Wednesday, October 15, 2008

Directorship: Election Disconnection

From Directorship
October 01, 2008

Yahoo’s flawed shareholder vote casts a shadow on the proxy-voting process.
by Django Gold

In the year since the furor surrounding Yahoo’s 2007 shareholder meeting and then-CEO Terry Semel’s subsequent resignation, the beleaguered Internet giant’s affairs have continued to slide. Facing a botched—some critics would say sabotaged—deal with Microsoft and the increased ire of investors who had endured a steady decline in stock value, the Yahoo board looked like it was heading for another trip to the woodshed. Shareholders and the media were calling for reorganization among upper management, and though Carl Icahn had secured his three board seats and was for the moment placated, there were many other shareholders who were out for blood.

Despite the energy of Yahoo’s critics in the weeks leading up to the August 1 annual meeting, the event itself seemed remarkably sedate. In fact, when the proxy votes were posted that afternoon, no director earned less than 78 percent approval—by no means a show of rousing support, but nowhere near the revolution that some had expected. Members of the media consequently dubbed the meeting a virtual non-event; the board had successfully weathered the storm and shareholders seemed more content than anyone had expected. “It’s almost as if the past six months never happened,” noted BusinessWeek in its coverage of the annual meeting.

Many dissident shareholders weren’t pleased with the meeting’s benign results. Others, among them Eric Jackson, founder of Ironfire Capital, an activist investment firm that owns about 3.2 million Yahoo shares, didn’t believe them. In a blog post on his website, Jackson questioned the validity of the election.

While allegations of wrongdoing in director elections are extremely rare, Jackson is not the first to cry foul. The proxy voting process is complex, obscure, and, as underscored by Jackson’s complaint, woefully imperfect.

Through the complications of custodial ownership (85 percent of shares are controlled by custodians—banks and brokerage firms) and the sheer scale of an election in which hundreds of millions—and sometimes billions—of votes are cast and counted, the proxy-voting process can be a web of confusion. A widely circulated essay on proxy voting titled “The Hanging Chads of Corporate Voting” describes the process as “noisy, imprecise, and disturbingly opaque.” Edward Rock, one of the paper’s co-authors, claims that “most of the people who run companies and administer the rules that govern them do not understand how proxy voting works.”

For example, Jackson knew that something was wrong with the Yahoo results, but he didn’t know how to prove it. Instead, he noted an inconsistency in the number of votes cast. He found that the publicly posted results from Yahoo’s 2007 proxy indicated a total of 1.2 billion votes, with the 2006 vote count closer to 1.3 billion. The 2008 vote count? Just under 1.05 billion—200 million fewer than the average of the last two years.

“It was bizarre,” says Jackson. “Given the increased scrutiny and media attention, there’s no reason for such a drastic drop [in shareholders casting votes].” Jackson posted the findings on his blog and shareholders took notice.

Gordon Crawford, portfolio manager for Capital Research Global Investors, which owns a 6.2 percent stake in Yahoo, immediately requested a recount from Yahoo and Broadridge Financial Solutions (formerly ADP), the proxy-services manager that administered the vote. Broadridge performed the recount with disarming speed: On August 5, Yahoo issued a press release claiming a “truncation error” that resulted in some directors getting fewer “withheld” votes than had actually been cast. The modified count added 200 million votes to three directors’ “withheld” column—CEO Jerry Yang and chairman Roy Bostock among them—and 100 million to two others. The changed votes weren’t enough to dislodge any directors (Bostock’s 39.6 percent disapproval was highest), and the overall vote count—1,046,098,584—remained the same. Yahoo maintains that the mishap was an honest mistake. Critics aren’t so sure. The problem is that without much transparency in the system, shareholders like Jackson are forced to take Yahoo’s and Broadridge’s word for it.

Nuts and Bolts

When a proxy vote occurs, the “issuing company” must perform a number of duties besides producing the proxy card and its accompanying literature, including identifying the shareholders. As most of the shares are held by custodians, the issuer must identify these custodians and determine the number of shares held by each. This is accomplished by soliciting the Depository Trust & Clearing Co. (DTCC), the holder and “bookkeeper” of the vast majority of all securities held in the United States. The task is complicated by the fact that custodians frequently lend the shares out to other institutions.

Because most investors prefer not to let the issuer know their vote, it is necessary to use a third-party administrator to find the beneficial shareholders. The administrator’s duties also include issuing and collecting the vote. The administrator is hired by the custodians, but is paid by the issuing company. The dominant administrator in this process is Broadridge, which administers most of the proxy votes in the United States—“the lion’s share,” according to a company representative. An archived SEC filing on Broadridge’s website claims the company processed 70 percent of all U.S. shareholder votes in 2006.

It is only after the voting rolls have been determined that the vote can take place. The administrator collects proxy-voting materials from the issuing company and transmits them to the beneficial shareholders. This is accomplished by either mailing voting materials (which include an individual ballot along with a proxy statement and the issuing company’s yearly report) to the beneficial owner, or posting them online so electronic votes may be cast.

After voting has closed, the administrator sends the returned votes to a separate transfer agent (also paid by the issuing company), who counts the votes and determines the
results. For votes that could be contested, such as elections at companies with shareholder unrest, a tabulator instead counts the votes. Two major tabulators are IVS and Corporate Election Services (which tabulated the contested Yahoo vote). After the tabulator or transfer agent counts the vote, making sure that the total number of votes cast matches the issuer’s records, the results go back to the administrator, who reports them to the issuer, and then the issuer releases them to the public. “It is a difficult, obscure, and complex system,” says Rock, “and with a system of this complexity, things will invariably go wrong.”

It’s not just complexity that raises the possibility of problems. Another obstacle is the narrow window in which the vote must be conducted. Delaware corporate law mandates that the “record date”—the point in time prior to a shareholder meeting at which the shareholder voting rolls are determined—must be within 10 and 60 days of the meeting. Most companies take the full allotment to allow for potential hiccups, but sometimes 60 days isn’t enough. Each of the steps required to ensure a smooth vote can take days and even weeks, and there are innumerable reports of voting materials never making it to shareholders, or of voting materials arriving well after the vote has concluded.

Another problem that accompanies the record date is the routine practice of securities lending. Voting rights go to the borrower of the share, usually a short seller, who ostensibly has an interest in seeing the share price decline. Therefore, short sellers may be inclined to vote against directors to foster the impression of turmoil at the company.

As in many corporate affairs, the specter of conflict-of-interest also rears its head during the proxy-voting process. In a given shareholder vote where the issuing company’s board is at stake, the conflict can be defined as the issuer versus the shareholders. But the issuer also happens to be in charge of controlling the vote up to a point, after which control cedes to an administrator, who is paid by the issuing company. This fundamental bias present in a proxy election means that the odds are, by default, positioned in the issuer’s favor, especially because abstaining votes (or those that never arrive in the first place) generally count in the existing board’s favor.

But none of these obstacles would matter were it not for the fundamental flaw in the proxy-voting system that Rock views as the chief impediment to legitimate elections: the lack of transparency in the process as a whole. “In any election, you want to establish an end-to-end audit trail so that you can show the vote was fair and accurate,” says Rock, “but the current proxy-voting system is too complex to allow that to happen.” Very few votes are contested, and regulators such as the Securities and Exchange Commission rarely probe into specific proxy contests. Critics charge that there are insufficient checks on the process to ensure that voting moves smoothly and in accordance with proper conduct. It is this lack of transparency that leaves shareholders, company personnel, and regulators in the dark.

In the Yahoo case, this lack of transparency has been a source of frustration for certain shareholders. “No one from Yahoo or Broadridge has provided an answer to where the extra votes went…it doesn’t give you confidence that they went back and analyzed the votes. It’s more like they just wanted a quick fix,” says Jackson.

Chuck Callan, Broadridge’s senior vice president of regulatory affairs, called the error “an isolated incident brought about by a confluence of factors,” and claimed a review of past votes found that no such error had occurred previously.

A Voting Monopoly

With its “lion’s share” control of the U.S. proxy-services market, Broadridge has a kind of monopoly that most companies dream of. Since Broadridge (then called ADP) began offering proxy-voting services in 1989, it has come to define the industry. In its first year, it administered voting for 31 client custodians; today, Broadridge annually processes around 818 billion votes in 14,000 elections.

Broadridge cites a variety of internal and external checks to ensure the integrity of its system, including annual reviews with both the SEC and NYSE. It also reports that its voting system—which constantly moves towards electronic recording and away from paper ballots—saved clients almost $500 million in the recent proxy-voting season. Broadridge’s services are “unparalleled in the public market,” Callan says.

But critics like Rock continue to cite transparency as being essential to an accurate and trustworthy voting system. “If the public had access to the vote, we could be confident in Broadridge’s ability to effectively administer the proxy,” he says, “but without that transparency, we can’t trust that this huge and complex process is going through without a hitch.”

A Better Way?

Identifying a problem is easy, but how to revamp a system as complex and far-reaching as proxy voting? An end-to-end audit trail that would allow a given proxy-election’s results to be verified by a third-party would require regulators such as the SEC to increase oversight and develop new methods to probe a given vote.

“Investors would feel better assured that their best interests were being looked out for if there was more oversight by the SEC,” says Patrick McGurn, special counsel at RiskMetrics. “Shareholders need to know that their vote counts, and that means more oversight on more levels. If there were more independent inspectors, voters would have better faith in the system.”

In their paper, Rock and co-author Marcel Kahan propose an outright “redesigning of the architecture” in which the complexities of the custodial ownership system of share-voting are discarded in favor of the “Spanish” model. Spain’s public companies distribute shares to investors through a centralized bookkeeping system in which the company registers its stock sales through a depository known as IBERCLEAR. Through this method, third-party intermediaries such as investment banks and stock brokers are not involved in the voting process; when a proxy vote occurs, the third-party vote administrator just has to contact IBERCLEAR to determine who should receive proxy materials.

The proof of the efficacy of this system is the fact that voter rolls are taken a mere five days before the shareholder meeting, not the 10-to-60-day window offered in the United States. One vote for one share, and one regulatory system to keep the numbers in line. “I’m not sure how easy it would be to implement,” says McGurn, “but the more streamlining, the better.”

We May Never Know

Several months after the Yahoo share-holder meeting, the controversy surrounding the alleged missing votes has for the most part faded from the public eye. Yahoo’s board remains whole—Carl Icahn’s negotiated additions notwithstanding.

Eric Jackson’s disappointment in what he now refers to as the “scandal” also remains. “I’m frustrated with how the voting scandal played out,” he says. “Yahoo’s strategy was ‘put your head down and hope it goes away,’ and that’s exactly what happened. It may have just been a mistake on Broadridge’s part, but Yahoo cooperated with it, and so we’ll probably never know just what happened with the vote.”

For Jackson, frustration with the outcome of the Yahoo vote gave rise to a brief flurry of media attention, but ultimately led to no changes in the makeup of the Yahoo board. However, this brief time in the limelight was perhaps not in vain, as it exposed deficiencies of proxy voting as a whole.

As companies and regulators consider the possibility of improving the proxy-voting process, expect more complaints like Jackson’s. Expect, too, that the conversation will likely emerge in the forefront of regulatory discussion.

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