DealLawyers.com Blog

June 4, 2009

Proxy Access: Chinese Menu Ballots Address Concerns

– by Professor J.W. Verret

The ghosts of securities law past, present, and future seem to haunt the headlines lately. But proxy access is heralded as the issue most likely to bring a tectonic shift in the balance of power between shareholders and boards – and the boundary between federal and state authority in corporate governance. Many are concerned that the SEC’s access proposal will empower special interests to hijack corporate policy toward objectives threatening long-term wealth maximization. In this article, Marty Lipton outlines his concerns. I have an answer that significantly alters the dynamic.

I call it the Chinese Menu Ballot. I explore the idea briefly in an article entitled “Pandora’s Ballot Box, or a Proxy with Moxie?” The SEC’s proxy access proposal concerns shareholder nominations. It says nothing about procedures to determine the winner of those elections. My method minimizes the ability of a small minority of highly interested, special interest shareholders to influence corporate elections. This danger is caused by the current plurality standard (most votes wins, even if not a majority) for contested elections.

The problem with plurality voting is that as more nominees appear on the ballot, the likelihood increases that a director not supported by a majority of voting shareholders will be able to win. And the number of nominees could be quite high. The SEC proposal limits individual shareholders from nominating more than a quarter of the total board size, but the presence of multiple shareholders nominating candidates could widen the field.

The reason why we don’t currently use majority voting for contested elections is that it may require a runoff, which would necessitate a second round of solicitations and double the expense. But my method alleviates the need for a runoff. A Chinese Menu Ballot would require a shareholder to rank the candidates in order of their preferences. The ballots would clearly state that any ballots that do not rank all candidates will be excluded. Then, any runoffs will be determined using the shareholders preferences to successively eliminate candidates in new vote tallies.

The result is very similar to what would happen if the company had a pure majority vote election with an actual runoff, and the result is significantly different from an election in which there are a large number of candidates and plurality voting is used. In each new round of a vote tally, the vote of a shareholder that voted for an eliminated candidate will be transferred to the next highest ranked candidate. And this transitive property of the Chinese Menu Ballot is the key to its ability to screen out special interest directors. The result is that candidates ranked high by a small number of shareholders, but not ranked within the top echelon by a majority of shareholders, are eliminated from the pool very quickly. Candidates ranked in the top echelon by a majority of shareholders will tend to emerge as winners.

There are a multitude of algorithms to use the shareholders’ rankings to generate an outcome. The appropriate method will depend upon circumstances particular to a company, including whether the board is staggered. The appropriate method will also depend on the demographics of a company’s shareholders, including the balance of institutional vs. retail investors and the type of institutional investors it has.

Consider a simple example: In the first round of vote tallying, each ballot’s vote will count toward the first ranked choice. After the first round of the tally, any seats not filled by a candidate receiving a majority of the votes will be determined by subsequent rounds of tallying. Before starting the second round of the tally, the candidate with the fewest number of votes (the candidate ranked first by the fewest number of shareholders) will be eliminated.

Any ballots that ranked the eliminated candidate first will now be registered as votes for their second ranked choice. This process would continue until the number of candidates remaining equals the number of available seats. There are a wide variety of available implementation methods and further recommendation would require a company-specific analysis.

For a brief analysis of the legality of this method under Delaware Corporate Law, I first note that DGCL 216 provides the plurality method as a default from which companies are free to opt-out via bylaw or charter amendment. And presuming that a company has the authority to amend the bylaws in its charter, it would be able to install this method unilaterally. In the unlikely event, however, that a company had a shareholder-adopted bylaw specifying the method for contested elections it would need to seek shareholder approval to implement this method.

I also do not think Chinese Menu Ballots would be subject to scrutiny under Blasius. Indeed, this method does not limit votes, it actually permits shareholders who voted for an eliminated candidate in one round to continue to have their vote counted in each successive round of the election. An analysis of this method under the federal proxy rules also indicates its legality. The Chinese Menu Ballot will need to include a space that permits withhold votes in accordance with Rule 14a-4(b)(2), but otherwise the proxy rules do not prohibit this method. I also note that this method would be difficult to implement, though not impossible, for companies that permit cumulative voting.

For assistance with implementing a Chinese Menu Ballot or other proxy access related issues, I am available for consultation.