Institutional shareholders, private equity, and antitakeover protection at the IPO stage.

• Author: Klausner, Michael
• Position: Initial public offerings - Symposium: Corporate Control Transactions

For well over a decade, institutional shareholders have been locked in battle with management of publicly held firms over matters of corporate governance generally, and takeover defenses specifically. The primary battles have been proxy contests over charter amendments. Institutional investors have opposed management proposals to amend charters in ways that would, in their view, impair governance and have supported shareholder proposals to amend charters in ways they believed would improve governance. The most common issues on which institutions have opposed management have involved takeover defenses. When management has proposed charter amendments to convert their boards from annually elected to classified boards, or to prevent shareholders from voting by written consent or calling special meetings, institutional investors have voted in opposition. In parallel fashion, when shareholders have submitted proposals to make charters more takeover-friendly--proposals to redeem poison pills, to submit poison pills to a shareholder vote, to declassify the boards of companies with classified boards, or to allow shareholders to vote by written consent or to call special meetings--institutions have voted in support of these proposals. In addition, institutions have supported shareholder governance proposals that are not directed specifically to takeover issues--including proposals requiring independent boards and board committees, separation of CEO and chairman positions, and confidential voting.

While the attention of institutional investors, academics, and the press has focused on proxy fights, thousands of companies have gone public with charters containing the same takeover defenses that institutions oppose and omitting the governance provisions that they advocate. Until recently, this phenomenon seems to have escaped the attention of institutional investors. Indeed, it occurred under the radar of corporate governance experts and advocates of all stripes. Among academics, the supposed absence of takeover defenses in the charters of firms going public was taken as axiomatic. (1) The fact that initial public offering (IPO) charters escaped the attention of institutional investors is particularly interesting because hundreds of the offending firms were funded by venture capital and leveraged buyout (LBO) funds, whose investors are the same institutions that wage corporate governance battles in the proxy context. (2)

Institutions have recently begun to make modest efforts to urge private equity funds (3) to have their portfolio companies adopt takeover-friendly charters when they go public. Because such efforts coincided with the collapse of the IPO market, we cannot yet gauge their success. There may be a systematic reason, however, why companies with private equity backing will continue to go public with antitakeover protection in their charters despite the opposition of institutional shareholders. If so, the proxy battles of institutional shareholders may amount to a rear-guard action.

This Article chronicles the contrasting efforts of institutional investors in the proxy and IPO contexts and develops a hypothesis regarding why institutions may face substantial obstacles in trying to banish takeover defenses from the charters of companies going public. In Part IV, I examine the explanations that others have put forward for why companies include takeover defenses in their charters at the IPO stage, and I explain why those explanations fall short, at least in the context of companies with private equity fund investment.

1. INSTITUTIONAL SHAREHOLDERS AND TAKEOVER DEFENSES IN THE PROXY VOTING CONTEXT

   Although the phenomenon of institutional shareholder activism in the proxy context is well known, some documentation of the phenomenon may be helpful. The Investor Responsibility Research Center (IRRC) has collected data each year since 1986 on the results of proxy contests. (4) Table 1 reports these data on two types of shareholder proposals: (a) proposals to repeal classified boards and (b) proposals either to redeem poison pills or to require the adoption of a pill to be ratified by shareholders. (5)

   As Table 1 shows, there has been substantial and growing shareholder opposition to takeover defenses since the IRRC began collecting these data. Although the incidence of proxy fights over poison pills and staggered boards has fluctuated around a mean of 1.5% and 2.7%, respectively, among firms in the IRRC sample, the average vote in favor of these proposals has increased two- to threefold between 1987 and 2002. For proposals opposing poison pills, the average vote rose from 29.4% to 60.2%; and for proposals to declassify boards, the average vote rose from 17.5% to 61.6%.

   Shareholder opposition to takeover defenses also appears in votes on management attempts to adopt classified boards. (7) Table 2 presents IRRC data on these management proposals. In 1986, the management of eighty-eight companies, which amounted to 8.8% of the IRRC sample at the time, sought amendments. From 1986 to 2002, the percentage of sample companies attempting to adopt classified boards declined to 0.3% of the IRRC sample. This decline apparently reflects management realization that there is no point in even asking shareholders to support a classified board. The IRRC has data, beginning in 1996, on the results of these efforts to classify boards. Of eight-nine attempts for which the IRRC has outcome data, sixty-four proposals for classified boards passed. Among the sixty-four that passed, however, there were many companies in which management held large blocks of shares. (8)

   Although these shareholder voting data combine both institutional and individual votes, other IRRC data confirm institutions' opposition to takeover defenses. In 2000, the IRRC surveyed institutions regarding their voting policies. (10) The respondents to the survey may not necessarily constitute a representative sample of institutions, and indeed the low response rate suggests that they do not. (11) Nonetheless, the basic results of the survey, which are consistent with other evidence, can be viewed as broadly indicative of institutional investors' views of takeover defenses. Table 3 summarizes some of the IRRC survey's key findings. (12) Among all survey respondents, 59% consistently vote against management proposals to adopt classified boards, and 65% vote in favor of shareholder proposals to repeal classified boards. Institutions oppose management control over poison pills as well, with 72% of survey respondents voting in favor of shareholder proposals that ask management to submit pills to shareholder vote before adoption. Some respondents express their opposition to takeover defenses symbolically as well, by withholding votes in elections of directors; 27% responded positively to a survey question asking whether they "would consider" doing so where a company has a classified board. Among institutions, public pension plans are the most uniformly opposed to takeover defenses, and, not surprisingly, corporate pension plans are the least opposed.

   The IRRC also reports that 57% of respondents consistently vote in favor of shareholder proposals to redeem poison pills, 82% of respondents vote against management proposals to prohibit voting by written consent, 78% of respondents vote against management proposals to prohibit shareholders from calling a special meeting, and 71% of respondents vote against the authorization of blank check preferred stock. (13) Because the IRRC Survey does not break down these votes by type of institution, these responses do not appear in Table 3.

   The responses to the IRRC survey are consistent with the Corporate Governance Policies of the Council of Institutional Investors (Council), a broad-based association of institutional investors that works to promote good corporate governance. Those policies include the following:

   * "[D]irectors should be elected annually. (no classified boards)." (14)

   * "A majority vote of common shares outstanding should be required to approve ... poison pills." (15)

   * "A majority vote of common shares outstanding should be required to approve ... abridging or limiting the rights of common shares to ... call special meetings of shareholders or take action by written consent ..." (16)

   Additional documentation of institutional investors' position regarding takeover defenses is found in the Institutional Shareholder Services' (ISS) Proxy Voting Manual (ISS Manual) which both advises subscribing institutions on how to vote their proxies and reflects commonly held positions among institutional shareholders. (17) The ISS Manual advises as follows:

   * Vote against staggered board proposals by management. (18)

   * Vote for shareholder proposals asking that a company submit its poison pill to shareholder ratification. (19)

   * Vote against management proposals to restrict shareholder action by written consent or special meeting. (20)

   * Vote in favor of shareholder proposals to ease shareholder action by written consent or special meeting. (21)

   This advice is absolute, in contrast to ISS advice on other issues where the recommendation is that institutions consider matters on a case-by-case basis. (22)

   Research on the impact of takeover defenses on shareholder wealth supports institutional investors' opposition to defenses, especially their opposition to classified boards. This research is by now well known, so there is no need to review it in detail, but the basic findings include: (a) staggered boards have a negative impact on share values; (23) (b) firms that have adopted staggered boards amendments receive fewer takeover bids than other firms, and the bids that they do receive do not provide higher premiums than do the bids made for other firms; (24) (c) following the adoption in the corporate charter of one of these provisions, management compensation tends to rise more than compensation at comparable firms without...