Stockholders' Hotel California: You Can Vote, But You Can't Sell

Regulating economic activity reflects a balance of market and politic dynamics. For example, the regulation of shareholder rights ranges from freely contracted arrangements to shareholder votes on corporate policy. We seek the mix of free markets and political intrusions that will best promote the movement of capital to its most productive users. This is what a "capitalist democracy" is.

Although financial crisis can be caused by an excess of capitalism or democracy, it will inevitably lead to more democracy and less capitalism. The current crisis has brought us to the point where the managers of GM, AIG, and other TARP recipients now answer primarily to political institutions.

While GM's and AIG's situation is probably temporary, pending changes in corporate governance rules will not be. The SEC has proposed to grant minority shareholders of public companies the right to nominate directors.

The major flaw in the SEC's proposal is that it expands shareholder democracy while ignoring the continuing violation of fundamental free market principles. The most fundamental shareholder right is not the right to vote, but the right to sell shares at a price of the shareholder's choosing.

Current state law creates the absurd situation where management cannot prevent a single shareholder from selling his shares at a tiny premium, but it can prevent a majority of shareholders from selling their shares at a huge premium. The SEC's proposal helps minority shareholders find a voice while ignoring the still silent majority.

Minority Shareholder Democracy
The pending SEC proposal would require large public companies to include directors nominated by 1% shareholders (or 3% or 5% for smaller companies) in the company's proxy materials. Thus, minority shareholders will be able nominate challengers to management's slate of nominees.

Under current rules, minority shareholders generally have no practical means to challenge management directors. Management can use corporate funds to run their slate of nominees, while shareholders must dig into their own pockets to finance candidates. Proxy regulations effectively prevent shareholders from communicating freely and unifying behind a dissident candidate.

The result is that corporations typically run an unopposed slate of management nominees. Plurality voting applies, which means that each director needs only one vote to be seated, even if 10 million votes are cast in opposition.

Some boards have acquiesced to demands that management nominees receive a majority of votes cast--only to reappoint the losing directors to the board. CF Industries (CF), a 7% owner of Terra Industries (TRA), recently elected three new members to Terra's board. Terra quickly increased its board from 8 to 11 directors and appointed the losing management-nominees to fill the three new slots.

The Corporate Library has correctly described this playing field as close to perpendicular. How will the SEC's new rule level the playing field? At first, it may trigger the director elections that resemble the kind of tabloid-quality, reputational bloodbath that makes bare-knuckle politics so entertaining and nauseating. Once management and minority shareholders have set the parameters of the new power dynamic, however, they will negotiate rather than fight. Minority nominees will assume board positions uncontested.

The board election at AIG last spring offered a microcosm of what the new rules might produce. Unions and public pension funds demanded that AIG's government-appointed directors block the re-election of James Orr. They publicly excoriated Orr for approving the much-maligned $165 million in AIG executive bonuses that made headlines last March. The government majority shareholder acquiesced. Orr stepped down rather than stand for election.

The new rule will likely usher in a model of minority shareholder democracy in which management and minority stakeholders negotiate the makeup of boards, with an occasional contested election to provide a reminder of the measure of each side's clout. We do not know whether these new minority directors will serve the interests of all shareholders or only their particular political constituencies. Prepare yourself for the brave new world of minority shareholder democracy.

Majority Shareholder Democracy
Contrast the SEC's proposal with the fundamental right of a shareholder to sell his shares. In the U.S., management cannot prevent a single small shareholder from selling his shares at a tiny premium above the market price. Yet management can use defensive tactics to prevent a majority of shareholders from accepting a tender offer at a huge premium.

In the U.K., defensive tactics are prohibited. For example, shareholders of U.K.-based Cadbury  will decide whether to accept Kraft's (KFT) pending tender offer at a 30% premium above Cadbury's pre-offer trading price. Kraft need not fear that Cadbury will turn around and make a tender offer for U.S.-based Kraft. Kraft's board could block it under U.S. law.

Why is the SEC focusing on giving Kraft's shareholders the opportunity to vote on minority director candidates while they are denied the more fundamental right to sell at a price of their choosing? Why is the SEC focused on allowing the minority to nominate directors while ignoring the right of a majority to sell their shares?

The SEC has no monopoly on hypocrisy. The same free marketers who criticize corporate democracy on the ground that shareholders can vote with their feet often defend management's right to prevent shareholders from accepting a tender offer. They argue, paternalistically, that managers' defensive tactics can get shareholders a better price.

In some cases, they undoubtedly do. But it is not for managers to decide matters that are extrinsic to the corporation's operation. A corporation does not "know" who owns its shares. Management's job is to manage the business, not its shareholders. If investors are allowed to decide at what price to buy shares of companies, then we should let them decide at what price to sell.

Many, perhaps most shareholders do not select specific companies, but invest in the market. They are likely to be shareholders of both Kraft and Cadbury and on both sides of the deal. They do not care about whether the price is too high or low. What concerns them is the waste of company funds on lawyers and investment bankers representing management on each side.

If investors are capable of voting intelligently on board nominees, they are certainly capable of deciding at what price to part with their shares. Free markets should be the SEC's first priority, not shareholder democracy.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com