The erosion of the power of the board of directors

by John Owen Gwathmey, David I. Meyers and
W. Lake Taylor, Jr.
Virginia Business
June 2005

Recent developments in both private securities litigation and enforcement actions by the Securities and Exchange Commission have begun to erode the traditional board of directors’ protections of indemnification and insurance. Much attention has been paid to the recent settlements of lawsuits against Worldcom and Enron directors, in which the outside directors agreed to pay out-of-pocket with their personal assets as a condition to being able to settle the claims against them. Regardless of whether these developments are good public policy, they are a fact of life in today’s corporate boardroom, a fact that will, without question, serve as a restraint upon the exercise of power by the board of directors. Less widely publicized is the attempt of unions and other institutional shareholders to limit the authority of the board of directors through the shareholder proposal process and the acquiescence of the SEC in this attack.

The cornerstone of American corporation law has always been that the business and affairs of the corporation are managed under the direction of the board of directors — at least until recently. Based upon recent SEC actions, decided in part as a result of headline grabbing corporate scandals, this fundamental corporation law principle is now being threatened.

Corporations are creatures of state law. Virtually every state provides that the shareholders of the corporation choose the individuals to whom the management of the business and affairs of the corporation is entrusted. In short, state law empowers shareholders to elect the board of directors. Thereafter, shareholders vote only on extraordinary transactions, such as charter amendments, mergers and dissolution of the corporation. In each case, however, shareholders generally vote only after the board of directors has approved the matter and then submitted it to the shareholders.

Institutional shareholders have greatly increased their ownership of American corporations. Some of these institutional shareholders, typically unions and pension plans for government employees, push agendas that are focused on objectives that may not be in the best interests of the corporation or the majority of its shareholders. The rise to power of institutions that claim to represent shareholder interests, such as Institutional Shareholder Services (ISS) and Glass, Lewis & Co., which has gone unchecked, has mirrored the increased ownership of American corporations by these institutional shareholders. These organizations have sought to restrict the statutory power of directors through various tactics, including supporting “withhold-the-vote” campaigns on elections of directors, bylaw amendments that bind the hands of board of directors with respect to such ordinary business decisions as executive compensation and proposals to change the vote required to elect directors from a plurality to a majority of the votes cast.

Historically, corporations have been able to limit the effectiveness of aggressive shareholder proposals by excluding those proposals from consideration by the shareholders because they violate either state or federal law. Recently, however, the SEC has in several cases required corporations to include shareholder proposals that, if implemented, would violate state law. In doing so, the SEC has ignored law firm opinions to this effect.

While the power of the board of directors should not go unchecked, it is in the best interests of shareholders if the business and affairs of the corporation continue to be managed under the direction of the board of directors. This fundamental process ensures the efficient operation of the corporation and maximizes shareholder value.

In response to shareholder proposals to adopt bylaw amendments that may violate state law, the Virginia General Assembly recently enacted amendments to the Virginia Stock Corporation Act. These amendments, which are effective as of July 1, clarify that any shareholder restrictions on the duties and powers of a board of directors must be set forth either in the corporation’s charter or a valid shareholders’ agreement. As ISS and other institutional shareholders continue to attack the bedrock principles of corporation law, additional, more far-reaching amendments may be required to preserve the most basic tenets of corporate governance.

John Owen Gwathmey and Dave Meyers are partners and Lake Taylor is a senior associate at Hunton & Williams LLP in Richmond. All are members of the Corporate Governance Section of the Global Capital Markets Mergers and Acquisition Team.