As reprinted from REIT Zone Publications, September 3, 2014
A lot of controversy has recently been swirling around Subtitle 8 of Title 3 of the Maryland General Corporation Law (“Subtitle 8”), especially its provision that allows a board of directors to classify itself into three classes without a stockholder vote and despite any contrary provision in the charter or bylaws. In fact, Subtitle 8 has been the law in Maryland since 1999, when the Maryland legislature, by overwhelming margins, approved the Unsolicited Takeovers Bill, which was signed by the Governor and became effective on June 1, 1999.
Subtitle 8 (occasionally called the “Maryland Unsolicited Takeovers Act” or “MUTA”) permits a Maryland corporation (or a Maryland real estate investment trust formed under Title 8) with a class of equity securities registered under the Securities Exchange Act of 1934 and at least three independent directors to elect, by provision in its charter or bylaws or by resolution of its board of directors and notwithstanding any contrary provision in the charter or bylaws, to be subject to any or all of five provisions, including:
- a classified board;
- a two-thirds vote of outstanding shares to remove a director;
- a requirement that the number of directors be fixed only by vote of the board of directors;
- a requirement that a vacancy on the board of directors be filled only by the affirmative vote of a majority of the remaining directors and for the remainder of the full term of the class of directors in which the vacancy occurred and until a successor is elected and qualifies; and
- a provision that a special meeting of stockholders must be called upon stockholder request only on the written request of stockholders entitled to cast a majority of the votes entitled to be cast at the meeting.
Subtitle 8 also permits the charter or a board resolution to prohibit the corporation or a Title 8 real estate investment trust from electing to be subject to any or all provisions of the Subtitle. (For convenience hereafter, we shall refer just to a REIT, whether formed under the Maryland General Corporation Law as a corporation or under Title 8 as a real estate investment trust.)
For many years, newly formed Maryland REITs have adopted classified boards and the substance of the other Subtitle 8 protections in their original charters or bylaws and have thus not needed to opt in to Subtitle 8. Some pre-1999 REITs and some post-1999 REITs without classified boards or other Subtitle 8 provisions have opted in to Subtitle 8 to adopt one or more of its provisions.
For the past several years, classified boards, like shareholder rights plans and plurality voting, have been under attack by proxy advisers, institutional shareholders and academics. These attacks have asserted the need for more “accountability” and a fear of “entrenchment.” In more recent years, some of these same activists have gone even further and demanded that boards not only declassify, redeem their rights plans and give up plurality voting but also promise never (at least without a shareholder vote) to reclassify, adopt a new rights plan or revert to plurality voting. In Maryland, as Barry Vinocur has pointed out, at least 13 REIT boards have declassified (or promised to do so in the near future) and adopted a charter provision that the REIT will not reclassify under Subtitle 8 without a shareholder vote. A shareholder vote, of course, requires an annual or special meeting of shareholders, a process likely to take at least several months, typically not soon enough to provide any timely or effective benefit to a company under attack.
Nevertheless, the pressure for REIT boards to give up the right to classify (or reclassify) under Subtitle 8 continues. Boards are wise to resist this pressure for several reasons:
- There is no economic benefit to the REIT. Declassifing (or promising not to classifyor reclassif)will not lease more space, increase rents orrt. It mayksomepointsonGreenStreets scorecard but plentyof REITs have successfullysold equitywith classified boards.yaking, it is better for a companyto have more choices than fewer. For example, Ido not know of a single REIT charter that caps a s power to borrow. o, whye, for no economic benefit to the RE,option that mayprovide some protection tnt yinvestors or activists with srneydyterm shareholders to seize control of the ynatterm basis in what maybe temporariye? The decision to opt out of Subte8stroyebwhichwouldatleastbediscussableintermsofgoodorbadcorporategovernance(see next paragraph), but whether to yepn the choice ofclassifing the bdteeern circumstances, therebying the hands of all e
- There is no significant reliable data showing a correlation, much less causation, between non-classified boards and economic performance. Economic performance of RETs is driven bymanagement and assets, notye.Just last year, usinga eeredm8h,Martijn Cremers, Lubomir P. Litov and Simone M. Sepe, in Staggered Boards and Firm Value, Revisited, showed that firms adopting a classified board increase in firm value and, conversely, that declassifying is associated with a decrease in firm value. Likewise, in 2010, Michael E. Murphy, in Attacking the Classified Board of Directors: Shaky Foundations for Shareholder Zeal, concluded that the value of companies with and without classified boards was nearly identical and that the effects on company value were insignificant if the company’s shares are widely held, without a ten percent or greater shareholder.
Indeed, Murphy surveyed previous literature (including articles by Harvard Law Professor Lucian Bebchuk, a well-known vocal opponent of classified boards) to conclude that classified boards do not affect operational performance and noted that there is some evidence to support the conclusion that companies with classified boards have improved operational performance. In short, Murphy concluded that classified boards actually have a very wide range of impacts on companies, and thus a “case-by-case” approach is best. There are other studies reaching similar conclusions.
- The primary purpose of classified boards is to provide continuity and stability to the company and its management in developing and executing its strategies. Classified boards have been around for nearly0ears. Theyencourage thetretention of new directors bypermitting them a reasonable period of time to become rheyegupagain for election.gdexecuting a lonterm strategycanynot be done in onlyone ar. REITboards and managements found this out during the financial crisis when they edoersand reposition their assets, often resultgrc, the benefits of which ynot be realized in onlyoneea. srars have held that the power to set the time horizon over which the company ledsy with the board. As a necessarycoroll,eddotempanyfrom changes to its strategies and policies. This is y true where the board makes a choice explicitlyconferred on it by the legislatur.
- The board, as the elected representatives of the shareholders and with more information than any single shareholder, is in the best position to decide on appropriate protections for its strategies. tthgeddgtedthe CEO and collaborativelydevelop the s strateg, some shareholders and dactivists want to tell the board what to do. We see this encroachment yintherecommendationsofInstitutionalShareholderServicesInc.(“ISS”)to dretsrasingle small infraction of ISSs policies, regardless of the company’s economic performance. SS also threatens to, and often does, recommend against directors who fail to implementnegreven just one precatoryproposal approved byss, regardless of the compance–aposition diametricallyopposite to generations ofsettled ewnland, Delawareand elsewhere.Even more vividl, we see this t in the efforts to restrict the boars exercise of its rights under Subtitle 8 to protect its strategies and policies. These moves are often advanced as a supposed antidote to “entrenchment” or as promoting “accountability.” Entrenchment, of course, is a loaded label and accountability sounds good but the result of depriving the board of the opportunity for limited protection of its business plan is exposure to attacks by holders with very different economic (or other) goals than shareholders generally. Take, for example, arbitrageurs, hedgers and “underweight” holders who openly pursue investment strategies very different from the value maximization sought by most shareholders. Indeed, one labor organization whose primary interest is organizing employees, not shareholder value, Unite Here, typically a small holder in its target companies, has successfully proposed opting out of the Subtitle 8 classified board provision at several lodging REITs.
- A classified board will not prevent a takeover. It is now common for a bidder in a hostile tender offer to reinforce its tender offer with an announcement of intention to file a competing slate of director nominees at the next annual meeting of shareholders.A classifiedboardwillgivetheincumbentirectorsadditionaltimetoconsiderthebidders proposal,explorealternativesand,often,negotiatewiththebidder.Becausetheboard has the power to declassify(if it has classified itself under Subtitle 8) or to initiate nfedsydne)doedefensivemeasures,ithasleverageinnegotiatingwithanotherwisehostilebidder,who will almost alwas prefer paing more for a sure deal todaythan running proxycontests of uncertain outome at two ls
In summary, it is difficult to see how a board maximizes value for the shareholders – the ultimate goal of any for-profit enterprise – by tying the hands of future boards by surrendering, effectively forever, a valid choice, like the power to classify, specifically conferred by statute, in return for no economic benefit for the REIT. Directors should be especially careful that they do not fall into the trap, of which they are so often unjustly accused, of appearing to act in their own self-interest by yielding to pressure, especially from unelected activists with little or no skin in the game, to opt out of Subtitle 8, in order to avoid a recommendation by ISS or Glass Lewis & Co. to withhold or vote against directors in a subsequent election.