August 3, 2022

Declassifying the Board: Is the Timing Right?

One topic that often comes up when discussing board refreshment and board diversity is the existence of classified boards. With a classified, or staggered, board, the directors are divided into roughly equal classes and are typically elected for three year terms, so that only the directors in each class are up for re-election at the annual meeting, rather than the full board. Critics say that classified boards are not in the interests of shareholders because the anti-takeover effect of a classified board can entrench management and discourage attractive takeover offers, while also discouraging accountability for the actions of directors.

Despite years of negative perceptions about classified boards, they still have not gone the way of the dinosaur. The prevalence of classified boards has waned among the largest companies, with only 12% of S&P 500 companies having classified boards today, as compared with 60% in 2000. In the broader market, however, classified boards are more common, with 43% of Russell 3000 companies have classified boards today.

What keeps the classified board in place at so many companies, despite the persistent investor dissatisfaction with classified boards? A classified board remains one of the strongest defenses against shareholder activism, and that makes the practice one of the last “problematic” governance practices that companies want to give up. With a classified board, an activist investor can only replace a majority of the directors serving on the board if it is able to wage a successful proxy fight over the course of multiple annual meetings. In contrast, where there is no classified board, an activist investor can replace all of the directors by launching a proxy contest at one annual meeting.

Further, despite the fact that institutional investors largely look askance at classified boards, their approach to classified boards is generally “transactional.” If a company or shareholder puts forth a proposal to eliminate the classified board, many institutional investors (and the proxy advisors) will vote in favor of that proposal, and those proposals generally receive very strong shareholder support. With that said, these same investors are unlikely to submit shareholder proposals seeking to dislodge the classified board or take other “aggressive” action, despite the negative perception of the practice. One institutional investor, Invesco, will generally vote against the incumbent governance committee chair or lead independent director if a company has a classified board that is not being phased out, but that more active approach to expressing dissatisfaction with a classified board tends to be an outlier.

Considering the removal of a classified board provision requires a careful consideration of the pros and cons by the board, with the full recognition that once the classified board is eliminated, it is unlikely to ever be reinstated. The board should carefully assess the company’s anti-takeover profile and the sentiment of the company’s key investors when weighing whether to phase-out a classified board, while also considering the overall market environment and the company’s rationale for retaining the classified board. Some feel strongly that classified boards promote stability and continuity on the board and promote a long-term strategic outlook, and even some institutional investors (such as BlackRock) may be open to considering the board’s rationale for retaining the classified board if the topic shows up on the company’s ballot. Ultimately, the board should periodically evaluate the classified board structure in the context of an overall evaluation of the company’s governance practices and in light of evolving “best practices” for similar companies.

– Dave Lynn