Chapter 13Governance Role of Public Shareholders

Chapter 13Governance Role of Shareholders

Outline

Chapter 13Governance Role of Public Shareholders

Overview
Theories of the Firm
The Berle – Means Corporation
separation of ownership and control
"management control"
law should be control device
The “Nexus of Contracts” Corporation
management-shareholder contract
mediated by markets: capital, control, employment, and chartering markets
law enforces implicit bargains
The “Political Product” Corporation
mandatory vs. enabling terms / fiduciary principles
anti-takeover legislation
law should be efficiency-minded
The “Team Production” Corporation
managers seek protection from institutional control
banks, mutual funds, pension funds systematically weakened
The Dynamics of Shareholder Voting
Shareholder voting rights
voting by proxy
state law: conditions
Federal proxy regulation
federal law: disclosure in public corporations
The proxy mechanism
the collective action problem
rational passivity
reasons
information costs
free-rider problems
prisoners' dilemma
overcome: large, organized investors
Institutional investors
Types of institutional investors，trend in ownership; concentration in public companies
constraints on institutional activism
government regulation
SEC proxy rules
insider trading rules
5% voting group disclosure
incentives / conflicts
private pension funds - who manages?
mutual funds - where get information to beat market?
insurance companies - what relation to corp. management?
banks - what is main business with corporations?
Federal Regulation of Proxy Solicitations
Management solicitations
Securities Exchange Act of 1934 - § 14(a)
"reporting companies" - § 12
equity securities listed on exchange
500 shareholders + $10 million assets
scope of SEC regulatory authority
“Proxy solicitation”
Long Island Lighting Company v. Barbash
SEC proxy rules
proxy card - Rule 14a-
proxy statement - Rule 14a-
when prepare?
filing obligation?
nature of disclosure?
proxy "solicitation" - Rules 14a-1, 14a-2
definition / part of "continuous plan"
Shareholder communications
1992 Amendments

Shareholder Proposals
Evolution of the shareholder proposal rule
Rule 14a-8 in operation
Lovenheim v. Iroquios Brands, LTD
Measuring the success of shareholder proposals
American Foundation of StateCounty v. American International Group

Class Notes

B.Theories of the firm
Berle-Means: corporation as ownership device

modern corporation: separation of ownership and control
proxy system creates de facto "management control"
law should be control device

/ "Ownership is so widely distributed that no individual or small group has even a minority interest large enough to dominate the affairs of the company.
"In the election of the board the stockholder ordinarily has three alternatives: [not vote, attend meeting, send proxy] ... Control will tend to be in the hands of those who select the proxy committee
Contractarians: corporation as contract

management-shareholder contract
contract mediated by markets: capital, control, employment, and chartering markets
law enforces implicit bargains

/ Butler & Ribstein / Easterbrook & Fischel
Easterbrook & Fischel - Why the widespread adoption and survival of the corporation as a primary vehicle of capitalism? The corporation as hypothetical bargain between shareholders and managers - reflected in mandatory/enabling terms.
Butler - "An alternative control mechanism, beyond the direct control of entrenchment managers, is found in the stock market. The stock market disciple of managers is manifest in the threat of tender offer, takeovers ....
"corporate law of fiduciary duties serves as a legal constraint on managerial opportunism .... to deal with last-period, or one-time, divergence's.
Butler & Ribstein - "... investors are not forced to accept any particular investment ... these are "adhesion contract" only i the sense that investors do not dicker over individual terms, but accept contractual packages.
Corporation as product of law

mandatory vs. enabling terms / fiduciary principles
case in point: anti-takeover legislation
law should be regulatory, efficiency-minded

/ Clark / Brudney / Bratton
Clark - "... this power of the principal to direct the activities of the agent does not apply to the stockholders as against the director or officers of their corporation.
"most of the particular rules that make up the legal relationships among corporate officers, directors and stockholders .... are not the product of actual contracts made by persons subject to them ....
" ... if its intuitively plausible that there are "standard presumptions" adopted to fit the normal case. .... Some corporate law rules cannot be bargained around .... Basic fiduciary duties fall in this category ...
Brudney - "... the traditional fiduciary concept ... forbids or substantially curtails opportunistic behavior by management .... that the contract notion permits.. Moreover traditional fiduciary doctrine permits "consent" to departure from those principles only in limited transactions
"... courts, aided by commentators, have substantially diluted fiduciary obligations of corporate management
Bratton - " .... why do shareholder rationally vote to approve an amendment that decrease value to them?"
".... developments begun in the late 1980s in response to takeover are prompting the nexus-of-contracts corporation's subsequent departure ... state legislatures came down emphatically on the side of defending managers.
Corporation as product of politics

managers seek protection from institutional shareholder control
banks, mutual funds, pension funds systematically weakened

/ Roe
"Disperse individuals would hold stock ... Institutions would neither hold nor vote big blocks or stock. Banks held none for their own account. Insurers rarely held stock.. Mutual funds and pensions have only recently become an important economic phenomenon.
" ... contractarians [and regulators] tend to look at state corporate law -- particularly Delaware's -- to find how law governs the relationship between shareholder and managers.
"Politics and the organization of financial intermediaries cannot be left out of the equation. ... American law and politics deliberately diminished the power of financial institutions
"The Darwinian survival of the fittest in law and economics fails to explain some important phenomenon -- [chaos, suited for environment at time, path dependence]
"We developed high-quality securities markets which allowed firms to raise capital in a national market, to remedy the absence of truly national financial institutions. ... Weak intermediaries ... led to strong managers.
" .... although Germany and Japan started with relatively strong intermediaries, they developed comparatively weak boards."
C. The Dynamics of Shareholder Voting
Impediments to "shareholder democracy"
Some background.You own stock in Blue Rhino, a leading national provider of propane grill cylinder exchange with headquarters in Winston-Salem. You bought at $12.75 when the company went public in May 1998. At first you were pleased with your investment which hit $24.50 in January 1999. But a month later, reports of accounting irregularities caused the stock to dip to $14.50, and it's been falling since. Last month, apparently on news the company is having to recall propane cylinders that may have defective valves, the stock price fell to a low of $3.188.
You wonder whether the management of Blue Rhino is right for the company. They seem to operate it like a bunch of convenience store operators - which they were - rather than professional managers. The accounting problems of last February were really quite serious: Blue Rhino management had treated a loan (that was convertible into common stock) as a debt, rather than as anequity investment, thus artificially increasing company assets. In addition, management had arranged for Blue Rhino to buy its cylinders from a company that they controlled. When Blue Rhinos's accountants demanded that the loan be treated as equity and that the related cylinder company be treated as a part of Blue Rhino, the company's financial picture changed overnight. Blue Rhino went from reporting $442,000 in positive earnings to $70,000 in losses. The recall has not helped. /
You would like to organize fellow shareholders to replace current management. A lot if information about U.S. companies is available on the Internet. For example, check Yahoo's summary of Blue Rhino

who manages Blue Rhino? See Market Guide Investor
who are the shareholders of Blue Rhino? See Market Guide Investor / Yahoo - Company profile

Organizing shareholder revolt.
Assume you own 10,000 shares of Blue Rhino, worth about $30,000 and representing 0.108% of the total shares outstanding. Assume further that Blue Rhino's stock might double in price if professional management were installed.

Is it worth the trouble for you to work toward replacing management?
How much should you willing to spend on this effort? Do the math.
What are your alternatives?

/ Traditional view of passive shareholders
[Apple lambastes IBM in "best commercial" ever]
/
Prisoner's dilemma
You have been arrested, along with somebody said to be your partner in crime. The police take you to an interrogation room and lay out your options.

If you confess (and the other person does not) -- you will be sentenced to 2 years in prison.
If you confess (and the other person does too) -- you will both be sentenced to 6 years.
If you do not confess (and the other person does) -- you will be sentenced to 10 years.
If you do not confess (and the other person does not either) -- you know that you're both off!

You cannot cooperate with the other person. What do you do?
YOUR MISSION: KICK OUT THE BOARD!
BOARD COMPOSITION. Youconsider the composition of the Blue Rhino board. How long will it take you to replace a majority of the board under a system of classified voting? Why would shareholders buy stock in a company with a staggered board? /

How many any directors are on the Blue Rhino board? See Blue Rhino's articles of incorporation [Seventh - 1] and Bylaws [Article II - Board of Directors] .
How are they elected? What is the meaning of a "classified board"? How does this affect your plans to replace the board? See Blue Rhino's articles of incorporation [Seventh - 2]
Who are the current directors? Who are outside directors and who are inside directors? Look at company's 1999 Annual Report. /1999 Proxy Statement [Def 14A - Board of Directors]

SHAREHOLDERS' MEETING.
Consider replacing the board. When does the company have its annual shareholders' meeting? See Blue Rhino bylaws [Article I - Stockholders Meetings].
According to Delaware law, when must the company hold its next annual shareholders' meeting? See Del GCL § 211.Blue Rhino - 1999 Proxy Statement. What if Blue Rhino were incorporated in North Carolina? / NC Bus Corp Act § 55-7-01 Annual meeting. [CompareDel GCL § 211]
(a) A corporation shall hold a meeting of shareholders annually at a time stated in or fixed in accordance with the bylaws.
NC Bus Corp Act § 55-7-03 Court-ordered meeting.
(a) The superior court ... may, after notice is given to the corporation, summarily order a meeting to be held:
(1) On application of any shareholder if an annual meeting of the shareholders was not held within 15 months after the corporation's last annual meeting; or
NC Bus Corp Act § 55-7-02 Special meeting. [CompareDel GCL § 211(d)]
(a) A corporation shall hold a special meeting of shareholders:
(1) On call of its board of directors or the person or persons authorized to do so by the articles of incorporation or bylaws; or
(2) Within 30 days after the holders of at least ten percent (10%) of all the votes entitled to be cast on any issue proposed to be considered at the proposed special meeting sign, date, and deliver to the corporation's secretary one or more written demands for the meeting describing the purpose or purposes for which it is to be held; except however that, unless otherwise provided in the articles of incorporation or bylaws, the call of a special meeting by shareholders is not available to the shareholders of a public corporation.
ACTION WITHOUT MEETING.
Is there any way you could remove and replace directors before the next annual shareholders' meeting? / NC Bus Corp Act § 55-7-04Action without meeting. [compare to Del GCL § 228]
(a) Action required or permitted by this Chapter to be taken at a shareholders' meeting may be taken without a meeting if the action is taken by all the shareholders entitled to vote on the action.
Institutional activism
Remember Blue Rhino, a leading national provider of propane grill cylinder exchange with headquarters in Winston-Salem. You bought at $12.75 when the company went public in May 1998. At first you were pleased with your investment which hit $24.50 in January 1999. But a month later, reports of accounting irregularities caused the stock to dip to $14.50, and it's been falling since. Last month, apparently on news the company is having to recall propane cylinders that may have defective valves, the stock price fell to a low of $3.188.

You wonder whether the management of Blue Rhino is right for the company. They seem to operate it like a bunch of convenience store operators - which they were - rather than professional managers. The accounting problems of last February were really quite serious: Blue Rhino management had treated a loan (that was convertible into common stock) as a debt, thus artificially reducing the stated shares outstanding. In addition, management had arranged for Blue Rhino to buy its cylinders from a company that they controlled. When Blue Rhinos's accountants demanded that the loan be treated as equity and that the related cylinder company be treated as a part of Blue Rhino, the company's financial picture changed overnight. Blue Rhino went from reporting $442,000 in positive earnings to $70,000 in losses. The recall has not helped.
Assume that you are Safeco Asset Management (a mutual fund group in Seattle, Washington) which owns 771,200 shares of Blue Rhino, worth about $6.2 million and representing 8.37% of Blue Rhino's stock. If new management would double the price of Blue Rhino, is it worth the effort? How much should Safeco be willing to spend on a shareholder insurgency? Do the math. What are Safeco's alternatives? Consider the ownership structure of a typical U.S. public corporation, according to the U.S Federal Reserve:
U.S. CORPORATIONS - SHAREHOLDER MIX
Type of Investor / 1999
($ billions) / 1999
(% market) / 1991
($ billions) / 1991
(% market)
Individuals / 7,829 / 41.3% / 2,571 / 52.8%
Institutional investors / 51.2% / 41.1%
Private pension funds / 2,491 / 13.1% / 791 / 16.3%
Public pension funds / 2,171 / 11.4% / 373 / 7.7%
Mutual funds / 3,457 / 18.2% / 330 / 6.8%
Bank trust departments / 358 / 1.9% / 244 / 5.0%
Insurance companies / 1,174 / 6.2% / 230 / 4.7%
Foundations / 181 / 1.0% / 29 / 0.6%
Foreign investors / 1,315 / 6.9% / 299 / 6.1%
Total corporate equities / 18,976 / 100% / 4,867 / 100%
Regulatory impediments
You want to begin to contact other Blue Rhino investors. What if you agree to work together to change the board composition: Any regulatory requirements?
Who will be interested in your agreement to pool your voting resources? Who must you tell? What would be the effect of disclosure? / Securities Exchange Act § 13(d)
(1) Any person who, after acquiring directly or indirectly the beneficial ownership of any equity security of a class which is registered pursuant to Section 12 of this title, ... is directly or indirectly the beneficial owner of more than 5 per centum of such class shall, within ten days after such acquisition, send to the issuer of the security at its principal executive office, by registered or certified mail, send to each exchange where the security is traded, and file with the Commission, a statement containing such of the following information, and such additional information, as the Commission may by rules and regulations prescribe as necessary or appropriate in the public interest or for the protection of investors--
(A) The background, and identity, residence, and citizenship of, and the nature of such beneficial ownership by, such person and all other persons by whom or on whose behalf the purchases have been or are to be effected;
(B) the source and amount of the funds or other consideration used or to be used in making the purchases, ...
(C) if the purpose of the purchases or prospective purchases is to acquire control of the business of the issuer of the securities, any plans or proposals which such persons may have to liquidate such issuer, to sell its assets to or merge it with any other persons, or to make any other major change in its business or corporate structure;
(D) the number of shares of such security which are beneficially owned, and the number of shares concerning which there is a right to acquire, directly or indirectly, by (i) such person, and (ii) by each associate of such person, giving the background, identity, residence and citizenship of each such associate; and

(E) information as to any contracts, arrangements, or understandings with any person with respect to any securities of the issuer, ...

(2) When two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a "person" for the purposes of this subsection.
What if you and your group hold together more than 10% of Blue Rhino's stock and you work together to vote out the current board? If you fail, could you then sell your stock? What would be the effect of selling your stock?
What if your group puts some of your representatives on the board? / Securities Exchange Act § 16(b)
[Any] profit realized by a [director, officer or 10% shareholder of a reporting company] from any purchase and sale, or any sale and purchase, of any equity security of such issuer .... within any period of less than six months, ... shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction ... Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer ...
Rule 16a-1 -- Definition of Terms
Terms defined in this rule shall apply solely to section 16 of the Act and the rules thereunder. These terms shall not be limited to section 16(a) of the Act but also shall apply to all other subsections under section 16 of the Act.
(a) The term beneficial owner shall have the following applications:
(1) Solely for purposes of determining whether a person is a beneficial owner of more than ten percent of any class of equity securities registered pursuant to section 12 of the Act, the term "beneficial owner" shall mean any person who is deemed a beneficial owner pursuant to section 13(d) of the Act and the rules thereunder ...
D. Federal Regulation of Proxy Solicitations
Assume you are a shareholder in General Electric. You want to participate in the company's corporate governance. How will this happen?