Classified or Staggered Boards

 Boards should not be staggered, and directors should be up for reelection annually.  We generally support resolutions to this effect.  As an alternative, we support measures that allow shareholders to remove any director without cause before his/her term expires.

Staggered board structure is usually a bad corporate governance practice because it prevents shareholders from unseating the board, thereby entrenching the management.

A classified board is normally divided evenly into three classes of directors.  Each class is elected in a separate year.  This way, each director is elected for a three year term.  In many states, including Delaware, where most listed companies are registered, a director in a classified board can only be removed “for cause” during his term (For more detail, see this link to § 141 K1 and 2 of Delaware General Corporation Law).  This way, if shareholders want to replace the majority of the board, someone needs to launch at least two successful proxy fights to unseat 2/3 of the board.  Consequently, it takes three years to unseat the entire board.

Note: theoretically, a classified board needs not be staggered if all classes come up for elections annually.  However, in practice board classification is used to stagger the board, which is why these two terms are used interchangeably.  Majority of shareholder proposals call to “Declassify the Board” because a declassified board cannot be staggered.

When it is impossible to change control of the board for two years, bad management can continue to run the company into the ground, while even super-majority of shareholders can do nothing about it.  Most of the best practices manuals, including CALPERS, require that boards not be staggered.  Although OECD Principles do not address staggered boards directly, the do list the effective ability to “elect and remove board members” as the basic shareholder right.

Alternatives:

One argument in support of staggered board is that companies require some stability, and directors need some time to prove that their strategy is effective without being exposed to re-election annually.

Consistent with our view that one size does not fit all, we believe that there are cases where such an argument can be made, especially in companies that recently had undergone significant change.  However, staggered boards are usually an anti-takeover defense.  There has to be a way for a majority of shareholders to get rid of the board without waiting for three years.  Hence, the alternative should be to allow a competing proxy to remove any and all members of the board without cause at any time.  Since a competing proxy costs money, it will only be launched if the sponsoring shareholder has a significant stake in the company and is reasonably sure that he can change control.

Some other alternatives to removing classified board structure have been proposed.  Montley Fool, for example, lists the following:

·         Getting rid of staggered boards, but giving companies the option to hold elections less frequently (perhaps every one to four years).

Our view: this really has the same effect as having a staggered board.  If the majority of shareholders have to wait three years to remove the board they will not be able to exercise their ownership rights over the entrenched claims of titular directors.

·         Giving extra votes to shareholders based on how long they've held the stock.

Treating shareholders of the same class differently in too many instances is a slippery slope.  This can be an ultimate ticket to violation of ownership rights and assuring the entrenchment of titular insiders.  As it is, currently many US states, including Delaware allow poison pills.  Additionally, there is discrimination on proxy access.   There should be no more ways to segregate the same class of shares.  However, there is another way, which is what Berkshire Hathaway did: create two classes of liquid shares and give them different voting rights.  We believe that this is better than making distinctions in the same class because ownership rights are transparent.  Buyers of Berkshire B. shares know that they have less voting rights, while control is concentrated among those who made a significant financial commitment to the company and can invest in activism.

·         Making it easier for long-term shareholders to nominate directors, as the [Shareholders Bill of Rights] does.

That is fine, but the board still should not be classified.  To be sure, the Shoemer’s Shareholder Bill of Rights proposes easier proxy access to long-term shareholders.  Anyone can launch their own proxy, regardless of how long they held the shares.

·         Banning the practice of voting with borrowed shares.

We are not clear on this proposition at all.  It is a common law right to transfer proxy rights.  You do not even need to borrow any shares.  In fact, freely transferring proxy rights is a good way for small shareholders to select those who invest more effort into understanding the corporate issues and can vote on their behalf.