The great advantage of publicly held companies is that they bring together capital and managerial expertise, to the benefit of both groups. An investor need not know anything about making or marketing chairs in order to invest in a chair factory. A gifted producer or seller of chairs need not have capital in order to start a business. When it runs well, both profit, and the capitalist system achieves its goals. Our system of capitalism has been less successful when the company does not run well. As some of America's most visible, powerful, and successful companies began to slide, they demonstrated an all-but fatal weakness in the ability of our system to react in time to prevent disaster. Managers and directors at companies like IBM, General Motors, and Sears took their success--and their customers--for granted. They took their investors for granted, too, until it was almost too late.
The problem is that the strength of the system, the separation of ownership and control, is also its weakness. A shareholder's investment in a chair factory gives him certain rights, including the right to elect the directors and the right to inspect the books. These rights may have some meaning when the company is small enough that the investors number in the hundreds. But in large, complex companies, with investors in the millions, they are likely to exercise a third right, the right to sell. While some economists will argue sale of the stock sends a signficant message to management, I agree with Edward Jay Epstein, who said that "just the exchange of one powerless shareholder for another in a corporation, while it may lessen the market price of shares, will not dislodge management--or even threaten it. On the contrary, if dissident shareholders leave, it may even bring about the further entrenchment of management--especially if management can pass new laws in the interim."1 Just because shareholders desert a sinking ship, that does not mean that management will plug the leaks.
Sears Roebuck was a classic example. For nearly a century, Sears deserved the title "America's favorite place to shop." It was the country's leading retailer, its catalogue a genuine part of American history. In the 1950s, the company founded Allstate Insurance. The company diversified into financial services in the early 1980s, acquiring the Dean Witter brokerage and realtor Coldwell Banker. The aim of the purchases was to create a giant supermarket of both goods and services, so that consumers could buy a house, finance it, insure it, and stock it with furniture -- all under the same roof. Wall Street referred to the diversification as a "stocks and socks" strategy.
The financial services performed superbly -- improving the company's earnings from 1984 to 1990 by 55 percent. But in the most literal terms, nobody was minding the store. The vast chain of over 850 outlets, the flagship division of the Sears Roebuck empire, were failing fast. In the seven years up to 1990 the retail group's earnings declined at an annual rate of 7.7 percent. The decline was reflected in the stock which, between January 1984 and November 1990, offered investors a total average return of as little as 0.1 percent.2 The company didn't even meet its own targets. Through the eighties, management continued to promise a return of equity of 15 percent a year. Not once did Sears achieve this goal. Indeed, in 1990, Sears produced a 6.8 percent ROE. [check]
From 1984-1990 Sears had a total annual return, including dividends, of a mere 0.7 percent. 1990 was a disastrous year for the company with earnings and stock prices at 1983 levels, a return on equity of 6.8 percent, and a loss in the first nine months of $119 million. Sears finally lost its century-long title as America's largest retailer, as Sears customers turned to Wal-Mart, K-Mart, and specialty stores like Circuit City, the Gap, and the Limited. But when I first looked at the company in 1990, the retail division was losing to Wal-Mart and K-Mart. In a survey of business leaders, Sears management was ranked 487 out of 500.3 It was no secret that the company's performance was poor, both in comparison to the market as a whole and in comparison to its peers. But all of that was not enough to get management to change direction. What could the shareholders do? They could sell out, as many of them did, even at a loss, but as noted above that does not force the company to improve. Those whose stake was big enough to merit some attempt at communicating with management tried that, too, but with little success.
Sears's twelve largest investors met with CEO Ed Brennan and retail chief Michael Bozic in August of 1990. Brennen and Bozic gave an upbeat assessment of the corporation's plans. But the investors wanted more than rosey projections. They cited a grim share performance -- value had dropped 15 points since 1989 -- and gave Brennan one year to achieve marked improvement in retail, or to look for another job. Brennan fired Bozic, and promised to make cuts.
But it was too little, too late, and the shareholders were not satisfied. In early December, the California Public Employees Retirement System (CalPERS), holder of 2.2 million shares, voiced its concern about Sears's performance, citing depressed stock and the failure of retailing strategies. CalPERS' message, says CEO Dale Hanson, was simple: "From 1984 on, Sears went to hell in a handbag."4 In an open letter to Brennan, Hanson proposed the creation of a shareholders advisory group. Such a group would give the board non-binding advice on matters such as major restructurings, acquisitions, mergers and executive compensation. Hanson hinted that he favored a major restructuring, thus joining the growing school of thought that argued that Sears's value could only be realized when the successful financial divisions were spun off from the plunging retail division.
After discussions with Sears officers, CalPERS agreed not to press for the shareholder advisory committee at the annual meeting in May of 1991, on condition that Sears executives meet with CalPERS at least twice a year. But performance continued to decline, and investors continued to seethe. Fourth-quarter earnings revealed early February showed a 37 percent decline in earnings, before a $155 million charge for the retail division restructure. Including the charge, earnings declined 74 percent .
Public confidence in Sears hit a new low. Wall Street analysts said that Sears required $1 billion in cuts to make it competitive, substantially more than the $600 million that Brennan said the cost-cutting program would achieve. Standard and Poors reduced its credit rating on Sears to single A. Asset Analysis Focus commented that: "Sears, Roebuck & Co. has one of the greatest price to intrinsic value disparities of any large publicly traded company."5 In February 1991, Sears traded at between $25 and $30 a share, while analysts speculated it had a breakup value of up to $90 a share.6
George Regan of the Teacher Retirement fund of Texas said: "Obviously whatever management is doing isn't working. Either you can change the management or you can change the system. And sometimes the only choice is to change the management."7 Business Week speculated that "a power shift may be in the works" and that P.J. Purcell, chief of Dean Witter, might be poised to take over.8
This public display of unhappiness put some pressure on the company, but it was still not enough. I had been looking for an opportunity to use shareholder activism to increase value at an underperforming company, and Sears was a perfect target. It had a value beyond its market price, it had a major strategic issue that was within the jurisdiction of shareholder initiatives, and it had unhappy shareholders who would be likely to support me.
The Rules of the Game
While Sears was an ideal target, the playing field was far from level. The thicket of laws and regulations governing shareholder initiatives created a number of intentional and unintentional impediments to any effort by shareholders to send a message or try to direct management. Viewed alone, most made at least some sense. Viewed together, they had a distinctly through the looking glass quality. I will begin with a brief intoduction, and then revisit them in more detail in my discussion of the proxy contest. These statutes and regulations included:
The SEC Proxy Rules
The most important were the proxy rules, promulgated by the SEC under Sections 14(a), (b), and (c) of the Securities Exchange Act of 1934. Some of these rules were changed after the Sears battles, in part due to the absurd consequences of applying them to our fight. These rules are designed to protect the shareholder franchise, and they apply to proxies, meaning any action a shareholder can take on a proposed corporate action, including a vote in favor, a vote against, a vote to abstain and even a decision not to vote at all. Recognizing that in most cases these actions would be taken by shareholders who were not in attendance at the annual meeting, the rules are designed to make sure that all information given to shareholders, by the company or by any other party, is fair and fairly presented. Many of the rules were specifically designed to protect shareholders from past abuses by assuring that they received full and fair information. But another significant goal of the rules was making the system work efficiently, a daunting task given the range of issues and the range and number of shareholders. In my view, efficiency took precedence over effectiveness. Ultimately, by the time I invested in Sears, it is doubtful that even efficiency was being optimally served by the rules, little changed since the 1930's despite enormous changes in technology and in the capital markets.
The need for efficiency was based on the overwhelming mechanics of the shareholder franchise. A company with millions -- or even tens of millions -- of outstanding shares that are continuously traded must somehow arrange for all of these shares to cast votes.9 Since only a tiny fraction of the shareholders will attend the annual meeting, everyone else must be able to vote by proxy. So the company (known in SEC parlance as "the registrant") sends out a proxy statement explaining the issues to be voted on and a proxy card, allowing the shareholder to indicate the way it wants the company to vote on his or her behalf, as a "proxy." In order for Sec. 14-a to apply, there must be not just a "proxy," but also a "solicitation." Both terms are very broadly defined. A proxy includes not just the election of directors but any item to be voted on by shareholders, including, for example, authorization to call a special meeting. Solicitation includes any request for a proxy, oral or written, even the act of sending out the proxy (or any other form of communication) under circumstances that are reasonably calculated to foster the submission or execution of a proxy.
The reach of the rules is thus very broad. And the substance of the requirements is extensive as well. With the possible exception of nuclear secrets, there is no other area of endeavor in the United States where the government becomes so deeply involved in reviewing and editing written material circulated by private parties to private parties. It is not at all unusual for solicitation material submitted to the SEC before public distribution has to be revised to respond to pages of SEC staff comments, mostly asking for documentation or clarification. During this period, fresh from the intense battles of the takeover era, the changes ordered by the SEC approached absurdity. My own experience involved the staff insisting on repeated insertions of "in our opinion," just in case anyone might think that we put our names to (and pay for) something that reflected anyone else's opinion. They also forced us to include in every reference to the Wall Street Journal or other independent source a disclaimer that the publication we were quoting was not a party to our efforts. Any reader of our materials who had not been through this process himself must have been bemused at best by the awkward construction imposed on us by the SEC. But other aspects of these rules had a much more serious and detrimental impact, as discussed below.
The NOBO (non-objecting beneficial owner) and OBO (objecting beneficial owner) rules In order to promote the goals of liquidity and privacy, TK has issued the NOBO (nonobjecting beneficial owner) and OBO (objecting beneficial owner) rules. A shareholder who does not want to be bothered with communications from the company management (or others) can become an OBO by notifying his broker that he does not want his name released to the company. Brokers vote the stock they hold for both NOBOs and OBOs as long as the issues to be voted on are "standard" (check to make sure this is right and find out where the decision is made about which are okay for the broker to vote). As shown below, this system interfered with our efforts to inform Sears shareholders about the issues and about my candidacy to an extent that, even without the other obstacles, it was alone enough to make my election impossible.
The Employee Retirement Income Security Act
The other two items on this list each deserve and each has had many full-scale articles about their provisions, but this one deserves a treatise. Contrary to those who have said that ERISA stands for "Every Rotten Idea Since Adam," it stands for the Employee Retirement Income Security Act, a statute enacted in 1974. It is symbolic of ERISA's many contradictions that its original impetus was the raiding of public employee pension funds, but that by the time it was enacted it applied only to private employees. In essence, it is designed to do two things: to provide incentives for employers to set up pension funds and to protect the money once those plans have been established. Recognizing, based on past experience, that this created certain conflicts of interest for the employer10, the law built in some protections. It used the strictest standard known to our legal system, the fiduciary standard, as a base, and then applied additional obligations that went even further. Despite this attempt (and, in some ways, because of it) conflicts within the system still provided major obstacles to my election. As described in more detail below, most proxy votes for securities held in corporate pensions are cast by the money managers hired by the corporate officers responsible for administering the plan. Without confidential voting, real or perceived economic pressure makes it impossible for these money managers to vote contrary to the recommendations of the officers and directors of the companies issuing stock. ERISA had another role in impeding my election, as well. At Sears, nearly one-quarter of the outstanding stock was held by Sears employees, in a company-sponsored plan. As described below, the trustees of the plan (Sears officers and directors) were able to prevent my getting information about my campaign to those employees.
State corporate laws
Corporate law is one of the few remaining major aspects of American life that is still the preserve of state legislatures. While most large companies are incorporated in Delaware, to get the benefit of that state's corporate-friendly legislature, Sears is incorporated in New York. With respect to the laws which presented obstacles to my campaign, however, the provisions were all but identical. The laws which provided the greatest impediment provided that shareholders should be allowed access to a shareholder list with certain important exceptions, as discussed below. The state corporate law also allowed manipulation of the board size to make my election mathematically impossible. And it failed to impose a meaningful standard of independent review on the Sears board of directors, who acted more like an operating division reporting to the CEO throughout the proxy contest than like the fiduciaries with a duty of care and loyalty to shareholders that legal theory traditionally paints them as.
My Run For the Board
It was in the context of these rules, then, as well as Sears' poor performance, that in May of 1991, I engaged in a proxy contest for one seat on the board of a public company. No one had ever done this before, probably because, as my experience shows, it is a brutal and all but impossible undertaking. Securities and merger and acquisition lawyers like to talk about a "level playing field." This one was so far from level it was perpendicular.
I had worked for many years on corporate governance issues, in the government, in the financial world, and as a consultant to institutional investors. In 1990, I looked for a more direct way to demonstrate the value of shareholder involvement in an underperforming company; instead of advising other shareholders on activism, I would become an activist shareholder myself. I looked at more than a dozen prospects before deciding on Sears as the first target of my new company, then called Institutional Shareholder Partners, now called LENS. I wanted a major American company that was performing poorly in its peer group. The poor performance had to be based on some problem that was susceptible to change by shareholder activism. Sears was an ideal candidate.
Sears had a number of corporate governance provisions that were suitable for shareholder activism. And it had cumulative voting, so that I could win a seat on the board with only 16 percent of the vote (assuming the company planned to nominate candidates for all five director seats whose terms were ending).
Admittedly, my campaign for a board seat was quixotic at best. I didn't have access to the shareholder list, I had no chance to put my proxy materials in the hands of the employees who owned 25 percent of the stock, I was not prepared to spend the millions of dollars usually associated with a proxy contest, and frankly, I didn't much want to serve on the Sears board. Even if I was elected, I wouldn't even be able to second my own motions. Some people saw my contest was as eccentric, even lunatic.
But it accomplished everything I intended, and more. Sears won the battle, but I (and the rest of the Sears shareholders) won the war. Though the company succeeded in keeping me out of the boardroom, the contest dramatized the acute failures of Sears' corporate governance system (and the corporate governance system in general), and catalyzed a powerful and angry shareholder protest against management. Sears ultimately responded to shareholder pressure in a massive restructuring, initiated in September 1992. The announcement boosted the company's market value by over a billion dollars in a single day. Its performance since then has been outstanding by any measure. [Note to the editor--I think these three paragraphs are probably better at the very beginning of the article, but will leave them here if you want to.]
My purpose with this contest was not just to improve the performance at Sears, but also to confront the smug acquiesence in an overall corporate governance system that, to my mind, was fundamentally flawed. The law assumes that the board of directors is responsible for overseeing management. They are entrusted with ensuring that management adopts a strategy compatible with the long-term success of the enterprise. More importantly, the board is entrusted with hiring the right managers to complete the task, and firing those who fail to measure up. If they fail, the shareholders are supposed to be able to replace them. As my Sears contest demonstrated, all of these assumptions were more myth than reality. My contest led to dramatic changes at Sears, and dramatic changes in the rules governing shareholder intiatives. In both cases, I believe I got a good return on my investment.
Around the time that Sears fired Michael Bozic in an attempt to placate angry institutional investors, I bought 100 shares of Sears stock. I then sent my name to the nominating committee of the Sears board, along with the names and numbers of six CEOs on many of whose boards I had served, as references. I had been working with institutional shareholders for many years, as CEO of a large institutional investor, which I sold to American Express, as the federal official responsible for the largest segment of institutional investors, private company retirement plans, and as founder of a company that advised institutions on shareholder issues.
It was my view that the rise of the institutional shareholders provided the first opportunity to resolve the problems created by the separation of ownership and control, as documented by Berle and Means. The traditional "Wall Street Rule" of "Vote with management or sell the shares," was unworkable for these enormous investors. They were too big to sell out every time they objected to a management proposal. The takeover era, with abuse of shareholders by both raiders and management, awakened "the sleeping giant" of the institutional investors, as they had to respond to the adoption of entrenching antitakeover devices . I wanted to take things one step further, to make it possible for shareholders to work with companies to improve their performance, without waiting for raiders to do it for them. Sears would be my test case.
The board did not accept my offer. Indeed, they did not even discuss my possible candidacy at the November meeting. Their explanation was that they did not have enough information. However, they made no attempt to contact my references. They did discuss my candidacy at the February meeting. It wasn't that they used the extra time to gather more information; they didn't. They explained later that they decided that additional information was not necessary since my record, already well known to them, clearly qualified me for the job.
They admitted I was qualified, but the board turned me down. Sears's own bylaws, however, provide that a shareholder may nominate a candidate for the board. As far as I know, no one ever tried to use this provision before, but I did. I was nominated by an old friend, also a Sears shareholder, and I sought election as a dissident candidate.
My candidacy raised questions that went to the heart of the myth and reality of corporate governance:
How should management respond to the candidacy of a single dissident shareholder?
What is the role of the board?
How can a "non-neutral fiduciary" exercise prudent judgment in evaluating the competing candidacies of the management that appointed him and the dissident who opposes them?
Do the current rules permit, prevent, inhibit or encourage legitimate exercise of the share ownership franchise?
What role should the law and the regulatory agencies play in encouraging, discouraging or monitoring gestures like mine?
Any defensive action taken by managers and directors must be in proportion to the threat posed. They are not allowed to respond to a slingshot with an atom bomb. The law has given us some guidance on proportionate responses to a contest for control, even a proxy contest for a full slate of board candidates when only one-third of the directors are up for election. But what is the duty of care when there is no possibility of a change of control, when only one seat is contested?
Sears management's response was nothing less than ferocious. They immediately hired renowned takeover lawyer Martin Lipton, who sued me to make sure I could not get a shareholder list. According to documents filed with the SEC, Sears budgeted $5.5 million dollars over and above its usual solicitation expenses, just to defeat me. This seemed something of an overreaction, since my budget (revealed, like Sears' budget, in SEC filings) was $250,000. As Crain's Chicago Business pointed out, $5.5 million equaled one out of every seven dollars made by the retail operation in the previous year. In addition to the money set aside to defeat me, Sears assigned 30 of its employees to spend their time working to defeat my candidacy.
Sears management refused to allow the largest group of shareholders, Sears' own employees, to have information about the alternative candidacy I was offering. But the biggest outrage was that they got rid of four of their directors, to make it mathematically impossible for me to get elected. Then, once the "threat" of my candidacy had passed, they increased the size of the board again. In the next part of this article, I will briefly discuss the legal and policy issues raised by each of these maneuveurs. It is important, to keep in mind, however, their cumulative impact, in evaluating the "proportionality" of the board's response.
In theory, every state corporate law entitles a shareholder to a list of fellow shareholders (or to have materials mailed to the fellow shareholders by the company), as long as it is for a "proper purpose." The purpose for which I wanted the shareholder list, the opportunity to send out my proxy statement and proxy card, was precisely the purpose for which the rule was designed. But Sears filed a lawsuit to prevent me from gaining access to a shareholder list, charging that in fact I wanted the list for an "improper purpose." The alleged "improper purpose" was to promote my book, published at about that time. The complaint made it sound as though I intended to use the shareholder list for some kind of direct mail solicitation for book orders.
I would have to be John Grisham to make enough money on a book to pay for a proxy contest, but I would have to be Sears in order to finance both a proxy contest and a lawsuit to make that point. So I dropped my request for a shareholder list, mooting the lawsuit. Of course, this, in effect mooted my candidacy as well, posing the question of the appropriateness of the other defensive maneuvers. If any one of them was enough to stop me, was it reasonable and "proportionate" to do them all?
Sears budgeted $5.5 million, 22 times my budgeted amount. They assigned 30 of their employees to spend full-time to defeat my candidacy. I believe this clearly fails the "proportionality" test on its face.11 They ultimately spent less than half of that amount, but still outspent me ten to one. Why not? I was spending my own money, and they were spending the company's money (more properly, the shareholders money, which made it in part my money, too).
It is a rare dissident who can afford to compete with a large corporate treasury. The costs of mailing to 450,000 shareholders and of distributing materials to 400,000 employees who were shareholders through the employee stock plan were severely inhibiting. I reckoned that it would cost me something in excess of $1.2 million in printing and postage to communicate with both shareholders and employees. Instead, I chose to target only the largest investors. My inability to reach shareholders with less than 1,000 shares cost me maybe 20 percent of the total vote; my inability to reach employees cost me another 25 percent.
"Honey I Shrunk the Board!"
Sears eliminated five insider directorships, just to prevent me from winning one seat.12 Four senior executives were to step down as directors, and the vacancy left by former CEO Ed Telling would not be filled. There are two questions raised by this action. The first is the "proportionality" -- was this a fair response to the threat posed by my candidacy? This "squeeze play" meant I now needed 21 percent of the vote to win a seat. This was virtually impossible to obtain, because 25 percent of the vote was held by Sears employees (and voted by Sears trustees) and the rest was held by individuals I could not solicit, because they sued to prevent me from getting a shareholder list. Even if I had a list, it would have cost me millions of dollars to send a proxy card to everyone on it who was willing to release his name (the NOBOs) to receive these communications.
But this last defensive action raised an even more important question. In the relationship between the directors and the management, who works for whom? In theory, the board hires and fires the management. In reality, when this management was challenged, it sacrificed its board members to stay in office.
The board is the corporate go-between, the link between management and shareholders. How should they respond to an angry shareholder on one side and a poorly performing management on the other?
I believe the announcement of my candidacy should have triggered a heightened duty of care from the board, in the same way that a full proxy fight for control would have done.13 Given the exceptional circumstances, the Sears board should have become an impartial referree, moderating the "creative tension" that between management and the shareholders. As the shareholders' representatives, I believe the board had a duty to assess my case impartially, deciding for themselves both whether my arguments were valid and whether they spoke for a sizable proportion of shareholders. The one thing I thought the law demanded was that the board not take sides.
But at Sears, as in many corporate boardrooms, the board behaved more like an operating division of the company. This is not surprising, considering that the company CEO since 1984, Edward Brennan, was not just the company's senior manager, but was the chief executive officer of the company's core retail division, trustee of the employee shareholding plan, chairman of the board, and head of the nominating committee of the board, responsible for selecting new directors. Brennan not only chaired the board, therefore controlling the agenda and information flow, but also picked the new directors. Brennan essentially controlled the body that was meant to monitor his performance. As noted below, he and fellow directors were also the trustees of the employee stock plan, so he in essence had circumvented all of the systems set up to provide checks and balances by the simple expedient of filling all of the positions himself.
The essence of governance is that no one can be accountable to himself, but that is the structure Sears had in place. The governance structure at Sears not only discouraged accountability, it all but prevented it.
The Dependence of "Independent" Directors
Over the last 20 years, observers of boards of directors from both the inside and the outside have pushed for more "independent" outside director, those directors not employed by the company as full-time staff or outside advisors. The theory is that outsiders are not dependent on the chief executive for promotion, or for legal or consulting business. Thus, they are free from conflicts of interest, and better able to protect the owners' interests. This philosophy prompted companies to raise the number of outside directors in America's boardrooms, and, more importantly, the ratio of outsiders to insiders on the typical board. Corporate apologists and critics alike agreed, at least in theory, that if outsiders command a powerful majority in the boardroom, they will be better able to check any tendency of those in top management to abuse their positions of power.14
Myth or reality, raising the ratio of outsiders to insiders on corporate boards proved extremely popular. Over the last two decades, America's boardrooms have witnessed a remarkable growth in the power of independent outside directors -- in 1973, insiders occupied 38 percent of the seats in the average boardroom; today that ratio has dropped to 25 percent.15
But "independent director" is something of an oxymoron in today's companies. The directors are selected by the CEO. The candidates run unopposed, and management counts the votes. In the rare case of an opposing slate, management gets to use the shareholders' money to pay for their side of the contest, without regard for the interests of shareholders, while the dissidents must use their own. The CEO determines the directors' pay, and the directors set the CEO's pay. It's a very cozy relationship, and one that has been most profitable for both parties, as CEO pay and director pay have skyrocketed over the past decade, at many times the rate of increase in pay for employees. This system does not promote accountability, or even the questions that are a necessary predicate for a climate of accountability.
To whom are the directors responsible? By law, it is the shareholders. In reality, it is management. When the CEO (who is also Chairman of the Board and head of the Board's nominating committee) tells three directors they are out, they are out, especially, as at Sears, when they are inside directors, full-time employees of the corporation. The whole notion of shareholders being involved in the process of selecting directors is stretched to the breaking point when (i) the board reduces its own size by 1/3 at the last possible moment before a proxy deadline; and then, (ii), announces its intention to expand the board again, when the nuisance of shareholder involvement at the Annual Meeting has been dealt with. While the Sears board had a number of insiders, a majority of the board met the definition of outsider. This action raised real question about whether they could be independent enough to exercise unbiased judgement with respect to my candidacy.
According to takeover law, any defensive maneveurs employed to defeat a potential acquirer must be "reasonably relationed to the threat posed."16 Yet, because I was not seeking control, Sears could take whatever steps they liked with no risk of breaching this rule. What was the threat posed? What can a single "independent" director do that will disrupt a board? It became increasingly clear to me that Sears believed in the "Imperial CEO" -- as shown by Brennan's domination of all the senior posts in the Sears hierarchy. Sears treated me as if I was applying for a position as an executive.
I turn now to the structural impediments to meaningful exercise of the share ownership franchise. These are rules that were in place either at the SEC or the company before my candidacy that I found to interfere (in most cases unintentionally) with my ability to provide an alternative to the management slate of directors.
The SEC Rules
Proxy solicitations are governed by rules promulgated by the SEC. A company does not have to put the name of any candidate it does not support on its proxy card. So, I had to print up and circulate -- and pay for -- my own. The company has access to the corporate treasury for its side of the proxy fight, but the dissident has to pay his own expenses. Thus, while a shareholder may sponsor shareholder resolutions, which then appear in the company's proxy statement, he or she may not sponsor a dissident candidate for director without bearing the cost of producing and mailing a separate proxy. A full solicitation would run to about $1.5 million, making it worthwhile only in the event of a contest for control (more than half of the board seats).
I was perfectly willing to list the names of the company's candidates on my proxy card, so that any shareholder who wanted to could vote for two of management's candidates and for me. But the SEC rules in effect at that time did not permit me to do this. They could vote all their shares for me on my card or all their shares for management's candidates, on their card. At least Sears had cumulative voting, enabling shareholders to give me all three of their votes. If they did not, anyone wanting to vote for me would have had to throw away their other two votes. It is almost unimaginable that the system did not permit shareholders who wanted to vote for me and for one or two of the Sears management candidates simply did not have that option, but that was the case.
Dissatisfied shareholders were faced with an "all or nothing" choice. They could inform management of their discontent and hope for a response (given the attitude Sears displayed to complaining shareholders, this choice offered little hope of success); or they could engage in a full proxy contest. The SEC rules did not allow for the kind of "limited engagement" that I planned. I could not begin to cover the cost of a mailing to all Sears shareholders (even if I could, Sears was still in the process of suing me to prevent my access to a shareholder list), and was left in the hopeless position of mailing my material to as many shareholders as I could afford, or reach. In the end, I believe my material reached only about 50 percent (true?) of Sears' shareholders. And remember, that since Sears had shrunk the board, it took at least 25 percent of the vote to be elected.
The SEC recognized the obstacles created by this "bona fide nominee" rule, and attempted to remove them in the 1992 amendments to the proxy rules. However, they were not fully successful (cite Fisch).
Another obstacle created by the SEC rules was the preclearance requirement. At that time, no shareholder was allowed to solicit votes from more than 10 other shareholders without having all of the written justification ("solcitation material") being cleared by the SEC before it was distributed to shareholders. Further, if a shareholder so much as discussed his concerns about a certain company with ten other shareholders, the substance of those discussions had to be precleared by the SEC. The purpose of this rule was supposedly to ensure that false or misleading information was not disseminated by either party in a proxy fight. In this instance, it meant that I could not even discuss my candidacy in the press for fear that my remarks would be interpreted as solcitation. Indeed, I could not even place an advertisement in the press announcing my candidacy without first having the SEC "declassify" the contents of the ad. Anyone would think I was running for a seat on the board of the CIA.
These rules were amended in part in 1992, so that shareholders can now circulate information about shareholder resolutions without pre-approval by the SEC. However, the rule still applies (with some modification) to proxy contests for board seats, even if the slate is only one or two directors and there is no question of a contest for control.
On March 1, I filed our initial proxy statement with the SEC. For reasons that I was never able to establish, my proxy didn't clear the Commission until the end of the month -- long after Sears had reduced their board, filed and cleared their proxy, had it received by shareholders, and discussed my candidacy with the press. The most frustrating part of this delay was that because I was not going to send proxies to all shareholders,17 I could not use the press conference as a device to communicate or even to answer Sears' characterizations. Thus, the earliest newspaper accounts duly recited that "Monks had no comment."
This was effectively a two week gag order at a critical time. Sears painted me as a gadfly who wished to use the Sears boardroom as an experiment, a classroom for corporate governance. Many press accounts hailed my effort to bring some fresh air into the Sears boardroom, but painted me as a less than ideal candidate because of my fixation on "governance issues" as opposed to the crucial issue of restoring Sears' performance. Once my proxy cleared I tried valiantly to deconstruct this myth. My argument was simple: Sears had failed to meet its own targets for a decade; if it continued to fail, the company should be restructured. This reiterated the theme recited my analysts and shareholders alike that deconglomeration was Sears' best hope for a profitable future.
The "Un-Level" Playing Field
The SEC rules gave management every advantage in the contest.
The company can spend limitless amounts of shareholder money to oppose a dissident shareholder; the dissident must bear the full costs of his campaign himself
Sears was able to make it prohibitively expensive for me to contact employees, who held 40 percent of the vote
The preclearance rule meant that I was unable to answer Sears' assertions for a crucial two week period.
While my actions were impeded on every front, there were no rules preventing Sears from adopting such "dirty tricks" as denying me access to the shareholder list or shrinking the board.
The "bona fide nominee" rule prohibited me from adding the Sears candidates to my proxy card, which I wanted to do to give shareholders a chance to vote for me and up to two of the other three candidates. There was thus no way for a shareholder to split a vote.
In theory, the SEC rules exist to "level the playing field" for competitors in a proxy fight. As I discovered, the rules distinctly favor management on many fronts. The regulatory atmosphere has been conditioned by deference to incumbents. Clearly, in the absence of contests such as mine, all of the momentum has worked to create familiarity and comfort with rituals that regularly return incumbents. Would there be more contests if the rules were less patently discriminatory to challengers? If there were more contests, would a more even handed view of the regulatory process emerge?
Changes in the Rules
On October 16, 1992, the SEC revised the rules on shareholder communications18, some based on the problems my contest at Sears had made apparent. One was the change to the "bona fide nominee" rule. Another was the elimination of the pre-clearance requirement for solicitation materials relating to shareholder proposals (though not for proxy contests).
There were two ways that ERISA affected my contest at Sears. The first relates to the 25 percent of the stock held by Sears employees under trustees who included current and former members of the Sears board and one outsider who was selected by Sears management. Since these were the people I was running against, these were not just "non-neutral fiduciaries," they were hostile. By manipulating the handling of voting by the employee benefit plans, Sears effectively denied me access to one quarter of the total outstanding vote. It also cheated the employees out of a voice without giving them adequate explanation. Brennan dealt with the employee plans in the time honored manner -- as if there was no contest for director.
I tried vainly to gain access to the employees, not least because my office received literally dozens of calls from employees who said they wished to find out more about me, but either couldn't or feared reprisal for doing so. In a normal year, Sears distributes proxies to employees along with explanatory material and an instruction form during "Voting Week." The plan documents recite that the trustees follow the "instructions" of the employees, and that shares as to which no valid instructions are voted in the same proportion as those where instructions have been validly received. However, in this year, the trustees chose to "take the vote back," and vote the on employees' behalf. It was fine to let the employees vote, as long as they were given only one choice to "vote" for. Given an important contest, the trustees decided that the legal position they have traditionally followed was no longer the most prudent route, and they felt free to disenfranchise the employees.
I did not believe that the trustees could maintain a dispassionate and independent view of the contest. The trustees, included two directors, one former director and an outsider. They were appointed by management annually. Until I insisted (with the support of the Department of Labor, which enforces fiduciary standards for private pension plans), they were going to vote without even meeting with me to see what I had to offer. Ultimately I had a pro forma one-hour meeting with the trustees the day before the annual meeting, and the two sitting directors were recused from having to decide between me and their colleagues on the board, but there was still no chance that they would support me against the nominees of Ed Brennan, the man to whom they owed their appointment, and the attendant fees.
Sears was required to allow me access to the employees -- they couldn't prevent my materials from reaching them. However, they could, and did, take every step to impede my access. First, Sears declined to send out my materials along with their own. Second, they declined to send mine via the company's internal mail system, or provide me with a list of relevant employees so I could send out my materials as I chose. Their best offer was for me to send my proxy card and suporting material to management, who would then distribute them to the employees and bill me for the cost. The material would be sent to all employees by first class regular mail, and would cost me $300,000. Since this would account for more than my entire budget for the contest, I declined.
Like the outside shareholders, Sears employees did not have the protection of confidential voting. May told me they feared reprisal on the job if they supported me. They told me, regretfully, they could not take that risk.
The legal questions surrounding the employee plans are complex, not least because they are addressed by several federal agencies. Essentially, the Department of Labor, viewing the issue from the standpoint of trust law, has taken the view that trustees ought to vote all shares -- certainly unallocated ones. Yet, certain IRS qualifications require some employee plans to "pass through" the vote to the beneficiaries. The incompatibility of the IRS and DOL positions has been noted, but not reconciled.
To my mind, the way out of this conundrum (in sharp contrast to the position of Sears in this situation) is through genuinely independent trustees, confidential voting, and resources dedicated to instructing and informing the employee beneficiaries of their rights and options. Clearly, the DOL's attitude is not meant to disenfranchise employees; it is simply to protect them. Yet the capacity of the employer to chose trustees inevitably creates a conflict of interest that is virtually impossible to sort out in every case.
I had almost as much trouble with other institutional shareholders, including pension funds governed by ERISA, largely because Sears does not have a policy of confidential proxy voting. Confidential voting is, of course, one of the cornerstones of our political system. But corporate elections are very different. Traditionally, most companies did not have confidential voting for their shareholders. Investor Relations and Corporate Secretary staff would often call a shareholder who voted contrary to management's recommendation, to try to persuade them to change their vote. This was a very troublesome practice, as it sometimes resulted in pressure on financial managers who did (or wanted to do) business with the companies applying the pressure.
As a result of requests from groups like T. Boone Pickens' United Shareholders Association, by 1991 confidential voting of proxies was increasingly the rule at many of America's largest and most prestigious companies, including General Electric, AT&T and IBM. Indeed, a few months before the Sears annual meeting the CIEBA of the Financial Executives Institute, the trade association for pension plans sponsored by corporations, endorsed confidential voting.
In a February 1991 letter, I wrote to Brennan requesting that the contest proceed with confidential voting. The letter was never answered. Sears' general counsel, David Shute, finally told me by phone that the company would "not be forthcoming" on this issue. My contest demonstrated all of the reasons that confidential voting is essential to ensure the integrity of the voting process.
There is virtually no institutional investor who does not have the prospect or the reality of an important business relationship with Sears. WIthout confidential voting, no institution was going to commit commercial suicide and confront Sears. I spent hours on the phone to Sears investors hoping to drum up votes, and there is no doubt in my mind that the absence of confidential voting cost me votes. It was clear that two firms in particular, who manage money for Sears, could not vote for me. Each of these firms held 1.5 percent of Sears. It is difficult to pinpoint all the ways in which institutions would perceive themselves to be the losers in publicly indicating opposition to the Sears management, but I think it is fair to estimate that I lost at least 10 percent of the vote this way. The problem is that the beneficial holders of stock in pension funds and other institutions do not know how the stock is being voted on their behalf--they often have no idea what company stocks are even held. But the companies whose stock is being voted do know, if, as here, there is no provision for confidential voting. And any money manager who is faced with a choice of voting on behalf of some nameless, faceless beneficial holders who will never find out about it anyway or on behalf of a major corporation that might send them some business does not have a hard time making that choice.19 The role of ERISA in this is that, despite statements by DOL officials about the importance of proxy voting20, they have undertaken no enforcement actions to demonstrate to ERISA money managers that failure to vote proxies "for the exclusive benefit" of the beneficial holders21 will subject money managers to penalties.
By the time of the annual meeting, I was able to pick up some significant support. My most crucial ally was the California Public Employees' Retirement System (CalPERS), the largest public pension fund in the country, and holder of 0.6 percent of Sears' stock.
When the final votes were counted I had won slightly over 12 percent of the votes cast. Though this was under half what I needed to be elected to the board, it wasn't much less than the 16 percent I would have required if Sears hadn't shrunk their board. At a press conference following the meeting, I said that Sears had changed as a result of my contest. Brennan answered, "Baloney." I believe time has proved me right. A year later, after they shrunk the board again to make it mathematically impossible for me to get elected again, I decided to take a different tack. Instead of running for the board I did a proxy solicitation on behalf of five shareholder resolutions sponsored by a range of Sears shareholders. The resolutions included governance changes like confidential voting and annual election of directors. One submitted by a Sears employee, an Allstate agent, asked the company to evaluate the options for divestiture of the non-merchandising divisions. We were able to get a lot of support for the resolutions by making phone calls and sending letters (approved by the SEC) to other shareholders, and by taking out a full-page ad in the Wall Street Journal calling the Sears board of directors "non-performing assets." Contrary to the 17 percent predicted by the company, we got more than 40 percent of the vote on two of the proposals, and the proposal to study divestment got 27 percent.
In the meantime, my arguments about the ability of Sears' investment banker to give an objective opinion about the value of remaining a conglomerate led to the disclosure that Goldman Sachs had indeed advised them that they could realize more value--as much as three times more--by spinning off the financial divisions. A lawsuit resulted from this disclosure, and its settlement resulted, directly and indirectly, in other changes, including two new directors. When I began my campaign at Sears, Brennan had five jobs, as described above. He now has two -- CEO and Chairman of the board. Since 1991, Brennan has removed himself from the nominating committee of the board, he is no longer one of the trustees of the employee benefit plan, and he has been replaced as CEO of the Merchandising Division by a highly-touted outsider, Arthur Martinez, who is receiving rave reviews for his shake up of Sears stores.
Also, in 1992, Sears added two very credible outsiders to the board -- Michael Miles, Chairman of Philip Morris, and William LaMother, former CEO of Kellogg, finally filling the vacancies left by the directors "fired" in the 1991 shrinkage. Ironically, Sears was left with a board with a higher percentage of outside directors. I believe Brennan found that at least some of the extra accountability I was seeking was the result of the actions he took to stop me.
Less than six months after the annual meeting, Sears announced a massive restructuring. Coldwell Banker would be sold off in its entirety, Dean Witter would be spun off to shareholders, as would 20 percent of Allstate. The market reacted to the news by sending Sears' stock up 8 percent in a single day.
Changes at Sears
I firmly believe that Sears' recent renaissance (STOCK PRICES) is a direct result of the increased accountability of management. I believe that Sears serves as a perfect study for the values to be generated by involved and informed shareholders.