Contrary to what many believe, significantly increasing the proxies voted by informed individual investors would appreciably improve the corporate governance landscape.

About 41% of the voting shares in U.S. companies are owned by individual investors. Approximately 72% of shares held by individuals were not voted in 2014—almost 30% of the total shares that could have been voted according to the ProxyPulse study. The study is produced annually by PricewaterhouseCoopers and Broadridge Financial Solutions.

The same study reports that institutions and individual investors are about 150% more likely to vote shares of companies with market capitalizations greater than approximately $10 billion (large caps) than companies with capitalizations approximately between $50 million and $300 million (micro caps).

This suggests that voting proxies on micro-cap stocks is even more likely to have significant influence on the governance of the tiny corporations who are generally presumed much more susceptible to governance issues that will negatively affect investment performance.

Some under-voting is no doubt related to the fairly understandable behavior of short-term technical traders. However, this author believes that misconceptions about the effectiveness and long-term benefits of individual investors voting their proxies, and the further erroneous belief that it is difficult for the average person to learn to vote in their own interest, are significant factors.

Why Not Just Sell Shares of Poorly Governed Corporations?

Selling the “bad” stocks may help with individual investments in the short term, but the long-term negative effects of corporate governance shortfalls on broader portfolios have been shown to be significant. The underperformance tends not to be smooth. It is jerky and appears as unpredictable large downturns. Everything looks to be fine, until it’s not. These corrections follow the paths of whatever governance failure triggered them. They are not usually limited to one company and sometimes spread through wide swaths of the market and general economy. For example, portfolios that didn’t hold Enron stock were still hurt when the governance failures became known in 2001. An investor also did not have to hold stock in an investment bank or mortgage broker to notice the economic fluctuations that began in 2007.

In addition to the anecdotal evidence, a body of research supports the claim that good corporate governance generates both short-term and long-term shareholder value across the entire market. One study by the National Bureau of Economic Research (NBER) found that a shareholder vote to pass the average corporate governance provision generates a 1.3% abnormal return on the day the vote is reported and an implied market value gain of 2.8%.

While the study concluded that the long-term effect on the return on equity (ROE) of individual companies was “modest,” many portfolio and fund managers believe that improved corporate governance reduces long-term price volatility (investment risk) and thereby improves long-term risk-adjusted returns across their portfolios. (The investor makes the same total return while taking less risk.)

Another study published in the Columbia Law Review seemed to confirm this finding, noting that broad collections of governance factors (governance indexes), while helpful to portfolios generally, were minimally effective when used to evaluate individual firms. The study attributed this to specific features unique to the structures and industries of the individual companies.

Also on the long-term side, the CFA Institute told the Securities and Exchange Commission (SEC) in September 2014 that its research suggests improved shareholder proxy access alone would enhance corporate board performance and raise U.S. market capitalization by between $3.5 billion and $140.3 billion.

Not Voting Can Make Matters Worse

There have been arguments that corporate governance failures were a primary driver of the recent economic downturn. Some also point to the government/corporate “revolving door” policies that may invite profiteering and bad behavior of regulators, corporate boards and executives.

One often-cited example is that several corporations have explicit policies, found in filings with the SEC, outlining automatic financial rewards and employment guarantees for executives who rotate into government positions. The government positions are often with regulatory agencies with responsibilities to oversee the business practices of the executives’ former industries. These payments are routine at energy companies and major banks. Goldman Sachs is one example of a company that offers “a lump sum cash payment” for government service. While what is sometimes termed partial “regulatory capture” can theoretically improve public policy, negative examples appear to be dominant in the U.S. and globally.

“Broker voting” is another reason for individual investors to vote their proxies, even if they vote to “abstain.” Under SEC rule 14a-4(b)(1), brokers, and perhaps banks and other voting agents, apparently have authority to vote proxies at their discretion if they are unvoted or left blank by shareholders. Usually these “uninstructed or discretionary” proxies are voted according to recommendations of the soliciting committee of the corporation, but not always.

In other words, if you don’t vote your proxy, it can be voted by others who may have financial interests that do not include building wealth for you. This is a particular governance problem for shareholders of corporations where there is undiscovered fraud, influence peddling between broker and corporate boards, or situations where corporate power is being abused in other ways. The SEC has been petitioned on this matter, but no action appears to have been taken as of this writing.

Ideal vs. Flawed Governance

Ideally, shareholders vote to elect the board of directors. The board of directors then creates corporate policy and makes major decisions on behalf of the shareholders to maximize shareholder value. The board hires the chief executive officer (CEO) to execute the policy and its specific strategy. It is important to note that the CEO is supposed to be an employee of the board. The CEO’s job is to implement policy, not make it.

In reality, companies are generally formed by a small group of individuals. This core group serves both as board members/directors and executive employees. Later investors may get board seats or simply have influence based on the amount of money they have invested. By the time the company grows large enough to offer shares to the public, the fiefdoms are fairly well-established and difficult to change. The CEO, chief operations officer (COO), chief financial officer (CFO) and others often continue to be employees and also hold seats on the board. In the worst situations, the other board seats could be patronage positions held by unskilled relatives or even people who have no interest in the company other than their compensation for board membership. They may serve on a dozen or more boards as professional directors. They have no reason to attempt to protect the interest of the collection of smaller shareholders, who may hold the majority of the outstanding shares. They have large incentives to build their own wealth by cooperating with the core group. The core group is now effectively their own boss. As the most powerful board members, they control all manner of corporate policies as well as their own compensation. As key managers, they are essentially unaccountable.

There are still many well-established corporations where the CEO and the board chair are the same person. Shareholders of such corporations depend on the goodwill of one conscientious manager with near-absolute control over the execution of policy. Sometimes, the CEO will also have significant de facto influence on the composition of the board. This individual can come to further dominate the corporation’s affairs by fashioning a loyal group of board members and executives around them.

Together this group could direct corporate resources and cash flow for the benefit of shareholders, but over time, they tend to favor their own ends. Although they can inflate their own cash compensation directly and by alleging nonexistent performance, much more wealth can be redirected through corporate policies that allow private use of corporate resources and both legal and semi-legal stock issuance, option, and buyback strategies that disadvantage general shareholders. They can also alter corporate strategy to consolidate their control and hire auditors who are favorably disposed.

Four Pillars of Good Governance

There are four pillars of good corporate governance shareholders should focus on: shareholder rights, the board of directors, auditors and compensation.

Shareholder Rights

Reasonable shareholder access to the proxy ballot is key to all other forms of governance change. Minority, but not necessarily small, shareholders are currently blocked from nominating director candidates. The “shareholder exclusion rule” (SEC Rule 14a-8(i)(9)) appears to allow corporate boards to exclude shareholder proposals from proxy ballots that directly conflict with management proposals.

The SEC proposed making proxy ballot access mandatory in 2010. This was prevented by subsequent legal action. Major pension funds, investment firms and mutual fund families have been promoting plans similar to the SEC’s on a case-by-case basis. They want to allow shareholders who collectively hold 3% of a company’s shares for at least two or three years to access the proxy ballot with proposals and nominations of corporate director candidates. The goal of the ownership and holding period thresholds is to protect the proxy ballot from changes proposed by short-term activist shareholders who may not share the objectives of long-term investors.

Though they agree in general, institutions have somewhat diverse opinions on the details of proxy access proposals. They also differ on what forms potential abuse might take and how to mitigate these problems. Therefore, the institutions, which set up “proxy voting policies” carried out by an agent, have difficulty creating broad policies on proxy ballot access issues in an organized way. Individual investors can thus have a significant impact here. [See the accompanying box for more on how institutions set up their proxy voting policies.]

The Board of Directors

A simple Internet search for the director’s name will generally produce a one- or two-paragraph biography. Individuals who are overworked or with no effective oversight have an increased probability of endangering shareholder value. Many institutional proxy voting policies withhold support from director candidates who already serve as an executive or board chair of any other corporation or serve as director on more than two public company boards. (Five board seats is the highest threshold seen recently.) They also withhold support from director candidates who are current employees or contractors of the corporation or its close affiliates.

Most proxy policies also encourage support for increasing the number of independent directors—that is, an individual who has not worked for the company for at least a year. The theory is that these individuals can improve the performance of the company with a more objective view of the company’s operations and financial health.

Unsurprisingly, proxy policies withhold support for any director or board member who has failed to implement a shareholder proposal that received the majority of votes cast in the prior year.

Institutions also withhold support from continuing directors who are members of the board’s audit committee if the independent auditor has issued an “adverse opinion” or found a “material weakness” during the director’s current term. These are both very serious issues that should not be overlooked by shareholders.

Auditors

It is important that the auditing firm be truly independent. The external auditor must have no financial interest in the corporation and not be affiliated with it in any way other than as independent auditor.

However, reputable auditing firms can have relationships that are red flags in their work with one corporation, but that are non-issues working for another.

Compensation

Research on compensation proposals must be done on a case-by-case basis. The purpose of a good compensation policy is to attract and retain appropriate employees and align their interests with those of the corporation and its shareholders.

Employee stock purchase plans do this very well, especially for the rank-and-file. Options, cash and other performance incentives appropriately sized and truly linked to corporate performance and profitability are beneficial to shareholder value.

Rich supplemental executive retirement plans, automatic benchmarking of pay in the top 50% or less of the peer group, base pay that is excessive for the peer group, and supplemental compensation tied to anti-takeover provisions (golden parachutes) are generally considered detrimental to shareholder value.

It is likely that you will want to heavily weight research prepared by an institution you trust when you vote compensation issues.

Table 1. Suggested Voting Guidelines for Proxy Ballot Proposals

Other Issues

Limit your votes on issues to what you can research. Remember to specifically abstain rather than leave issues blank on your ballots and realize that most individual investors are limited in their ability to accurately evaluate the merits of complicated ballot initiatives without some level of research. Use blogs and financial websites to help evaluate such things as anti-takeover measures and complex executive compensation programs evaluated across industries and professions. Table 1 lists other issues you might see on proxy ballots.

You can sometimes view the upcoming votes of an institution that has a proxy voting policy you like. Open records laws require that public institutions like pension funds make their policies and votes public. Table 2 links to resources that can help you with this.

A typical ballot can be voted in less than 10 minutes after catching stride. A fairly substantial proxy ballot takes about 15 minutes to vote starting from scratch.

When you are finished, you might consider allowing others to benefit from your research by posting on social networking and financial sites that discuss the proxy issues for companies in which you own shares. You will either help someone understand the issues better or gain new understanding yourself.

Table 2. Proxy Voting Resources

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