed by challengers. On the other hand, some of the data supports an economic theory of settlement. That is, the board's decision to settle appears related to indicators of previous performance. Specifically, the firm's immediate past performance, price-to-book value, and relative indebtedness appear to partly drive the board's decision to settle. Somewhat surprisingly, however, other financial indicators, including a board's longer-term performance (i.e., five-year performance) have little to do with whether the board settles with a challenger. Also, surprisingly, relative debt load is negatively associated with settlement. In other words, though it defies initial intuition, the finding here is that firms with high levels of debt are less apt to settle with challengers.

   Part IV briefly discusses implications of the findings. As mentioned, the board of directors, in these cases, sidesteps the contested corporate election and any benefits that might accompany it. For instance, periodic challenges have a disciplinary effect on managerial behavior, encourage debate regarding the firm's strategic direction, reinforce the core ideals of shareholder democracy, and can lead to wholesale changes in the firm' s management structure, among other benefits. In addition, the findings may help activist investors identify targets for launching a contest. The data reveal what types of boards of directors are vulnerable and, as a result, helps clarify the type of targets that activist investors might move into...