The declassification movement, spearheaded by institutional investors and their proxy advisor firms, continues apace. Due to pressure from investors, there has been a dramatic decline over the past few years in the prevalence of classified boards of directors.1 While there are still a significant number of companies of all types and sizes that continue to maintain classified boards—and, in our experience, companies continue to go public with classified board structures—many of these companies may well soon be the subject of shareholder pressure, including precatory shareholder proposals, to declassify their boards. Is it possible for the traditional classified board structure to be modified, so that the benefits to shareholders are retained while board accountability and responsiveness to shareholder concerns and interests are ensured?
As companies seek to avoid proxy contests, and as declassification continues as a predominant trend,
companies faced with shareholder proposals to declassify are increasingly agreeing quickly to declassify.
Harvard Law School’s Shareholder Rights Project (“SRP”) has reported that about three-quarters of the
thirty-one S&P 500 and Fortune 500 companies that received declassification proposals for 2014 annual
meetings from investors represented by SRP had already entered into agreements to declassify as of
early March. Declassification efforts are likely to become more prevalent at smaller cap companies now
that most larger companies already have declassified.
Companies with a classified board view the structure as enhancing shareholder value, by providing the
company with leverage to negotiate if a hostile bid is made for the company
and by providing continuity
of membership on (and therefore stability of) the board. However, Institutional Shareholder Services
(“ISS”) and the other proxy advisory firms and many institutional shareholders believe that the primary
effect of the classified board structure has been to entrench directors and managements and to deter and
impede bids for companies that would enhance shareholder value. The debate so far has been a stark
one—classification (preferred by most companies) or declassification (preferred by proxy advisory firms
and many institutions).
The first issue for a company with a classified board is whether a challenge from shareholders is likely.
The SRP is beginning the third year of its campaign to aggressively promote and support institutional
shareholder activism to declassify boards. Vanguard has recently written letters to 350 companies,
encouraging them to declassify. The likelihood of a challenge at any particular company will depend on
the nature of the shareholder base, the history of board action and shareholder engagement, and
company financial and stock performance. However, the trend appears to be that any company with a
classified board has at least a reasonable chance of being targeted for declassification.
The second issue is whether the requisite vote of shareholders required for amendment to eliminate the
company’s classified board provisions is likely to be obtained if the company’s board presents such an
amendment for a vote of its shareholders.
A company with a classified board should, in advance of any challenge to the structure, determine what shareholder vote would be required for an amendment to the
classified board provisions,
as well as the composition of its shareholder base to determine if the vote
likely would be obtained. The lower the shareholder vote required for amendments (many companies
have a 66-2/3% or 80% supermajority vote requirement), and the more institutional (as compared to
retail) investors, the more likely it will be that the requisite shareholder vote would be obtained. Moreover,
the major advisory firms (including ISS and Glass Lewis), major investor trade groups (including The
Council of Institutional Investors), and major funds (including the American Funds, BlackRock, CALPERS,
Fidelity, TIAA-CREF and Vanguard) all have policies to vote in favor of board declassifications; and the
average vote of shareholders supporting declassification proposals is now about 80%. Accordingly, the
requisite shareholder vote could be defeated only if directors and management (and other shareholders)
not opposed to a classified board structure hold a sufficient amount of stock to do so.
Most companies would prefer to retain the classified board structure as is, without weakening the benefits
it offers in terms of negotiating leverage in the event of hostile bids and continuity on the board. Most
shareholders would prefer to eliminate the structure in its entirety in order to maximize board
accountability. The question arises whether it is possible that certain types of modifications to the
traditional structure could result in preserving the structure’s value-enhancing benefits, while addressing
shareholders’ concerns about board accountability and responsiveness to shareholders. If shareholders’
concerns that the classified board structure hurts long-term performance by entrenching the board and
deterring or impeding bids for the company were adequately addressed, presumably shareholders should
be glad to preserve the real benefits the structure provides. If companies are faced with a choice of a
modified classified board structure, or no classified board structure, presumably companies would prefer
the modified structure.
Many types of modifications, and combinations of modifications, to the classified board structure could be
For example, to address shareholders’ perceived connection between the existence of a classified board
and lower long-term company performance, the classified board structure could be modified so that the
board would become automatically declassified in the event the company underperforms its peer group
over a period of time. A financial model to measure performance could include a combination of
operating results and stock performance; and the time period for measurement could be, say, any three
years in a rolling period of five years.
To address the perceived connection between the existence of a classified board and the deterrence of
bids, or the impeding of bids made, the classified board structure could be modified so that the board
would become automatically declassified if the company received a “qualifying bid”—such as a fully
financed offer for any and all shares at a “minimum” (even if not “adequate”) price. The objective would
be for bids not to be deterred, and for the best price to be obtained if a bid were made. Therefore, the
definition of minimum price could include, for example, a combination of measures based on the target’s
current and historical stock price; a minimum premium above the highest price paid by the bidder for any shares accumulated in the market prior to the bid; as well as other factors. The definition of qualifying bid
could include such factors as the offer being made for a minimum period of time prior to the company’s
annual meeting; the offer being left open for a minimum period of time; and the bidder not owning more
than a specified percentage of the company’s shares at the time the bid is made. While these factors can
never substitute for, or provide the same protection as, a board’s reasoned judgment as to adequacy of
price of a bid, presumably it would be better for all constituencies to have the protection the structure
offers than to have no classified board.
Other possible modifications could be considered, alone or in combination. There could be an automatic
(supermajority) vote on declassification every, say, five years. Alternatively, a company might declassify
its board, but provide for automatic re-classification on the occurrence of specified events, such as the
company’s receiving a non-“qualified bid”, or its outperforming its peer group for at least a specified
period. Or, a company might suspend classification of the board for a period of time on the occurrence of
A critical factor, of course, will be whether institutional investors and the proxy advisory firms will be willing
to engage in considering modifications to a classified board structure in the midst of the current very
successful declassification movement. A further key issue will be whether concepts like “qualified” bid
and “minimum” price, or a formula to compare financial performance to peers, can be crafted so that
companies find that the benefits of the structure have not been vitiated, and institutional shareholders and
proxy firms find that real benefits to shareholders have been provided while perceived detriments have
been significantly reduced.
For example, if a “qualified” bid is defined in a way that includes all types of bids currently being made,
then any bid for the company will trigger declassification—defeating the purpose of having the structure at
all. On the flip side, if a “qualified” bid is defined in a way that excludes all bids that would realistically be
made (for example, if the “minimum” price formula picks up any bid that is at less than the highest price a
bidder might conceivably pay at the end of a negotiating process), then no bid for the company will trigger
declassification—defeating the purpose of modifying the structure.
It may be that institutional shareholders and proxy firms, on the one hand, and companies, on the other
hand, will find that they are too entrenched in their respective positions to change the existing paradigm.
In our experience, many shareholders, and the proxy advisory firms, genuinely believe that boards tend
not always to act in the shareholders’ best interests (particularly in hostile bid situations), and their instinct
is that nothing other than the increased accountability to shareholders that comes with annual elections of
the board can change that. Also, in our experience, boards typically genuinely believe that they act in the
shareholders’ best interests (including in hostile bid situations), and their instincts would be to disregard
shareholder proposals for declassification if they could.
Moreover, boards have accepted declassification, in part, because of the protection that a poison pill can
offer, even if it is kept “on the shelf” and adopted only in the context of an imminent hostile bid. A pill,
however—which, in effect, simply blocks further acquisition of a company’s shares—is a much cruder and potentially more limiting mechanism than a classified board. Moreover, absent a classified board, an
insurgent can have a pill eliminated by winning just one proxy fight (since the new board installed by the
insurgent can vote to redeem the pill). In that context, boards may not be able to achieve maximum value
As institutional investors and proxy firms push forward with the declassification movement, all corporate
governance constituencies might consider whether it would be preferable to try to develop a template for
a modified classified board structure that would retain most of the value-enhancing potential of the
structure, while significantly reducing the entrenchment potential. If such a template could be crafted—
providing companies with time to negotiate for a higher price in a hostile bid situation and with stability on
the board, while preventing directors’ entrenchment and non-responsiveness to shareholders’ interests
and concerns—one would expect that structure to be embraced by boards and shareholders alike.